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 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: IAS 24 Loans at below-market interest rates
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?
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 IAS 24 Loans at below-market interest rates
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.
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:
- 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’).
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. IAS 24 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 timeframe 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.
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. IAS 24 Loans at below-market interest rates
Accounting for the below-market element IAS 24 Loans at below-market interest rates
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.
In summary: IAS 24 Loans at below-market interest rates