Measurement of intra-group loans

Publication date: 12 Apr 2018

Introduction

Financing arrangements between entities within the same group can take various forms. On the one hand, they might be formal contractual lending agreements that are enforceable under local law; on the other hand, they might, in substance, be part of the investment in another entity. The terms of financing arrangements can vary, or they might not be clearly defined, with some being repayable on demand, others having a fixed maturity, and still others having no stated maturity.

The first step is to ascertain if a financing arrangement is (i) within the scope of IFRS 9, (ii) an investment in a subsidiary within the scope of IAS 27, or (iii) an investment in an associate or a joint venture within the scope of IAS 28. For instruments within the scope of IFRS 9, the standard’s impairment requirements apply to all debt instruments held at amortised cost or fair value through other comprehensive income. This includes ‘quasi-equity’ loans (that is, an item for which settlement is neither planned nor likely to occur in the foreseeable future and that forms part of the net investment in the borrower for under IAS 21, ‘The Effects of Changes in Foreign Exchange Rates’).

This practice aid outlines a number of common funding scenarios that have been identified as applying in practice. It only addresses instruments that are within the scope of IFRS 9 and that are not accounted for under IAS 27, ‘Separate Financial Statements’, or IAS 28, ‘Investments in Associates and Joint Ventures’. It provides guidance on their accounting treatment from the perspective of both the borrower/subsidiary and the lender/parent. It does not address the question of whether an instrument is within the scope of IAS 27 or IFRS 9, nor does it address the application of IFRS 9’s impairment requirements. For further guidance on the application of the impairment requirements of IFRS 9 to intra-group loans, see ‘In depth – IFRS 9 impairment practical guide: inter-company loans in separate financial statements’.

The appropriate treatment for any particular transaction depends on the facts and circumstances of that transaction. Evidence of past payments or planned payments should be considered, together with any contractual or agreed terms. In certain situations, it might be necessary for an entity to obtain legal advice for it to understand the terms of an agreement.

In some of the scenarios outlined below, there are two alternative accounting approaches that might be adopted. Where these accounting alternatives exist, management should apply the principles set out in IAS 8, ‘Accounting policies, changes in accounting estimates and errors’, in determining the appropriate approach. In particular, the approach adopted by an entity should reflect the economic substance of the transactions [IAS 8 para 10(b)(ii)], be applied consistently to all similar transactions [IAS 8 para 13], and be clearly disclosed in its financial statements [IAS 1 para 117]. It might be appropriate to apply different treatments to transactions that are not similar.

In addition, since this guidance addresses specific transactions, application by analogy would not always be appropriate and therefore requires careful analysis.

It is presumed, in all of the following examples, that (i) the loans are within the scope of IFRS 9, (ii) the cash flows of the loans are solely payments of principal and interest, and (iii) the loans are held by the parent in a ‘hold to collect’ business model.

Index

Section A

Loan provided on commercial terms

Section B

Loan at non-commercial terms with fixed term

Section C

Loan repayable on demand with no interest

Section D

Loan where both borrower and lender must agree to repayment

Section E

Parent waives loan with subsidiary

A. Loan provided on commercial terms

Background

Parent Co provides a loan to Subsidiary Co. The loan has fixed terms for repayment and bears a market rate of interest. There are no transaction costs incurred on the issuance of the loan.

Question A1 

How is the loan accounted for by the parent entity in its separate financial statements?

Answer A1

Under IAS 32, the loan is a financial liability from the perspective of the subsidiary. From the perspective of the parent entity, the loan is therefore a debt instrument under IFRS 9 [IFRS 9 para BC5.21]. The loan is initially recognised at its fair value – which, in this case, would be equal to the principal amount of the loan, because a market rate of interest is being charged. The loan is subsequently measured at amortised cost [IFRS 9 para 5.2.1(a)], with interest accrued using the effective interest rate method.

The loan is also subject to the impairment requirements of IFRS 9 [IFRS 9 para 5.2.2]. For further guidance on the application of the impairment requirements to intra-group loans, see ‘In depth – IFRS 9 impairment practical guide: inter-company loans in separate financial statements’.

Question A2 

How is the loan accounted for by the subsidiary in its financial statements?

