Loans at below-market interest rates

Loans at below-market interest rates – Normally the transaction price of a loan (ie the loan amount) will represent its fair value. For loans made to related parties however, this may not always be the case as such loans are often not on commercial terms. Where this is the case, the fair value of the loans must be calculated and the difference between fair value and transaction price accounted for. A framework for analysing both the initial and subsequent accounting for such loans is discussed in here. Common examples of such loans include inter-company loans (in the separate or individual financial statements) and employee loans. Loans at below-market interest rates

Financing arrangements between entities within the same group can take various forms. On the one hand, they might be formal contractual lending agreements that are enforceable under local law; on the other hand, they might, in substance, be part of the investment in another entity. The terms of financing arrangements can vary, or they might not be clearly defined, with some being repayable on demand, others having a fixed maturity, and still others having no stated maturity.

The first step is to ascertain if a financing arrangement is (i) within the scope of IFRS 9, (ii) an investment in a subsidiary within the scope of IAS 27, or (iii) an investment in an associate or a joint venture within the scope of IAS 28. For instruments within the scope of IFRS 9, the standard’s impairment requirements apply to all debt instruments held at amortised cost or fair value through other comprehensive income. This includes ‘quasi-equity’ loans (that is, an item for which settlement is neither planned nor likely to occur in the foreseeable future and that forms part of the net investment in the borrower for under IAS 21, ‘The Effects of Changes in Foreign Exchange Rates’).

This practice aid outlines a number of common funding scenarios that have been identified as applying in practice. It only addresses instruments that are within the scope of IFRS 9 and that are not accounted for under IAS 27, ‘Separate Financial Statements’, or IAS 28, ‘Investments in Associates and Joint Ventures’. It provides guidance on their accounting treatment from the perspective of both the borrower/subsidiary and the lender/parent. It does not address the question of whether an instrument is within the scope of IAS 27 or IFRS 9, nor does it address the application of IFRS 9’s impairment requirements. For further guidance on the application of the impairment requirements of IFRS 9 to intra-group loans, see ‘In depth – IFRS 9 impairment practical guide: inter-company loans in separate financial statements’.

The appropriate treatment for any particular transaction depends on the facts and circumstances of that transaction. Evidence of past payments or planned payments should be considered, together with any contractual or agreed terms. In certain situations, it might be necessary for an entity to obtain legal advice for it to understand the terms of an agreement.

In some of the scenarios outlined below, there are two alternative accounting approaches that might be adopted. Where these accounting alternatives exist, management should apply the principles set out in IAS 8, ‘Accounting policies, changes in accounting estimates and errors’, in determining the appropriate approach. In particular, the approach adopted by an entity should reflect the economic substance of the transactions [IAS 8 para 10(b)(ii)], be applied consistently to all similar transactions [IAS 8 para 13], and be clearly disclosed in its financial statements [IAS 1 para 117]. It might be appropriate to apply different treatments to transactions that are not similar.

In addition, since this guidance addresses specific transactions, application by analogy would not always be appropriate and therefore requires careful analysis.

It is presumed, in all of the following examples, that (i) the loans are within the scope of IFRS 9, (ii) the cash flows of the loans are solely payments of principal and interest, and (iii) the loans are held by the parent in a ‘hold to collect’ business model.

Loans are one type of financial instrument. As such they are governed by IFRS 9 Financial Instruments which requires all financial instruments to be initially recognised at fair value. This can create issues when loans are made at below-market rates of interest, which is often the case for loans to related parties.

Key issue:

Where related party loans are made on normal commercial terms, no specific accounting issues arise and the fair value at inception will usually equal the loan amount.

Where a loan is not on normal commercial terms however, the ‘below-market’ element of the transaction needs to be evaluated and separately accounted for.

The first question is: – What are normal commercial terms? Loans at below-market interest rates

Normal commercial terms include the market interest rate that an unrelated lender would demand in making an otherwise similar loan to the borrower. This interest rate would reflect the borrower’s credit risk, taking into account the loan’s ranking and any security, as well as the loan amount, currency duration and other factors that would affect its pricing.

