Recently, I was invited by a Big 4 firm in the Cayman Islands to develop and facilitate a seminar for their clients on IFRS 9 Financial Instruments. One of the issues they wanted me to speak about was the accounting for intercompany loans under IFRS 9. Easy enough, I thought, and agreed to include it my presentation.
Well, was I in for a treat! When researching this issue, I discovered that IFRS does not contain any specific guidance that is “on point” related to transactions with shareholders. Great! Furthermore, many intergroup loans:
- Do not have a written agreement;
- Have no (or a below market) interest rate; and/or
- Do not have a fixed repayment date.
As a result, many clients that enter into intercompany loans consider them due on demand, classifying them as debt. The question they wanted me to cover was whether such loans meet the tests within IFRS 9 to be accounted for at amortized cost.
Little did I know the accounting issues that I would uncover! This blog serves to document my research on the topic.
For purposes of this blog, let’s assume a Parent “lends” USD 1 million to its Subsidiary. Furthermore, let’s assume the “loan” does not have a written agreement, charge interest, or have a fixed repayment date.
Issue #1: Is the loan within the scope of IFRS 9?
The first “issue” is I noted was determining whether the intercompany loan is within the scope of IFRS 9 or not. As previously mentioned, there is no specific guidance related to transactions with shareholders. As a result, most accounting firms note entities should refer to the IASB Conceptual Framework and the substance of the transaction.
- If the intention of the Parent was to lend money and there exists a possibility the loan will be repaid, then the Subsidiary should record a liability and the Parent would record a loan receivable within the scope of IFRS 9.
- However, if the Subsidiary is not required to repay the amount under any circumstance and repayment is entirely at their discretion, or the intention of the Parent was to provide a capital contribution, then the substance of the transaction is a capital contribution. In this case, the Subsidiary would record the amount received within equity and the Parent would increase its investment in the Subsidiary. As a result, this capital contribution would be outside the scope of IFRS 9.
To make the determination as to whether it is a loan or a capital contribution, entities (and their auditors) should look at things such as past practice, payment history, and/or documented terms. For example, if the “loan” (or similar “loans”) have been outstanding for some time and repayment has not yet been received, the financing by the Parent would be more akin to a capital contribution rather than a loan within the scope of IFRS 9.
Issue #2: If within the scope of IFRS 9, how should the loan be classified and subsequently measured?
Under IFRS 9, a financial asset is classified and subsequently measured at amortized cost if it meets both the:
- Business model test; and
- “SPPI” contractual cash flow characteristics test.
Trade receivables and loan receivables with “basic” features are examples of financial instruments likely to be accounted for at amortized cost under IFRS 9.
Assuming the loan is within the scope of IFRS 9 and is repayable on demand of the Parent, the loan would appear to meet these tests and subsequent measurement at amortized cost would be appropriate. However, it would appear that the “repayable on demand” assumption would be something that should be documented between the parties!
Issue #3: How should this loan initially be measured under IFRS 9?
Under IFRS 9, there is an exception to initially recognize trade receivables without a significant financing component at transaction price instead of fair value. However, we have a loan and not a trade receivable. Therefore, it doesn’t qualify for this scope exception and must be initially measured at fair value.
Remember our loan did not charge interest. As a result, the loan receivable needs to be discounted using a market rate of interest to determine its fair value. Any difference between the loan’s fair value and the case disbursement (i.e. the “day 1 difference”) would most likely be added to the investment in the Subsidiary. The rationale for this treatment is that the Parent would never have made this “off-market” loan had it not had the relationship with the Subsidiary. Note, as this loan is repayable on demand, and assuming repayment was expected rather quickly, this “day 1 difference” is likely to be immaterial.
Issue #4: What about the other requirements of IFRS 9?
Here’s where it gets interesting! Since the loan is within the scope of IFRS, all the requirement of IFRS 9, including the new impairment guidance would need to be applied! Furthermore, intercompany loans don’t qualify for the simplified approaches to impairment available under IFRS 9. As such, the full impairment model will apply.
Under the full impairment model, the Parent would be required, on initial measurement, to determine the 12-month expected losses. Note this impairment loss should be added to the cost of the Subsidiary as the “day 1 difference” discussed above, but booked to profit and loss immediately. Subsequently, if the credit risk of the loan decreases significantly, additional impairment provisions would need to be considered. This becomes a challenge for intercompany loans because the Parent would need to determine how long the loan will remain outstanding (i.e. when will the loan be repaid) to determine the lifetime expected credit losses.
Hasn’t this been fun? Let’s switch it up a bit and give you a bonus issue!
Bonus Issue: Would the accounting discussed be the same if the loan were between two subsidiaries?
Generally, loans between fellow subsidiaries fall within the scope of IFRS 9. Such loans would likely meet the tests within IFRS 9 for subsequent measurement at amortized cost. In addition, the loan would initially be recorded at fair value. However, the difference between the loan’s fair value and the cash disbursed, the “day 1 difference,” would need to be immediately recorded in profit and loss as a “day 1 loss.” Finally, the full impairment model of IFRS 9 would apply, with any credit losses also recorded in profit of loss.
We hope this blog helps you navigate the issues surrounding intercompany loans under IFRS 9. As always, feel free to contact us if you have any questions.
Disclaimer
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.
Comments (11)
Perry:
Nov 20, 2017 at 04:25 PM
Hey Mike,
I got excited when you mentioned the implication of the intercompany loan when a lifetime assessment is required. I.e. when there has been a significant increase in credit risk. I noted however that you did not delve into that aspect.
