This ICAEW Know-How was created by the Corporate Reporting Faculty.

Most straightforward loans, including those with a fixed or determinable repayment date and a positive fixed or variable interest rate, are classified as basic financial instruments under FRS 102. In most cases, basic financial instruments are initially measured at the transaction price (including transaction costs) and subsequently measured at amortised cost, using the effective interest rate method.

However, if an arrangement constitutes a financing transaction, paragraph 11.13 of FRS 102 requires the initial measurement to be at the present value of the future payments (including interest payments and repayment of the principal), discounted at a market rate of interest for a similar debt instrument, adjusted for transaction costs. An arrangement constitutes a financing transaction if payment is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate. Loans provided interest free or at below-market interest rates will therefore constitute a financing transaction and be subject to the above requirements. Intercompany loans and loans between an entity and its directors are common examples of such loans in practice.

Paragraph 11.13A) does, however, include an exception that allows some financing transactions to be measured initially at transaction price. Importantly, this exception applies to a basic financial liability of a small entity that is a loan from a person who is within a director’s group of close family members, when that group contains at least one shareholder in the entity. This exemption does not apply to intra-group loans.

The application of the standard will mean that loans with a fixed or determinable repayment date that have been provided interest free or at a below-market rate of interest will be initially recorded at less than the face value of the loan. FRS 102 does not set out specific requirements for how to account for the difference between the face value of the loan and the amount initially recognised; an entity should apply judgement to select an accounting policy that results in relevant and reliable information in accordance with FRS 102 paragraph 10.4. The individual facts and circumstances in each case should be considered, including the reason(s) the lender decided to make the loan at a non-market rate of interest.

In the case of intercompany loans, the loan is often made at a non-market rate of interest because the parent controls its subsidiary and is acting in its capacity as owner. How the difference between the face value of the loan and the amount initially recognised is accounted for depends on the circumstances of the loan:

• If the loan is from the parent to the subsidiary, the difference is effectively an additional investment in the subsidiary (the borrower) by the parent (the lender); in turn, the subsidiary is effectively receiving an additional capital contribution from its parent.
• If the loan was from a subsidiary to the parent, the difference will generally be accounted for as a distribution by the subsidiary. Many companies do not realise it, but this is legally a distribution. The subsidiary would therefore need to ensure that it had sufficient distributable reserves for the transaction to be permitted.
• For loans between subsidiaries, assuming they are made at the behest of the parent, the difference would typically be accounted for as a distribution by the lender and a capital contribution by the borrower. No entries are generally necessary in the parent’s accounts.

Although most loans with a fixed or determinable repayment date and which are provided interest free or at below-market interest rates will meet the criteria to be classified as basic financial instruments, this classification should not be assumed without a thorough analysis of all contractual terms. If a loan fails to qualify as basic, it will be measured at fair value at each reporting date, with movements recognised in profit or loss.

Example

On 1 January 20X1, a parent company lends its subsidiary £5m at a zero rate of interest. The loan is repayable on 31 December 20X4. The market rate of interest for a similar debt instrument is 3%.
On 1 January 20X1, the subsidiary initially measures the loan at the present value of £5m payable in four years, discounted at 3% being the market rate of interest for a similar debt instrument ie, £5m/1.034 = £4,442,435. The loan is subsequently accounted for as follows:

In this example, where the loan is from the parent to the subsidiary, the difference between the face value of the loan and the amount initially recognised, being £557,565 (£5,000,000 less £4,442,435), will generally be accounted for by the subsidiary as a capital contribution from its parent.

The double entries recorded by the parent and the subsidiary in their individual financial statements are below.

The appendix below illustrates how this loan might be accounted for if it was from a subsidiary to its parent or between two subsidiaries at the behest of their parent.

Loans with rolling notice periods

Where a parent provides a loan to a subsidiary at a below market rate with an agreed rolling notice period of a year or more, the initial accounting treatment is the same as in the example above with the period over which the loan repayment value is discounted being the length of the notice period. The carrying value will remain at the amount initially recognised until notice is given, at which point interest will start to accrue over the notice period. Discounting may not be required if the amounts involved are immaterial, which may be the case if the rolling notice period is for one year.

Loans that are repayable on demand

A loan is considered ‘repayable on demand’ if the lender can demand repayment at any time.⁴

An intercompany loan that is repayable on demand must be recognised at the undiscounted cash amount required to settle the obligation and would need to be shown as a current liability. Such a loan would not meet the criteria for a financing transaction as described above.

Letters of support

Sometimes a parent will issue a letter of support stating that it will not demand repayment of a loan within a specified period (often the following financial reporting year). In most instances, a letter of support is merely an expression of the parent’s intention. In other words, it is not a binding legal document. Where this is the case, a letter of support will not alter the accounting treatment.

Interest-free loans may also be made between an entity and one or more of its directors. How the difference between the face value of such loans and the amount initially recognised is accounted for will depend on whether the loan was made in the director’s capacity as a shareholder or for another reason.

If a director acting in their capacity as a shareholder provides or receives a fixed term interest-free loan, the measurement difference is accounted for in a manner similar where there is a loan between a parent and its subsidiary as illustrated above ie, it is treated as a capital contribution if the loan is made by the director to the entity and as distribution if the loan is made by the entity to the director. It can generally be presumed⁵ that the loan was made in the director’s capacity as a shareholder if a director is the majority shareholder.

A director who is not acting in their capacity as a shareholder or who has no direct ownership interest in the entity may also provide the entity with an interest-free loan. The appropriate accounting treatment will depend on the individual circumstances of each transaction.

If an entity provides an interest-free loan to a director who is not acting in their capacity as a shareholder or who has no direct ownership interest in the entity, the terms of the loan and the reasons for making it will need to be carefully assessed to determine the appropriate accounting treatment. Often such loans will be made for a specific purpose, such as purchasing a season ticket. In such circumstances, the entity should account for the measurement difference as an employee benefit in accordance with Section 28 of FRS 102.

Sometimes an interest-free loan will be made between entities that are not members of the same group, but that are related parties because they are owned and controlled by the same person. The accounting for such loans will be the same for an interest-free loan between fellow subsidiaries unless the facts and circumstances indicate that the loan has been provided interest-free for a reason other than that the entities are controlled by the same owner.

• Further guidance on the accounting treatment of financial instruments under FRS 102 is provided by the Financial Reporting Council in their FRC Staff Fact Sheet 4 FRS 102: Financial Instruments.
• Further guidance on the impact on distributable profits is available in Tech 02/17BL Guidance on realised and distributable profits under the Companies Act 2006

Further resources on FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland are accessible at icaew.com/frs102.

For more guidance on the requirements of IFRS and UK GAAP visit icaew.com/financialreporting

ICAEW members, affiliates, ICAEW students and staff in eligible firms with member firm access can discuss their specific situation with the Technical Advisory Service on +44 (0)1908 248250 or via live web chat.