Overview

The first step is to determine whether the loan is on normal commercial terms. If not, this indicates that part of the transaction price is for something other than the financial instrument and should therefore be accounted for independently from the residual amount of the loan receivable or payable. This separate element should be accounted for under the most relevant Standard. For example, in the case of a loan to an employee that pays interest at a rate less than the market rate, the difference between the loan amount and fair value is, in substance, an employee benefit that should be accounted for under IAS 19. Loans at below-market interest rates

Where the ‘below-market’ element of the loan is not directly addressed by a Standard, reference should be made to the IASB’s Conceptual Framework for Financial Reporting (the Conceptual Framework) in determining the appropriate accounting. For example in the case of a loan from a parent to a subsidiary that pays interest at less than the market rate, the difference between the loan amount and the fair value (discount or premium) will typically be recorded as: Loans at below-market interest rates

  • an investment in the parent’s separate financial statements (as a component of the overall investment in the subsidiary)
  • a component of equity in the subsidiary’s individual financial statements (sometimes referred to as a ‘capital contribution’).
Something else -   IFRS 9 Modified financial assets

Having separately accounted for this element of the loan, the remaining loan receivable or payable should be accounted for under IFRS 9. IFRS 9 sets out the classification and measurement requirements for the loan receivable or payable as well as the impairment requirements for the receivable.

Special case: Loans with limited stated documentation

Sometimes loan agreements between a parent and subsidiary will lack the level of detail and documentation of commercial lending agreements. In such circumstances, the parties may need to take additional steps to clarify (and document) their rights and obligations under the agreement in order to determine the appropriate accounting. This might include obtaining legal advice if necessary. Loans at below-market interest rates

It is worth noting that in some parts of the world (eg South Africa), loans without stated repayment terms are deemed to be legally payable on demand under the local law. If so, the loan should be accounted for as an on-demand asset or liability (see guidance). Even in the absence of legislation, loans without stated repayment terms are often deemed to be payable on demand due to the nature of the parent and subsidiary relationship whereby the parent can demand repayment as a result of the control it exercises over the subsidiary.

In practice, a parent may provide some form of assurance that it does not intend to demand repayment of a loan to a subsidiary within a certain time frame despite having the contractual right to do so. This assurance may be provided verbally, via a comfort letter or as an amendment or addendum to the contract. In our view, amendments to the contract should be reflected in the accounting for the loan asset or liability while non-binding assurances should not (although they should be considered as part of the impairment assessment). Legal advice may need to be obtained to make that distinction. Loans at below-market interest rates

Loan – below the market element and residual (market-related) element

If the loan amount does not represent fair value, the loan should be split into the element that represents the below-market element of the loan and the remainder of the loan that is on market terms.

Accounting for the below-market element

Where a loan to a related party is not on normal commercial terms, the substance of the below-market element should be ascertained. The substance will then determine the accounting for this part of the loan receivable. The most relevant Standard should be applied to this part of the loan. If there is no relevant Standard, reference should be made to the general concepts in the Conceptual Framework in order to reflect the substance of this part of the loan. Loans at below-market interest rates

Loans at below-market interest rates

This process is illustrated by a number of examples, considering inter-company loans first and then loans to employees.

Loan at non-commercial rates with fixed term

Background

Parent Co provides a loan to Subsidiary Co. The loan bears no interest, but the loan agreement includes fixed terms for repayment. There are no transaction costs incurred on the issuance of the loan.

Question

How is the loan accounted for by the parent entity in its separate financial statements?

Answer

Under IAS 32, the loan is a financial liability from the perspective of the subsidiary. From the perspective of the parent entity, the loan is therefore a debt instrument under IFRS 9 [IFRS 9 BC5.21]. The loan is initially recognised at its fair value – which, in this case, would be equal to the present value of the future cash to be received, discounted using the prevailing market rate for a similar instrument (for example, currency, term, type of interest rate and other factors) with a similar credit rating [IFRS 9 B5.1.1].

As a result of the non-market interest rate (in this case, nil) inherent in the loan, there will be a difference between the cash paid and fair value on initial recognition. This difference should be accounted for in accordance with the substance of the transaction [IAS 8 10(b)(ii)]. Commonly, the substance is a capital contribution (see 4.25 of the Conceptual Framework), because the difference arises from the parent acting in its capacity as parent/shareholder, in which case it is reflected as an additional investment in the subsidiary. In rare circumstances, the substance might be that the difference represents consideration for something other than the financial instrument. For example, the subsidiary might also provide a service to the parent, in which case the additional amount lent is recognised as an expense in accordance with IFRS 9 B5.1.1, unless it qualifies for recognition as some other type of asset.

