FRS 102: Loans between related parties

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FRS 102 has now kicked in for accounting periods commencing on or after 1 January 2015 and will apply to small companies on or after 1 January 2016 with earlier adoption permissible.

A controversial issue which has arisen is the way that Section 11 Basic Financial Instruments works – particularly with loans entered into at below market rates of interest.

This is likely to affect intra-group loans which are commonly entered into between small and medium-sized groups as well as loans entered into between companies under common control and directors’ loans.

A separate article on intra-group loans was published illustrating how such loans should be accounted for under the provisions in Section 11. This article considers the accounting aspects of loans entered into between other related parties (including directors’ loans). Any associated tax implications for both the company and the individuals have been ignored but will need to be considered in practice.

Loans between companies owned and controlled by the same individual

Many companies are owned by the same individual but are not part of a group; however the companies become related parties on the grounds that they are both owned and controlled by the same individual.

In such setups, it is not uncommon for loans to take place between those individual companies – sometimes for simplicity but also because the company receiving the loan may have struggled to obtain finance from its bank for a variety of reasons.  Likewise with group structures, the owner may stipulate that the loan is either interest-free or the interest charged on the loan may be at below market rates. 

Where the loan is interest free, or is at a rate which is below market rates, a measurement difference will arise because of the way that the accounting for such loans under FRS 102 works. 

The measurement difference is the difference between the present value of the loan and the fair value of the loan (i.e. the proceeds) on initial recognition.  This is because Section 11 uses the amortised cost method of accounting for such loans which, in turn, uses the effective interest rate. 

This can be illustrated by the following example:

Lisa owns 100% of the shares in both North Ltd and South Ltd which both have an accounting reference date of 31 December.  Both companies are not members of the same group but are related to each other on the basis that they are owned and controlled by the same person. 

On 1 January 2015 North Ltd provides a loan to South Ltd amounting to £20,000.  The loan is repayable on 31 December 2016.  Lisa has stipulated that the loan is interest-free and if South Ltd were to obtain a similar loan from its bank an interest rate of 5% would be charged. 

This loan would fall to be classed as a basic loan and hence accounted for under the provisions in Section 11 of FRS 102 using the amortised cost method.  The accounting for this loan under Section 11 is as follows:

Step 1 – Discount the loan to present value using a market rate of 5%

Therefore £20,000 / 1.052 = £18,141

Step 2 – Calculate and account for the measurement difference

The measurement difference is the difference between the present value of the loan (£18,141) and the fair value of the loan proceeds (£20,000) which is £1,859.  This difference represents the benefit which South (the borrowing company) is receiving by being provided with an interest-free loan.  Under FRS 102 principles this benefit has to be reflected in both sets of books.

In substance South has received a capital contribution from its owner and North has made a distribution to its owner because the loan has been entered into on instructions from the owner.  Hence the journals to initially recognise this loan are as follows:

In the books of North Ltd:

       

DR loan debtor

 

18,141

DR distribution (equity)

 

1,859

CR cash at bank

 

(20,000)

Being loan to South Ltd

   

In the books of South Ltd:

       

DR cash at bank

 

20,000

CR loan creditor

 

(18,141)

CR capital contribution (equity)

(1,859)

Being loan from North Ltd

   

Step 3 – Allocate the interest

The amortised cost method in Section 11 requires the effective interest rate to be calculated and charged to profit or loss over the life of the loan.  This is illustrated as follows:

 

Opening

Interest

Cash

Closing

Year

balance

at 5%

flow

balance

         

31.12.2015

18,141

907

-

19,048

31.12.2016

19,048

952

(20,000)

-

The journals in the books of each company are as follows:

North Ltd:

       

DR loan debtor

 

907

CR interest income

 

(907)

Interest income on loan 31.12.15

 
       

DR loan debtor

 

952

CR interest income

 

(952)

Interest income on loan 31.12.16

 
       

DR cash at bank

 

