Imagine Rajesh & Co. Pvt. Ltd. takes a ₹2 crore loan to build a factory. Should the interest on that loan hit the P&L as an expense, or get added to the cost of the factory? AS 16 — Borrowing Costs answers exactly this. When a company borrows money to build or acquire a qualifying asset, the interest (and related costs) must be capitalised — added to the asset's cost — not expensed. This makes the profit figure fairer, since the asset isn't even generating revenue yet.
A qualifying asset is one that takes a substantial period of time (generally taken as more than 12 months in practice) to get ready for use or sale. Think: a building under construction, a ship being manufactured, or a power plant being set up. Inventories that are routinely produced in large quantities do NOT qualify — only assets that inherently take a long time.
Borrowing costs covered under AS 16 include: interest on loans and overdrafts, amortisation of discounts/premiums on borrowings, finance charges on finance leases, and exchange differences on foreign currency borrowings (to the extent they are an adjustment to interest costs). Three rules govern when to capitalise:
1. Commencement: Capitalise when you start spending on the asset, incurring borrowing costs, AND undertaking activities to prepare the asset. All three must happen together.
2. Suspension: Stop capitalising during extended periods when active development is interrupted (e.g., a six-month labour strike). Brief, normal interruptions don't trigger suspension.
3. Cessation: Stop capitalising when substantially all activities to prepare the asset are complete — even if paperwork or minor finishing work remains.
For specific borrowings (loan taken only for that asset): capitalise actual borrowing costs minus any income earned by temporarily investing surplus borrowed funds. For general borrowings (company uses its overall loan pool): apply a capitalisation rate (weighted average interest rate of all general borrowings) to expenditure incurred on the asset, subject to a cap of actual borrowing costs incurred during the period. This is the most exam-tested calculation.