Case 1 Qualifying Assets

LieDharma Inc. engaged a consulting firm to advise it on many projects that it had been
planning to undertake in order to diversify its operations and enhance its public image and
ratings. With this mandate, the consulting firm set out to prepare a feasibility study for the
construction of a shopping mall that would house anchor tenants such as world-class
international designers and well-known global retail chains. The consulting firm advised
LieDharma Inc. that this kind of a project would do wonders to its corporate image. This
shopping mall had certain distinguishing features that were unique in many respects, and it
could easily win the coveted title of the most popular commercial complex in the country. Based
on this advice, LieDharma Inc. began construction of the shopping mall on a huge plot of land in
the heart of the city. Substantial amounts were spent on its construction. Architects from around
the globe competed for the project, and the construction was entrusted to the best construction
firm in the country. The construction took over two years from the date the project was
launched. The total cost of construction was financed by a term loan from an international bank.

The consulting firm also advised LieDharma Inc. to launch a car dealership that deals only in
world-renowned, expensive brand names, such as Rolls-Royce and Alfa Romeo. According to
the research study undertaken by the consulting firm, this would be yet another business to
diversify and invest in order to enhance the corporate image of LieDharma Inc. with people who
matter, as such an exclusive car dealership would cater only to the needs of the top
management of multinational corporations (MNCs) operating in the country. LieDharma Inc.
invested in this business by borrowing funds from major local banks. Besides the corporate
guarantees LieDharma Inc. gave to the banks, they also insisted on depositing with the banks
title deeds of the cars as security for the loans until the entire loan amounts remain unpaid.

Questions:

(a) Would the shopping mall be considered a qualifying asset under the Standard? Would the
interest expense on the term loan borrowed for the construction of the shopping mall qualify as
eligible borrowing costs?

(b) Would the expensive cars purchased by the car dealership be considered qualifying assets
under the Standard, thereby making it possible for LieDharma Inc. to capitalize the borrowing
costs, which are substantial, compared to the costs of the cars? Would borrowing costs include
guarantee commission paid to banks for arranging corporate guarantees in addition to interest
expense on bank loans?

Solutions:

(a) Yes, the shopping mall would be considered a qualifying asset as envisaged by the standard
because construction took a substantial period of time. Furthermore, the interest expense on the
funds borrowed for the construction of the shopping mall would qualify as eligible borrowing
costs.
(b) Although the cars purchased are expensive assets, because they are ready for use when
purchased (and do not take a substantial period of time to get ready for their intended use), they
are not qualifying assets. Neither the interest expense on bank borrowings nor the guarantee
fees for corporate guarantees given to banks by LieDharma Inc. would be capitalized with the
cost of cars and would be expensed in the year of acquisition of the cars.

Case 2 General Borrowings

A socially responsible multinational corporation (MNC) decided to construct a tunnel that will link
two sides of the village that were separated by a natural disaster years ago. Realizing its role as
a good corporate citizen, the MNC has been in this village for a couple of years exploring oil and
gas in the nearby offshore area. The tunnel would take two years to build and the total capital
outlay needed for the construction would be not less than $20 million. To allow itself a margin of
safety, the MNC borrowed $22 million from three sources and used the extra $2 million for its
working capital purposes.

Financing was arranged in this way:

Bank term loans: $5 million at 7% per annum

Institutional borrowings: $7 million at 8% per annum

Corporate bonds: $10 million at 9% per annum

In the first phase of the construction of the tunnel, there were idle funds of $10 million, which
the MNC invested for a period of six months. Income from this investment was $500,000.

Question:

If the MNC decided to opt for the allowed alternative treatment under IAS 23, how would it
treat the borrowing costs? How would it capitalize the borrowing costs, and what would it do
with the investment income?

Solution:

Under the allowed alternative treatment under IAS 23, borrowing costs would be capitalized as
part of the cost of the asset.

(a) In order to capitalize the borrowing costs, a weighted-average cost of funds borrowed is
computed:

= ($5 million 7%) + ($7 million 8%) + ($10 million 9%) / ($5 million + $7 million + $10
million)

= ($1.81 million / $22 million) 100

= 8.22 % per annum

(b) Total borrowing cost = $20 million 8.22 % per annum 2 years

= $1.644 million 2 years

= $3.288 million

(c) Borrowing costs to be capitalized = Interest expense investment income [resulting from
investment of idle funds]

= $3,288,000 $500,000

= $2,788,000