20,000

CR loan debtor

 

(20,000)

Redemption of loan from South

 

South Ltd:

       

DR interest expense

 

907

CR loan creditor

 

(907)

Interest charge on loan 31.12.15

 
       

DR interest expense

 

952

CR loan creditor

 

(952)

Interest charge on loan 31.12.16

 
       

DR loan creditor

 

20,000

CR cash at bank

 

(20,000)

Repayment of loan to North

 

Care must be taken where distributions are concerned (as in the example above where North Ltd has taken the measurement difference to distributions in equity).  This is because the distribution may not necessarily be a distribution for legal purposes and in some cases it might be worth seeking legal advice where the company does not have any (or sufficient) distributable reserves.

Directors’ loans

Where directors’ loans are concerned, these will also require additional consideration where they are either interest free or at below market rates of interest. This is because they will also be accounted for under the provisions in Section 11 using the amortised cost method.

This can be illustrated as follows:

Example – Loan from a director

Lucas is a director of East Ltd and owns 100% of the ordinary share capital.  East has an accounting reference date of 31 December each year and on 1 January 2015 Lucas made an interest-free loan of £20,000 to the company which is repayable on 31 December 2016.  Market rates of interest on a similar loan would be 5%.  A measurement difference would arise amounting to £1,859 (£20,000 / 1.052 less £20,000) and hence the journals in this scenario would be:

     

  

DR cash at bank

 

20,000

CR director's current account

 

                            (18,141)

CR capital contribution (equity)

   (1,859)

Being loan from director

   

The measurement difference is taken to equity as a capital contribution on the basis that the company has received an additional benefit by the director-shareholder providing it with an interest-free loan. 

Example – Loan to a director

Using the same facts as above, but now consider that the company provides Lucas with a £20,000 loan.  In this reversed scenario the director-shareholder is receiving an additional benefit by being provided with an interest-free loan from the company and so the journals will be:

       

DR director's current account

18,141

DR distribution to owner (equity)

1,859

CR cash at bank

 

(20,000)

Being loan to director

   

Again, care should be taken where the company may not have sufficient (or any) distributable reserves because the accounting requirements under Section 11 for such loans will now draw more attention to the distribution and hence legal advice may need to be sought in some situations. 

It is often the case that a director may not necessarily be a shareholder, but a measurement difference will still arise on an interest-free or below market rate loan.

Example – Loan to a director who is not a shareholder

Sarah is a director of West Ltd but does not own any shares.  The majority shareholder agrees to provide Sarah with a £20,000 interest-free loan to put towards the deposit on a house.  The loan is repayable in two years’ time.  Sarah would be charged 5% on an equivalent loan from her bank. 

A measurement difference arises (as in the previous examples) of £1,859 (£20,000 / 1.052 less £20,000).  This difference is accounted for as interest income. 

Conclusion

Accounting for loans among related parties is going to be more complicated under the provisions of FRS 102 because such loans are deemed to be financing transactions under Section 11.

These sorts of financing transactions have to be measured at the present value of the future payments which are discounted at a market rate of interest for a similar sort of loan with interest being calculated using the effective interest method. 

A potential way to avoid measurement differences would be to make such loans repayable on demand and recognise them as current assets/liabilities in the balance sheet or to charge market rates of interest.

Where this is not an option, or not the case, and such loans are provided either interest-free or at below market rates then measurement differences will arise which need to be accounted for under the new UK GAAP.

About Steven Collings

collings

Steve Collings, FMAAT FCCA is the audit and technical partner at Leavitt Walmsley Associates Ltd where Steve trained and qualified.

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02nd Jul 2015 07:55

But surely it is very rare indeed for loans between entities under common control, or between entities and their controllers to have fixed repayment dates. Whether any agreement as to fixed repayment dates in those circumstances should be taken any notice of is also a moot point.

So in practice having to deal with measurement differences in the way described above will surely be the exception rather than the rule. Am I missing something?