Something else -   Other business models - How 2 best account it in IFRS 9

The loan is subsequently measured at amortised cost [IFRS 9 5.2.1(a)], with interest accrued using the effective interest rate method, taking into account the unwind of the difference between the cash paid and fair value on initial recognition.

The loan is also subject to the impairment requirements of IFRS 9 [IFRS 9 5.2.2].

Question

How is the loan accounted for by the subsidiary in its financial statements?

Answer

The loan meets the IAS 32 definition of a financial liability. The liability is initially recognised at its fair value. In this case, it is equal to the present value of the future cash to be paid, discounted using the prevailing market rate for a similar instrument (for example, currency, term, type of interest rate and other factors) with a similar credit rating [IFRS 9 B5.1.1]. Assuming that the subsidiary does not elect to carry the loan as at fair value through profit or loss, the liability is subsequently measured at amortised cost, with interest accrued using the effective interest rate method.

Consistent with the rationale in answer B1, the difference between the fair value of the loan and the amount of funds received from the parent entity should be accounted for in accordance with the substance of the transaction [IAS 8 10(b)(ii)]. Commonly, the substance is an addition to the subsidiary’s equity, but it might rarely be treated as a gain in the income statement.

Loan repayable on demand with no interest

Background

Parent Co provides a loan to Subsidiary Co which is contractually repayable on demand and bears no interest. Parent Co can recall the loan in the future, but its intention (as communicated to Subsidiary Co) is that the loan is only recalled when the subsidiary has surplus cash and the parent requires the cash for other purposes, such as the payment of dividends to the parent’s shareholders or to make alternative investments. Parent Co does not expect any such events to occur in the foreseeable future. There are no transaction costs incurred on the issuance of the loan.

Question

How is the loan accounted for by the parent entity in its separate financial statements?

Answer

Under IAS 32, the loan is a financial liability from the perspective of the subsidiary (see Answer C2 below). From the perspective of the parent, the loan is therefore a debt instrument under IFRS 9 [IFRS 9 BC5.21]. The loan is initially recognised at its fair value – which, in this case, would be equal to the amount lent, because it is repayable on demand [IFRS 13 47].

The loan is also subject to the impairment requirements of IFRS 9 [IFRS 9 5.2.2]. For further guidance on the application of the impairment requirements to intra-group loans, see ‘In depth – IFRS 9 impairment practical guide: inter-company loans in separate financial statements’.

Question

How is the loan accounted for by the subsidiary in its financial statements?

Answer

Although there is no expectation that the parent will demand repayment of the loan, the subsidiary is still obliged to deliver cash to the parent at the parent’s request. The parent (as part of its normal ongoing decision-making process), and not the subsidiary, determines when the loan is repaid. Since the subsidiary does not have the unconditional right to avoid settlement of the obligation, the loan meets the definition of a financial liability [IAS 32 19].

The loan has no minimum contractual term, and the parent can require it to be repaid at any time, even though the parent does not expect to require repayment in the foreseeable future. As a result, the loan is recognised as a liability for the face value of the loan [IFRS 13 47]. The loan is also classified as a current liability, because the subsidiary does not have an unconditional right to defer settlement beyond 12 months [IAS 1 60].

Note: In practice, the funding provided by a parent to its subsidiary might be documented as a loan, although there might not be any documented repayment terms. The accounting for such instruments will depend on the specific facts and circumstances, and it might be necessary for an entity to obtain legal advice to determine its contractual position. If the conclusion is that the loan is payable on demand, the guidance above would apply.

Additional background – Letter of support issued

Subsequent to issuing the loan outlined above, the parent entity provides a letter of support to the subsidiary, prior to the balance sheet date, indicating that payment will not be required for a period of at least 12 months from the balance sheet date.

Note: A letter of support issued after the reporting date is a non-adjusting post balance sheet date event, and so it will not impact the classification or measurement of the loan at the reporting date.

Something else -   Regular way purchase or sale

Question

What impact does the letter of support have on the measurement of the loan by the parent in its separate financial statements?

Answer

The treatment by the parent depends on whether the letter of support is legally binding or simply an expression of intent. Where the letter is legally binding, the parent needs to determine whether the change in the terms of the loan represents a modification of the existing loan or the extinguishment of the original loan and the recognition of a new loan, in accordance IFRS 9 3.2.3.

