Audit and Technical Partner Leavitt Walmsley Associates Ltd
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FRS 102: Intra-group loans

2nd Apr 2015
Audit and Technical Partner Leavitt Walmsley Associates Ltd
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FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland has now come into mandatory effect for accounting periods commencing on or after 1 January 2015. 

A new financial regime such as FRS 102 brings with it new ways of accounting for certain transactions and events. One of several emerging issues which many in the profession are asking about is the subject of intra-group loans.

Overview of financial instruments in FRS 102

A loan is a financial instrument.  Financial instruments are dealt with in FRS 102 at Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues.  Basic financial instruments can include:

  • Trade debtors
  • Trade creditors
  • Share capital
  • Basic bank and other loans

Section 12 deals with the more complex financial instruments including:

  • Options
  • Swaps
  • Forward contracts
  • Futures contracts
  • Loans with complex features

The issue of intra-group loans becomes more complex under the provisions of FRS 102 and for the purposes of this article the assumption is made that intra-group loans are those which fall to be classed as ‘basic’ financial instruments.

Intra-group loans

Many groups enter into intra-group loans for a variety of reasons, some because of convenience (the group member may require finance at a relatively short period of notice and hence the parent, or another group member, may provide that finance quicker than, say, a bank). 

Another reason may be that the group member is unable to secure finance because of a bad credit-rating, or may already have existing borrowings and the bank may want to charge a higher rate of interest to reflect the increased risk and the group may not be willing to accept this and hence another group member may provide the loan.

Whatever the reason for group members entering into intra-group loans, the accounting for such loans will need to be made in the individual financial statements of both the lender and borrower. Where consolidated financial statements are prepared, the intra-group loan (and interest charges) will, of course, be eliminated on consolidation. 

This article considers intra-group loans which are considered to be long-term. Under the provisions contained in FRS 4 Capital instruments, the issue of intra-group loans is quite straightforward; the borrower will recognise a creditor at the amount payable and the lender will recognise a corresponding debtor. 

The only complicated part about this treatment is that the lender will consider the amount recognised as a debtor at each balance sheet date for impairment and, where evidence of impairment exists, the lender will write-down the debtor to recoverable amount. The difference with FRS 102 is that Section 11 requires the amortised cost method to be applied in accounting for the loan.

Intra-group loans under FRS 102 principles

The first thing to point out where intra-group trading is concerned is that there will not normally be an issue with short-term intra-group trade debtors and trade creditors. 

This is because these are normally recognised in the individual financial statements at undiscounted invoice amount. But where payment is deferred beyond normal trading terms, these will become financing transactions and paragraph 11.13 requires such transactions to be recognised at the present value of the future payments which are discounted at a market rate of interest.

For long-term intra-group loans there are two issues to consider:

  • Is there a rate of interest being charged on the loan?
  • If there is, is the interest rate at market rate?

Problems will emerge where loans are charged at zero rates of interest, or interest rates which are below market rates. 

This is because in such cases measurement differences will arise on initial recognition of the loans at fair value in both the lending group member and the borrowing group member (see next section). To avoid measurement differences the client should be advised to charge market rates of interest, or, alternatively include provisions in the loan agreement that the lender can demand repayment at a very short notice period. 

Including repayment terms at a very short notice period could potentially get around the issue of measurement differences because the loan which is repayable on demand will then be recorded in the borrower’s books at not less than the amount repayable so as to recognise the immediate demand feature of the loan. 

However, this may not necessarily get around all measurement differences (particularly for the lender) because even if the loan is repayable on demand, immediate repayment may not be possible as the funds could be tied up and take time to be released.

Example – Intra-group loan at market rates

A parent company agrees to a five-year working capital loan for its wholly-owned subsidiary.  The loan terms say that a market rate of interest will be charged on the intra-group loan.

Where a market rate of interest is charged by the lending company, there will not be any complex accounting issues that arise because the transaction price (i.e. the loan proceeds) will reflect fair value.  The parent company would, however, need to test the intra-group debtor at each reporting date for impairment.

Obtaining a market rate of interest for a company will depend on various factors, such as the duration of the loan, the type of security pledged (if any), the company’s gearing and credit risk and interest basis. 

A market rate of interest for a company could be the rate of interest which the company’s bank would charge on an equivalent loan. 

Hence, if the company was already highly geared and had relatively few (or no) assets which it could pledge as security, market rates of interest would be higher to reflect the higher risk. Conversely, a company that had lower gearing levels and had assets available which it could pledge as security would receive a lower market rate of interest.

Measurement differences

Although a basic intra-group loan under FRS 102 principles is initially recorded at fair value, Section 11 requires the ‘amortised cost’ method to be applied and this is where measurement differences will arise on a loan that is below market rate.  In the following examples it is assumed that the loan does not contain any demand features (it is merely a fixed-term loan).