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02nd Jul 2015 08:55

Not good
We have a lot of these as we have several "business angel "clients. I didn't realise we had to do this with companies under common control as well! Where does this end ? This just creates more work especially when we convert the client.

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02nd Jul 2015 09:06

But see my point about the fact that in practice is will be a very rare thing indeed to have to do it where the lender and borrower are in effect the same person.

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02nd Jul 2015 09:15

Sorry john
I don't think I was very clear.In our case it is not rare. We have a lot of clients that own different companies not in a group that may enter into loans with each other. a client might own 10 companies who all provide loans to each other over a 3 year period interest free. This gets caught under these new rules. I only thought it applied to groups but in our case a lot of ours are not groups but companies owned by one or more common parties.

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02nd Jul 2015 10:12

Do you mean there are formal loan agreements specifying fixed repayment dates when both parties are controlled by the same person?

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02nd Jul 2015 10:35

Yes
There has to be due to the way our client works. I've just had a chat with the tech advice line to see any ways around the issue but they basically say what this article says. I don't think we can rewrite history either and make the loans on demand which is what the technical advice line suggested as a workaround as the loan agreements are already in place. Looks like more work for us :-(

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02nd Jul 2015 11:03

Well that's very unusual because such agreements are completely pointless when the debtor and creditor are, in effect, the same person.

So I think my general point is valid - that in practice these situations will be extremely rare, but you seem to have one of those extremely rare cases. I have never seen such a case in all my career.

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02nd Jul 2015 11:11

Lawyers
I see your point John but it seems this is more to do with the legalities of the arrangements. The lawyers view the companies involved and the controlling party to be distinct in law so where say 2 companies enter into a loan the debtor and creditor aren't necessarily the same person. They're just controlled by the same person. I don't think they are that rare to be honest as I've dealt with a few of these over the years. It's just seems that going forward they will create more work. Oh well not far off retirement I suppose. Thanks for your input.

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02nd Jul 2015 13:21

Yes of course they are separate legal persons. But think about it. Will the controller of both companies ever arrange for the creditor company to sue the debtor company for non-payment of the loan. Of course not. He would be sectioned within 5 minutes of he went down that route, and rightly so.

So I think you have lawyers just charging fees for producing useless and unnecessary documents.

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02nd Jul 2015 13:40

Not sure
It's quite as simple as that John in our clients cases. We can only go off the facts for our client not what we might desire or focus on if's but's and maybe's. There are specific reasons why loan accounts have to have formal terms due to the relatively short term the controlling shareholders are in office compared to other companies.

In any event it doesn't alter the fact that these new rules will apply and will cause more headaches for us so we will have to grit our teeth and get on with it!

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03rd Jul 2015 12:00

Lovely!

Once again the smaller companies are falling foul of the more complex financing arrangements of larger companies and the efforts of the accounting and regulatory bodies to keep up and report these arrangements. And who is going to pay for the extra work - I doubt very much whether the client will....at least not without a time consuming and trust-busting fight!

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03rd Jul 2015 12:13

The biggest impact for our clients

will be that we either have to go through this calculation process, or shift the debt into current liabilities.

 

Not a difficult thing, but the call from the client saying that his credit rating has just collapsed because his latest accounts have been filed at Companies House will almost certainly be.

 

Yes the debt wont be called in because it would probably be that self destruct button for the company but the calculation will just make life more complicated and costly from the clients point of view, hardly what i would call progress...

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03rd Jul 2015 12:44

Capital contribution/Distribution arguments

Another excellent article from Steve, so many thanks.

There is nothing explicit in FRS 102 that says we should treat the difference between the present value of the cash flows and the amount lent or borrowed as a distribution/capital contribution where the two parties are connected (while not disagreeing that it can be seen as a reasonable thing to do).

