Jul

2

Related party loans under FRS 102

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accountancyFRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland has now come into effect for accounting periods commencing on or after 1 January 2015 and is expected to apply to small companies (with the exception of micro-entities) for accounting periods commencing on or after 1 January 2016 with earlier adoption permissible.  The new UK GAAP for small and micro-entities are due to be issued by the Financial Reporting Council in July.

A controversial issue which has arisen where this new framework is concerned is the way that Section 11 Basic Financial Instruments works – particularly with loans entered into which are at below market rates of interest.  This is likely to affect intra-group loans which are commonly entered into between small and medium-sized groups as well as loans entered into between companies under common control and directors’ loans.  A separate article on intra-group loans was published illustrating how such loans should be accounted for under the provisions in Section 11.  This article considers the accounting aspects of loans entered into between other related parties (including directors’ loans).  Please note that in the examples, any associated tax implications for both the company and the individuals have been ignored but will need to be considered in practice.

Loans between companies owned and controlled by the same individual

There are many companies which are owned by the same individual but which are not part of a group; however the companies become related parties on the grounds that they are both owned and controlled by the same individual.  In such setups, it is not uncommon for loans to take place between those individual companies – sometimes for simplicity but also because the company receiving the loan may have struggled to obtain finance from its bank for a variety of reasons.  Likewise with group structures, the owner may stipulate that the loan is either interest-free or the interest charged on the loan may be at below market rates.

Where the loan is interest-free, or is at a rate which is below market rates, a measurement difference will arise because of the way that the accounting for such loans under FRS 102 works.  The measurement difference is the difference between the present value of the loan and the fair value of the loan (i.e. the proceeds) on initial recognition.  This is because Section 11 uses the amortised cost method of accounting for such loans which, in turn, uses the effective interest rate.  This can be illustrated as follows:

Example – Loan between two companies owned and controlled by the same individual

Lisa owns 100% of the shares in both North Ltd and South Ltd which both have an accounting reference date of 31 December.  Both companies are not members of the same group but are related to each other on the basis that they are owned and controlled by the same person.

On 1 January 2015 North Ltd provides a loan to South Ltd amounting to £20,000.  The loan is repayable on 31 December 2016.  Lisa has stipulated that the loan is interest-free and if South Ltd were to obtain a similar loan from its bank an interest rate of 5% would be charged.

This loan would fall to be classed as a basic loan and hence accounted for under the provisions in Section 11 of FRS 102 using the amortised cost method.  The accounting for this loan under Section 11 is as follows:

Step 1 – Discount the loan to present value using a market rate of 5%

Therefore £20,000 / 1.052 = £18,141

Step 2 – Calculate and account for the measurement difference

The measurement difference is the difference between the present value of the loan (£18,141) and the fair value of the loan proceeds (£20,000) which is £1,859.  This difference represents the benefit which South (the borrowing company) is receiving by being provided with an interest-free loan.  Under FRS 102 principles this benefit has to be reflected in both sets of books.

In substance South has received a capital contribution from its owner and North has made a distribution to its owner because the loan has been entered into on instructions from the owner.  Hence the journals to initially recognise this loan are as follows:

In the books of North Ltd:

£

DR loan debtor

18,141

DR distribution (equity)

1,859

CR cash at bank

(20,000)

Being loan to South Ltd

In the books of South Ltd:

£

DR cash at bank

20,000

CR loan creditor

(18,141)

CR capital contribution (equity)

(1,859)

Being loan from North Ltd

Step 3 – Allocate the interest

The amortised cost method in Section 11 requires the effective interest rate to be calculated and charged to profit or loss over the life of the loan.  This is illustrated as follows:

Opening

Interest

Cash

Closing

Year

balance

at 5%

flow

balance

£

£

£

£

31.12.2015

18,141

907

19,048

31.12.2016

19,048

952

(20,000)

The journals in the books of each company are as follows:

North Ltd:

£

DR loan debtor

907

CR interest income

(907)

Interest income on loan 31.12.15
DR loan debtor

952

CR interest income

(952)

Interest income on loan 31.12.16
DR cash at bank

20,000

CR loan debtor

(20,000)

Redemption of loan from South

South Ltd:

£

DR interest expense

907

CR loan creditor

(907)

Interest charge on loan 31.12.15
DR interest expense

952

CR loan creditor

(952)

Interest charge on loan 31.12.16
DR loan creditor

20,000

CR cash at bank

(20,000)

Repayment of loan to North

Care must be taken where distributions are concerned (as in the example above where North Ltd has taken the measurement difference to distributions in equity).  This is because the distribution may not necessarily be a distribution for legal purposes and in some cases it might be worth seeking legal advice where the company does not have any (or sufficient) distributable reserves.