Example – Measurement difference

A parent company agrees to provide a loan to its subsidiary for £20,000 on 1 January 2015.  The loan is repayable on 31 December 2016.  Market rates of interest are 5% but the parent agrees to an interest rate at 2%. 

Under FRS 102 principles, the first step is to discount the cash flows to present day values as follows:

Year            Cash flow            Discount factor at 5%            Present value

                            £                                                                                  £

2015                400                                0.952                                    381

2016          20,400                                0.907                               18,503

                                                                                                        18,884

The £400 is calculated as the interest rate charged by the parent on the loan of £20,000 (hence £20,000 x 2% = £400).  In 2016, another year’s worth of interest will be charged plus the redemption amount of £20,000.

A measurement difference has arisen on the fair value of the loan proceeds (£20,000) and the present value of the future cash flows (£18,884).                      

The measurement difference in the example above amounts to £1,116 (£20,000 less £18,884). 

Because Section 11 uses the amortised cost method to account for the intra-group loan the question arises as to where to take this initial measurement difference in the individual books of both the lender (in this case the parent) and the borrower (the subsidiary).

In the parent’s books, the measurement difference is debited to the cost of the investment in the subsidiary.  This reflects the fact that the parent has contributed to the subsidiary by giving them a loan at less than market rates of interest and hence the journals will be:

Debit loan debtor (balance sheet of parent) £18,884Debit investment in subsidiary                           £1,116

Credit cash at bank                                             £20,000

Being initial recognition of intra-group loan to subsidiary

In the subsidiary’s books, the measurement difference is credited to equity (capital contribution), again to reflect the fact that its parent has contributed to the subsidiary by providing loan at less than market rates, hence the journals in the subsidiary’s books will be:

Debit cash at bank (balance sheet of sub)     £20,000Credit loan creditor                                            £18,884

Credit capital contribution                                  £1,116

Being initial recognition of intra-group loan from parent

Allocating the interest

Once the loan’s initial recognition has taken place, the next step is then to allocate the interest to the profit and loss account.  The interest charge in the profit and loss account will reflect the market rate of interest and will be charged as follows:

Year            Opening balance            Interest (5%)            Cash flow            Closing balance                                  £                                      £                             £                                £

2015                     18,884                             944                        (400)                        19,428

2016                     19,428                             972                  (20,400)                                   -

Journals in the parent’s books:

2015

Debit cash at bank                                      400

Debit loan debtor                                       544

Credit interest income (P&L)                  (944)

Being interest income on loan to subsidiary in 2015

2016

Debit cash at bank                                    400

Debit loan debtor                                     572

Credit interest income (P&L)                (972)

Being interest income on loan to subsidiary in 2016

Debit cash at bank                              20,000

Credit loan debtor                             (20,000)

Being redemption of loan

Journals in the subsidiary’s books:

2015

Debit interest expense                           944

Credit cash at bank                                (400)

Credit loan payable                               (544)

Being interest charge on loan from parent in 2015

2016

Debit interest expense                          972

Credit cash at bank                               (400)

Credit loan payable                              (572)

Being interest charge on loan from parent in 2016

Debit loan creditor                           20,000

Credit cash at bank                         (20,000)

Being redemption of loan

As can be seen in the illustration above, measurement differences can cause additional complexities.  With regard to any subsequent adjustment of the cost of the investment in the parent and corresponding capital contribution in the subsidiary arising from the measurement difference, companies could choose to write off the additional cost of the investment so as to match the unwinding discount passing through profit or loss and then adjust the capital contribution in the subsidiary via a movement on reserves.  Alternatively they may choose to leave the measurement difference within the cost of the investment and corresponding capital contribution and deal with any write-down as part of an impairment adjustment.

Loan from subsidiary to parent

It is not always the case that a parent will enter into a loan with a subsidiary – the reverse can apply.  Where a subsidiary makes an intra-group loan to the parent which is below market rate the following will apply in the individual company’s books (assuming a fixed-term loan with no demand features):

Subsidiary is the lender

The subsidiary recognises the loan at fair value and the measurement difference is treated as a distribution to the parent, hence the journals are:

  • Debit intra-group debtor (present value of loan)
  • Debit dividends paid (measurement difference)
  • Credit cash at bank (loan proceeds)

Parent is the borrower

The parent also recognises the loan at fair value and the measurement difference is treated as income received from the subsidiary, hence the journals are:

  • Debit cash at bank (loan proceeds)
  • Credit intra-group creditor (present value of loan)
  • Credit income from subsidiary (measurement difference)

The above accounting treatment recognises that the subsidiary has contributed to the parent by way of a below market rate loan with the measurement difference being a dividend to the parent.  Interest charges/income will be accounted for in the same way as the example above (although the subsidiary will recognise the interest income and the parent the interest expense). 

