IFRS 9 and Intercompany Loans Payable

The accounting of intercompany loans has always been a very common scenario during most of my audits. I have therefore finally thought to write on this topic. Although accounting treatment of intercompany loans or financial liabilities under IFRS 9 Financial Instruments is almost same as discussed in our obsolete accounting standard i.e. IAS 39 Financial Instruments: Recognition and Measurement, I will be discussing common scenarios that I have been seeing during the audits related to intercompany loans.

Note that I am only discussing the intercompany loans from the borrower(s)' perspective or loans from related parties.

Here is the list of the most common scenarios:

1. Intercompany loans on normal commercial terms.
2. Intercompany loans with zero interest or below the market interest rate.
3. Intercompany loans with no loan agreement/documentation.

I will be discussing each of the aforementioned scenarios in detail but before we go ahead we need to take a quick recap of what IFRS 9 says about the classification, measurement, and recognition of financial liabilities.

CLASSIFICATION

The classification of financial liabilities under IFRS 9 is just the same as in IAS 39 i.e. the financial liabilities are classified as either:

1. at amortized cost; or 
2. at fair value through profit or loss (FVTPL)

INITIAL AND SUBSEQUENT MEASUREMENT

IFRS 9 requires all financial instruments to be measured on initial recognition at fair value. This is normally a transaction price in a transaction between unrelated parties. 

Subsequently, the financial liabilities are measured at amortized costs unless the financial liabilities are classified as measured at FVTPL.

Note that I am only discussing the different scenarios in intercompany loans and therefore the treatment of financial liabilities classified as measured at FVTPL is irrelevant in the context of this article. 

The accounting treatment of financial liabilities classified as measured as amortized costs under IFRS 9 is relatively simple but in case of intercompany loan agreements, few considerations have to be taken before we simply classify the loans as financial liabilities.

Let's look at each of the aforementioned scenarios in detail.

INTERCOMPANY LOANS ON NORMAL COMMERCIAL TERMS

This is a very rare situation where intercompany loans are made on normal commercial terms specifically on the market interest rate and the repayments are actually specified in a formal document. In such kind of scenarios, no specific accounting issues arise. Such loans from related parties are initially classified as measured at Fair value and thereafter at amortized cost. The fair value at initial recognition equals to the loan amount.

INTERCOMPANY LOANS WITH ZERO INTEREST OR BELOW MARKET INTEREST RATE

This is the most common scenario I have seen during my audits where loans are taken from inter-companies/related companies at a below-market interest rate or even at zero interest rate. A common rule to account for such loans:

If the loan does not represent fair value, it should be split bewteen the below-market/zero element of the loan and the loan that is on the market terms. 

Following diagram will help you understand this scenario clearly. 

Where intercompany loans are made that are not on normal commercial terms, the substance of the below-market element is checked. The accounting treatment below-market element under intercompany loans is not discussed in any accounting standard and that is where Conceptual Framework makes an entry. 

For more understanding of a conceptual framework for financial reporting, please read my article where I have summarised the updated requirements by the IASB: The Conceptual Framework for Financial Reporting 2018. 

There are following types of intercompany loans under this scenario that can be made which have different accounting treatments that I can discuss separately:

1. Fixed term loans from a parent to a subsidiary.
2. Loans between fellow subsidiaries.
3. Loans from subsidiaries to parent.
4. Loans to related parties that are not repayable.  

Fixed Term Loans From a Parent To a Subsidiary

Where a loan is made from a parent company that is not on normal commercial terms, the difference between the loan amount and the fair value i.e. below-market element is accounted for as "capital contribution" in subsidiary's financial statements. The capital contribution is equity in nature.

The substance of this transaction is that it is consistent with the basic principles under the conceptual framework for financial reporting. The capital contribution can also be justified by the fact that the loan has a favorable condition for the parent company so that a relative income could be recognized for the below-market element which is not the case.

Loans Between Fellow Subsidiaries

Where a loan is made from a fellow subsidiary, deep consideration will need to be made. The substance of the transaction needs to be taken into consideration. Where for example, the substance of the below-market element of the loan is something other than the financial instrument, the difference between the fair value of the loan and the loan amount will be taken into profit or loss. From the borrower's perspective, it will be considered as "income" and recognized under the statement of profit or loss in accordance with the general guidance of IFRS9.

However, in circumstances where the loan was made from a fellow subsidiary by the special instruction from a parent entity, the treatment would be different i.e. the difference between the loan amount and fair value of the loan would be taken into "equity" and hence would be considered as "capital contribution".

Loans From Subsidiaries To Parent

Where a loan was made from a subsidiary, the substance of the below-market element would be that as if distributions are made from a subsidiary. Any difference between the actual loan amount and fair value of the loan will be recorded under the statement of profit or loss as "income" in the financial statements of the parent company (the borrower).

