Just two weeks’ ago we published an insight explaining some of the benefits of capitalising interest costs during the construction of an asset. This has prompted a few enquiries about the practicalities of doing this, which we hope to address in this article. As ever the devil can be in the detail!
What interest costs can I capitalise? Is one obvious question. It is often cited that you can capitalise interest incurred for ‘assets under construction’, but the actual wording to the Code is that you can capitalise borrowing costs ‘directly attributable to the acquisition, construction or production of a qualifying asset’ where ‘qualifying asset’ is an ‘asset that necessarily takes a substantial period of time to get ready for its intended use or sale’. So, this doesn’t always have to be buildings constructed on a building site: the writing of a computer programme, or the final fit-out of a purchased building to make it ready to be used would also count. Like a lot of things in accounting ‘substantial period of time’ is widely interpreted to mean more than one year.
In most cases local authorities won’t be borrowing a specific loan for the specific asset that is being acquired/constructed/produced. In fact, the Prudential Code actively discourages this, as borrowing should meet the cash needs of the authority as a whole in the most cost effective way. If this is the case, are you allowed to capitalise borrowing costs where you can’t directly attribute them to a certain project and how do you work out what these borrowing costs are?
The Code is very clear that yes, you can capitalise non-project specific interest costs the authority incurs as a whole. The percentage interest you can capitalise is calculated from the weighted average of the borrowing costs that are outstanding during the period. This will be the authority’s weighted average cost of debt during the year and should include any short term borrowing. Only actual borrowing costs can be included: notional ‘lost investment income’ if you are an authority that is debt free does not count. Borrowing costs calculated at an effective interest rate can be included even if this is different to the cash interest cost, for example for a soft loan.
When can I capitalise interest costs? Can I go back to previous years and backdate previous interest costs and capitalise them?
The answer to the first question is that if it is your policy to capitalise interest costs you can capitalise them when:
The latter point means that work must be active to get the asset ready. If there are significant periods where work is stopped, or, for example, if land is purchased and then not built on for a long period, costs cannot be capitalised during this time.
The answer to the second question is that yes you not only can but you have to go back and backdate previous interest costs that are applicable and capitalise them. This is because to capitalise interest is an accounting policy. If you have not capitalised interest costs in the past you will need to change your policy to do this. Arlingclose is happy that changing this policy would ‘result in the financial statements providing reliable and more relevant information on the authority’s financial position’ as required by the code in order to change accounting policies. Capitalising interest more accurately reflects the development of an asset and is mandatory under private sector IFRS accounting. When you change an accounting policy, unless the code says otherwise, this has to be done retrospectively, meaning you have to apply it if it was always applied. This will mean going back and looking at previous years.
If your authority has a number of assets that have been in development over a few years there is the potential for quite substantial savings to be made. Work will be required to work out what borrowing costs were incurred in past years and what assets were being developed in these years. The amount of interest that can be capitalised will be included in the assets’ values, with the saving in interest now not charged to revenue going to the general fund or HRA. This will also affect the CFR and MRP calculation for these assets. It is important to remember that this needs to be done for all relevant assets as it is your accounting policy: you can’t pick and choose some assets to apply it to. You don’t have to go back forever in a way that’s impossible. The Code does state that retrospective application should be done except where it would be ‘impractical’ – so whilst you should make every reasonably effort go back and look at past records, it is probably not necessary to be looking at what happened forty years ago.
If you would like further advice on how to capitalise interest and make savings please contact the Arlingclose Team at treasury@arlingclose.com or on 08448 808 200.
Related Insights
The Benefits of Capitalising Interest Costs During the Construction of an Asset