Subsidiary to subsidiary

Parent companies do not necessarily have to be a party to an intra-group loan transaction; intra-group loans can arise between subsidiary companies and where intra-group loans arise between subsidiaries at below market rates, the following will apply in the individual subsidiary’s books (again assuming a fixed-term loan with no demand features):

Lender

The lending subsidiary recognises the loan at fair value and the measurement difference is recognised within interest expense, hence the journals are:

  • Debit intra-group debtor (present value of loan)
  • Debit interest expense (measurement difference)
  • Credit cash at bank (loan proceeds)

Borrower

The borrowing subsidiary recognises the loan at fair value and the measurement difference is recognised as interest income, hence the journals are:

  • Debit cash at bank (loan proceeds)
  • Credit intra-group creditor (present value of loan)
  • Credit interest income (measurement difference)

Care must be taken, however, where loans between subsidiaries are concerned because the parent company could instruct the lending subsidiary to recognise the measurement difference as a distribution and the borrowing subsidiary to recognise the measurement difference as a capital contribution.  If the parent does not instruct such accounting treatments, the default will be to recognise an interest expense in the books of the lending subsidiary for the measurement difference and a corresponding interest income in the borrowing subsidiary.

Planning point

Where you have a client that is about to enter into an intra-group loan, it is worthwhile advising the lender to charge a market rate of interest to overcome measurement differences.  In addition, accounting complexities may also be potentially eradicated by making provisions in the loan agreement to demand repayment at a very short notice period.  The fair value of an on-demand financial liability will not be less than the amount payable on demand (paragraph 12.11 of FRS 102).  Initial measurement differences may, however, arise where the lender might not get immediate repayment on demand and the borrower has to be given time to get the funds in (i.e. where they have already been invested by the borrower).

Conclusion

The issue concerning intra-group loans is clearly going to cause more complexities in FRS 102 than was the case under previous UK GAAP and therefore thought should be given as to how best to advise clients that are group companies to ensure the correct accounting treatment in the individual accounts of the parent and subsidiaries are applied and understanding how the amortised cost method works within FRS 102.  Existing loan terms cannot be changed retrospectively and hence any amendments needed to existing loan terms should be made before the date of transition. 

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Replies (15)

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By Ayesha Bham
02nd Apr 2015 19:47

Amortised cost
Whilst I can understand how this illustrates the method we "have" to adopt I completely don't agree with it at all. Steve I attended a course you were lecturing on a couple of weeks ago and expressed my frustration (admittedly a little too much for which I apologised) at you but I cannot for the life of me understand why we are being forced into this.
I stand by my defence in that my clients won't pay me to do this extra legwork so I am going to carry on regardless with what I have done for the last 30+ years. It's going to take inordinate amounts of time to even start recalculating these things.
Retirement cannot come quick enough.

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Replying to johngroganjga:
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By SDGREEN
03rd Apr 2015 18:42

Got to agree with Ayesha
Its just a nonsense

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By Stuart.thomson
06th Apr 2015 10:19

Personally I agree completely with Ayesha.

This is just wasting time for little value. So a loan to a sub below market value is an increased investment in the sub. Really? So what if the group chairman gives some free advice to the staff at the team. Is that similarly an increased investment. No doubt step two will be to value free advice at market value and so strip out the value for the parents benefit without needing a dividend!

Many companies are manipulating their books through non-market interest but this is for major corporations who have cross border tax advantageous (if they can still use them!). Small groups won't want this and won't appreciate it. It is another layer of red tape on the small business.

I am minded to skip it or at least tell clients that only short term loans,frequently rolled over , should be used as it reduces market rate interest to (hopefully) whatever you charge. The taxman has always insisted on market rate anyway given the connected nature anyway.

Whatever next!

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By Ayesha Bham
06th Apr 2015 22:02

Problem is
When I questioned this with my professional body technical helpline they completely agreed with this treatment and went as far as saying that if we didn't comply with these standards we'd be producing negligent accounts.
I still say that it's wrong and there's nothing that should change for small companies. I'm thinking of resigning my professional body membership as we don't do any audits now and this whole FRS 102 lark is just another nail in the coffin.

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By Michael Norton
07th Apr 2015 12:40

Intra-group loans

Agree with all the comments. There is nothing in these requirements under FRS 102 that will provide SME owner/managers with information that will help them improve the performance of their businesses. What there is instead is confusion and additional cost. In other words the total opposite of what the owner/manager of an SME needs  

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By Michael Norton
07th Apr 2015 14:20

frs102

Wasn't there supposed to be a reduced disclosure frs102 for small companies - less than £10.2m turnover and £5.1m assets? Would these provisions be excluded or included?