Answer A2

The loan meets the IAS 32 definition of a financial liability. The liability is initially recognised at its fair value – which, in this case, would be equal to the principal amount of the loan, because a market rate of interest is being charged. Assuming that the subsidiary does not elect to carry the loan as at fair value through profit or loss, the liability is subsequently measured at amortised cost, with interest accrued using the effective interest rate method [IFRS 9 para 4.2.1].

B. Loan at non-commercial rates with fixed term

Background

Parent Co provides a loan to Subsidiary Co. The loan bears no interest, but the loan agreement includes fixed terms for repayment. There are no transaction costs incurred on the issuance of the loan.

Question B1 

How is the loan accounted for by the parent entity in its separate financial statements?

Answer B1

Under IAS 32, the loan is a financial liability from the perspective of the subsidiary. From the perspective of the parent entity, the loan is therefore a debt instrument under IFRS 9 [IFRS 9 para BC5.21]. The loan is initially recognised at its fair value – which, in this case, would be equal to the present value of the future cash to be received, discounted using the prevailing market rate for a similar instrument (for example, currency, term, type of interest rate and other factors) with a similar credit rating [IFRS 9 para B5.1.1].

As a result of the non-market interest rate (in this case, nil) inherent in the loan, there will be a difference between the cash paid and fair value on initial recognition. This difference should be accounted for in accordance with the substance of the transaction [IAS 8 para 10(b)(ii)]. Commonly, the substance is a capital contribution (see para 4.25 of the Conceptual Framework), because the difference arises from the parent acting in its capacity as parent/shareholder, in which case it is reflected as an additional investment in the subsidiary. In rare circumstances, the substance might be that the difference represents consideration for something other than the financial instrument. For example, the subsidiary might also provide a service to the parent, in which case the additional amount lent is recognised as an expense in accordance with paragraph B5.1.1 of IFRS 9, unless it qualifies for recognition as some other type of asset.

The loan is subsequently measured at amortised cost [IFRS 9 para 5.2.1(a)], with interest accrued using the effective interest rate method, taking into account the unwind of the difference between the cash paid and fair value on initial recognition.

The loan is also subject to the impairment requirements of IFRS 9 [IFRS 9 para 5.2.2]. For further guidance on the application of the impairment requirements to intra-group loans, see ‘In depth – IFRS 9 impairment practical guide: inter-company loans in separate financial statements’.

Question B2

How is the loan accounted for by the subsidiary in its financial statements?

Answer B2

The loan meets the IAS 32 definition of a financial liability. The liability is initially recognised at its fair value. In this case, it is equal to the present value of the future cash to be paid, discounted using the prevailing market rate for a similar instrument (for example, currency, term, type of interest rate and other factors) with a similar credit rating [IFRS 9 para B5.1.1]. Assuming that the subsidiary does not elect to carry the loan as at fair value through profit or loss, the liability is subsequently measured at amortised cost, with interest accrued using the effective interest rate method.

Consistent with the rationale in answer B1, the difference between the fair value of the loan and the amount of funds received from the parent entity should be accounted for in accordance with the substance of the transaction [IAS 8 para 10(b)(ii)]. Commonly, the substance is an addition to the subsidiary’s equity, but it might rarely be treated as a gain in the income statement.

C. Loan repayable on demand with no interest

Background

Parent Co provides a loan to Subsidiary Co which is contractually repayable on demand and bears no interest. Parent Co can recall the loan in the future, but its intention (as communicated to Subsidiary Co) is that the loan is only recalled when the subsidiary has surplus cash and the parent requires the cash for other purposes, such as the payment of dividends to the parent’s shareholders or to make alternative investments. Parent Co does not expect any such events to occur in the foreseeable future. There are no transaction costs incurred on the issuance of the loan.

Question C1

How is the loan accounted for by the parent entity in its separate financial statements?

Answer C1

Under IAS 32, the loan is a financial liability from the perspective of the subsidiary (see Answer C2 below). From the perspective of the parent, the loan is therefore a debt instrument under IFRS 9 [IFRS 9 para BC5.21]. The loan is initially recognised at its fair value – which, in this case, would be equal to the amount lent, because it is repayable on demand [IFRS 13 para 47]. For further guidance on the measurement of an on-demand loan, see the Manual of accounting at ‘FAQ 45.59.5 – Interest-free loans from parent to its subsidiary: parent’s separate financial statements’.

