If your business has borrowed money to build something — a warehouse, a new factory line, a block of flats to let — you have probably asked your accountant a simple question: does the loan interest reduce this year’s profit, or does it get added to the cost of the asset? Get this wrong and the consequences are not academic. Expensing interest that should have been capitalised understates your asset value, overstates your finance costs, and can quietly breach a loan covenant that is measured on interest cover or net profit. Capitalising interest that should have been expensed does the opposite — it flatters profit and overstates the balance sheet. This article walks through IAS 23 Borrowing Costs using a real £250,000 construction loan, so you can see exactly where the line falls and what the bookkeeping looks like.
What Is IAS 23 and Why Does It Matter to You?
IAS 23 is the international accounting standard that tells you how to treat interest and other costs of borrowing money. The default rule for most borrowing is simple: interest is a cost of financing your business, so it goes through the profit and loss account as a finance expense in the period it is incurred. But IAS 23 carves out an important exception. When you borrow specifically to fund the construction or production of an asset that takes a substantial period of time to get ready for use — think months, not days — the interest incurred during that building period is not treated as an expense at all. Instead, it is added to, or capitalised into, the cost of the asset on the balance sheet. The logic is straightforward once you see it: the interest is part of what it genuinely cost you to create that asset, in the same way as bricks, labour and materials. If you ignore the interest, you understate what the asset actually cost your business to build.
Which Borrowing Costs and Assets Qualify?
Not every loan and not every asset qualifies for this treatment. The asset has to be what the standard calls a qualifying asset — one that necessarily takes a substantial period to get ready for its intended use or sale. In practice, this usually means property under construction, major plant being installed, ships, or large infrastructure projects. A delivery van you buy off the forecourt does not qualify, because it is ready to use the moment you collect it — there is no substantial construction period during which interest is building up alongside the asset. The borrowing itself also has to be linked to the asset. If you take out a loan specifically earmarked for the construction project, the whole of that interest is in scope. If you simply borrow generally for the business and some of that cash happens to fund a construction project, you still have to capitalise a portion — calculated using a weighted average rate across your general borrowings — but the principle is the same.
Under full IFRS, capitalising borrowing costs on qualifying assets is not optional — it is mandatory. There is no accounting policy choice here, unlike many other areas of financial reporting. If you report under FRS 102 (the main UK GAAP standard used by most private SMEs), you do get a genuine choice: you can either capitalise borrowing costs on qualifying assets or expense them as incurred, but whichever policy you pick, you must apply it consistently to all similar assets, year after year.
Worked Example: The £250,000 Construction Loan
Let us put real numbers to this. A manufacturing SME draws down a £250,000 loan on 1 October, at a fixed annual interest rate of 6%, specifically to fund a new warehouse extension. Planning permission is still being finalised and no capital expenditure has yet been incurred on the asset, so physical building work does not begin until 1 January — a three-month gap. Building work then runs steadily from 1 January through to 31 October, when the warehouse is structurally complete and ready for use. That gives us three distinct periods to think about: the three months before qualifying expenditure and construction started, the ten months of active building work, and the point from which the asset is ready for use, after which any further interest reverts to being a normal expense.
