The question everyone asks

A UAE company is building a plant. To fund it, treasury borrows in a foreign currency instead of AED, because the foreign interest rate is cheaper. A year later, the exchange rate has moved, and there is a real exchange loss sitting on that loan. So the question comes up: can this exchange loss be added to the cost of the asset, the same way we capitalise interest?

The answer is: only part of it, and only in specific conditions. IAS 23 does not allow a company to capitalise currency risk in general. It only allows the part of the exchange loss that is really acting like extra interest. Anything above that goes to profit or loss like a normal exchange loss.

Why this rule exists

IAS 23 treats exchange differences on a foreign currency loan as a borrowing cost, but only to the extent they work like an adjustment to interest. Here is the simple idea behind it, if a company borrows in a foreign currency just to get a lower interest rate, part of the currency risk it is taking on is really the other side of that cheap rate. So if the currency moves the wrong way, part of that movement is treated as if it were interest that arrived through a different path.

To find that part, you compare two things every year:

•     What the loan would have cost in interest if it was taken in local currency

•     What the loan actually cost in interest in the foreign currency

So you never capitalise the whole exchange loss. You capitalise only up to that gap, and the rest is expensed.

Example

The facts

§  A UAE company, with AED as its functional currency, is building a qualifying asset.

§  If it borrowed in AED, the rate would be 7% per year.

§  Instead, it borrows EUR 1,000,000 at 3% per year on 1 April, Year 1, because the EUR rate is much cheaper.

§  At the time of borrowing, EUR 1 equals AED 4.00, so the loan is worth AED 4,000,000.

§  Interest is paid every year, and the loan itself is not due for repayment yet.

 Year 1: the currency moves against the company

By 31 March, Year 2, EUR 1 equals AED 4.20.

Notice that the total amount capitalised, AED 280,000, is exactly what the AED loan would have cost. That is the whole idea of the cap. The company can never capitalise more than what it would have paid anyway if it had borrowed locally.

Year 2: the currency comes back a little (a gain)

By 31 March, Year 3, EUR 1 equals AED 4.10. The euro has weakened compared to last year, but it is still above the original rate of 4.00.

This is the part people often miss. Once a loss has been capitalised as if it were interest, a gain in a later year is not simply treated as normal income. It first has to reverse the earlier loss, up to the amount that was capitalised before. Only a gain bigger than that earlier amount would be treated as an ordinary exchange gain.

If the euro kept falling in a later year, all the way back below 4.00, the company would eventually reverse the full AED 154,000 it had capitalised in Year 1. Anything beyond that would then be a normal exchange gain in profit or loss, not a further reduction in the cost of the asset.

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