Capitalization of borrowing costs

Getting capitalization timing wrong directly shifts cost between the balance sheet (asset cost, and therefore future depreciation) and the current period's finance expense, materially affecting both reported profit in the construction period and EBITDA/interest coverage ratios used by lenders during a capital-intensive build-out. In the GCC/MENA region, Islamic financing (murabaha, ijara, sukuk) is a common substitute for conventional interest-bearing debt, and failing to identify its embedded profit/markup as an economic borrowing cost is a genuine, recurring risk that understates capitalized project cost (or, in reverse, over-capitalizes financing costs incurred after the plant is operational), misleading margin, ROI and covenant analysis for new capacity investments.

Is there a qualifying asset under construction taking a substantial period to complete, and is the financing (loan, murabaha, sukuk) specific or general? Has the profit/markup component of Islamic financing been assessed for whether it is economically equivalent to interest and thus capitalizable? At what point did capitalization start, and is it paused during extended construction interruptions?

1. Confirm the asset under construction is a 'qualifying asset' - one that necessarily takes a substantial period of time to get ready for its intended use (e.g. a new plant or major line expansion), as opposed to assets ready for use quickly.
2. Identify whether the financing is a specific borrowing taken out for that asset, general borrowings used for multiple purposes, or a mix; determine in substance whether Islamic financing arrangements (murabaha, ijara, sukuk-based structures) carry a profit/markup charge that is economically equivalent to interest - if so, treat that profit charge as a borrowing cost for capitalization purposes.
3. Begin capitalization only when all three conditions are simultaneously met: expenditures on the asset are being incurred, borrowing costs are being incurred, and activities necessary to prepare the asset for its intended use are in progress (this includes technical/administrative work, not only physical construction).
4. Suspend capitalization during extended periods in which active development is interrupted (e.g. a genuine multi-month halt in construction) - but continue capitalization through brief or technically necessary interruptions (e.g. waiting for equipment installation as part of the normal process).
5. Cease capitalization when substantially all activities necessary to prepare the asset for its intended use are complete, even if minor finishing work continues; if the asset is completed in identifiable parts that can be used independently, stop capitalizing on the completed part while continuing for the rest.
6. Deduct any investment income earned on the temporary investment of specific borrowings (before they are spent on the asset) from the borrowing costs eligible for capitalization.
7. For general borrowings, apply a weighted average capitalization rate to the qualifying asset expenditure (excluding expenditure funded by specific borrowings), capped at the actual borrowing costs incurred in the period.

Measurement basis: borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset are capitalized as part of the cost of that asset; all other borrowing costs are expensed in the period incurred. What's included: interest and profit/markup charges economically equivalent to interest (including murabaha, ijara and similar Islamic financing profit components), amortization of related transaction costs/discounts, and finance charges on qualifying finance leases used to fund the asset. What's excluded: borrowing costs on debt not related to a qualifying asset, and (per the capitalization mechanics) any investment income earned on temporarily invested, unspent specific-borrowing proceeds, which is netted against capitalizable cost rather than included. Subsequent re-measurement/trigger points: capitalization is suspended during extended interruptions to active development and resumed when activity restarts; it ceases when substantially all activities necessary to prepare the asset for use are complete (assessed part-by-part for assets completed in stages), after which further borrowing costs on that facility are expensed as incurred.

Disclose: the amount of borrowing costs capitalized during the period; the capitalization rate used to determine the amount of general borrowing costs eligible for capitalization; the qualifying assets to which capitalization relates and the period(s) over which capitalization occurred (including any suspension); how Islamic financing profit charges (murabaha, ijara, sukuk) are characterized as borrowing costs, if material and different from conventional interest presentation; total borrowing costs incurred in the period, split between the amount capitalized and the amount expensed.

• Continuing to capitalize borrowing costs after the plant/line is substantially ready for its intended use (even if formal handover or minor snagging work continues)
• treating Islamic financing profit/markup charges (murabaha, ijara) as outside the scope of borrowing cost capitalization purely because they are not labeled '
• interest'
• , ignoring their economic substance
• capitalizing financing costs during extended work stoppages (e.g. permitting delays, contractor disputes lasting several months) instead of suspending capitalization
• applying the specific-borrowing treatment to funds that were in substance commingled with general corporate financing
• forgetting to net off investment income earned on temporarily invested, unspent specific-borrowing proceeds against capitalized borrowing costs.