Loans To Related Parties That Are Not Repayable

Where a loan is made from one related party that are not repayable or the repayment is at the discretion of the borrower. In such circumstances, the transaction may not be termed as a loan. It may be termed as an "advance". The whole amount will be taken to equity and will be considered as "capital contribution" in the financial statements of the borrower. There will be no need to discount the loan.

Now that I have discussed the second scenario in detail, let's look at the last one of this article.

INTERCOMPANY LOAN WITH NO LOAN AGREEMENT OR DOCUMENTATION

I have seen such scenarios in almost every audit where for example, parent company remittances huge amounts during the year without any formal documentation or agreement is signed between both the parties.

In such kind of scenarios, we need to understand the substance of the transactions as I have focused on every scenario above. The accounting standards give lots of importance to the preparers of financial statements to see the substance of the transaction rather than its legal form.

We need to think if the transaction is actually a loan from the parent?

If the parent demands repayment of the loan, then it will be considered as "liability" and the accounting treatment will be the same as mentioned under the heading "fixed term loans from a parent to a subsidiary".

However, in circumstances where the remittance of money was just to manage the working capital of the subsidiary or same kind of reasons, the transaction would be treated as a "capital contribution" and will be accounted for as discussed under the heading "Loans to related parties that are not repayable".  

From the audit's perspective, formal documentation needs to be taken directly from the lender. This is what we call a balance confirmation and that's where the intention of the lender for the loan is mentioned.

The most common sentence in auditors' world:

"The aforementioned loan is unsecured, interest free, and repayable on demand."

That's it!!

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My name is Muhammad Shazaib and I am a Chartered Certified Accountant (ACCA Member) having more than 5 years of international working experience in  Audit, Accounting, and Value Added Tax in Pakistan, United Arab Emirates (UAE), and Malta (Europe).

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The Conceptual Framework for Financial Reporting 2018

Ever wondered what does this heavy phrase "The conceptual framework for financial reporting" mean?

I have always been wondered with what actually the conceptual framework for accounting is until I dug into this.

What is it?

In simple words, the conceptual framework for financial reporting ("the Framework") is a basic document that sets objectives and concepts for general purpose financial reporting.

We need to make one thing clear in mind that the framework is not an accounting standard, rather acts as a guide for the preparers of the financial statements. It acts as a tool for the management to use judgment in applying accounting policies where a specific standard is not applied.

History

In 1989, the Framework for the Preparation and Presentation of Financial Statements was issued by Internation Accounting Standards Committee (ISAC) which is now known as the International Accounting Standard Board (IASB).

But, then the IASB made amendments to it and the new and finished framework was issued with a new name The Conceptual Framework for Financial Reporting in 2010.

It stayed in progress for many years and in March 2018, the ISAB issued the final version of the framework which is called The Conceptual Framework for Financial Reporting 2018.

Why did the IASB revise the Framework?

The previous versions of frameworks were useful but incomplete and required improvements:

1. There were Filling Gaps. For example, guidance on measurement, presentation, and disclosure was missing.  
2. Updating. For example, the definition of an asset and a liability.

The changes?

The major changes that the ISAB made were:

1. Measurement: concepts on measurement, including factors to be considered when selecting a measurement basis.
2. Presentation and disclosure: concepts on presentation and disclosure, including when to classify income and expenses in other comprehensive income.
3. Derecognition: guidance on when assets and liabilities are removed from the financial statements.

Let's Get Started

The new framework has 8 chapters in total and here is the list. We will look at each of these in detail.

1. The Objective of general purpose financial reporting;
2. Qualitative characteristics of useful information;
3. Financial statements and the reporting entity;
4. The elements of financial statements;
5. Recognition and derecognition;
6. Measurement;
7. Presentation and disclosure; and
8. Concepts of capital and capital maintenance.

The Objective of General Purpose Financial Reporting

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to the existing and potential 1) Investors, 2) Lenders and 3) other creditors to make various decisions. For example about the trading of debt and equity instruments.

So what financial information should a reporting entity report in the general purpose financial reports?

1. The entity should present financial information in the general purpose financial reports about the economic resources and claims. In simple words, this is the statement of financial position of an entity.
2. The entity should also report changes in economic resources and claims resulting from financial performance and other events. In simple words, we are talking about the statement of profit and loss and other comprehensive income.
3. The financial performance should be reflected by accrual accounting.
4. The entity should also present financial performance resulted from past cash flows.

