- 1 Lately it has been observed that various practices are being followed in accounting for director’s loan to an entity. Therefore it was felt that guidance from the Institute should be issued to have consistency in accounting within the industry. The principal issues involved are whether the amount received by the entity from director is in the nature of financial liability or equity, valuation basis on initial recognition (fair value or face amount) and determination and treatment of difference between fair value and face amount, if any, arising on initial recognition.
1.2 There can be multiple scenarios like:
a.The terms of the director’s loan are documented or there are no written terms available. The loan is repayable on demand or after a fixed period of time or payable at the discretion of entity;
b. The loan is return/interest free or carries below market rate of return/interest ;
- The following discussion provides the principles and basis for the accounting guidance provided in paragraph 3.
2.1 IAS 32 contains the principles for distinguishing between liabilities and equity issued by an entity. The substance of the contractual arrangement of a financial instrument, rather than its legal form, governs its classification. The overriding criterion is that if an entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the contract is not an equity instrument.
2.2 The International Accounting Standards Board’s (IASB) definition of liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from entity of resources embodying economic benefits’. [Framework paragraph 4.4 (b)]
Obligations do not have to be legally binding, but they do not include future commitments. Liabilities include those provisions that require estimation. [Framework paragraphs 4.15 to 4.19]
2.3 Equity is a residual item – that is the residual interest in the assets of the entity after deducting all its liabilities. [Framework paragraph 4.4 (c)]
2.4 A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. (IAS 32 paragraph 11)
2.5 IAS 32 defines a financial liability as any liability that is:
a. a contractual obligation
i.to deliver cash or another financial asset to another entity; or
ii.to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
b.a contract that will or may be settled in the entity’s own equity instruments and is:
i.a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
ii.a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include puttable instruments and obligations arising on liquidation that are classified as equity, rights issues denominated in a currency other than the functional currency of the issuer if they meet certain conditions or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.
2.6 An equity instrument is defined as any contract that evidences a residual interest in an entity’s assets after deducting all of its liabilities. [IAS 32 paragraph 11]. A residual interest is not necessarily a proportionate interest ranking pari passu with all other residual interests, for example, it may be an interest in a fixed amount of the entity’s shares that may rank first in preference. An instrument is an equity instrument if, and only if, both of the conditions below are met:
- The instrument includes no contractual obligation:
- to deliver cash or another financial asset to another entity; or
- to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.
2. If the instrument will or may be settled in the issuer’s own equity instruments, it is:
- a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or
- a derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. For this purpose, rights and other issues denominated in any currency are equity instruments provided certain conditions are met. Also for this purpose, the issuer’s own equity instruments do not include puttable instruments and obligations arising on liquidation that are classified as equity or instruments that are contracts for the future receipt or delivery of the issuer’s own equity instruments.
2.7 The elements of income and expenses are defined as follows:
a. Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
b. Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. [Framework para 4.25].
Relevant provisions of IFRSs and Analysis
2.8 An issuer of a financial instrument should classify a financial instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the contractual arrangement’s substance and the definitions of a financial liability, a financial asset and an equity instrument. [IAS 32 paragraph 15].
2.9 The key feature of the definition of financial liability is contractual basis of the financial liability. All financial instruments are defined by contracts. The rights or obligations that comprise financial assets or financial liabilities are derived from the contractual provisions that underlie them.
‘Contract’ or ‘contractual’ refers to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts, and thus financial instruments, may take a variety of forms and need not be in writing. [IAS 32 paragraph 13].
Liabilities or assets that are not contractual (for example obligations established from local law or statute, such as income taxes) are not financial liabilities or financial assets. Similarly, constructive obligations, as defined in IAS 37, do not arise from contracts and are not financial liabilities. [IAS 32 paragraph AG12].
2.10 The role of ‘substance’ in the classification of financial instrument should be restricted to considering the instrument’s contractual terms. Anything that falls outside the contractual terms should not be considered for the purpose of assessing whether an instrument should be classified as a liability under IAS 32. The impact of relevant local laws, regulations and the entity’s governing charter in effect at the date of classification should also be considered but not expected future amendments to those laws, regulations and charter [IFRIC 2 paragraph 5].
2.11 A contractual right or contractual obligation to receive, deliver or exchange financial instruments is itself a financial instrument. Some common examples of financial instruments that give rise to financial assets representing a contractual right to receive cash in the future for the holder and corresponding financial liabilities representing a contractual obligation to deliver cash in the future for the issuer are as follows:
- Trade accounts receivable and payable
- Notes receivable and payable
- Loans receivable and payable
- Bonds receivable and payable
In each case, one party’s contractual right to receive (or obligation to pay) cash is matched by the other party’s corresponding obligation to pay (or right to receive). [IAS 32 paragraph AG 4].
Determining the capacity in which transaction is carried out
2.12 An entity should assess the facts and circumstances to determine whether the lender is acting in its capacity as shareholder in the transaction.
Contributions from owners in their capacity as owners of the entity are distinguished from transfers that arise from trading activities in the normal course of business.
Contributions are non-reciprocal in nature. In essence, they are a gift. They can be assets or services given or liabilities forgiven, without the transferee being obliged to give anything of benefit in exchange. Where a company receives consideration from one or more shareholders without a contractual obligation to repay it (a gift or a ‘capital contribution’), this is an increase in equity. Typically, such amounts are recorded in a separate reserve. Under IAS 1, capital contributions are presented in the statement of changes in equity as a transaction with owners in their capacity as owners.