 

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By AndrewV12
08th Apr 2015 09:09

Blimey its complicated

There is a lot to take on board, just looking at the article, when i read the following, I cannot but think the seeds of the next Banking crisis have already been sown, I know the following have been around years, but just reading their names frightens me.

 

Section 12 deals with the more complex financial instruments including:

OptionsSwapsForward contractsFutures contractsLoans with complex features

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By Greenslades
08th Apr 2015 11:15

FRS102

I agree with all the comments so far.  A complete waste of time for  90% of all companies and 99.9% of SME's.

What are our professional bodies thinking about?  For those of us old enough to remember the proposals on inflation accounting that ended going nowhere (after years of effort)  this just looks like a bad dream that should have been consigned to the dustbin.

 

I concede there is a case for financial enterprises of significant size, but from contact with friends running modest financial institutions they are effectively now going to keep 2 sets of books .- one conventional set to run the business by in traditional format a second parallel set solely for reporting.  Whoever put this together  needs throwing out of their professional  institute - its that bad!

 

 

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By Laurahenry
08th Apr 2015 17:34

Overdrawn director loan accounts

Has anyone thought about the implications in relation to overdrawn director loan account balances?

If we need to present value loans back under the new requirements, could this be a planning opportunityto help in reducing S455 liability going forward?

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By 4aterr1ers
17th Apr 2015 17:18

FRS 102


Completely agree with the earlier comments. I see that a lot of small companies currently using FRSSE will have to operate FRS 102 because they are above the Micro company threshold - simplification or what ?

It is just a load of twaddle (polite wording), and means absolutely nothing to sme owners, indeed they will just look at us as if we've lost our marbles - a loan of £50,000 to go on the accounts at say £48,999, or some other fictitious value; I'm sure that makes no sense to the client or to the bank or to HMRC.

No doubt some will say that it puts "real" value into the balance sheet, but it doesn't - because different people will use different discount rates, and no-one will consider inflation anyway.

I've tried explaining to one client who enters into forward currency contracts to fund the purchase of materials bought in US $, and explained how the accounts will have to reflect spot rates for the derivative contract at the year end instead of the contract rate - his expression was priceless !

Let us at least prepare accounts that the we, the client, the bank and the taxman understand.

 

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By Ayesha Bham
17th Apr 2015 17:39

Small clients
I totally agree - small clients are not going to know what's happened to us! not only that but they are not going to pay us! Will our professional bodies knock some money off our subs for all this extra work we are going to have to do because of their new rules. Hardly likely!
I am certainly not renewing my membership after this year and will continue preparing accounts that mean something to my clients! FRS 102? What's FRS 102?

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By ian.dandiwalton.co.uk
22nd Jun 2015 21:27

Substance over form?

Steve makes the point that a loan technically repayable on demand should be carried at "cost" rather than fair value - an approach supported by ICAEW guidance. ICAEW go further, stating that where no repayment terms are set out, loans are to be treated as repayable on demand and classified as creditors due within one year.  I foresee a significant number of loans being reclassified as due within one year once FRS 102 is adopted. Even where both parties know that the loan will still be outstanding in 12 months' time we are told that the correct classification is "due within one year", because legally the loan is repayable on demand.

However, FRS 102, para.2.8 firmly restates the concept of "substance over form".  For many years we have happily brought leased assets onto the balance sheet knowing full well that the entity will never actually own them, because that reflected the substance of the transaction.

Now, however, we are told that a loan must be classified as "due within one year" because that is its legal form, even if its substance is something different.  This is inconsistent at best.  At worst, the results are misleading or meaningless.

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By DilenV
16th Nov 2017 11:07

So who decides what market interest rate is and how readily available is this information to perform the calculations? I have been searching for this information and the guidance is pretty vague. The hassle you have to go through to shop around market interest rate is unbelievable and an utter waste of time. Might as well just estimate a figure...which has a high probability of being wrong anyway!

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By MBCC
23rd Aug 2018 22:03

Hi,

Just to reignite this one!

If a non EU company issued an interest free loan to a UK subsidiary (owns 75%) would the above treatment still apply?

Thanks

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By davidbrewster
28th Oct 2018 10:41

A company with two equal shareholders. One shareholder lends working capital but the other does not. Both shareholders agree an interest rate but agree that interest will be forward applied only in the event of winding up the company or one or other share buy outs. Question under FRS 102 need the forward interest be applied to Profit/Loss at the end of annual reporting periods in the interim?

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