The loan is also subject to the impairment requirements of IFRS 9 [IFRS 9 para 5.2.2]. For further guidance on the application of the impairment requirements to intra-group loans, see ‘In depth – IFRS 9 impairment practical guide: inter-company loans in separate financial statements’.

Question C2

How is the loan accounted for by the subsidiary in its financial statements?

Answer C2

Although there is no expectation that the parent will demand repayment of the loan, the subsidiary is still obliged to deliver cash to the parent at the parent’s request. The parent (as part of its normal ongoing decision-making process), and not the subsidiary, determines when the loan is repaid. Since the subsidiary does not have the unconditional right to avoid settlement of the obligation, the loan meets the definition of a financial liability [IAS 32 para 19].

The loan has no minimum contractual term, and the parent can require it to be repaid at any time, even though the parent does not expect to require repayment in the foreseeable future. As a result, the loan is recognised as a liability for the face value of the loan [IFRS 13 para 47]. The loan is also classified as a current liability, because the subsidiary does not have an unconditional right to defer settlement beyond 12 months [IAS 1 para 60].

Note: In practice, the funding provided by a parent to its subsidiary might be documented as a loan, although there might not be any documented repayment terms. The accounting for such instruments will depend on the specific facts and circumstances, and it might be necessary for an entity to obtain legal advice to determine its contractual position. If the conclusion is that the loan is payable on demand, the guidance above would apply.

Additional background – Letter of support issued

Subsequent to issuing the loan outlined above, the parent entity provides a letter of support to the subsidiary, prior to the balance sheet date, indicating that payment will not be required for a period of at least 12 months from the balance sheet date.

Note: A letter of support issued after the reporting date is a non-adjusting post balance sheet date event, and so it will not impact the classification or measurement of the loan at the reporting date.

Question C3

What impact does the letter of support have on the measurement of the loan by the parent in its separate financial statements?

Answer C3

The treatment by the parent depends on whether the letter of support is legally binding or simply an expression of intent. Where the letter is legally binding, the parent needs to determine whether the change in the terms of the loan represents a modification of the existing loan or the extinguishment of the original loan and the recognition of a new loan, in accordance with paragraph 3.2.3 of IFRS 9. Further guidance on determining whether the change in terms should result in derecognition is included in the Manual of accounting at ‘FAQ 44.27.2 – De-recognition of financial assets’.

If the change in terms is treated as a modification, paragraph 5.4.3 of IFRS 9 should be applied, to calculate the new carrying amount of the loan by discounting the revised cash flows at the original effective interest rate. For further guidance on the measurement of an on-demand loan, see the Manual of accounting at ‘FAQ 45.59.5 – Interest-free loans from parent to its subsidiary: parent’s separate financial statements’.

The difference (if any) between the previous carrying amount and the revised carrying amount, arrived at by discounting the loan back from the date that repayment could now be demanded, is treated either as an addition to the investment in the subsidiary (that is, as a capital contribution to the subsidiary) or as an expense in the income statement, depending on the economic substance. See the discussion in Answer B1 regarding the assessment of economic substance. In the scenario described, the substance is commonly a further investment in the subsidiary.

If the letter is not legally binding, it does not give rise to a change in terms. It might, however, impact the measurement of impairment under IFRS 9. Further guidance on the application of the impairment requirements of IFRS 9 to intra-group loans is included in the ‘In depth – IFRS 9 impairment practical guide: inter-company loans in separate financial statements’.

Question C4

What impact does the letter of support have on the measurement and current/non-current classification of the loan by the subsidiary in its financial statements?

Answer C4 

The treatment by the subsidiary depends on whether the letter of support is legally binding or simply an expression of intent.

Where the letter is legally binding, the subsidiary needs to determine whether the change in the terms of the loan represents a modification of the existing loan or the extinguishment of the original loan and the recognition of a new loan, in accordance with paragraph 3.3.2 of IFRS 9. If the change in terms is treated as a modification, paragraph 5.4.3 of IFRS 9 should be applied, to calculate the new carrying amount of the loan by discounting the revised cash flows at the original effective interest rate. For further guidance on the measurement of an on-demand loan, see the Manual of accounting at ‘FAQ 45.59.5 – Interest-free loans from parent to its subsidiary: parent’s separate financial statements’.

