IAS 23 Borrowing Costs: The Investment Income Trap and How to Build the Capitalisation Rate

There is a trap in IAS 23 that catches careful people. Where a project is funded by a specific borrowing, you deduct investment income earned on the temporary investment of those funds. Where it is funded from general borrowings, you do not. Students net it in both cases, reflexively, because it feels like the same logic. It is not, and the standard is quite deliberate about it.

IAS 23 Borrowing Costs is short, mandatory and heavily examined, and almost all the marks sit in three places: what qualifies, how the rate is built, and when capitalisation starts, stops and pauses.

Mandatory, with two narrow exemptions

Paragraph 8 is unambiguous: an entity shall 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. Other borrowing costs are expensed as incurred.

There is no policy election. The pre-2009 version of IAS 23 permitted a choice between capitalising and expensing, and that choice was removed. Anyone citing SIC-2 Consistency, Capitalisation of Borrowing Costs is citing an interpretation that belonged to the old optional regime and is long superseded.

Two genuine exemptions survive, both in paragraph 4, and both are optional rather than scope exclusions. An entity is not required to apply IAS 23 to borrowing costs directly attributable to a qualifying asset measured at fair value, a biological asset within IAS 41 for example, or to inventories manufactured or otherwise produced in large quantities on a repetitive basis. Separately, paragraph 3 confirms the standard does not deal with the actual or imputed cost of equity, including preferred capital not classified as a liability. Notional equity funding costs are never capitalised, however the project was actually financed.

What counts as a qualifying asset

Paragraph 5 defines it as an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. Substantial period of time is deliberately not quantified. There is no bright line in the standard, and asserting a twelve-month rule is inventing one.

Paragraph 6 sets out what borrowing costs comprise: interest expense calculated using the effective interest method under IFRS 9, interest on lease liabilities recognised under IFRS 16, and exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs. That last limb is narrow and is not a licence to capitalise foreign exchange losses generally.

Specific borrowings versus general borrowings

Paragraph 10 sets the underlying test. The borrowing costs directly attributable to a qualifying asset are those that would have been avoided if the expenditure on the asset had not been made. Paragraph 11 then concedes that it may be difficult to identify a direct relationship between particular borrowings and a qualifying asset, which is what the general-borrowings machinery exists to solve.

For a specific borrowing, paragraph 12 gives the amount eligible for capitalisation as the actual borrowing costs incurred on that borrowing during the period, less any investment income on the temporary investment of those borrowings. Paragraph 13 reinforces it: income earned on borrowed funds held before they are spent is deducted.

For general borrowings, paragraph 14 requires a capitalisation rate to be applied to the expenditures on the asset, the rate being the weighted average of the borrowing costs applicable to all borrowings of the entity outstanding during the period.

And paragraph 14 contains no deduction for investment income. That is the point of the trap in the opening paragraph. The logic holds up once you see it: with a specific borrowing you can trace the funds, so the avoidable cost genuinely is the net cost. With general borrowings the capitalisation rate is already an abstraction applied to an expenditure base, and there is no identifiable set of those borrowings to have been invested. There is nothing to net.

Two refinements to the rate

First, paragraph 14 requires an entity to exclude from the weighted average the borrowing costs applicable to borrowings made specifically for the purpose of obtaining a qualifying asset, until substantially all the activities necessary to prepare that asset for its intended use or sale are complete. A specific borrowing is stripped out of the general pool while the asset it funds is in progress.

Second, and this is the subtlety the Annual Improvements to IFRS Standards 2015 to 2017 Cycle amendment introduced, effective for periods beginning on or after 1 January 2019: once that asset is substantially complete, its specific borrowing joins the general pool and feeds into the capitalisation rate for other qualifying assets. Continuing to exclude it after completion is a common and examinable error.

Paragraph 14 also sets a hard cap: the amount capitalised during a period shall not exceed the borrowing costs incurred during that period. Checking that cap is free marks in any exam answer.

Worked example: general borrowings with a suspension

Entity B has two borrowings outstanding throughout the year ended 31 December 20X5, neither taken out for a specific qualifying asset. Loan A is £6,000,000 at 8 per cent, costing £480,000. Loan B is £4,000,000 at 5 per cent, costing £200,000. Total principal £10,000,000, total cost £680,000.

The capitalisation rate is £680,000 divided by £10,000,000, which is 6.8 per cent. Note it is not the simple average of 8 and 5 per cent, which would give 6.5 per cent. That slip is worth marks in itself.