Directors’ loans

Where directors’ loans are concerned these will also require additional consideration where they are either interest-free or at below market rates of interest because they will also be accounted for under the provisions in Section 11 using the amortised cost method, which is illustrated as follows:

Example – Loan from a director

Lucas is a director of East Ltd and owns 100% of the ordinary share capital.  East has an accounting reference date of 31 December each year and on 1 January 2015 Lucas made an interest-free loan of £20,000 to the company which is repayable on 31 December 2016.  Market rates of interest on a similar loan would be 5%.  A measurement difference would arise amounting to £1,859 (£20,000 / 1.052 less £20,000) and hence the journals in this scenario would be:

  £

DR cash at bank

20,000

CR director’s current account                             (18,141)
CR capital contribution (equity)

   (1,859)

Being loan from director

The measurement difference is taken to equity as a capital contribution on the basis that the company has received an additional benefit by the director-shareholder providing it with an interest-free loan.

Example – Loan to a director

Using the same facts as above, but now consider that the company provides Lucas with a £20,000 loan.  In this reversed scenario the director-shareholder is receiving an additional benefit by being provided with an interest-free loan from the company and so the journals will be:

£

DR director’s current account

18,141

DR distribution to owner (equity)

1,859

CR cash at bank

(20,000)

Being loan to director

Again, care should be taken where the company may not have sufficient (or any) distributable reserves because the accounting requirements under Section 11 for such loans will now draw more attention to the distribution and hence legal advice may need to be sought in some situations.

It is often the case that a director may not necessarily be a shareholder, but a measurement difference will still arise on an interest-free or below market rate loan.

Example – Loan to a director who is not a shareholder

Sarah is a director of West Ltd but does not own any shares.  The majority shareholder agrees to provide Sarah with a £20,000 interest-free loan to put towards the deposit on a house.  The loan is repayable in two years’ time.  Sarah would be charged 5% on an equivalent loan from her bank.

A measurement difference arises (as in the previous examples) of £1,859 (£20,000 / 1.052 less £20,000).  This difference is accounted for as interest income.

Conclusion

Accounting for loans among related parties is going to be more complicated under the provisions of FRS 102 because such loans are deemed to be financing transactions under Section 11 and these sorts of financing transactions have to be measured at the present value of the future payments which are discounted at a market rate of interest for a similar sort of loan with interest being calculated using the effective interest method.

A potential way to avoid measurement differences would be to make such loans repayable on demand and recognise them as current assets/liabilities in the balance sheet or to charge market rates of interest.  Where this is not an option, or not the case, and such loans are provided either interest-free or at below market rates then measurement differences will arise which need to be accounted for under the new UK GAAP.

Category: Accounting and standards, Audit

About the Author ()

Steve Collings is the audit and technical director at Leavitt Walmsley Associates Ltd and the author of 'Interpretation and Application of International Standards on Auditing'. He is also the author of 'IFRS For Dummies' and 'The AccountingWEB Guide to IFRS'. More about Steve's publications can be found by clicking on the 'Published Work' tab on the homepage. Steve is also a regular contributor of articles to www.accountingweb.co.uk, the UK's largest resource for professional accountants on a free subscription basis and is a member of the Society of Authors. Steve is an Editorial Board member for Wiley Insight IFRS and sits on the AAT's Financial Reporting Technical Panel. In 2011 Steve was named 'Accounting Technician of the Year' at the British Accountancy Awards and won 'Outstanding Contribution to the Accountancy Profession' by the Association of International Accountants in 2013. Follow Steve on Twitter - @stecollings

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