IFRS Viewpoint - Grant Thornton Ireland

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IFRS viewpointRelated party loans at below-market interest ratesOur ‘IFRS viewpoint’ series provides insights from our global IFRS team on applyingIFRSs in challenging situations. Each edition will focus on an area where thestandards have proved difficult to apply or lack guidance. This edition provides aframework for accounting for loans made by an entity to a related party that are atbelow-market levels of interest. Common examples of such loans include: inter-company loans (in the separate or individual financial statements); and employee loans.What’s the issue?Loans are one type of financial instrument. As such theyare governed by IFRS 9 (2014) ‘Financial Instruments’which requires all financial instruments to be initiallyrecognised at fair value. This can create issues when loansare made at below-market rates of interest, which is oftenthe case for loans to related parties.Normally the transaction price of a loan (ie the loanamount) will represent its fair value. For loans made toRelevant IFRSsIFRS 9 (2014) financial instrumentsIFRS 2 share-based paymentIAS 24 related party disclosuresIAS 19 employee benefitsIssue 1 September 2015related parties however, this may not always be the caseas such loans are often not on commercial terms.Where this is the case, the fair value of the loans must becalculated and the difference between fair value andtransaction price accounted for. This IFRS viewpointprovides a framework for analysing both the initial andsubsequent accounting for such loans.

IFRS viewpointOur viewWhere related party loans are made on normal commercial terms, no specific accountingissues 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’ elementof the transaction needs to be evaluated and separately accounted for.Practical insight: What are normal commercial terms?Normal commercial terms include the market interest rate that an unrelated lenderwould demand in making an otherwise similar loan to the borrower. This interestrate would reflect the borrower’s credit risk, taking into account the loan’s rankingand any security, as well as the loan amount, currency duration and other factorsthat would affect its pricing.The diagram illustrates the framework webelieve should be applied in analysingsuch questions. The first step is todetermine whether the loan is on normalcommercial terms. If not, this indicatesthat part of the transaction price is forsomething other than the financialinstrument and should therefore beaccounted for independently from theresidual amount of the loan receivable orpayable. This separate element should beaccounted for under the most relevantstandard. For example, in the case of a2Issue 1 September 2015loan to an employee that pays interest at arate less than the market rate, thedifference between the loan amount andfair value is, in substance, an employeebenefit that should be accounted forunder IAS 19.Where the ‘below-market’ element ofthe loan is not directly addressed by astandard, reference should be made to theIASB’s Conceptual Framework forFinancial Reporting (the ConceptualFramework) in determining theappropriate accounting. For example, for

Related party loans at below-market interest ratesreasons we will explain, in the case of aloan from a parent to a subsidiary thatpays interest at less than the market rate,the difference between the loan amountand the fair value (discount or premium)will typically be recorded as: an investment in the parent’s separatefinancial statements (as a componentof the overall investment in thesubsidiary); and a component of equity in thesubsidiary’s individual financialstatements (sometimes referred to as a‘capital contribution’).Having separately accounted for thiselement of the loan, the remaining loanreceivable or payable should beaccounted for under IFRS 9. IFRS 9 setsout the classification and measurementrequirements for the loan receivable orpayable as well as the impairmentrequirements for the receivable.The remainder of this IFRS viewpointdiscusses these issues in more detail.Diagramme: Framework for analysing related party loans at below-market interest ratesAssess whether the loan is on normal commercial terms?NoYesNo specialconsiderationsSplit into a ‘below-market’ element and a ‘loan’ elementBelow-market elementResidual loan elementAccounted for under relevantStandard (eg IAS 19 for loansmade to employees) or under theConceptual Framework whereno relevant Standard existsAccounted for by applyingIFRS 9’s requirements(covering classificationand measurement, andimpairment)Issue 1 September 20153

