Our 'IFRS Viewpoint' series provides insights from our global IFRS team on applying IFRSs in challenging situations. Each issue will focus on an area where the Standards have proved difficult to apply or lack guidance. This issue provides a framework for accounting for loans made by an entity to a related party that are at below-market levels of interest. Common examples of such loans include:
- inter-company loans (in the separate or individual financial statements)
- employee loans.
Loans are one type of financial instrument. As such they are governed by IFRS 9 (2014) '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.
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. This IFRS Viewpoint provides a framework for analysing both the initial and subsequent accounting for such loans.
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 diagramme illustrates the framework we believe should be applied in analysing such questions. The first step is to determine whether the loan is on normal commercial terms. If it is not, the 'below-market' part 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, for reasons we will explain, 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.
Review the attached pdf for more analysis and examples.