In fact many groups of companies have used the rules in IFRS (which in this case are the same as FRS 102) to create a non-trading loan relationship credit (profit) on lending interest free. This would then absorb brought forward non-trading loan relationship debit (loss) which would otherwise go unrelieved.

When the loan is unwound this creates an interest expense each year which is now a current year debit (loss) and (for example) could be group relieved.

This effectively converted a brought forward loss into current year losses and worked until Finance Act 2015 put a stop to it.

Malcolm

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03rd Jul 2015 12:58

specifcs

shoshana wrote:

Another excellent article from Steve, so many thanks.

There is nothing explicit in FRS 102 that says we should treat the difference between the present value of the cash flows and the amount lent or borrowed as a distribution/capital contribution where the two parties are connected (while not disagreeing that it can be seen as a reasonable thing to do).

In fact many groups of companies have used the rules in IFRS (which in this case are the same as FRS 102) to create a non-trading loan relationship credit (profit) on lending interest free. This would then absorb brought forward non-trading loan relationship debit (loss) which would otherwise go unrelieved.

When the loan is unwound this creates an interest expense each year which is now a current year debit (loss) and (for example) could be group relieved.

This effectively converted a brought forward loss into current year losses and worked until Finance Act 2015 put a stop to it.

Malcolm

Thank you Malcolm. We have been trying to work out why the differences above are taken to dividends/capital contributions but couldn't find anything in FRS 102 to suggest why. The technical helpline also said that the differences would go to distributions and capital contributions but could only offer an explanation of the substance of the transaction being that the difference represents a benefit that a reduced rate loan inherently gives the receiving company.

Why doesn't FRS 102 outline this specifically as these sorts of transactions are not rare in practice? Surely the standards themselves should be specific!

Interesting that the finance act 2015 stops brought forward losses arises. :-(

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03rd Jul 2015 13:09

Whilst I agree it would be helpful if FRS 102 pushed us in the right direction with the complete double entry, I don't think we want it so prescribed. Exercising judgement is an important concept in selecting accounting policies.

As I said, I think the capital/distribution treatment is reasonable, I just know for a fact that groups have been using P&L for it which is why the tax law has been changed.

 

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03rd Jul 2015 14:45

Accounting blah blah

I am concerned the cients wont understand this and wont have it in their bookkeeping records and the only time it will be picked up is if theres an audit happening...

 

Anyone want to throw their hat in the ring and let us all know how the tax works on this?

 

many thanks

 

Mr Sunburnt

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03rd Jul 2015 15:11

Tax treatment

If the client is a company, debits and credits booked in the P&L or other comprehensive income (the artist formerly known as the STRGL) are deductible or taxable, respectively. Receipt or payment is irrelevant.

 

For unincorporated businesses, I think the same principle would apply for loans taken out for trading purposes (as we use the profit according to generally accepted accounting principles, subject to any statutory adjustments) but for loans taken out for a non-trading purpose such as the purchase of an investment, I think interest is taxed on a receipts and payments basis - this (leading to the ugly spectre of deferred tax on the accounting adjustment - so we will have a figure they won't understand based on a figure they won't understand).....

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03rd Jul 2015 15:56

Substance over form?

Steve makes the point that a loan technically repayable on demand should be classified as a current asset/liability and not at present value - an approach supported by ICAEW guidance.  ICAEW guidance goes 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.  It seems as though, 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 we are told that a loan must be classified as "due within one year" because that is its legal form, even though its substance is something different.  This is inconsistent at best.  At worst, the results are misleading or meaningless.

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03rd Jul 2015 16:53

Wrong tree?

Nobody seems to be taking any notice of my thought that the times when we will actually have to take any notice of this where related entities lend to each other are very few and far between because the terms of such lending will hardly ever have been formalised. Am I barking up the wrong tree altogether? 

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03rd Jul 2015 16:59

It all depends John

on your client mix.

 

We have quite a few clients that "cross-fertilise" their finances, we also (although these are a rare breed indeed) have directors with accounts in credit - yes i know hard to believe but true!