IFRS viewpointMore analysisIs the loan on normal commercialterms?IFRS 9 requires all financial instrumentsto be measured on initial recognition atfair value. This will normally be thetransaction price in a transactionbetween unrelated parties. If a loan ismade on normal commercial terms (bothin terms of principal and interest), nospecific accounting issues arise and thefair value at inception will usually equalthe loan amount.This may not always be the casehowever – especially for loans to relatedparties. Such loans are often not onnormal commercial terms. An entitymaking a loan to a related party such asanother entity within a group or anemployee should therefore evaluatewhether the loan has been made onnormal commercial terms. We think it isuseful to make a distinction betweenon-demand or short-term loans andlonger fixed term loans in doing this:4Issue 1 September 2015Short-term and on-demand loans torelated partiesIn our view loans that are expected to berepaid in the near future shouldgenerally be recorded at the loan amountby both parties (subject to IFRS 9’simpairment requirements). We believethe loan amount is likely to be asufficiently close approximation to fairvalue in most such cases. Inter-companycurrent accounts or balances arising fromcash pooling (or sweep) arrangementsmight fall into this category.Fixed term loans to related partiesAdditional analysis may be needed for alonger-term loan to a related party suchas a subsidiary.On initial recognition the fair valueof loans to related parties can beestimated by discounting the futureloan repayments using the rate theborrower would pay to an unrelatedlender for a loan with otherwise similarconditions (eg amount, duration,currency, ranking and any security).The estimated future loan repaymentswill usually be the same as thecontractual loan provisions, but thismay not always be the case.Loans with limited stated documentationSometimes loan agreements between a parent and subsidiary will lack thelevel 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 todetermine the appropriate accounting. This might include obtaining legal adviceif necessary.It is worth noting that in some parts of the world (eg South Africa), loanswithout stated repayment terms are deemed to be legally payable on demandunder the local law. If so, the loan should be accounted for as an on-demand assetor liability (see guidance). Even in the absence of legislation, loans without statedrepayment terms are often deemed to be payable on demand due to the nature ofthe parent and subsidiary relationship whereby the parent can demand repaymentas a result of the control it exercises over the subsidiary.In practice, a parent may provide some form of assurance that it does notintend to demand repayment of a loan to a subsidiary within a certain timeframedespite having the contractual right to do so. This assurance may be providedverbally, 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 forthe loan asset or liability while non-binding assurances should not (although theyshould be considered as part of the impairment assessment). Legal advice mayneed to be obtained to make that distinction.

Related party loans at below-market interest ratesSplit the loan into the below-marketelement and the residual loan elementIf the loan amount does not representfair value, we believe the loan should besplit into the element that represents thebelow-market element of the loan andthe remainder of the loan that is onmarket terms.Accounting for the below-marketelementWhere a loan to a related party is not onnormal commercial terms, the substanceof the below-market element should beascertained. The substance will thendetermine the accounting for this part ofthe loan receivable. The most relevantstandard should be applied to this part ofthe loan. If there is no relevant standard,reference should be made to the generalconcepts in the Conceptual Frameworkin order to reflect the substance of thispart of the loan.We illustrate this process by a number ofexamples, considering inter-companyloans first and then loans to employees:Inter-company loans (in the separateor individual financial statements)transactions by applying the principlesset out in the Conceptual Framework, inparticular its definitions of assets,liabilities and equity. We consider belowthe effect of this in accounting for thebelow-market element relating to thefollowing types of inter-company loans: fixed term loan from a parent to asubsidiary; loans between fellow subsidiaries; loans from subsidiaries to parent; and loans to related parties that are notrepayable.Fixed term loan from a parent toa subsidiaryWhere a loan is made by a parent to asubsidiary and is not on normalcommercial terms, we believe thedifference between the loan amount andits fair value should be recorded as: an investment in the parent’s separatefinancial statements (as a componentof the overall investment in thesubsidiary); and a component of equity in thesubsidiary’s individual financialstatements (this is sometimesreferred to as a capital contribution).This is consistent with the principles setout in the Conceptual Framework whichdefines income as “increases in economicbenefits during the accounting period inthe form of inflows or enhancements ofassets or decreases of liabilities that resultin increases in equity, other than thoserelating to contributions from equityparticipants”. The definition of expensessimilarly excludes distributions to equityparticipants. If a loan is made by a parentto a subsidiary on favourable terms, thesubstance of the transaction is that thesubsidiary has received a contributionfrom the parent to the extent that thecash advanced exceeds the fair value ofthe subsidiary’s financial liability.Under the Framework this contributionis not income. This thinking alsounderpins the way in which we accountfor the below-market element of otherinter-company loans.The accounting for the below-marketelement of an inter-company loan in theseparate or individual financialstatements of the entities is not addressedby a specific standard. As a result weapproach the accounting for suchIssue 1 September 20155

