Enquiry:

I am writing to draw attention of your good-self to section 2.3 “Key Findings” of the QAB report 2014 where it has been reported in paragraph 2.3.1 the deficiency in respect of Interest Free Long Term Loans from Related Parties (Directors & Shareholders) due to non-application of IAS 39 with respect to discounting of the loan amount at assumed market rate for the assumed period of repayment which according to the interpretation of the directorate is mandatory under IAS 39.

2. The said paragraph 2.3.1 of the report is reproduced below for ready reference and for your convenience:

“2.3.1 Application of IAS 39 ‘Financial Instruments: Recognition and Measurement

Deficiencies in initial recognition and subsequent measurement of interest free long term loans and liabilities were noted in number of audit engagements reviewed during the period.

It was observed that interest free long term loans and liabilities, most of them from related parties, were recognized initially at the loan amount received as against the fair value of the loan amount and were not subsequently carried at their amortized cost using effective interest method. Most of the audit engagement partners were of the opinion that these are interest free loans with no agreed repayment terms or defined maturity; therefore it was difficult for management to estimate future cash flows and calculate effective interest rate of the loan.

The QAB would like to draw attention to requirements of IAS 1 “Presentation of Financial Statements” which requires that the liabilities can be classified as non-current only in specific circumstances. One of the requirements is for the entity to have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. Accordingly, all liabilities with no agreed repayment terms or defined maturity are to be considered as due on demand and should be classified as current.

Whereas in respect of loans and liabilities where the entity has agreed with the lenders not to demand repayment for a particular period (in excess of twelve months after the reporting period) should be discounted over the agreed period.”

3. It may please be noted that the aforesaid QAD’s finding has been reported without giving full facts about the nature of the loans and is based upon highly inappropriate, debatable reasoning and arbitrary interpretation of IAS-39. May be for this reason it has been given in very vague wording without quoting any relevant paragraphs of the said IAS because of the misapplication of the said standard.

4. The entire confusion is because it has been assumed that the ‘Directors and Shareholders Loans which are interest free and are payable at the discretion/convenience of the company are financial instruments and on this wrong assumption IAS 39 ‘Financial Instruments: Recognition and Measurement’ has been applied.

5. Definition of ‘Financial Instrument’ and ‘Financial liability’ are given in Paragraph 11 of IAS 32 which is reproduced below for ready reference and for better understanding of the concept:

“A ‘financial instrument’ is any contract that gives rise to a financial asset of one entity and financial liability or equity instrument of another entity.

And

A ‘financial liability’ is 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, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Also, for these purposes true entity’s own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipts or delivery of the entity’s own equity instruments.”

6.    If we put to test “Directors Interest Free Loans payable at the discretion/ convenience of the company” against the definitions of given above it would be observed that:
• There is no contract.
• There is no commitment to pay as it is payable at the discretion/convenience of the company – Loan is a sort of “Qaraz e Hassna”.
• There is no commitment to settle the loan in exchange of any financial assets or financial liabilities under conditions that are potentially unfavourable to the entity
• There is no commitment to settle this loan with the equity instruments of the entity.

7. I would also like to draw your kind attention to the definition of ‘contract’ given in the Contract Act (1872) applicable in Pakistan which is reproduced below:

An agreement enforceable by law is a contract; and every promise and every set of promises, forming the consideration for each other, is an agreement.

On the basis of aforementioned definition, the essentials of a (valid) contract are:
(a) Intention to create a contract;
(b) Offer and acceptance;
(c) Consideration;
(d) Capacity to enter into a contract;
(e) Free consent of the parties;
(f) Lawful object of the agreement;

8. In the case of the directors loans mentioned above two very important ingredients required for a valid contract that is “intention to create a contract” and “consideration” are missing and hence there is no contract.

9. I trust in view of explanations given in the aforementioned paragraphs it is abundantly clear that liability in respect of “Directors Interest Free Loans payable at the discretion/convenience of the company” is merely a “Qaraz e Hassna” and in not a financial liability as defined in IAS 32 and hence IAS 39 – ‘Financial Instruments: Recognition and Measurement’ is not applicable under the circumstances.

Therefore, this liability to the Directors would be disclosed on the face of the balance sheet without amortisation as non-current liability like ‘liability for deferred tax’ or other liabilities which are not termed as “financial liability”.

10. I would also like to add that IAS-39 was first issued in March 1999 and since then has been considered as one of the most complex and controversial standards ever issued by IAS Board. In view of the complexity this standard has been revised numerous times since then and in many countries in the world has still not been implemented. Even in Pakistan the financial institutions (i.e. banks, insurance companies etc.) which are most resourceful with respect to technical support have not been obliged to enforce it due to lot of contagious issues. It is therefore suggested that one should avoid unnecessary innovative interpretations of the standards related to financial instruments, particularly when in fact there is no actual or legal financial impact.

Moreover Pakistan is an Islamic Country and under the constitution it is obliged to follow the principles of Islam and anything which is in conflict is against the Constitution. Therefore forcing some-one to take interest against his will, even if it is called “notional interest” is against Islam and the Constitution of Pakistan. ICAP realises this and has therefore constituted a committee to make Sharia Compliant Islamic Accounting Standards which are being implemented through SECP.

