SME Borrowing Costs (S25)

Section 25 of the IFRS for SMEs Accounting Standard is the shortest section in the standard and one of its bluntest simplifications: all borrowing costs are recognised as an expense in profit or loss in the period incurred. There is no capitalisation of borrowing costs into qualifying assets — the entire IAS 23 apparatus of identifying qualifying assets, tracking avoidable borrowing costs, suspending capitalisation and computing capitalisation rates is deleted for SMEs. A company building a factory over two years expenses its loan interest as incurred; a developer constructing inventory expenses the financing rather than adding it to the asset. The IASB's reasoning is proportionality: capitalisation computations demand tracking systems whose cost exceeds their informational value for smaller entities, and lenders focus on interest coverage computed on expensed interest anyway. The effect on reported profit during construction phases is material — SME statements show lower profit and lower asset values than full-IFRS equivalents — and the difference reverses over the asset's life through lower depreciation. Anyone comparing an SME builder with a full-IFRS peer must adjust for this before drawing conclusions.

The policy is simple to apply but its consequences ripple. Interest coverage ratios are computed on the full interest charge with no capitalised portion sheltered in assets — a heavily borrowing SME shows thinner coverage during build phases than its capitalising peer, which can matter for covenant tests drafted against full-IFRS-style numbers. Loan agreements should therefore define their financial covenants by reference to the applicable framework, or the SME borrower may breach an interest-cover covenant that a capitalising borrower would pass. Project appraisals that capitalise interest in their internal models will show a different asset base from the statutory statements — the reconciliation between the project model and the financial statements should be an explicit working, not a year-end mystery. For groups with mixed frameworks (an SME subsidiary in a full-IFRS group), the consolidation adjustment reinstates capitalisation for group purposes where the group policy requires it — one more line in the consolidation bridge. The simplicity of Section 25 is real, but it is simplicity at the price of comparability, and the price should be acknowledged wherever the numbers travel.

While the section's rule is one line, the interest expense it captures is computed with full rigour: the effective-interest method. Interest on a loan is not the coupon paid — it is the rate that exactly discounts the estimated future cash payments through the expected life to the liability's initial carrying amount, applied to the amortised balance each period. Arrangement fees, points and premiums are folded into the effective rate, so a '2% arrangement fee' on a three-year loan is interest expense spread over three years, not a day-one cost. For finance leases, the finance charge is the constant-periodic-rate allocation from Section 20. Foreign-exchange differences on borrowings count as borrowing costs only to the extent they adjust interest costs — the interest-rate-differential element, not the full currency swing. UAE SMEs with EIBOR-linked facilities apply the effective-interest method to the floating rate with re-estimation as rates reset; the re-computation is prospective, adjusting the carrying amount with the catch-up in profit or loss. The discipline is in the amortised-cost working — every material borrowing needs one, rolled forward each period.

Under IAS 23, borrowing costs directly attributable to a qualifying asset — one taking a substantial period to get ready — are capitalised; under Section 25 they are expensed. The comparison matters at three moments. First, when an SME transitions to full IFRS (crossing the AED 50 million revenue threshold under Ministerial Decision No. 114 of 2023), previously expensed borrowing costs on qualifying assets under construction are not retrospectively capitalised on transition — but the entity must implement capitalisation prospectively, which means standing up the tracking (expenditure schedules, capitalisation rates, suspension periods) before the transition year. Second, when a full-IFRS entity moves to the SME standard, capitalised borrowing costs in asset carrying amounts are dealt with under the transition provisions. Third, in M&A, the acquirer's Section 19 fair values are unaffected by the acquiree's borrowing-cost policy — fair value is fair value. The transition planning point is the actionable one: an SME building a qualifying asset while approaching the threshold should run a shadow IAS 23 computation during the SME years, so the full-IFRS opening position is evidenced rather than reconstructed.

Section 25 requires disclosure of the amount of borrowing costs recognised as an expense in the period — a single line that the standard nevertheless insists on. The notes typically show it within the finance-costs analysis: interest on bank facilities, finance-lease charges, the effective-interest accretion on discounted liabilities, each identified. Where borrowing costs are material to understanding performance — a developer in its construction phase, a leveraged buyout — the accounting policy note states the Section 25 expensing policy explicitly so the reader does not assume capitalisation. Under the third edition the section is unchanged in substance; its brevity survives. The disclosure may be short, but its absence is a finding — auditors check that the finance-costs note reconciles to the expensed amount and that no capitalisation has crept into asset additions through project-cost allocations.

For Corporate Tax, interest expense is generally deductible subject to the law's interest-limitation rules — the UAE's general interest deduction limitation (30% of EBITDA-style cap under the CT law's provisions) applies regardless of the accounting treatment. Because Section 25 expenses all borrowing costs, the SME's accounting interest and its tax interest start from the same number — unlike a capitalising entity, where the tax computation must first unwind the capitalisation. This is one of the rare cases where the SME simplification aligns accounting and tax rather than diverging: the starting point is shared, and the adjustments are the limitation rules, related-party interest transfer pricing, and any non-deductible penalties. Related-party loans must bear arm's-length interest for the deduction to survive scrutiny; an interest-free shareholder loan has no accounting interest under Section 25 (nothing incurred) and no tax deduction — while Section 11's present-value mechanics may impute accounting interest on initial recognition with the discount as a capital contribution. The interest-limitation computation should be run alongside the accounting close, not after it.