I am contending with the same question. How do I determine the life of the loan when there is no repayment terms and when there is no history of repayment pattern in relation to such lending arrangement. I must say, after days of research I am no closer to an answer. Any further thought on how you would treat with this situation?
Thanks in advance.
Maria:
Jan 04, 2018 at 02:30 AM
My question is the same as Perry above, if the loan is repayable on parent's demand, how will it be discounted at market rate in the first place without knowing the repayment date?
I have such loans from shareholders pending at my organisation that I now need to discount. After giving a lot of thought, I think I am going to use my future free cash flows ( of the sub-subsidiary) to determine the repayment dates, assuming that parent will only make repayment demands when we will have enough free cash.
Hope somebody can give a better reply. Thanks
Mike Walworth, CPA:
Jan 04, 2018 at 08:26 AM
Perry and Maria,
Regarding initial recognition, everything I have read indicates that an "on demand" loan really doesn't need to be discounted as discussed above. As Perry noted, the issue comes up when you have to measure lifetime expected credit losses (ECL) and, unfortunately, I could not find any guidance out there either other that the "reasonable and supportable" jargon in so many of the technical literature. I do believe Mariah's suggested approach sounds very reasonable. Also, could you possible you probability of default (PD) as the loans enters the various three stages of the ECL model such as included in Example 25 of this BDO document? https://www.bdo.global/getattachment/Services/Audit-Accounting/IFRS/IFRS-in-Practice/IFRS9_print.pdf.aspx?lang=en-GB
If either of you (or anybody else on the interwebs) has some guidance, please opine!
Mike Walworth, CPA:
Jan 04, 2018 at 08:48 AM
Although not completely "on point" I think I found something that might be helpful. It comes from paragraph 4 of the Grant Thornton publication referenced below. Although it relates to determining the fair value of such loans under IAS 39, I think the premise is the same.
"Loans within a group are sometimes made without stated repayment terms. In such cases, it will be necessary for management to determine the appropriate accounting based on the expected timing of repayments."
The paragraph then goes on to discuss things like if the loan is never going to be repaid, it is going to be repaid in a short amount of time, etc.
I believe this further supports that Mariah's approach above is reasonable!
Here is the link to the publication:
https://www.grantthornton.com.au/globalassets/1.-member-firms/australian-website/technical-publications/local-technical--financial-alerts/gtal_2009_ta_alert_2009-11_inter_company_loans.pdf
Shivkumar:
Feb 03, 2019 at 11:45 PM
So the difference between risky rate and risk free rate will be the ECL.
What will be component of LGD will be part of interest rate difference or a standard lgd is applied for inter company loan as per Basel
Ahmed Mansour:
Mar 15, 2019 at 08:43 AM
Hi
In case of a related party loan to an associate, would the treatment of that day 1 difference differ (i.e. is it added to the cost of investment)?
if so, and also in the case of loan to a subsidiary, what happens to that amount added to investment cost after repayment of the loan? would it be impaired? and the corresponding equity amount in the books of the subsidiary how is it treated after repayment?
Mike Walworth, CPA:
Mar 15, 2019 at 03:16 PM
Shivkumar and Ahmed,
Thanks for reading and my apologies for the late reply (we had some issues with spam and I wasn't being notified of legitimate comments). In addition to the BDO and Grant Thornton publications referenced in the comments above, I did find another resource from PwC that might be helpful (at least to Ahmed). It can be found at this link:
https://www.pwc.com/gx/en/audit-services/ifrs/publications/ifrs-9/ifrs-9-impairment-intercompany-loans.pdf
Unfortunately, I do not think I completely understand Shivkumar's question and, even if I did, I confess that I am not an expert in Basel III. Sorry!
I hope this additional link helps the discussion.
Mike
Ahmed Mansour:
Mar 17, 2019 at 02:14 AM
Thanks a lot Mike, this is very helpful indeed.
Ahmed Mansour:
Mar 17, 2019 at 02:14 AM
Thanks a lot Mike, this is very helpful indeed.
Tamarin Wilson:
Jan 13, 2022 at 04:12 PM
Hi Mike, I know this is an old post, but I have actually attended all your training in Cayman and I am a BIG fan of everything you do and how you explain it all! Thank you! I am facing the same situation with these intercompany loans. I am very familiar with the IFRS treatment, but still not certain of how US GAAP would account for these. These loans are from the sole shareholder into an investment company, interest free and payable on demand. Do you have any suggested US GAAP guidance for these? THANK YOU!!!!
Mike Walworth, CPA:
Jan 15, 2022 at 08:49 AM
Tamarin, thanks for being a fan! I asked our resident IM expert (Bob Laffler) about your question and here is his response:
I assume since the question is being asked from the standpoint of the investment company (i.e. borrower from shareholder)? If so, I would say you have to look at the typical debt vs. equity guidance and conclude whether it is a liability or equity classified instrument. Given that the note is payable on demand, it seems like it would be liability-classified.
As far as measurement goes, I don't think US GAAP and IFRS would be much different, however, I would argue that for an instrument like this at a fund, I would elect the FV option so that the redemption amount that is payable on demand would represent the "fair value" on any given reporting date (i.e. similar to a interest free deposit due on demand for a bank). This way there is no concern over determining an interest expense/ market rate of interest and discounting period.
Unfortunately, the Guide and ASC 946 don't seem to deal with this issue. So I think "normal" US GAAP rules would apply.
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