FRS 102
Inter-Company loans
As Fair Value (FV) concept kicks-in, it’s a
challenge not only to define the maturity periods of the inter company loans
but also allocating the rate of interest. Though defining the maturity period
would always be the responsibility of the management, the rate of interest
would surely be the headache of professionals.
FRS 102, debt instruments, including loans, should be
measured at amortised cost using the effective interest method. Debt instrument
at market rate of interest will not result in any differences to the current
accounting treatment. However, discounting the value based on Net Present Value
would be certainly necessary where it is below-market rate.
Accounting treatment for similar transactions would
differ from entity to entity based on the relationship between two companies. Before
we proceed with accounting treatment lets understand Net Present Value.
Net
Present value
FRS 102 has specific requirements for transactions
that, in effect, constitute a financing transaction. Such transactions must be
measured at the present value of future cash flows, discounted at a market rate
of interest that would apply to similar debt instruments.
Adopting a standard rate for discounting would not
be advisable as the rate of interest charged by the lending institutions is
usually dependent on their risk exposure. In my opinion a 3 Tier formulae would
be advisable where Rate of Interest can be allocated based on High, Medium or
Low Risk.
In an example of Interest free
loan of £100,000 repayable in 1-5 years’ time:
If the market rate for such a
loan was, say, 10% considering High Risk then the NPV would be:
For Loan maturing after Year 1
= 90,900; Year 2 = 82,640; Year 3 = 75,130; Year 4 =68,300; Year 5 = 62,090.
Discounting factor for ROI =
10% : Year 1 = 0.9090; Year 2= 0.8264; Year 3 = 0.7513; Year 4 = 0.6830; Year 5
= 0.6209.
However FRS 102 does not contain any requirements
about how the financing shortfall between the actual loan and the discounted
value should be accounted for on FV recognition. Below are some scenarios which
would give an idea on various options available on accounting the shortfall.
Accounting
for the difference/ shortfall
The financing shortfall is either interest income
or an interest expense on the date of recognition of FV with the other effect
going to Creditors or Debtors. The interest receivable or payable would be
reversed as the discounting unwinds.
However, this approach would not take account of
the relationship between the lender and borrower. In order to correctly reflect
the impact of the relationship between the lender and the borrower the below
treatment would be advisable.
Loan from Subsidiary
Company to Parent Company
Where a Subsidiary Company makes an interest-free
loan to a Parent Company, the shortfall given to the parent should be shown as distribution
of income by the subsidiary. In the books of the Parent Company it should be
shown as Income.
Loan from Parent Company
to Subsidiary Company
Where a Parent Company makes an interest-free loan
to a Subsidiary, the shortfall on recognition of FV should be accounted as an
increase in the cost of investment. In the books of the Subsidiary company it
should be shown as Capital contribution by the Parent Company.
Loan from Subsidiary
Company to another Subsidiary Company within the same group
IF the loan is given on instructions
of the parent then it the lender should show it as distribution of income and
the borrower should show it as a Capital contribution.
IF the loan is not on the instructions
of the Parent Company then the shortfall should be treated as interest expense
in the books of the Lender and interest income in the books of the Borrower.
LOANS TO/FROM DIRECTORS AND
SHAREHOLDERS
We can adopt similar principles when interest free funds
are borrowed/lent from/to a Director or Shareholder.
Loan To/From a Director
IF loan is given to a Director who is not a
shareholder, the shortfall should be accounted for as interest expense. IF loan
is received from a Director then the excess should be accounted as interest
income.
Loan To/From a Shareholder
IF loan is given to a Shareholder who is not a Director,
the shortfall should be accounted for as distribution of income. If loan is
received then the surplus should be shown as capital contribution from the
Shareholder.
Example
Let’s take an example wherein Company
XYZ has Mr. A as a shareholder Director. The company is adopting FRS 102 for
its accounting year ending on 31 December 2015. The Date of Transition
therefore would be 01 January 2014.
XYZ has taken a loan of 100,000 at the
beginning of 2013 interest free from Mr. A for a fixed term of 4 years. Let’s
consider the market rate of interest at the time (2013) would have been 10%. We
will have to go back to the date of inception in 2013 to establish what the
accounting would have been from the start. We would have to do the below presentation
of the loan in the accounts under FRS 102:
Year Op. Balance Interest
@10% Closing Balance
2013 68,300 6,800 75,130
2014 75,130 7,513 82,643
2015 82,643 8,264 90,907
2016 90,907 9,100 100,000
The 2013 closing value of 75,130 will be
used as the carrying value of the liability on the date of transition (Balance
sheet at 01 January 2014) and the accounting continues from there.
As there would be
difference of 24,870 on the date of transition, the question that arises is,
how should this difference be accounted for? In the above example, Mr. A should
recognise the additional amount as part of the cost of investment in XYZ. The Company XYZ
should recognise the loan liability at 75,130 and record the difference of 24,870
in equity as a capital contribution from the Director.
The maturity amount of the Loan would be
correct at the end of 4 year term as the discounted loan unwinds coming closer
to maturity.
Caveat
The opinions expressed are those of Mr. Devendraprasad Kankonkar (Deva). The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for yourself as the advice may change based on your circumstances.
