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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