The difference (if any) between the previous carrying amount and the revised carrying amount, arrived at by discounting the loan back from the date that repayment could now be demanded, is treated either as an addition to the subsidiary’s equity or as income in the income statement, depending on the economic substance. See the discussion in Answer B1 regarding the assessment of economic substance. In the scenario described, the substance is commonly a capital contribution recognised in equity. Since repayment cannot be required within 12 months of the balance date, it should be reclassified as a non-current liability.

Where the letter is not legally binding, the loan is still repayable on demand, notwithstanding that the loan is unlikely to be called. The loan continues to be classified as a current liability, because the subsidiary does not have an unconditional right to defer settlement beyond 12 months [IAS 1 para 60].

D. Loan where both borrower and lender must agree to repayment

Background

Parent Co provides a loan to Subsidiary Co. The loan bears no interest and does not include any fixed terms for repayment. One of the conditions of the loan is that repayment of the loan is only required on a date agreed by both the parent and subsidiary. There are currently no expectations of repayment in the short term. There are no transaction costs incurred on the issuance of the loan.

Question D1

How is the loan accounted for by the parent entity in its separate financial statements?

Answer D1

Based on the contractual terms, the loan meets the definition of equity from the perspective of the subsidiary, because the subsidiary has the unconditional right to avoid settlement of the loan in cash, by another financial asset, or in a variable number of equity instruments [IAS 32 para 16]. Since the loan is not of a commercial nature, has no set term and is intended to provide the subsidiary with a long-term source of additional capital, it is, in substance, an addition to the parent’s investment in its subsidiary.

Question D2

How is the loan accounted for by the subsidiary in its financial statements?

Answer D2

Since the contract requires the parent and subsidiary to agree before any repayment of the loan is made, the subsidiary has the unconditional right to avoid settlement of the loan in cash, by another financial asset, or in a variable number of equity instruments. Such an instrument meets the definition of an equity instrument under IAS 32 [IAS 32 para 16]. The loan is classified as an equity instrument in its entirety, with no subsequent remeasurement required.

If the subsidiary agrees to a repayment at a future point in time, the amount to be repaid is reclassified from equity to financial liabilities. The agreement to repay results in the initial recognition of a financial liability, so the liability is recognised at its fair value [IFRS 9 para 5.1.1]. No gain or loss is recognised in the income statement at this time [IAS 32 para 33]. Any difference between the previous carrying amount and the new fair value is recognised in equity.

E. Parent waives loan with subsidiary

Background

Parent Co provides a loan to Subsidiary Co. Parent Co decides to waive its loan to Subsidiary Co.

Question E1

How does the parent entity account for the waiver of the loan?

Answer E1

The waiver should be accounted for in accordance with the substance of the transaction [IAS 8 para 10(b)(ii)]. Commonly, the substance is a capital contribution (see para 4.25 of the Conceptual Framework), because the waiver arises from the parent acting in its capacity as parent/shareholder, in which case it is reflected as an additional investment in the subsidiary. In rare circumstances, the substance might be the derecognition of a receivable, with a loss (after accounting for any impairment) equal to the carrying amount of the receivable that is forgiven recognised in profit or loss [IFRS 9 para 3.2.12]. An indicator that this might be the case is if, for example, an unrelated third party would also have waived the receivable because the subsidiary is unable to pay.

Question E2

How does the subsidiary account for the waiver of the loan?

Answer E2

The waiver should be accounted for in accordance with the substance of the transaction [IAS 8 para 10(b)(ii)]. Commonly, the substance is a capital contribution (see para 4.25 of the Conceptual Framework), because the waiver arises from the parent acting in its capacity as parent/shareholder, in which case it is reflected as a capital contribution in equity, with no gain or loss being recognised. In rare circumstances, the substance might be the extinguishment of a liability, with a gain equal to the carrying amount of the liability that is forgiven recognised in profit or loss [IFRS 9 para 3.3.3]. An indicator that this might be the case is if, for example, an unrelated third party would also have waived the liability because the subsidiary is unable to pay.

 
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