 

I have had to explain to one of them why his lending the company £1m+  is now a bad idea, i must not have made myself clear about PV etc because he still cant understand how a tax liability can arise simply because the pound might be worth a bit less in a few years time.

 

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06th Jul 2015 09:20

Missing the point

The Minion wrote:

We have quite a few clients that "cross-fertilise" their finances, we also (although these are a rare breed indeed) have directors with accounts in credit - yes i know hard to believe but true!

My point is not that it is very rare for companies under common ownership to lend to each other, of for company owners to lend to their companies.  I agree, of course, that it happens all the time. My point is that it is, or should be, rare for those arrangements to be formalised (what would be the point of someone entering into a formal agreement with himself?). 

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03rd Jul 2015 17:47

Wrong tree, again?

John.  You are right that most of these loans will not be formal arrangements, but could you be a bit more explicit about why you feel that the lack of formality means we will not have to consider this issue? 

Under FRS 102, the only way a loan can be carried at anything other than present value is if it is NOT a "financing transaction" (not defined).  FRS 102 para 11.13 suggests that virtually any arrangement where a loan is outstanding beyond "normal business terms" OR is provided at a below-market rate of interest, is a financing transaction.

If I understand your line of thought, you are suggesting that lack of formality means that the loan is repayable on demand and is, therefore, not a financing transaction and is simply to be measured at "cost".  Presumably, such a loan would necessarily be shown as "due within one year".

Firstly, showing such a loan as due within one year may cause problems for the entity's credit rating, bank covenants, etc.

But secondly, in many cases it is nonsense.  Both parties will know that the loan will remain outstanding in 12 months time.  Showing all such non-formal loans as "due within one year" will render many a balance sheet meaningless.

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03rd Jul 2015 17:53

i know its late on Friday but bear with me here

Is a creditor who isn't paid within normal terms i e the trade terms agreed at the time a "financing transaction"

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03rd Jul 2015 21:32

It's even later on Friday

Is a creditor who isn't paid on normal terms a financing transaction? ...

Yes.  See FRS 102, para 11.13

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03rd Jul 2015 21:44

Oh my god

ian.dandiwalton.co.uk wrote:

Is a creditor who isn't paid on normal terms a financing transaction? ...

Yes.  See FRS 102, para 11.13

This is really worrying me now. Surely not.

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03rd Jul 2015 18:14

On demand
Basically the technical advice line said exactly what Ian dandiwalton said above - these loans are financing transactions and have to be accounted for such and where no rates of interest are charged which is usually the case for these loans then we have to do the accounting treatment in FRS102 which is what the article is suggesting. The lady on the phone said that "no matter how you dress it up, it is a financing transaction and has to be accounted for as such!" (Verbatim). Whether these loans are rare or not doesn't come into it having thought about it and made enquiry after enquiry after enquiry. So we are stuck with it seemingly.

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03rd Jul 2015 21:22

Substance over form again

As Ayesha says, we are stuck with it!  But how do we apply it in practice?

Although FRS 102 mentions below-market rate loans, I cannot see any mention of the open-ended loans (whether interest-free or not) which we often find in practice.  ICAEW guidance says that, where no repayment terms are formally agreed, such loans are legally repayable on demand and must be treated as "due within one year".

But FRS 102 para. 2.8 says that "transactions ... should be accounted for and presented in accordance with their substance and not merely their legal form".

So we seem to have a conflict.  Either:

we apply ICAEW guidance, use strict legal form, and show such loans as "due within one year", valued at "cost"; or

we apply para 2.8, recognise that in substance the loan is really long-term and show it as "due after more than one year" valued at present value (how to determine the present value of an open-ended loan probably deserves a thread in its own right!).

All very unsatisfactory.

