Directors’ loans under FRS 102
The treatment of directors’ loans under FRS 102 still causes an element of confusion for some practitioners and was an area which was amended as part of the Financial Reporting Council’s triennial review of UK GAAP.
Steve Collings addresses some of the areas causing confusion where such loans are concerned.
Company law disclosures
At the outset, it is worth noting that section 413 of the Companies Act 2006 requires information about directors’ advances, credit and guarantees. The details required of an advance or credit are:
- its amount;
- an indication of the interest rate;
- its main conditions;
- any amounts repaid;
- any amounts written off; and
- any amounts waived.
The details required of a guarantee are:
- its main terms;
- the amount of the maximum liability that may be incurred by the company (or its subsidiary); and
- any amount paid and any liability incurred by the company (or its subsidiary) for the purpose of fulfilling the guarantee (including any loss incurred by reason of enforcement of the guarantee).
Directors’ loans to a small company
The FRC made amendments to FRS 102, Section 11 Basic Financial Instruments as part of the triennial review of UK GAAP. While the majority of the triennial review amendments apply mandatorily for accounting periods commencing on or after 1 January 2019, this particular amendment is available for early adoption separately without having to early adopt FRS 102 (March 2018).
The amendment provides an exemption for small companies and LLPs only which allows such entities to measure loans from a director, or their group of close family members when that group contains at least one shareholder at transaction price instead of imputing a market rate of interest and measuring the loan at present value. FRS 102, paragraph 11.13A states:
|As an exception to paragraph 11.13, the following financing transactions may be measured initially at transaction price:
A loan from a director who is not a shareholder, and has no close family members that are shareholders, will not qualify for the exemption.
In a lot of cases, a director’s loan (whether it be to or from the company) may not be formally structured with loan terms. In these instances, the loan will be repayable on demand and hence must be presented as a current asset or current liability at (typically) their nominal value.
Related party disclosure requirements
Small companies applying the disclosure requirements in FRS 102, Section 1A Small Entities are only required to provide particulars of material transactions with directors which have not been concluded under normal market conditions. Where a material loan from a director has been provided to the small entity at, say, a below market rate of interest or interest free, the loan will be caught by the related party disclosure requirements in FRS 102, paragraph 1AC.35 and the related party disclosures must include:
- the amount of the transaction;
- the nature of the related party relationship (the names of the transacting related parties need not be disclosed as FRS 102 only requires the nature of the related party relationship); and
- other information regarding the transaction necessary for an understanding of the financial position of the entity.
Structured loans (non-small entity)
Where a loan has been provided at below market rates of interest, or at zero rates of interest, FRS 102 would normally require the loan to be initially recorded at the present value of the future payments discounted at a market rate of interest for a similar debt instrument and subsequently measured at amortised cost under FRS 102, Section 11.
In these circumstances, it will be necessary to impute a market rate of interest and discount the loan to present value as shown in the following example:
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Example: Loan containing formal terms
On 1 January 2018, a medium-sized company provides an interest-free loan to a director-shareholder of £50,000. The terms of the loan state that the loan is repayable in three years. The market rate of interest for a similar loan is 7%.
Under Section 11 of FRS 102, the amortised cost method is applied. The loan is initially recognised in the company’s books at its present value of £40,815 (£50,000 / 1.073). The loan is then profiled as follows:
|Interest at 7%
The double entry is as follows:
On inception of the loan
Dr Loan debtor 40,815
Dr Distribution (equity – see below) 9,185
Cr Bank 50,000
Being initial recognition of loan
End of 2018
Dr Loan debtor 2,857
Cr Interest income 2,857
Being interest income under the amortised cost method
The same entries apply for the interest income of £3,057 in 2019 and £3,271 in 2020.
Redemption in 2020
Dr Bank 50,000
Cr Loan debtor 50,000
Being repayment of loan
The measurement difference of £9,185 is taken to equity as a distribution. TECH 02/17BL at paragraph 2.6A states that an undervalue transaction with a shareholder is capable of being a distribution because it involves in substance an element of gift to the transferee. In other words, the director is benefiting by receiving a loan at a rate of interest which is below market rate.
However, TECH 02/17BL, paragraph 2.6A then goes on to confirm that the state of mind of those orchestrating an undervalue transaction may be relevant. In this respect, the company may wish to seek legal advice.
Interest free loan to the company
If the loan in the example above was the other way around (i.e. a loan to the company from the director-shareholder), the measurement difference would be credited equity, i.e.:
Dr Bank 50,000
Cr Capital contribution (equity) 9,185
Cr Loan payable 40,815
TECH 02/17BL states that the credit to equity and the interest expense are not realised profits or losses. The capital contribution could be taken to either retained profits or a separate component of equity (a capital contribution reserve). If a separate capital contribution reserve is used, the company might wish to make an annual transfer from the capital contribution reserve to retained earnings (profit and loss reserves) of an amount equal to the interest expense recognised under the amortised cost method, but this is not required by FRS 102.
Care must be taken with the application of FRS 102, paragraph 11.13A because it only relates to loans from a director to a small company/LLP (or from a group of the director’s close family members when that group contains at least one shareholder). It is not the other way around (i.e. loan from the company to the director) nor does the exemption apply to intra-group loans.
In other cases, it will be necessary to impute a market rate of interest and discount the loan to present value. FRS 102 is silent on how the difference between the nominal value and the present value should be accounted for. However, in most cases the application of the amortised cost method will see the measurement difference unwinding through profit and loss as a finance charge (finance income) over the life of the loan.
Steve Collings, FMAAT FCCA is the audit and technical partner at Leavitt Walmsley Associates Ltd where Steve trained and qualified.