Non-market rate loans under FRS 102 – not repayable on demand?

In my first blog post on non-market rate loans under FRS 102 I noted:

'we'll either end up accounting for these loans as a current liability (which we probably don't want to do) without the need for funny double entries...or we'll end up with a non-current liability accounted for at present value with funny double entries (which we also probably don't want to do).'

Having already dealt with the first thing we probably don't want to do, let's look at the second in this blog post.

I've got to say, though, before putting this blog together I sat for a little while thinking of reasons why FRS 102 improves the quality of financial reporting from the normal old-GAAP position in this area. Then I went to make a cup of tea and thought about it some more. Conceptually I get the consistency and technical lines from the FRC - fine, but I still struggle with the practical benefits for most businesses. But that's just me - you might love it! Let's see what the standard says...

Are you sure it isn't repayable on demand?

OK, I know, we did this one last time. But it's worth a final check - the detail (where it is repayable on demand) is in my previous blog.

What do we know about the loan?

There ought to be some sort of agreement in place that will give us clues as to how it will need accounting for. These clues include:

• Amounts loaned / borrowed
• Term of the loan
• Rates of interest (if any)
• The parties to the agreement

Each of the above will give us a piece of the accounting jigsaw when accounting for this financing transaction. We might need other information as well, such as the market rate for a similar loan.

How do we recognise a financing transaction?

Where a loan is at a market rate for a similar loan, then calculating the present value of future payments discounted at a market rate of interest would just bring you back to the transaction price. However, when the terms are below (or above) a market rate, the present value of the loan will be different to the transaction price. Let's look at an example:

Parent Limited lends Sub Limited £1m. No interest is being charged and the loan is repayable in full in 5 years' time. Sub Limited recently took out a similar loan with the bank (how convenient) with interest charged at 10%.

The parent is providing its subsidiary with financing, in addition to the underlying loan and FRS 102 says we need to account for the loan at present value of the future payments discounted at the appropriate market rate.

In this example, therefore we work out the present value of £1m over 5 years at a rate of 10%. To do this we take £1m / 1.105 which gives us a present value of about £621k.

So my double entry in the books of Parent Limited (I'll talk about Sub Limited later) is:

Dr Group debtors £621k

Cr Cash £1,000kAt which point, you'll notice that my debits don't equal my credits! The balancing figure here is the financing element of the arrangement - ie Parent is giving Sub something for nothing and there is a price to reflect in doing this to this. Where I post this floating debit is determined by the relationship between the parties and the nature of the agreement in place.

Where does my floating debit / credit go in initial recognition?

It depends. Let's continue the above example, then highlight some other common scenarios.

Having established that Parent Limited is the parent of Sub Limited (yes, really) we look at the substance of what is going on here. The parent is financing its subsidiary. However, the floating debit of £379k doesn't get treated as an expense in Parent's books (it doesn't technically meet the definition of expenditure in Section 2 of FRS 102) - we treat it as an investment. This kind of makes sense insofar as the substance of the transaction is that the parent is plugging extra money into its subsidiary -ie making an investment.

Dr Investment in Sub £379k

And now the double entry balances.

Other scenarios that obviously exist include subsidiary-to-parent loans, subsidiary-to-subsidiary loans, loans to employees and loans to and from shareholders. And the floating debit could end up being shown as a distribution, finance charge, employee remuneration, debtor distribution or capital contribution depending on the circumstances and the agreements in place. Of course, the other party (if preparing their accounts under FRS 102) will post a similar entry in their accounts (but the other way around). So Sub Ltd would be looking at a capital contribution in their books. As a footnote, I need to note that distributions or capital contributions aren't necessarily linked to distributable profits.

What happens in year two and beyond?

In year two and beyond, these financing transactions are accounted for at amortised cost using the market rate of interest as the effective interest rate. So, to continue the example:

The carrying value of the Parent Ltd to Sub Ltd loan at the end of its first year is as follows:

£1m / 1.104 = approx. £683k

No cash has changed hands, the only movement in the present value is because a pound in your pocket in four years' time is worth more than one in five.

So, to continue to account for the loan at present value we need to post:

Dr Group debtors £62kCr Finance income £62k

This present value calculation continues until the debtor works its way up to £1m (£1m / 1.100). Then Parent gets paid £1m cash and the debtor disappears (you'll recognise the last bit from old UK GAAP no doubt).

This credit to finance income often raises an eyebrow (or two). Surely it must go back against the investment? Well, no. The finance income is reflecting the financing element of the transaction once you have stripped the investment element out of the transaction. Whilst on the subject of the investment (which we increased by £379k on day one) we would need to consider the increased amount for impairment- but may be able to justify it remaining on our balance sheet.

Where material (which it could well be) the accounting required under FRS 102 introduces a number of additional steps when compared to the simple old-GAAP double-entry. And that's before we get to thinking about where we would get an equivalent rate from or the tax effect of some of these types of transaction.

This may feel like an academic exercise that adds little or no value to the accounts. Though if I'm applying new UK GAAP's centrepiece standard that's what I'm to do. Hurrah for the micro-entity, eh?

If you have been affected by any of the issues raised in this in the above blog post, you may be interested in the following:

• Staff Education Note 16: Financing Transactions - the FRC's go-to guide for accounting for financing transactions under FRS 102.
• Corporation Tax treatment of interest-free loans and other non-market loans
• Explanatory Note Clause 23: Loan relationships: non-market loans (Finance Bill 2016) - a note of the proposed amendments due to take effect from 1 April 2016.

Are you ready for the New UK GAAP changes? See what we have in-store to help you with the transition by visiting this link, New UK GAAP.