 

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03rd Jul 2015 21:38

Very unsatisfactory
Indeed!! I think from today's stress about all this the answer is loan terms across the board. that's clearly where FRS 102 is sending us or telling us that without terms it's in as current. See you.

Grrrr.

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04th Jul 2015 09:50

Still don't see what I am missing. In the absence of any agreement to the contrary all loans are repayable on demand. In the case of an informal loan where there are no specific repayment terms, as nearly all loans between related parties are, there will almost always be an absence of any agreement to the contrary, so all such loans are likely to be repayable on demand. We are told that FRS 102 says that loans repayable on demand are not financing transactions. So what is the problem?

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04th Jul 2015 11:28

With
The greatest respect John you imply that these cases never have loan terms. This is just simply not true as is evidenced by other posters concerns to this topic whose clients clearly DO have loan terms. I appreciate that your clients may not such terms but you can't then assume they do not exist throughout the entire country because the clearly do,

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04th Jul 2015 14:00

So is it agreed then that when there are no formal loan terms (let's not worry about how often that is in fact the case) then none of this applies?

By the way my view that most related party loans in fact will have no formal terms associated with them is not particularly based on personal observation, but on the fact that formalising loan terms when one person is lending to himself is self-evidently pointless, and on a perhaps naive assumption that a practice that is pointless will not be widespread. I may be wrong on that of course.

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04th Jul 2015 21:17

All agreed?

I agree we (as accountants) may be spared the task of calculating the present value of a loan, so long as we show the loan as a current liability, but I am not sure that is the most important point.  Am I the only person who finds it frustrating that we do have to show it as a current liability?  Although that may be the strict legal form, many of these arrangements will persist for a number of years and showing them as long-term creditors would give a much fairer view. Clearly, calculating the present value of an open-ended loan presents some difficulties, but that simply shows up the lack of imagination on the part of standard setters.  Not all financing transactions are equal and forcing us to account for them all in the same way will lead to accounts that are less meaningful.

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06th Jul 2015 09:49

I don't think you are looking at the bigger picture John

The "few clients" were in fact companies under common ownership/control.

 

The reason that there needs to be a proper agreement there (and yes we have found that proper agreements don't always exist) is because it leaves both (all) the related companies at risk.

 

The simple route being espoused here is just treat them all as payable on demand. That is fine if it doesn't self destruct the Balance Sheet. The reason we insist on clients having formal agreements is simply because even though all parties realise that the loan wont be repaid in the next 12 months they don't formalise that situation and it sits in current liabiltities.

 

The credit reference agencies (for it is their opinion that ultimately matters) view these as bad things rather than debts repayable in over 12 months as good. We have seen ridiculous transformations in credit rating simply by restating the balance sheet, we have also seen the reverse.

 

When you think that the accounts can be 9 months old when they hit the public domain it makes little sense (anything older than 9 months at CH is a black mark anyway).

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06th Jul 2015 10:23

Risk

The Minion wrote:

The reason that there needs to be a proper agreement there (and yes we have found that proper agreements don't always exist) is because it leaves both (all) the related companies at risk.

How does the absence of a formal agreement, per se, put two companies under common control at risk?

But yes of course if debtors want to exclude their indebtedness from current liabilities they will have to formalise the repayment terms.  There will be other occasions when formality is needed too.  Lending banks may insist on formal postponement.  Letters of comfort may have been given to auditors containing undertakings that need to be formalised.  My guess is that these situations will be the exception rather than the rule.

As formalising loan terms from now on brings with it an obligation to comply with onerous accounting requirements, perhaps it is not idle to speculate that this will lead to even fewer loan arrangements being formalised in future.

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03rd Aug 2015 12:01

But what about ....

What happens when a Company purchases an item of plant say on behalf of the other Company, its complicated enough (Vat, name & address on invoice, agreeing inter company loans, no terms of repayment etc), do all these little bits and bobs get treated as a loan subject to an interest charge. 

 

Or is it a question of if its not a moneatary loan the above rules do not apply.

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