Enquiry:

As per lAS 39 Para 39, limited companies have to amortize the director loan over a period of repayment thereof. Please note that most of our client’s director’s loan repayment period is undeterminable. The loans are interest free. Additionally the clients are also not ready to amortize their loan from directors.

This will attract income tax. Some of the loans are subordinated with banks. The loans are given by the sponsors /directors to tide over the liquidity position of the company. Banks are not ready to advance such loan.

We are facing the following limitation in accruing the director’s loan.

Company is not able to repay the loan
Client income will be liable to income tax.
Disclosure of repayment as per ISA 39 Para 9 will have significant impact on Financial Statement.
Please advise on the following:

What steps should we take if the client refuses to amortize the directors/sponsors loan?
What time period does amortization of the directors loan needs to be carried out?
Please guide how the amount should be disclosed in the accounts when the loan relates to more than 10 years and payable when able. In actual fact it is not repayable by the company.

Under the Companies Ordinance, 1984 company can’t hold share application money for indefinite period.

Opinion: The Committee 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; or

(b) a contract that 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 counterparty 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:

1. Financial liabilities at fair value through profit or loss
2. Other financial liabilities measured at amortised cost using the effective interest method.

Loans are within the scope of IAS 39 and complications arise if they are not on arm’s length terms. Loans/ advances to or from related parties fall under the definition of financial instruments and are required to be dealt with as per the requirements of paragraphs 45 to 47 and AG64 to AG66 of IAS 39. 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).

AG64 and AG65 of IAS 39 give recognition of interest free long-term loan. Interest free loans are commonly made between entities in a group or a loan given by directors to company on a non-arm’s length terms and/ or made with no stated date for repayment. In this case, 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. 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.

Inter-company loans also meet the definition of related party transactions in IAS 24.9 and the disclosures required by IAS 24.12-22 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.

The Committee understands that 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 as 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. In such cases, it will be necessary for management to determine the appropriate accounting based on the expected timing of repayments.

Para 69 of IAS 1 explains the classification of liabilities 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.

However, if the loan is of long term nature then there should be a loan covenant and in that case, the loan will be stated at amortized cost in accordance with the requirements of IAS 39.

With regard to your specific queries, the Committee response is as follows:

1. The auditor’s opinion whether or not to qualify audit report will be based upon the evidence obtained during the audit. The Committee is of the view that if the client refuses to amortize the director’s loan then the auditor will have to analyze the evidences obtained and should form an appropriate opinion considering the compliance of respective IFRSs and the requirements of ISAs.

2. It depends on repayment terms and conditions of loan. If there is no repayment term then loan should be classified as short term.

3. When the loan relates to more than 10 years and it is certain that company will be unable to pay it or repayment is indeterminable then it would be classified as a liability.

4. For share deposit money, the Committee would like to refer its Selected Opinion No. 1.4 of ‘Volume XVI on ‘clarification on share deposit money’ which addresses your issue.

(August 21, 2015)