When borrowing costs is not your friend

The impact of borrowing costs on the cash flow statement.

The classification of cash flows has been under scrutiny by the JSE for multiple years in their JSE Proactive Monitoring Report and justly so. IAS 7 requires that the preparer classify the cash flows in the statement of cash flows as either operating-, investing-, or financing activities. This requires the use of judgement to determine the appropriate classification.

IAS 7 requires that interest paid be disclosed separately from the capital amount for payments, regardless of whether it has been recognised as an expense in the statement of profit or loss or capitalised and that the total interest paid must be disclosed. Since borrowing cost must be capitalised to an asset in terms of IAS 23 Borrowing cost, the question is where should the capitalised interest be classified?

The first consideration is whether the interest was paid or not. If it is not paid, the full interest expense per the income statement must be added back as part of non-cash transactions. Therefore, only the interest actually paid will be included in the statement of cash flows. IAS 23 requires that the amount being capitalised should be determined by applying a capitalisation rate to the expenditure on the asset, either using the specific rate or a general borrowing rate. This interest is therefore based on the accrual principal and is not the amount paid.

For a financial institution, interest paid is usually classified as operating activities. This is because the principal revenue activities are to generate interest.

For other entities, this is not as clear, interest paid could be financing activities (as a cost of borrowing) or operating activities (because it impacts the statement of profit or loss). However, what if the interest is capitalised and it increases the asset base? One can argue that it should be an investing activity because the asset base increases, meeting the definition of investing activities.

Currently, the guidance in IFRS is not sufficiently clear, in practice we have seen two different approaches:

  1. The classification of the capitalised interest paid is treated in the same way as the uncapitalised interest, i.e., normally financing
  2. The classification of the capitalised interest is treated in the same way as the classification of the underlying interest, i.e., if it is used to acquire operating assets such as inventory the related cash flow is classified as operating; or if the interest paid has been capitalised as part of investing assets such as property, plant and equipment the related cash flows would be classified as investing.

Remember, if it is shown as part of property, plant and equipment, it must be shown separately from the additions and other costs. it must also be clear that the interest only relates to amounts actually paid and not the borrowing cost determined per IAS 23. The policy must be consistently applied for all general and borrowing cost.

Therefore, it remains an accounting policy choice by the preparer of the financial statements. Disclosure of this choice would be useful to the user if the amounts are material.

It is important to note that the IASB issued an amendment to IAS 7 in 2014 on this very issue. The amendment was subsequently removed it as it was considered too difficult to apply and recommended to include interest in operating activities.

27 October 2022