FRS 102: Intra-group loans

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland has now come into mandatory effect for accounting periods commencing on or after 1 January 2015. A new financial regime such as FRS 102 brings with it new ways of accounting for certain transactions and events. One of several emerging issues which many in the profession are asking about is the subject of intra-group loans.

Overview of how financial instruments are dealt with in FRS 102

A loan is a financial instrument. Financial instruments are dealt with in FRS 102 at Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues. Basic financial instruments can include:

• Trade debtors
• Trade creditors
• Share capital
• Basic bank and other loans

Section 12 deals with the more complex financial instruments including:

• Options
• Swaps
• Forward contracts
• Futures contracts
• Loans with complex features

The issue of intra-group loans becomes more complex under the provisions of FRS 102 and for the purposes of this article the assumption is made that intra-group loans are those which fall to be classed as ‘basic’ financial instruments.

Intra-group loans

Many groups enter into intra-group loans for a variety of reasons – some usually because of convenience (the group member may require finance at a relatively short period of notice and hence the parent, or another group member, may provide that finance quicker than, say, a bank). Another reason may be that the group member is unable to secure finance because of a bad credit-rating, or may already have existing borrowings and the bank may want to charge a higher rate of interest to reflect the increased risk and the group may not be willing to accept this and hence another group member may provide the loan.

Whatever the reason for group members entering into intra-group loans, the accounting for such loans will need to be made in the individual financial statements of both the lender and borrower. Where consolidated financial statements are prepared, the intra-group loan (and interest charges) will, of course, be eliminated on consolidation.

This article considers intra-group loans which are considered to be long-term. Under the provisions contained in FRS 4 Capital instruments, the issue of intra-group loans is quite straightforward; the borrower will recognise a creditor at the amount payable and the lender will recognise a corresponding debtor. The only complicated part about this treatment is that the lender will consider the amount recognised as a debtor at each balance sheet date for impairment and, where evidence of impairment exists, the lender will write-down the debtor to recoverable amount. The difference with FRS 102 is that Section 11 requires the amortised cost method to be applied in accounting for the loan.

Intra-group loans under FRS 102 principles

The first thing to point out where intra-group trading is concerned is that there will not normally be an issue with short-term intra-group trade debtors and trade creditors. This is because these are normally recognised in the individual financial statements at undiscounted invoice amount. However, where payment is deferred beyond normal trading terms, these will become financing transactions and paragraph 11.13 requires such transactions to be recognised at the present value of the future payments which are discounted at a market rate of interest.

For long-term intra-group loans there are two issues to consider:

• Is there a rate of interest being charged on the loan?
• If there is, is the interest rate at market rate?

Problems will emerge where loans are charged at zero rates of interest, or interest rates which are below market rates. This is because in such cases measurement differences will arise on initial recognition of the loans at fair value in both the lending group member and the borrowing group member (see next section). To avoid measurement differences the client should be advised to charge market rates of interest, or, alternatively include provisions in the loan agreement that the lender can demand repayment at a very short notice period. Including repayment terms at a very short notice period could potentially get around the issue of measurement differences because the loan which is repayable on demand will then be recorded in the borrower’s books at not less than the amount repayable so as to recognise the immediate demand feature of the loan. However, this may not necessarily get around all measurement differences (particularly for the lender) because even if the loan is repayable on demand, immediate repayment may not be possible as the funds could be tied up and take time to be released.

Obtaining a market rate of interest for a company will depend on various factors, such as the duration of the loan, the type of security pledged (if any), the company’s gearing and credit risk and interest basis. A market rate of interest for a company could be the rate of interest which the company’s bank would charge on an equivalent loan. Hence if the company was already highly geared and had relatively few (or no) assets which it could pledge as security, market rates of interest would be higher to reflect the higher risk. Conversely, a company that had lower gearing levels and had assets available which it could pledge as security would receive a lower market rate of interest.

Measurement differences

Although a basic intra-group loan under FRS 102 principles is initially recorded at fair value, Section 11 requires the ‘amortised cost’ method to be applied and this is where measurement differences will arise on a loan that is below market rate. In the following examples it is assumed that the loan does not contain any demand features (it is merely a fixed-term loan).

Example – Measurement difference

A parent company agrees to provide a loan to its subsidiary for £20,000 on 1 January 2015.  The loan is repayable on 31 December 2016.  Market rates of interest are 5% but the parent agree to an interest rate at 2%.

Under FRS 102 principles, the first step is to discount the cash flows to present day values as follows:

*The £400 is calculated as the interest rate charged by the parent on the loan of £20,000 (hence £20,000 x 2% = £400).  In 2016, another year’s worth of interest will be charged plus the redemption amount of £20,000.