IFRS viewpointLoans between fellow subsidiariesLoans from subsidiary to parentWhere a loan is made between fellowsubsidiaries, additional analysis may beneeded.As in the other situations describedabove, the entities involved should assesswhether the facts and circumstancesindicate that part of the transaction priceis for something other than the financialinstrument. If it is, then the fair value ofthe financial instrument should bemeasured. Any difference between thefair value and the amount actually lentwill often be recognised in profit or lossin accordance with IFRS 9’s generalguidance in this area (IFRS 9 containsspecific guidance on when such ‘day 1’gains or losses should be recognised inprofit or loss).In some circumstances however itwill be clear that the transfer of valuefrom one subsidiary to the other hasbeen made under instruction from theparent company. In these cases, webelieve an acceptable alternativetreatment is to record any difference as acredit to equity (capital contribution)and for any loss to be recorded as adistribution (debit to equity).Where a loan is made by a subsidiary toits parent on terms that are favourable tothe borrower, we believe any initialdifference between loan amount and fairvalue should usually be recorded: as a distribution in the subsidiary’sindividual financial statements; and as income in the parent’s separatefinancial statements.6Issue 1 September 2015Distributions received from a subsidiarywill usually be recognised in profit orloss in the parent’s separate financialstatements (an exception would bewhere the distribution clearly representsa repayment of part of the cost of theinvestment). Depending on thecircumstances, the parent entity may alsoneed to consider whether thedistribution is an indicator ofimpairment in the investment in thesubsidiary (interests in subsidiaries aregenerally outside the scope of IFRS 9and therefore subject to the requirementsof IAS 36 ‘Impairment of Assets’).If the loan contains a demand feature,it should, as in other scenarios, berecorded at the full loan amount by theparent (the borrower).Loans to related parties that are notrepayableSometimes in a group situation, a parentmay make an advance to a subsidiary(the advance may or may not be termeda ‘loan’) whereby the contractual termsstate that the amount: is not repayable; or is repayable at the discretion of thesubsidiary in all circumstances (otherthan on liquidation).In our view, this advance should berecorded as equity by the subsidiary (nodiscounting or amortisation is necessary)and as part of the net investment in thesubsidiary by the parent (sometimesreferred to as a ‘capital contribution’) forthe same reasons as outlined in thesection on ‘fixed term loans from aparent to a subsidiary’ above.

Related party loans at below-market interest ratesLoans to an employeeIn contrast to the accounting for thebelow-market element of inter-companyloans, we believe the treatment of thebelow-market element of a loan to anemployee is addressed by specificstandards. We expand on this byconsidering below the effect of abelow-market element for the followingtypes of loans to employees: loans to employees generally; loans to an employee linked to theentity’s shares; and forgivable loans.Loans to employees generallyWhere an entity makes a loan to anemployee that is not on normalcommercial terms, our view is that theinitial difference between thetransaction price of the loan and its fairvalue represents an employee benefit.IAS 19 should therefore be applied tothe initial difference or non-financialelement of the loan. In applying IAS 19,our view is: if the benefit (ie the favourableterms of the loan) is not dependenton future service by the employee, itshould be recorded as an employeebenefit expense when the loan isadvanced; and i f benefit is linked to future employeeservice, the initial difference shouldbe recognised as an expense over theservice period. The amount recordedas an expense can be estimated as thedifference between:– the interest income for theperiod based on the fair value ofthe loan asset and the amortisedcost using the effective interestmethod; and– the interest actually charged tothe employee.Examples of situations in which thebenefit is linked to future employeeservice include loans that: are repayable if the employee leaveswithin a certain period; or revert to a market interest rate if theemployee leaves within a certainperiod.In these examples, although theemployee receives the loan proceeds upfront, the interest benefit is availableonly while the employee providesservice to the entity. Accordingly IAS 19requires an expense to be recognisedwhen the employee provides services.Split loan amount into its separateelementsBelow-marketelementResidual loanelementApply IAS 19Apply IFRS 9The allocation of the employee benefitexpense under IAS 19 depends (amongstother things) on whether the benefit isconsidered long-term or short-term.In our view, most low-interest loanarrangements involve the payment ofbenefits in each period in which service isrendered and are therefore short-term.Other subsidised goods and services arealso typically considered to be short-termbenefits. However, some arrangementsmight have conditions or features thatmake them long-term in nature.Issue 1 September 20157

