When private sector organisations invest in the construction of long-term assets, such as buildings, infrastructure, or large-scale equipment, they often incur significant borrowing costs to finance the project.
Under IFRS businesses are required to capitalise interest costs during the construction phase. Capitalising interest involves adding the interest incurred on the borrowed funds to the cost of the asset, rather than recognising it as an immediate expense in the P&L Account.
This approach offers several advantages for businesses, including enhanced financial performance, improved tax efficiency, and a more accurate reflection of the asset’s value.
Some of the main advantages that private sector organisations benefit from which can also apply to local authorities include:
One of the primary benefits of capitalising interest costs is that it helps improve the financial performance of a company during the construction period. If interest costs were expensed immediately, they would reduce net income, resulting in lower profitability during the construction phase. Capitalising interest defers this expense by adding it to the cost of the asset, meaning it will not impact the P&L Account until the asset is placed in service and begins depreciation. By spreading the cost over the useful life of the asset, the business reports healthier earnings in the short term, which can enhance its financial metrics and attract investors.
As many local authority’s expense interest costs, even those that can be allocated to the construction of an asset, some capital schemes can be deemed to be unaffordable in the construction period whereby capitalising these costs can defer the immediate cost which can then be written down over the life of the asset.
Capitalising interest costs results in a more accurate reflection of the actual cost of constructing an asset. Major capital projects often require substantial financing, and interest is an integral part of the cost of acquiring and constructing the asset. If interest is expensed separately, it can give a skewed view of the asset's true value, underestimating the total investment made. By capitalising interest, the balance sheet shows a more comprehensive and realistic value of the asset, helping stakeholders understand the full cost of its creation.
These arguments apply to the public sector and if interest costs are not included in the balance sheet value of an asset, then the true value of the asset is not being fully disclosed to key stakeholders.
Another key benefit of capitalising interest is the alignment of costs with the revenues generated by the asset. For example, if a company is building a new production facility, the interest costs incurred during construction do not generate immediate revenue. By capitalising the interest, the costs are recognised over the life of the asset, during which time the asset is contributing to the company’s revenue. This matching principle ensures that the financial statements accurately reflect the relationship between the costs incurred to build the asset and the revenues it helps to generate over time.
Not all public sector assets are income generating but they do in most cases provide a service for a reasonable period so all service users both now and in the future should contribute to the full costs associated with bringing the asset into use, including interest costs.
Capitalising interest is not only beneficial but often required under certain accounting frameworks. International Financial Reporting Standards (IFRS) allow for and, in some cases, mandate the capitalisation of interest on qualifying assets. By capitalising interest, businesses ensure compliance with these accounting standards, avoiding potential regulatory or audit issues. It also ensures consistency across financial statements, providing a clearer picture of the company's financial health to stakeholders.
In local authority accounting the capitalisation of interest is allowable but is often not implemented.
The Code of Practice on Local Authority Accounting contains detailed guidance on this issue and states that “a local authority can capitalise borrowing costs that are directly attributable to the acquisition. Construction or production of a qualifying asset as part of the cost of that asset, when it is probable that they will result in the future economic benefits or service potential to the authority and the costs can be measured reliably.”
Capitalising interest encourages a long-term focus on the company’s financial performance. Instead of experiencing an immediate hit to earnings due to high interest expenses during construction, companies take a more strategic view by spreading the cost over the life of the asset. This approach is particularly beneficial for businesses in industries with long construction cycles, where the true economic benefits of the asset may not be realised for many years. Capitalising interest supports a forward-looking financial strategy that aligns with the long-term use and benefits of the asset.
With many local authorities trying to obtain the lowest cost of borrowing when funding their capital programmes, perhaps if a capitalisation policy was used then this may make some schemes more affordable and easier to deliver.
So, in summary it makes sense to consider a capitalisation policy if you have a major capital programme which is funded by borrowing and where interest costs are becoming an issue.
There are several considerations that need to be considered before embarking on this approach such as determining what is a qualifying asset, what costs are eligible to be capitalised and over what period can this take place. With that in mind it would be worth speaking to us at Arlingclose where we are able to offer you advice and assistance in assessing the impact of a capitalisation policy and changing your accounting policies to allow you to achieve any positive benefits.
If you would like to discuss this in more detail, please contact your usual client representative or contact us at treasury@arlingclose.com or on 08448 808 200.
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