Determining the value for transaction recognition
2.13 There are no requirements in IAS 32 on the initial recognition and measurement of equity. In many instances, equity is recorded at the proceeds of issue, net of transaction costs, and is not subsequently re-measured.
2.14 When a financial asset or financial liability is recognised initially, an entity shall measure it at its fair value plus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. (IAS 39 paragraph 43)
After initial recognition, an entity shall measure all financial liabilities at amortised cost using the effective interest method. There are certain exceptions that are explained in IAS 39 paragraph 47.
Related party disclosure and valuation of non-arm’s length transaction
2.15 Directors loans meet the definition of related party transactions (IAS 24 paragraph 9). The disclosures required by IAS 24 paragraphs 12 – 22 must be given in sufficient detail to enable the effect of the loans on the financial statements to be understood. Where there are significant uncertainties, such as the expected terms of a loan, the disclosures should refer to this.
Such loans are commonly made on a non-arm’s length terms (i.e. terms that are favourable or unfavourable in comparison to the terms available with an unrelated third party lender). For example, such loans are often:
- interest free or have a below-market rate of interest; and/or
- made with no stated date for repayment / subordinated to external liabilities.
2.16 These loans with contractual obligation are within the scope of IAS 39. The fair value of such loans is not usually the same as the loan amount, and as stated above IAS 39 paragraph 43 requires both parties to initially record the asset or liability at fair value. Given that there is no active market for such loans, fair value will usually need to be estimated. The appropriate way to do this is to determine the present value of future cash receipts using a market rate of interest for a similar instrument (IAS 39 AG paragraph 64).
The difference between fair value and loan amount then needs to be accounted for.
2.17 Where the loan is from a parent to a subsidiary or shareholder acting in its capacity as shareholder, it would be inappropriate to recognise a gain or loss for the discount or premium; in substance this is an additional contribution by the parent/shareholder (or a return of capital/distribution by the subsidiary). Contributions from and distributions to “equity participants” do not meet the basic definition of income or expenses (Framework 70 4.25).
- Based on above discussion and principles the accounting for the multiple scenarios relating to director’s loan (for the purpose of this TR it is assumed that the director is also an equity participant) identified in paragraph 1.2 is explained below:
3.1 Contractual Director’s Loan that is Interest-Free
3.1.1 A director might provide a loan to an entity that bears no interest, but the loan agreement does include a fixed date for repayment.
3.1.2 As the contractual obligation to deliver cash exists the transaction is to be recorded as financial liability. When a financial liability is recognised initially, IAS 39 requires the entity to measure it at its fair value. In this case the consideration given or received (say the face amount) is not the financial instrument’s fair value as the loan carries no interest and therefore part of the consideration received is something other than its fair value. As the loan would have to be recorded initially at its fair value, its fair value has to be estimated. This is a financing transaction, since the loan is made at a non-market rate of return/interest. It is initially recognised at the present value of future payments discounted at a market rate of return/interest for a similar debt instrument. There will be a difference between the cash paid and present value on initial recognition. The entity shall recognise this difference as an addition to its equity. This is to reflect the economic substance of the transaction – that the interest-free element is a capital contribution.
3.1.3 In subsequent periods, interest is recognised on the loan in the income statement using the effective interest method. The interest recognised will be the unwind of the difference between present value on initial recognition and the cash received.
3.2 Contractual Director’s loans that are interest-free and repayable on-demand
3.2.1 An entity’s director might provide a loan to the entity that bears no interest, but the loan agreement specifies that the amount lent is repayable on-demand.
3.2.2 A loan to an entity that is due on-demand is a financial instrument. Upon initial recognition, a loan that is due on-demand is not discounted, as it has no term and can be demanded at any time. It is recognised at the full amount receivable – its face value. Although the loan is made at a non-market rate of interest and is a financing transaction, because the director can demand payment at any time, discounting from the first date when the amount could be required to be paid has no impact.
3.3 Contractual Director’s loan that is interest free and repayable at the discretion of the entity
3.3.1 A loan to an entity by the director which is agreed to be paid at the discretion of the entity does not pass the test of liability and is to be recorded as equity at face value. This is not subsequently re-measured.
3.3.2 The decision by the entity at any time in future to deliver cash or any other financial asset to settle the director’s loan would be a direct debit to equity.
3.4 Directors loans / financing with no written contractual terms or on-going interest charges
3.4.1 A director might provide financing to the entity. There are no written terms for the repayment of the financing or any on-going interest charges. The financing is not documented in a written contract.
3.4.2 The entity needs to make an assessment of any implied contractual terms, in the absence of an explicit contract.
3.4.3 In the absence of any written or other evidence characterising the financing as a loan or a capital contribution, the substance is likely to be regarded as an on-demand loan. The accounting is the same as for a contractual director’s loan that is interest-free / low interest and repayable on-demand.
- Effective date and transition
4.1 This technical release is applicable for preparation of financial statements for the period beginning on or after 1 January 2016. Earlier application is permitted. If an entity applies this technical release for an earlier period, it shall disclose that fact.
4.2 Change in accounting policy resulting from the initial application of this technical release shall be accounted for retrospectively in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
(271st meeting of the Council January 9, 2016)