Audit and Technical Partner Leavitt Walmsley Associates Ltd
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FRS 102: The impact on directors’ current accounts

It is vital that practitioners have a sound understanding of the implications and impact of FRS 102 on directors’ current accounts, writes Steve Collings.

26th Nov 2019
Audit and Technical Partner Leavitt Walmsley Associates Ltd
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This is the second of two articles which examine the accounting implications of directors’ loans to and from a business under FRS 102. The first in the series looked at the company law aspects and the relevant disclosure requirements.

Loans to or from a director are caught under the rules in FRS 102, Section 11 Basic Financial Instruments.

FRS 102 (March 2018), paragraph 11.13A(a) offers a simplification to small entities to simply recognise loans from a director-shareholder/group of the director’s close family members which contains a shareholder at transaction price.

However, this simplification does not apply to companies outside the small companies regime. FRS 102, paragraph 11.13A was included as part of the Financial Reporting Council’s triennial review amendments.

At the outset, it is worth noting that if a loan is not formalised with loan terms, the loan would be regarded as being repayable on demand and hence would be presented as either a current asset or a current liability in the financial statements ie no discounting would be required.

Similarly, where a market rate of interest is being charged for a loan with formalised terms there would also not be a need to discount the loan using an imputed rate of interest.

Quite often, a company will make a loan to a director which is either at a below-market rate of interest or interest-free (usually the latter). Where such a loan is made to or from a director, it will fall to be treated as a financing transaction and the consequence of this is where the loan is below market rate, a measurement difference will arise where the loan is covered by formal terms and is repayable after more than one year from the balance sheet date. The measurement difference is the difference between the face value of the loan and the present value.

Example 

On 1 January 2019, Largeco Ltd makes an interest-free loan to a director who is also a shareholder amounting to £50,000. The loan has been formalised with loan terms which state that the director is to repay this loan on 31 December 2020 and the market rate for a similar loan (ie if the director had gone to the bank for the funds) would be 5.5% per annum. The net present value of the loan is £44,923 (£50,000/1.0552). The measurement difference is the difference between the fair value and the present value which is £5,077 (£50,000 - £44,923).

In the example above, the substance of the arrangement is that the director has benefitted personally by receiving a loan from the company interest-free. If the director had gone to the bank, the director would have had to pay interest at market rate. The measurement difference, therefore, represents a transfer of value from the company to the director-shareholder which must be reflected in the financial statements under FRS 102.

Example 

Using the example above, the measurement difference of £5,077 represents a distribution to the director in their capacity as a shareholder (ie because the director-shareholder has benefited from the company providing them with a loan at below-market rates of interest). In this example, we are using the director’s current account to record the loan receivable.

The entity would record the transaction as follows:

         

£

Dr Director's current account

 

44,923

Dr Distribution (equity)

   

5,077

Cr Cash at bank

     

50,000

Being interest-free loan to director

   

 

The measurement difference has been taken to equity as a distribution because the director is a shareholder. If the director was not a shareholder, it would be taken to payroll expense in the profit and loss account.

The above scenarios were based on a loan TO a director-shareholder. It is commonplace for the reverse to apply ie where the director-shareholder will make a loan to the company.

Example 

On 1 January 2019, Sarah, a director of Pastures Ltd, provides an interest-free loan of £50,000 to her business in which she is a shareholder. The market rate of interest for a similar loan is 5.5%. The loan has been formalised with loan terms which state repayment is to be made on 31 December 2020. The loan is material to the financial statements.

Scenario 1: The entity is small, reports under FRS 102, Section 1A and chooses to apply FRS 102, para 11.13A(a)

As the company is small, it can take advantage of the simplification in FRS 102, para 11.13A(a) and simply recognise the loan at transaction price (ie at £50,000). Hence the loan is recorded as follows:

         

£

Dr Cash at bank

     

50,000

Cr Directors' current account

 

50,000

Being loan from director-shareholder at transaction price

There would be no notional interest charges recognised in profit or loss over the loan term. As the loan is material, it is disclosed as a related party transaction to comply with the requirements in FRS 102, paragraph 1AC.35 because the loan has not been concluded under normal market conditions.

Scenario 2: The entity is medium-sized (or small without taking advantage of para 11.13A(a))

The loan terms state that the loan will be repaid on 31 December 2020. A measurement difference arises amounting to £5,077 (see calculations above).