11. I believe my letter would receive due consideration by the Committe and the office would help them to resolve existing and future controversies in the best interest of the ICAP, members, profession and industry.

Opinion:

The Committee considered your enquiry and would like to draw your attention to the following paragraphs of IAS 32 ‘Financial Instruments: Presentation’:

11 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.

A financial liability is 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; orat will or may be settled in the entity’s own equity instruments……..

19   If an entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the obligation meets the definition of a financial liability, except for those instruments classified as equity instruments in accordance with paragraphs 16A and 16B or paragraphs 16C and 16D. For example:

(a) a restriction on the ability of an entity to satisfy a contractual obligation, such as lack of access to foreign currency or the need to obtain approval for payment from a regulatory authority, does not negate the entity’s contractual obligation or the holder’s contractual right under the instrument.

(b) a contractual obligation that is conditional on a counter party exercising its right to redeem is a financial liability because the entity does not have the unconditional right to avoid delivering cash or another financial asset.

20   A financial instrument that does not explicitly establish a contractual obligation to deliver cash or another financial asset may establish an obligation indirectly through its terms and conditions………………

A financial instrument will be a financial liability, where it contains an obligation to repay. Para 47 of IAS 39 ‘Financial Instruments: Recognition and Measurement’ recognises two classes of financial liabilities:

• Financial liabilities at fair value through profit or loss

• Other financial liabilities measured at amortised cost using the effective interest method.

Some of the examples of financial liabilities are trade payables, loans from other entities, and debt instruments issued by the entity. IAS 39 requires recognition of a financial asset or a financial liability when, and only when, the entity becomes a party to the contractual provisions of the instrument [IAS 39.14]. Following relevant features need to be considered when classifying a financial instrument as liability:

• The instrument is a liability if the issuer can or will be forced to redeem the instrument.
• The instrument is a liability if the choice of settling a financial instrument in cash or otherwise is contingent on the outcome of circumstances beyond the control of both the issuer and the holder, as the issuer does not have an unconditional right to avoid settlement.
• An instrument is a liability if it includes an option for the holder to put the rights inherent in that instrument back to the issuer for cash or another financial instrument.

AG64 and AG65 of IAS 39 give recognition of interest free long-term loan. Interest free loans or below-market rate of interest are commonly made between entities in a group on a non-arm’s length terms and/or made with no stated date for repayment. The fair value of such loans is not usually the same as the loan amount, and IAS 39 requires both parties to initially record the liability at fair value.

Where intercompany loans are made on normal commercial terms, no specific accounting issues arise and the fair value at inception will usually equal the loan amount. However, where the loan is not on normal commercial terms that is interest free, the required accounting depends on the terms, conditions and circumstances of the loan. It is therefore necessary to ascertain the terms and conditions, which may not be immediately apparent if the loan documentation is not comprehensive.

The Committee understands that the Contract Act, 1872 at its own does not specifically require a contract to be in writing and nowhere mentions that any unwritten agreement will not be enforceable under law and deemed as a contract. Due to this, verbal and implied agreements create contractual obligations. It is pertinent to note that IAS 32 also does not put a condition that contractual obligation must be evidenced by a written or registered contract.

The above is also supported from statutory requirements contained in Sections 196, 214 to 216, and 218 to 219 of the Companies Ordinance, 1984 (the Ordinance) in case loan is borrowed from a director. Discussion of proposed loan/ borrowing in the board’s meeting, due deliberations regarding objectives and usability of such loan / borrowing and the resolution passed by the Board to approve such loan / borrowing also establishes the contractual obligations. Though many times, repayment terms and conditions are not defined but at one point or the other these would be defined and it does not change the substance as well the legal form of the transaction. It is important to note that where no repayment period is defined and loan is dependent on the entity’s ability to repay (or payable on demand) it becomes current liability of the borrower.

The Committee believes that the directors’ interest in the entity is the consideration of loan. The director gives interest free loan to the company with the intention to support or improve the liquidity position of the company or as share deposit. In future, when the company’s financial position improves, the director ultimately earns the return in the form of good dividend or capital gain. So the intent and consideration elements both exist, therefore, the Committee does not agree with your views that these two elements of contract as defined in Contract Act are missing.

With regard to your views that directors interest free loans payable at the discretion/convenience of the company is a “Qaraz e Hassna”, the Committee is of the view that the term “Qaraz” in itself reflect liability of the borrower and “Qaraz e Hasana” also reflects intention of lender to recover subject to ability of borrower to repay. The existence of contract to borrow and repay is reflected by entity’s own actions where the company records the sum obtained as liability and if that is not correct the person giving the sum can correct that mistake and then such sum given and obtained would become grant.

The classification of liabilities is covered in para 69 of IAS 1 which requires that a liability should be classified as current and one of the conditions for classification as current include when the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. The comment in the QAB annual report related to classification of liabilities with uncertain repayment terms and was based on the guidance given in IAS 1. The comment in the QAB report did not require use of any assumed market rate or assumed period of repayment.

Based on above, the Committee is of the view that loans including inter-company interest free loans meet the definition of financial instruments and come within the scope of IAS – 39 and also establishes binding contract between a director and company.