| Loan principal | £250,000 |
| Annual interest rate | 6% |
| Monthly interest cost (£250,000 x 6% / 12) | £1,250 |
| Pre-construction period: 3 months x £1,250 (expensed) | £3,750 |
| Active construction period: 10 months x £1,250 (capitalised) | £12,500 |
| Total interest incurred over the 13-month loan period | £16,250 |
| Period | Dates | What Was Happening | Accounting Treatment | Interest Amount |
|---|---|---|---|---|
| Pre-construction | 1 Oct to 31 Dec (3 months) | Loan drawn down; planning permission pending and no asset expenditure incurred | Expensed to profit and loss as a normal finance cost | £3,750 |
| Active construction | 1 Jan to 31 Oct (10 months) | Foundations, structure and fit-out works underway | Capitalised into the cost of the warehouse asset | £12,500 |
| Post-completion | From 1 Nov onwards | Warehouse structurally complete and ready for its intended use | Capitalisation stops; any further loan interest is expensed as normal | Expensed going forward |
The key test for when capitalisation can start is that three conditions must all be met at the same time: you are incurring expenditures for the asset, you are incurring borrowing costs, and you are undertaking activities necessary to prepare the asset for its intended use or sale. While IAS 23 clarifies that necessary activities can include technical and administrative work prior to physical construction (such as obtaining permits), capitalisation cannot commence if no expenditures on the asset have yet been incurred or if the asset is merely being held without active development. During those initial three months, no asset expenditure had occurred and no qualifying development was underway — so capitalisation had not begun, and that £3,750 is expensed as a normal finance cost.
| Account | Dr | Cr |
|---|---|---|
| Finance costs (profit and loss) | £3,750 | |
| Loan interest payable / bank | £3,750 |
Interest incurred during the three-month pre-construction period, while the loan was drawn but no qualifying expenditure had commenced. Expensed as a normal finance cost in the period.
| Account | Dr | Cr |
|---|---|---|
| Property, plant and equipment — warehouse under construction | £12,500 | |
| Loan interest payable / bank | £12,500 |
Interest incurred during the ten months of active construction. Capitalised into the cost of the warehouse asset rather than charged to profit and loss, because expenditure, borrowing costs and preparatory activities were all occurring together.
Three mistakes come up again and again in practice. First, businesses forget to stop capitalising once the asset is substantially complete and ready for use — interest kept building past 31 October in our example would overstate the warehouse’s cost and understate expenses. Second, if construction is paused for an extended period for reasons other than the technical steps of the build itself (say, a four-month delay because a contractor went into administration), capitalisation should be suspended during that gap, not continued automatically. Third, if any of the £250,000 was temporarily invested before being spent on the build — for example sitting in a deposit account for a few weeks — any investment income earned must be deducted from the borrowing costs you capitalise, not kept separate. Missing any of these three points is one of the most common findings in external audits of construction-heavy SMEs.
When Must Capitalisation Stop?
Capitalisation stops when substantially all the activities necessary to get the asset ready for its intended use are complete — not when every last invoice has been paid or every snag fixed. In our example, once the warehouse structure is finished and usable on 31 October, interest from 1 November onwards goes back to being an ordinary finance expense, even though the loan itself may run for several more years. If the asset is completed in separate parts that can each be used independently — for example, three retail units in one development, where unit one is ready for occupation while units two and three are still being fitted out — capitalisation should stop for unit one as soon as it is ready, even though building work continues elsewhere on the site. This part-completion rule catches many SMEs managing phased developments by surprise, because it means tracking capitalisation separately for each usable part rather than treating the whole project as a single block.
Key Takeaways
- Check whether your asset actually qualifies: it must take a substantial period — typically interpreted as several months to a year or more — to get ready for use. Vans, laptops and off-the-shelf equipment never qualify, however they are financed.
- Pin down your three conditions precisely: when expenditure started, when borrowing costs started, and when activities necessary to prepare the asset began (which can encompass technical and administrative work such as obtaining permits). Capitalisation can only start once all three are happening together, and it must stop once the asset is substantially ready for use.
- Watch for suspension periods: if building work genuinely stops for an extended stretch for reasons unrelated to the normal technical process, pause capitalisation for that period and resume it only when work restarts.
- Know which framework you report under: full IFRS and FRS 101 make capitalisation mandatory for qualifying assets, while FRS 102 gives you a policy choice to capitalise or expense — just make sure whichever you choose is applied consistently and disclosed in your accounting policies note.
Not sure how your borrowing costs should be treated?
Capitalisation rules affect your reported profit, your asset values and your loan covenants all at once. We help SME owners and finance teams apply IAS 23 and FRS 102 correctly, with clear worked calculations you can show your accountant or auditor.
