After I wrote an article about capitalizing borrowing cost, I got a lot of e-mails asking me actually HOW to account for loans that do not bear the interest rate reflecting market conditions.
In other words, how to account for loans at below-market interest rate, or even interest-free loans.
Such advantageous loans are seen in many circumstances:
- They are provided by a government to support some activities, such as construction of some assets, creation of employment, reimbursement of operating expenses;
- They can be provided by an employer to its employees as one form of employee benefits;
- They can be as well provided by a parent to its subsidiary (or vice versa) in order to support global business, etc.
In today’s article we will focus on the loans provided to the employees, but you can apply measurement criteria to other types of “advantageous” loans, too.
What rules do apply here?
Any loan provided to anybody meets the definition of a financial instrument under IFRS 9 Financial Instruments (and IAS 39, too). Therefore, we will be looking at the rules for initial and subsequent measurement of financial instruments.
However, here’s the other side of the transaction:
Employee loans are provided to a company’s employees and therefore, there is some employee benefit involved, whether falling under the scope of IAS 19 Employee Benefits or IFRS 2 Share-based Payments at some circumstances.
We will assume here that the loans are not connected to some share purchases or anything like that and therefore we will focus on IAS 19 Employee Benefits.
To break the transaction into small easy pieces, let’s come up with a simple example:
Practical example – question
On 1 January 20X1, Goodie Ltd. provided a loan to its employee Mr. Jones amounting to CU 20 000 at interest rate of 1% p.a., repayable in 3 installments of CU 6 800 on 31 December 20X1, 31 December 20X2 and 31 December 20X3. (Note: if you discount 3 payments of 6 800 at 1 %, you should arrive to CU 20 000).
The market interest rate on similar loans is 5%.
How should Goodie Ltd. recognize and measure this loan initially and subsequently?
Initial recognition and measurement of an employee loan
As I wrote above, any loan meets the definition of a financial instrument under IAS 39 or IFRS 9. Both standards require measuring the financial assets initially at their fair value (plus the transaction cost in some cases).
Let’s say that Goodie Ltd. classifies the loan at amortized cost under IFRS 9 (or into “loans and receivables” category under IAS 39).
If the loan would have been made on market terms, then clearly, its fair value at inception would have equaled the loan amount of CU 20 000.
But this is NOT the case.
So what is the fair value of the employee loan?
In order to determine the fair value of the loan, Goodie Ltd. needs to take the following steps:
- Determine the market interest rate for similar instruments (here: 5% p.a.)
- Discount all cash flows from the loan with the market interest rate to arrive at their present value.
The present value of all cash flows is the fair value of the loan.
There are few methods of discounting. Here, let’s apply simple Excel formula “PV” or “present value”, as the cash flows or installments are the same each period. Simply type =PV in the excel file and insert the following parameters:
- Rate = 0.05 (that’s for 5% being the market interest rate)
- Nper = 3 (for 3 regular installments)
- Pmt = – 6 800 (that’s how much employee will repay in each installment)
- Fv = 0 (the future value after repayments, in this case 0)
- Type = 0 (payments are made at the end of period)
Your formula should look something like =PV(0.05;3;-6800;0;0) and if you did it right, the fair value of the employee loan is CU 18 518.
You can do this calculation also in the table format, using the discount factors for the individual year – up to you. I elaborate more on this in my premium training package The IFRS Kit, so if interested, please check it out.
How to treat the difference between loan’s fair value and nominal amount?
There’s a difference between:
- The nominal amount of the loan (or the cash paid to an employee): CU 20 000, and
- The loan’s fair value of CU 18 518
- Difference = CU 1 482
Normally, this would be recognized directly in profit or loss, but here’s the trick:
This difference is an employee benefit and Goodie Ltd. must recognize it in line with IAS 19 rules.
The problem is that IAS 19 does NOT provide any direct guidance on accounting for this form of benefits, and therefore we need to apply general principles of IAS 19.
Determine the type of the employee benefit
First of all, we need to determine the type of the employee benefit under IAS 19 and it depends on the specific terms of the loan agreement.
You should seek answers to the following questions:
What happens when the employee leaves the company? Can he still keep the loan at favorable conditions and continue paying beneficial interest? Or will he need to start paying the market interest rate? Or will the loan become repayable?
If the employee can continue with the loan under the same favorable conditions even after he terminates the employment, it means that the employee benefit has already been earned.
In practical terms – it is recognized straight in profit or loss and the journal entry is:
- Debit Profit or loss – Employee benefits: CU 1 482
- Debit Financial assets – Loans: CU 18 518
- Credit Cash: CU 20 000
If the loan will revert to a market interest rate after the employee leaves, then the benefit has not been fully earned and is available only while the employee provides services to the entity.
In line with IAS 19, an expense should be recognized when the employee provides its services, therefore in this case, we cannot recognize the full amount of CU 1 482 in profit or loss at the time of making the loan.
Instead, we need to defer the expense and allocate it to the periods when the employee provides services.
The journal entry is:
- Debit Prepaid (deferred) expenses for employee benefits: CU 1 482
- Debit Financial assets – Loans: CU 18 518
- Credit Cash: CU 20 000
Amortize the benefit in profit or loss
Then you need to determine HOW you will amortize these prepaid expenses in profit or loss.
Here, several methods are acceptable, but let me show you the method I have seen very frequently. This method looks at the employee benefit as short-term benefit, i.e. settled within 12 months after the employee renders the service.
You can estimate the cost of such an employee benefit in each period as the difference between:
- The interest income for the period based on the fair value of the loan asset (using effective interest method at the market rate of 5%); and
- The interest payable by the employee (at 1%).
I have prepared the simple calculation in the following table:
The specific numbers depend on the year. Let’s draft the journal entries at the end of the year 1:
#1 Interest income on the loan using the effective interest method (at 5%):
- Debit Financial Assets – Loans: CU 926
- Credit P/L – Interest income: CU 926
#2 The 1st installment paid by the employee:
- Debit Cash: CU 6 800
- Credit Financial Assets – Loans: CU 6 800
#3 The employee benefit resulting from the employee loan:
- Debit P/L – Employee benefits: CU 727
- Credit Prepaid (deferred) expenses for employee benefits: CU 727