The measurement difference will be treated as a capital contribution by Sarah because the substance of the arrangement is that the company has benefitted by receiving a loan from her at a rate of interest which is below market rate. Hence the loan is recorded as follows:

 

       

£

Dr Cash at bank

     

50,000

Cr Director's current account

 

44,923

Cr Capital contribution (equity)

 

5,077

Being loan received from director-shareholder

 

The liability will then be measured under the amortised cost method as follows:

Year

Balance b/f

Interest 5.5%

Balance c/f

1

44,923

2,471

47,394

2

47,394

2,606

50,000

In year 1, interest is charged to the profit and loss account of £2,471 and the corresponding credit is taken to the director’s current account. The same applies in year 2.

Small entity becomes medium

But what happens to a loan accounted for using the simplification in FRS 102, para 11.13A(a) on initial recognition when the company becomes medium-sized at a later date?

Some small companies may eventually outgrow the small companies regime and become medium-sized. Where the company has applied the optional simplification in FRS 102, paragraph 11.13A to measure the loan at transaction price but then becomes medium-sized, it will no longer be able to continue measuring the loan at transaction price because this option is only available to small entities.

FRS 102, para 11.13B states:

An entity taking advantage of the exemption in paragraph 11.13A(a) that subsequently ceases to be a small entity may, when remeasuring the financial liability to present value prospectively from the first reporting date after it ceases to be a small entity, determine the present value on the basis of the facts and circumstances existing at that time or at the date the financing arrangement was entered into.

Example 

On 1 January 2016 Jason, a director-shareholder in Rapidco Ltd, provides an interest-free loan to the business of £50,000 which is repayable on 31 December 2021. The loan is formalised with written terms and the company applied the exemption in FRS 102, para 11.13A(a) on initial recognition of the loan. The company has now become medium-sized for the first time for the year ended 31 December 2019. No changes to the loan terms/circumstances have arisen since the loan was entered into.

For the year ended 31 December 2019, Rapidco Ltd cannot continue to record the loan at transaction price because this exemption is only available to small entities. The loan needs to be restated to the present value of future cash flows using a market rate of interest. The market rate of interest for the purposes of this example is 5.5%.

The present value of a two-year loan at 5.5% is £44,923 (£50,000 / 1.0552). The journals to restate this as at 31 December 2019 are:

         

£

Dr Director's current account

 

5,077

Cr Capital contribution (equity)

 

5,077

Being restatement of loan to present value

 

As the company has grown from a small company to a medium-sized company, it would be required (not encouraged) to present a statement of changes in equity and this would show the capital contribution for the year ended 31 December 2019.

Notional interest would be charged to the profit and loss account over the remaining two-year life of the loan using the amortised cost method as follows:

Year

Bal b/f

5.5% interest

Bal c/f

 

£

£

£

2019

   

44,923

2020

44,923

2,471

47,394

2021

47,394

2,606

50,000

For the year ended 31 December 2020, the journal would be:

         

£

 

Dr Interest payable

     

2,471

 

Cr Director's current account

 

2,471

 

Being notional interest for the year ended 31 December 2020

On repayment, the journals would be to credit bank £50,000 and debit director’s current account.

Medium-sized entity becomes small

It may be the case that a medium-sized entity contracts and becomes eligible to apply the small companies regime. If the entity has received a loan from a director-shareholder/group of close family members which contains at least one shareholder, the entity can choose to continue to measure the loan at present value. Alternatively, it can apply the exemption in paragraph 11.13A(a) but it must apply the exemption retrospectively (FRS 102, para 11.13C).

Example
On 1 January 2016 Sharon, a director-shareholder of Glastonbury Ltd, provided a seven-year interest-free loan to the business for £50,000. The company prepares financial statements to 31 December each year. A market rate of interest is 5.5% and the present value of the loan on initial recognition was £34,372 (£50,000 / 1.0557).On initial recognition of the loan, it was profiled as follows:

Year

Opening balance

5.5% interest

Closing balance

 

£

£

£

2016

34,372

1,890

36,262

2017

36,262

1,994

38,256

2018

38,256

2,104

40,360

2019

40,360

2,220

42,580

2020

42,580

2,342

44,922

2021

44,922

2,471

47,393

2022

47,393

2,607

50,000

On initial recognition, the balance on the capital contribution reserve is £15,628 (£50,000 less £34,372).

At the end of 2019, the company becomes small and becomes eligible to apply the exemption in FRS 102, para 11.13A(a) which it wishes to do. Therefore, a retrospective restatement is needed because this is a change in accounting policy.