If the change in terms is treated as a modification, IFRS 9 5.4.3 should be applied, to calculate the new carrying amount of the loan by discounting the revised cash flows at the original effective interest rate.

The difference (if any) between the previous carrying amount and the revised carrying amount, arrived at by discounting the loan back from the date that repayment could now be demanded, is treated either as an addition to the investment in the subsidiary (that is, as a capital contribution to the subsidiary) or as an expense in the income statement, depending on the economic substance. See the discussion in Answer B1 regarding the assessment of economic substance. In the scenario described, the substance is commonly a further investment in the subsidiary.

If the letter is not legally binding, it does not give rise to a change in terms. It might, however, impact the measurement of impairment under IFRS 9. Further guidance on the application of the impairment requirements of IFRS 9 to intra-group loans is included in the ‘In depth – IFRS 9 impairment practical guide: inter-company loans in separate financial statements’.

Question

What impact does the letter of support have on the measurement and current/non-current classification of the loan by the subsidiary in its financial statements?

Answer

The treatment by the subsidiary depends on whether the letter of support is legally binding or simply an expression of intent.

Where the letter is legally binding, the subsidiary needs to determine whether the change in the terms of the loan represents a modification of the existing loan or the extinguishment of the original loan and the recognition of a new loan, in accordance with IFRS 9 3.3.2. If the change in terms is treated as a modification, IFRS 9 5.4.3 should be applied, to calculate the new carrying amount of the loan by discounting the revised cash flows at the original effective interest rate.

The difference (if any) between the previous carrying amount and the revised carrying amount, arrived at by discounting the loan back from the date that repayment could now be demanded, is treated either as an addition to the subsidiary’s equity or as income in the income statement, depending on the economic substance. See the discussion in Answer B1 regarding the assessment of economic substance. In the scenario described, the substance is commonly a capital contribution recognised in equity. Since repayment cannot be required within 12 months of the balance date, it should be reclassified as a non-current liability.

Where the letter is not legally binding, the loan is still repayable on demand, notwithstanding that the loan is unlikely to be called. The loan continues to be classified as a current liability, because the subsidiary does not have an unconditional right to defer settlement beyond 12 months [IAS 1 60].

Loan where both borrower and lender must agree to repayment

Background

Parent Co provides a loan to Subsidiary Co. The loan bears no interest and does not include any fixed terms for repayment. One of the conditions of the loan is that repayment of the loan is only required on a date agreed by both the parent and subsidiary. There are currently no expectations of repayment in the short term. There are no transaction costs incurred on the issuance of the loan.

Question

How is the loan accounted for by the parent entity in its separate financial statements?

Answer

Based on the contractual terms, the loan meets the definition of equity from the perspective of the subsidiary, because the subsidiary has the unconditional right to avoid settlement of the loan in cash, by another financial asset, or in a variable number of equity instruments [IAS 32 16]. Since the loan is not of a commercial nature, has no set term and is intended to provide the subsidiary with a long-term source of additional capital, it is, in substance, an addition to the parent’s investment in its subsidiary.

Question

How is the loan accounted for by the subsidiary in its financial statements?

Answer

Since the contract requires the parent and subsidiary to agree before any repayment of the loan is made, the subsidiary has the unconditional right to avoid settlement of the loan in cash, by another financial asset, or in a variable number of equity instruments. Such an instrument meets the definition of an equity instrument under IAS 32 [IAS 32 16]. The loan is classified as an equity instrument in its entirety, with no subsequent remeasurement required.

If the subsidiary agrees to a repayment at a future point in time, the amount to be repaid is reclassified from equity to financial liabilities. The agreement to repay results in the initial recognition of a financial liability, so the liability is recognised at its fair value [IFRS 9 5.1.1]. No gain or loss is recognised in the income statement at this time [IAS 32 33]. Any difference between the previous carrying amount and the new fair value is recognised in equity.

Loans at below-market interest rates

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Something else -   Change in the fair value of a bond

Loans at below-market interest rates Loans at below-market interest rates Loans at below-market interest rates Loans at below-market interest rates Loans at below-market interest rates Loans at below-market interest rates Loans at below-market interest rates Loans at below-market interest rates Loans at below-market interest rates

Leave a comment