Qualitative Characteristics of Useful Information

Chapter two of the framework discusses the qualitative characteristics of useful information and there are two types of characteristics:

1. Fundamental:
1. The first fundamental characteristic is Relevance. Relevant financial information is capable of making a difference in the decisions made by the users of financial information. Here the concept of Materiality applies. So the material information must be presented in the financial information and should not be omitted.
2. The second fundamental characteristic is the Faithful representation. Information should be faithfully represented, meaning that, it should be complete, neutral and free from error. 
2. Enhancing:
1. The useful information should have both fundamental as well as Enhancing characteristics. Here the meaning of enhancing characteristics it should be:
1. Comparable - between entities and different time periods.
2. Verifiable - Knowledgeable users should be able to verify the information with given sources.
3. Timeliness - The information should be available in time to the users so that timely decisions can be made.
4. Understandability - The information should be classified, presented clearly and concisely. 

Financial Statements and The Reporting Entity

Chapter 3 discusses the financial statements and the reporting entity. We all are pretty familiar with this chapter from the very early stages of our studies. Let us take a quick recap.

Here we are talking about the full financial statements but not only the reporting itself. The entity presents relevant information in the Statement of Financial Position by recognizing Assets, Liabilities, and Equity.

The financial performance is provided in the Statement of Financial Performance by recognizing Income and expenses.

And, the entity reports financial information in Other Statements where information about elements of the financial statements, cash flow of the entity, assumptions and estimates used, and contributions made by shareholders/ owners, and distributions made to the shareholders is presented.

Chapter 3 also discusses the Reporting Entity. The financial statements can be prepared by:

1. A single entity.
2. A portion of an entity.
3. More than 1 entity.

Note that the reporting entity needs not to be a Legal entity!.  

The reporting entity can present its financial statements in the following way:

1. Consolidated - Where there is a relationship between parent and subsidiary and the financial statements are presented as a single entity.
2. Unconsolidated - Where information is only presented for a single/ parent entity.
3. Combined financial statements - This is where there is no relationship between parent and subsidiary but the entities are somehow related to one another. For example, the entities are owned by one shareholder.

Financial reports are always reported for a specified period of time and on a going concern basis. This means that the entity will continue its operation in the foreseeable future. 

The Elements of Financial Statements

We are also very familiar with this chapter. The chapter discusses the elements of the financial statements i.e. statement of financial position or traditionally called balance sheet, statement of profit (Income statement) and loss and other comprehensive income. Chapter 4 also discusses the statement of changes in equity, where equity-related transactions reported and statement of cash flows. I will not go into detail since we already know about these statements.

Recognition and Derecognition

This chapter is newly incorporated by the IASB. Although different accounting standards have already given us guidance on the recognition and derecognition of elements of financial statements, the framework incorporated the definition and criteria in this framework where guidance is not available in the specific standards.

As per the framework - Recognition is the process of incorporating into the balance sheet or income statement an item that meets the definition of an element and recognition criteria:

1. It is probable that any future economic benefit associated with the item will flow to or from the entityIt is probable that any future economic benefit associated with the item will flow to or from the entitItItsdlskdl;aksd;sakd;lsakd It is probable that any future economic benefit associated with the item will flow to or from the entity; and 
2. The cost or value related to that item can be measured reliably.

Derecognition is the process of removal of an item from the balance sheet or income statement and the criteria to remove the element from the financial statements is the same as mentioned above.

Note that, the general definitions of elements of financial statements i.e. Assets, Liabilities, Equity Income, and expenses are very important before an element can be recognized or derecognized.

Measurement

Chapter 6 talks about measurement.

Recognition means when and whether to recognize in the financial statements while measurement means in what amount the element should be recognized.

The framework has presented two measurement basis of accounting.

1. Historical costs - which is actually the transaction price of an item; and
2. Current Value - this is subdivided into following.
1. Fair value.
2. Value in use.
3. Current cost.

Note that while using the measurement basis of an item we need to consider the relevance and faithful representation of financial information.

Presentation and Disclosure

Here the concept of effective communication is very important since the presentation and disclosures act as a communication tool for the users of financial information.

The communication in the presentation and disclosures in the financial statements will only be effective if it focuses on the objective and principles of the presentation and disclosure but not merely the rules.

Moreover, the classification in the presentation and disclosure is also taken care of. Meaning that similar items are grouped and dissimilar items are separated.

Concepts of Capital and Capital Maintenance

Finally, the framework laid down the concepts of capital and capital maintenance. However, this chapter is copied from the previous versions of frameworks and there is nothing new here.

The framework explains two types of capital:

1. The Financial Capital - Which is basically the net assets of an entity. The profit is calculated as the difference between net assets at the end of the period and net assets at the beginning of the period after deducting contributions.
2. Productive Capital - This is the productive capacity of the entity based on, for example, units of output per day. Here the profit is earned if physical productive capacity increases during the period, after excluding the movements with equity holders.

This is all!!!

Want to know about me?
My name is Muhammad Shazaib and I am a Chartered Certified Accountant having more than 5 years of international working experience in  Audit, Accounting, and Value Added Tax in Pakistan, United Arab Emirates (UAE), and Malta (Europe).

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