The measurement difference in the example above amounts to £1,116 (£20,000 less £18,884). Because Section 11 uses the amortised cost method to account for the intra-group loan the question arises as to where to take this initial measurement difference in the individual books of both the lender (in this case the parent) and the borrower (the subsidiary).

In the parent’s books, the measurement difference is debited to the cost of the investment in the subsidiary. This reflects the fact that the parent has contributed to the subsidiary by giving them a loan at less than market rates of interest and hence the journals will be:

In the subsidiary’s books, the measurement difference is credited to equity (capital contribution), again to reflect the fact that its parent has contributed to the subsidiary by providing a loan at less than market rates, hence the journals in the subsidiary’s books will be:

Allocating the interest

Once the loan’s initial recognition has taken place, the next step is then to allocate the interest to the profit and loss account. The interest charge in the profit and loss account will reflect the market rate of interest and will be charged as follows:

As can be seen in the illustration above, measurement differences can cause additional complexities. With regard to any subsequent adjustment of the cost of the investment in the parent and corresponding capital contribution in the subsidiary arising from the measurement difference, companies could choose to write off the additional cost of the investment so as to match the unwinding discount passing through profit or loss and then adjust the capital contribution in the subsidiary via a movement on reserves. Alternatively they may choose to leave the measurement difference within the cost of the investment and corresponding capital contribution and deal with any write-down as part of an impairment adjustment.

Loan from subsidiary to parent

It is not always the case that a parent will enter into a loan with a subsidiary – the reverse can apply. Where a subsidiary makes an intra-group loan to the parent which is below market rate the following will apply in the individual company’s books (assuming a fixed-term loan with no demand features):

Subsidiary is the lender

The subsidiary recognises the loan at fair value and the measurement difference is treated as a distribution to the parent, hence the journals are:

• Debit intra-group debtor (present value of loan)
• Debit dividends paid (measurement difference)
• Credit cash at bank (loan proceeds)

Parent is the borrower

The parent also recognises the loan at fair value and the measurement difference is treated as income received from the subsidiary, hence the journals are:

• Debit cash at bank (loan proceeds)
• Credit intra-group creditor (present value of loan)
• Credit income from subsidiary (measurement difference)

The above accounting treatment recognises that the subsidiary has contributed to the parent by way of a below market rate loan with the measurement difference being a dividend to the parent. Interest charges/income will be accounted for in the same way as the example above (although the subsidiary will recognise the interest income and the parent the interest expense).

Subsidiary to subsidiary

Parent companies do not necessarily have to be a party to an intra-group loan transaction; intra-group loans can arise between subsidiary companies and where intra-group loans arise between subsidiaries at below market rates, the following will apply in the individual subsidiary’s books (again assuming a fixed-term loan with no demand features):

Lender

The lending subsidiary recognises the loan at fair value and the measurement difference is recognised within interest expense, hence the journals are:

• Debit intra-group debtor (present value of loan)
• Debit interest expense (measurement difference)
• Credit cash at bank (loan proceeds)

Borrower

The borrowing subsidiary recognises the loan at fair value and the measurement difference is recognised as interest income, hence the journals are:

• Debit cash at bank (loan proceeds)
• Credit intra-group creditor (present value of loan)
• Credit interest income (measurement difference)

Care must be taken, however, where loans between subsidiaries are concerned because the parent company could instruct the lending subsidiary to recognise the measurement difference as a distribution and the borrowing subsidiary to recognise the measurement difference as a capital contribution. If the parent does not instruct such accounting treatments, the default will be to recognise an interest expense in the books of the lending subsidiary for the measurement difference and a corresponding interest income in the borrowing subsidiary.

Planning point

Where you have a client that is about to enter into an intra-group loan, it is worthwhile advising the lender to charge a market rate of interest to overcome measurement differences.  In addition, accounting complexities may also be potentially eradicated by making provisions in the loan agreement on demand repayment at a very short notice period.  The fair value of an on-demand financial liability will not be less than the amount payable on demand (paragraph 12.11 of FRS 102).  Initial measurement differences may, however, arise where the lender might not get immediate repayment on demand and the borrower has to be given time to get the funds in (i.e. where they have already been invested by the borrower).

Conclusion

The issue concerning intra-group loans is clearly going to cause more complexities in FRS 102 than was the case under previous UK GAAP and therefore thought should be given as to how best to advise clients that are group companies to ensure the correct accounting treatment in the individual accounts of the parent and subsidiaries are applied and understanding how the amortised cost method works within FRS 102. Existing loan terms cannot be changed retrospectively and hence any amendments needed to existing loan terms should be made before the date of transition.

Category: Accounting and standards