Capitalising interest into assets out of IAS 23 habit — the most common error in transitioning files. Expensing arrangement fees immediately instead of folding them into the effective interest rate. Treating the full foreign-exchange swing on borrowings as a borrowing cost rather than only the interest-adjustment element. Omitting finance-lease charges from the borrowing-costs disclosure. Capitalising interest in internal project models and never reconciling to the expensed statutory number. And drafting loan covenants on capitalising-framework assumptions, then breaching interest cover that the SME framework was always going to show thinner.

Internally, developers and manufacturers almost always capitalise interest in their project appraisals — the project model shows the true economic cost of the asset including its financing, and investment decisions should reflect it. The statutory statements under Section 25 show something different: the financing expensed, the asset at construction cost. Both are correct for their purpose, and the reconciliation between them is a required working, not an embarrassment. Build it explicitly: project-model asset cost, less capitalised interest per the model, equals the statutory carrying amount; project-model profit, plus the interest differential, equals statutory profit. Where the project model drives management bonuses or earnout computations, the definition of 'profit' in the agreement must specify the framework — an earnout measured on statutory profit during a build phase will underperform a model that capitalises interest, and the dispute that follows is contractual, not accounting. For groups reporting to a full-IFRS parent, the consolidation pack includes the IAS 23 adjustment reinstating capitalisation — the subsidiary's Section 25 numbers are the starting point, never the group answer. Three views of the same interest — project, statutory, group — reconciled on one page.

Several situations test the section's boundaries. Finance-lease interest is a borrowing cost — the constant-periodic-rate charge from Section 20 is disclosed within borrowing costs, not hidden in lease expense. Foreign-currency borrowings: only the exchange-difference element that adjusts interest costs counts — where a USD loan's effective cost exceeds the AED equivalent borrowing rate, the differential is a borrowing cost; the remaining currency movement is a foreign-exchange gain or loss under Section 30. Related-party interest-free loans: where Section 11 imputes interest on initial recognition at a market rate (the discount treated as a capital contribution), the subsequent unwinding is interest expense — a borrowing cost with no cash paid, disclosed as such. Islamic finance structures — Murabaha, Ijara — are analysed by substance: the profit element economically equivalent to interest is a borrowing cost, recognised over the financing period by the effective-profit-rate method. Penalty interest and default surcharges are borrowing costs too, recognised when incurred. The unifying test is economic: is this the cost of having the money? If yes, it is a borrowing cost, expensed under Section 25 whatever the contract calls it.

The audit of borrowing costs is a reconciliation exercise, and the file should be built to be re-performed. For each material borrowing: the facility agreement (rate, term, fees, covenants), the amortised-cost working rolling the opening balance through interest at the effective rate, cash payments and the closing balance, the covenant-compliance computation where the agreement defines ratios on the applicable framework, and the tie from the workings to the profit-or-loss charge and the disclosure. The auditor re-performs the effective-interest computation on a sample, traces the disclosure to the workings, and checks that no interest has been capitalised into asset additions — scanning the fixed-asset register for project-cost allocations that smuggle financing into capital. Cut-off is tested on the interest accrual: the days between the last bank statement and the reporting date. For EIBOR-linked facilities, the rate-reset history is agreed to bank confirmations. A clean finance-costs file has one property: every dirham of interest in profit or loss traces to a working, and every working traces to an agreement. Build that chain during the year, not in the audit.

Expensed borrowing costs make the financing burden visible in the period it is borne — and that visibility is information, not just conservatism. A reader comparing two developers, one capitalising and one expensing, sees different profits but the same cash interest paid; the SME statements show the cost where the cash went, in the year it went. Analysts adjusting for the framework difference add back the expensed interest and amortise it notionally — but the starting point, the actual charge, is disclosed and auditable rather than embedded invisibly in asset values. For management, the expensed charge disciplines borrowing decisions during build phases: the P&L feels the financing immediately, which is the economically honest signal when the asset generates no revenue yet. Lenders, for their part, typically add back the interest when computing debt-service capacity from cash flows while using the reported charge for covenant tests — the two uses need the two presentations, and Section 25 supplies the reported one cleanly. The lesson for preparers: do not apologise for the expensed interest in the management commentary — explain it. 'Finance costs of AED 630,000 relate to the factory construction and are expensed under our IFRS for SMEs policy; the factory will depreciate over 20 years from commissioning' turns a confusing P&L dip into a understood investment phase.

A Ras Al Khaimah manufacturer builds a AED 10 million factory over 18 months, funded by a AED 7 million loan at 6% with a 1.5% arrangement fee. Under Section 25, the interest — roughly AED 630,000 over the build — and the amortised arrangement fee are expensed as incurred across the two financial years; the factory is capitalised at its AED 10 million construction cost with no financing added. Interest cover in the build years reflects the full charge. The notes disclose the borrowing-costs expense and state the expensing policy. For tax, the interest is deductible subject to the limitation rules — the accounting and tax start aligned. A shadow IAS 23 working is maintained because the group plans a full-IFRS transition within three years; on transition, capitalisation begins prospectively from the transition date. One policy, applied consistently, with the future framework change already in the working papers.