Entity B constructs a factory. Expenditure, activities and borrowing costs all first coincide on 1 March 20X5, which is the commencement date. Active development is suspended for the whole of August and September by an industrial dispute. The factory is substantially complete on 31 December 20X5.

The window is 1 March to 31 December, ten months, less two months suspended, leaving eight eligible months: March to July and October to December.

Expenditure of £1,200,000 on 1 March earns eight eligible months: £1,200,000 at 6.8 per cent is £81,600, times eight twelfths is £54,400. Expenditure of £1,800,000 on 1 July earns four eligible months, being July, October, November and December: £1,800,000 at 6.8 per cent is £122,400, times four twelfths is £40,800. Expenditure of £600,000 on 1 November earns two months: £600,000 at 6.8 per cent is £40,800, times two twelfths is £6,800.

Total capitalised is £54,400 plus £40,800 plus £6,800, which is £102,000, against total expenditure of £3,600,000. Check the cap: £102,000 is well below the £680,000 incurred, so it does not bind.

Commencement, suspension and cessation

This is where most of the examinable difficulty lives, and the errors are predictable.

Commencement

Paragraph 17 requires all three conditions to be met before capitalisation begins: the entity incurs expenditures on the asset, it incurs borrowing costs, and it undertakes activities necessary to prepare the asset for its intended use or sale. Drawing down the loan satisfies only the second. Starting capitalisation on drawdown is the commonest mistake.

Paragraph 18 defines expenditures as payments of cash, transfers of other assets or the assumption of interest-bearing liabilities, reduced by any progress payments and grants received in connection with the asset. Note the cross-link: a government grant reduces the expenditure base on which borrowing costs are capitalised. See our guide to IAS 20 government grants for how those are recognised.

Paragraph 19 is where students go wrong in the opposite direction. The necessary activities encompass more than physical construction: they include technical and administrative work prior to the commencement of physical construction, such as obtaining permits. But they exclude holding an asset when no production or development that changes its condition is taking place. So land held undeveloped earns no capitalisation, while permit work on an asset under development does.

Suspension

Paragraph 20 requires capitalisation to be suspended during extended periods in which the entity suspends active development of a qualifying asset. Two exceptions in paragraph 21 pull in the other direction: capitalisation is not suspended during a period when substantial technical and administrative work is being carried out, or where a temporary delay is a necessary part of the process of getting the asset ready. The standard example is high water levels delaying bridge construction where such levels are common during the construction period in that region.

Put together, the test is about extended suspension of active development, not about every delay. A rainy fortnight is not a suspension. A six-month industrial dispute is. And the permit phase, which students instinctively treat as dead time, is expressly protected by both paragraph 19 and paragraph 21.

Cessation

Paragraph 22 requires capitalisation to cease when substantially all the activities necessary to prepare the asset for its intended use or sale are complete. Not when the asset is brought into use, and not when it is sold. An asset finished in October and commissioned the following January stops attracting borrowing costs in October.

Paragraph 23 gives the practical marker: an asset is normally ready when physical construction is complete, even though routine administrative work might continue, and outstanding minor modifications such as decoration to the purchaser specification indicate that substantially all activities are complete. The decoration point is the standard giveaway in exam scenarios.

Paragraph 24 adds part-by-part cessation where construction is completed in parts and each part is capable of being used while construction continues on others. Paragraph 25 draws the contrast that makes it concrete: a business park comprising several individually usable buildings ceases part by part, whereas a steel mill involving several sequential processes at different parts of one site has a single cessation point. That contrast is tailor-made for a question and routinely overlooked.

Paragraph 16 adds a sense check: where the carrying amount or expected ultimate cost exceeds recoverable amount or net realisable value, write down or write off under the relevant standard.

The FRS 102 difference

This is the cleanest divergence of any of the measurement standards. Capitalisation is mandatory under IAS 23 for qualifying assets. Under FRS 102 it is an accounting policy choice, so a UK entity applying FRS 102 may expense all borrowing costs as incurred.

That makes the capitalisation question a framework question before it is a technical one, and it means an entity transitioning from FRS 102 to IFRS may find it has to start capitalising where previously it did not. Such a change is a change in accounting policy, with the retrospective consequences set out in our guide to IAS 8 policies, estimates and errors, rather than a change in estimate. The FRS 102 periodic review amendments effective for periods beginning on or after 1 January 2026 did not change the borrowing costs position; the substantive changes there were to leases and revenue.

For how capitalised borrowing costs then behave within the asset, including component depreciation and subsequent revaluation, see our guide to IAS 16 property, plant and equipment.