IFRS viewpointUnder short-term benefit accounting,the entity should recognise theundiscounted expense payable inexchange for employee services in eachperiod. As discussed above, the cost tothe entity in each period can beestimated as the difference between: the interest income for the periodbased on the fair value of the loanasset and IFRS 9’s amortised costusing the effective interest ratemethod; and the interest payable by the employee.Forgivable loansOther methods of allocation might alsobe acceptable.Accounting for the residual loanelementLoans to an employee linked to theentity’s sharesLoans linked to the entity’s shares insome way need careful analysis.This type of arrangement may (whollyor partly) be within the scope of IFRS 2.For example, a loan made to anemployee to purchase shares of theentity, and which is secured only overthose shares, may in substance representthe grant of a share option. A number ofissues can arise in such situations, whichare beyond the scope of this publication.8Issue 1 September 2015An employee loan might be forgivable(for example after a certain period ofservice or if performance targets areachieved). The terms and conditions ofthis type of arrangement should beevaluated to determine if it gives rise toany financial asset. The substance of suchan arrangement might be that it is aprepaid employee benefit in its entirety.A loan that is forgiven after a certainperiod of service exceeding 12 monthswould be a long-term employee benefit.Having separated the ‘below-market’element of the transaction, the remainingpart of the loan receivable is accountedfor as a financial instrument underIFRS 9. Accordingly, the entity that hasgranted the loan will need to considerthat standard’s requirements on: classification and measurement (inparticular the impact of any complexloan terms on the ‘solely payments ofprincipal and interest’ classificationtest); and impairment, including therecognition of expected credit losses.Where there is a change to the terms of aloan to a related party at a below-marketrate of interest, IFRS 9’s requirements onderecognition, including the guidance onmodifications will also need to beconsidered.More detailed information on theserequirements can be found in ourSeptember 2014 special edition of IFRSnews on ‘IFRS 9 (2014)’.Related party disclosuresBoth inter-company loans and loans toemployees meet IAS 24’s definition ofrelated party transactions and thedisclosures required by that standardmust therefore be given in sufficientdetail to enable the effect of the loans onthe financial statements to beunderstood. Where there are significantuncertainties, such as the expected termsof a loan, the disclosures should refer tothis.

Related party loans at below-market interest ratesExamplesLoan to a subsidiary at below-market interest rateParent (P) company makes a three year interest-free loan of CU100 to its Subsidiary (S) on 31 December 20X0.The borrowing rate available to S in the market is 8%. The approach to be taken in accounting for the loan and the entriesto be recorded in P’s and S’s separate financial statements are as follows:Step 1: Assess whether the loan is on normal commercial termsThe loan is not on normal commercial terms as it pays no interest in contrast to a loan on market terms which would pay8%. It is therefore necessary to proceed to step two.Step 2: Split the loan into the below-market element and the loan elementThe fair value of the financial element can be computed by discounting the future cash flows o

IFRS viewpoint Related party loans at below-market interest rates Our ‘IFRS viewpoint’ series provides insights from our global IFRS team on applying IFRSs in challenging situations. Each edition will focus on an area where the standards have proved dif

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