The exemption is applied as far back as the date of transition (the start date of the comparative period reported in the financial statements), which in this case will be 1 January 2018. At this date, the loan has a carrying amount of £38,256 and £40,360 at the end of the comparative year ended 31 December 2018. The value of the capital contribution reserve as at 1 January 2018 is £11,744, reconciled as follows:

     

£

£

Capital contribution at start of loan

 

15,628

Transfer to retained earnings re interest equivalent amounts

 
 

31.12.16

 

(1,890)

 
 

31.12.17

 

(1,994)

 
       

(3,884)

         

Capital contribution balance at 31 December 2017 (1 January 2018)

11,744

Equity as at 1 January 2018

Equity (retained earnings) is increased by £11,744 which is also the difference between the face value of the loan of £50,000 and the carrying value of £38,256 and therefore removes the capital contribution reserve as at this date, i.e.:

         

£

Dr Capital contribution

 

11,744

Cr Retained earnings (P&L reserves)

 

11,744

Being removal of capital contribution at date of transition

Profit and loss account for prior year ended 31 December 2018

The profit and loss account is restated to remove the notional interest charge of £2,104 as follows:

         

£

Dr Loan

       

2,104

Cr Interest expense

   

2,104

Being reversal of prior year notional loan interest

 

The loan will then be carried in the financial statements at its transaction price as at 31 December 2019 and there is no notional interest charge in the profit and loss account. The entity must also disclose the change in accounting policy and the effect this has had on the financial statements.

Conclusion

This article has examined the accounting aspects of FRS 102 in respect of directors’ loans. Take care with directors’ loans under FRS 102 because it may be the case that the company is small and can apply the simplification in FRS 102, paragraph 11.13A and measure the loan at transaction price.

However, where the loan is material do not forget that it will be caught under the related party rules in FRS 102, Section 1A, paragraph 1AC.35.

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Replies (7)

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By ShaunSpalding
27th Nov 2019 09:56

Good article thanks.
Under the first example where a £50k loan is made to a Director and is recorded as Dr DCA £44,923. What are the accounting entries please when on 31 Dec 2020 the Director repays £50k?

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Replying to ShaunSpalding:
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By johnt27
27th Nov 2019 18:09

DR Cash £50k
CR DLA £50k

The unwinding of the interest over 2 years will bring the DLA back up to £50k
DR DLA
CR Interest Rec'd

For interest payable this would always hit P&L but for interest receivable, in the other example, you have a choice to record this in P&L or OCI depending on whether or not you believe this is a realised profit or loss.

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By Trethi Teg
27th Nov 2019 10:27

Nice technical piece and very interesting for those out there who worry about the niceties of accounting presentation. Presumably the time spent will be billed to clients who couldn;t care less.

In my view practitioners should spend their time concentrating on helping their clients either improve their business or reduce the amount of tax they pay to a minimum i.e. something usefull rather than a load of nonsense.

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By Kevinb69
27th Nov 2019 13:07

Not covered by the article but what tax implications does this have for both the Company and the Director/Shareholder. If, as in the example there is a deemed distribution of £5,077 is that taxable on the shareholder?

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By johnt27
27th Nov 2019 18:08

The deemed distribution isn't taxable on the shareholder but would be subject to CT in the company as would the unwinding of the interest over subsequent years. Tax neutral in theory assuming rates stay the same...

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By unclejoe
27th Nov 2019 15:26

How do you determine the market rate? Example: a family member makes a loan to a family controlled company for working capital, with agreed interest rate of 5%. A bank loan would probably be a bit higher than this, say 8%, but the circumstances of the company are that no bank would provide the loan. They might possibly get a loan from someone like Wonga at a zillion %. So what is the market rate - 5%, 7%, a zillion%? And what of the tax position on the lender who will appear to have income, and the company a cost, both fictitious in reality. It is a nonsense, and will cause problems. I understand the need for controls where company loans to director, but what justification is there for making it complicated for people to loan money to a struggling family company?

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Replying to unclejoe:
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By johnt27
27th Nov 2019 18:15

This is the million dollar question and the thing that is hardest to determine, particularly for non-quoted companies. The problem here lies with the auditors, given you're unlikely to see this in 1A accounts, who will have to make some significant judgements around the client's estimates.

The reality of the situation is that most director loans, whether debit or credit, are provided with no formal agreement or terms and so are not required to be discounted as they deemed repayable on demand.

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