Demystifying interest-free and below-market-rate loans
Terms vary depending on the nature of the finance and the recipient
The accounting recognition for interest-free and below-market-rate loans is an area that has caused difficulty for many advisers and businesses.
Most loans are basic financial instruments accounted for under section 11 of FRS 102. If loans are granted on commercial terms between unconnected parties, market rate of interest is usually charged. The initial recognition of such loans is at transaction value (the amount of cash loaned or borrowed). Subsequently, the loan is recognised at amortised cost, with the interest increasing the loan balance and charged to PL and any repayment of the interest or interest and capital reducing the carried-forward balance of the loan at each year end to the end of the loan term.
When loans are granted between connected parties they are often granted at non-commercial rates: no interest or below market rate of interest. The terms of such loans, especially between companies and their directors or their relatives, often remain fluid, with repayment conditions agreed informally or not addressed at all at the time of the loan.
The application of FRS 102 section 11.13 requires that loans at non-market rates are recognised initially at ‘present value of the future payments discounted at a market rate of interest for a similar debt instrument’.
For accounting periods starting on or after 1 January 2016, small companies can take advantage of an exemption from discounting and recognition of the loan at present value (Financial Reporting Council in FRED 67, Draft Amendments to FRS 102: The Financial Reporting Standard applicable in the UK and Republic of Ireland). The exemption applies to loans between companies and connected individuals, and does not extend to corporate lenders and the borrowers – for example, to group loans.
Companies that are not small remain to be bound by s11.13. This means that:
For loans with terms exceeding 12 months, non-small companies need to identify the loan terms and an effective interest rate at which to discount the loan to its present value.
The accounting for the difference between the amount of cash loaned/ borrowed and the liability or debtor shown at the discounted amount depends on who the parties to the loan agreement are.
Non-small entities applying FRS 102 and small entities applying FRS 102 1A and not taking advantage of the recent FRED 67 exemption can, and perhaps should, make a reference to the policy of recognising loans from connected individuals at present value.
For small entities applying FRS 102 1A, whether taking advantage of the exemption from the recognition of directors’ or shareholders’ loans at present value or not, the existence of interest-free or below-market-rate loans between directors or shareholders and their companies is a transaction under non-market conditions. FRS 102 1A requires the disclosure of such transactions in a related-party note, which should specify:
(a) the amount of such transactions
(b) the nature of the related-party relationship
(c) other information about the transactions necessary for an understanding of the financial position of the small entity.
All such transactions between the various groups of connected parties can be aggregated and disclosed. References to specific amounts loaned by or to various individuals and the company are not required.
Medium and large entities applying full FRS 102 should make relevant disclosures of all transactions between directors and shareholders and other connected parties irrespective of their terms (market or non-market).
Creditors’/debtors’ disclosure Relevant balances relating to interest-free/below-market-rate loans will be disclosed in the note, alongside various other creditors’ or debtors’ balances included in the balance sheet.
If an interest-free/below-market-rate loan was granted under the old GAAP and a transitional adjustment was required on the adoption of the new UK GAAP, a prior-year adjustment should be made. A relevant transitional adjustment disclosure note specifying the transitional journals posted should be included in the disclosure.
If no transitional adjustment as a result of adopting the new accounting regime arose in relation to interest-free or below-market-rate loans, this should be stated in the note.
The requirement to show interest-free or below-market-rate loans at present value is not referred to in FRS 105. Companies applying FRS105 should record such loans at transaction amount loaned or borrowed and not present value.
In the case of an interest-free loan, interest will not be recognised in the financial statements, with the carrying amount of the loan adjusted only by the amount of repayments made during the year, if applicable, and any write-offs.
In the context of an interest-free loan (or indeed any loan) from a company applying FRS 105 to its director(s), the standard requires that the following is disclosed (FRS 105 6A.1), irrespective of whether the directors’ loan account is in debit or credit at the end of the year:
interest rate – in this case, 0%
amounts written off
Other possible disclosures in relation to interest-free loans under FRS 105 relate to any security granted by the company and any guarantees given by the company to the director.
In case any security was given to the lender-director by the micro-entity benefiting from the loan, a disclosure of the nature and form of such security is required (FRS 105, 9.29).
If any guarantee was given by the company to its director or shareholder lender in connection with the granting of the loan, this fact should be disclosed (Companies Act s413 and FRS 105 6.2(a)).