Example: Expected Credit Loss on Interest-free On-demand Loan
Let’s face the truth: most intercompany loans (or at least many of them) are special in some way:
- They are undocumented – a parent simply sends cash to a subsidiary with no contract whatsoever and no one has an idea what the terms of the loan are;
- There is no maturity date – a loan can be documented but there is no maturity date stated and no repayments are required;
- There is no interest and/or no repayments required – probably the loan is repayable in one amount at the end (“bullet” loan) at its nominal amount,
just to name a few specific features of intercompany loans.
The first challenge is to determine whether the “loan” is indeed a financial asset under IFRS 9 or some sort of capital contribution out of IFRS 9 scope.
On top of it, if it is a financial asset, you need to recognize an expected credit loss provision if you are a lender.
However, thanks to these special features, it is quite challenging to apply the general approach as described here.
Therefore, let me come up with a very specific but frequent example of expected credit loss provision on intercompany loans.
Example: Undocumented loan
ABC has a newly established subsidiary DEF involved in a real estate development. To finance new projects, ABC sends cash of CU 10 million to DEF.
This transfer of cash is not documented in any contract, but the negotiations between ABC and DEF indicate that ABC will demand the repayment of this cash when DEF becomes profitable (not expected within the next few years).
Before we even start thinking about expected credit loss on this loan, we must decide how to recognize this loan first.
Clearly, from ABC’s point of view, this is a financial asset and not a capital contribution to subsidiary’s equity, because ABC expects repayment in some future date.
Also, this financial asset is not credit impaired and therefore it can be classified at amortized cost.
Initially, ABC needs to recognize the financial assets classified at amortized cost at their fair value.
Normally, you would discount all the cash flows from the loan with some market interest rate to arrive at fair value at initial recognition.
However, what to do now – there is no clear repayment schedule, no interest…?
Well, in most cases, these undocumented loans with no clearly stated maturity date are deemed repayable on demand.
Of course, this would also depend on the local legislation.
In this case, the effective interest rate of the loan is zero and the loan is initially recognized in its nominal amount of CU 10 million.
Recognizing the loan subsequently
Let’s say that after 1 year, ABC needs to recognize ECL provision at the reporting date.
IFRS 9 says maximum period over which ECL should be measured is the longest contractual period where the lender is exposed to credit risk.
In this case, if the loan is repayable on demand, this maximum period is short – it takes only as many days as needed to transfer cash from the borrower (DEF) to lender (ABC).
Therefore, we need to calculate ECL assuming that the lender demands the repayment at the reporting date – even if the lender has NO intention to do so!
With this in mind, we can take the steps to calculate ECL:
1. Determine the stage of a loan
As you may remember, we need to assess whether the credit risk has significantly increased since initial recognition:
- If not, then the loan is at Stage 1 and we need to recognize 12-month ECL;
- If yes, then the loan is at Stage 2 (or even at Stage 3) and we need to recognize lifetime ECL
However, in this particular case, 12-month expected credit loss will be just the same as lifetime expected credit loss.
The loan is repayable on demand – which is shorter than 12 months for sure.
As a result, “lifetime” of a loan is that short period required to transfer cash when demanded by the lender.
Easy, isn’t it?
2. Calculate and recognize ECL
IFRS 9 (B.5.5.41) says that you should measure ECL as probability-weighted amount reflecting at least 2 possibilities:
- Credit loss occurs;
- Credit loss does not occur.
In this specific case of on-demand repayable loan, there are just two options:
- The borrower is able to pay immediately (if demanded), or
- The borrower is NOT able to pay immediately.
The thing is that we need to examine whether the borrower (DEF) has sufficient liquid assets to repay the loan immediately.
Now, let me outline what happens in both cases.
Scenario 1: The borrower has sufficient liquid assets.
If the borrower has sufficient highly liquid assets (cash and cash equivalents) to repay the outstanding loan, then ECL is close to zero, because probability of default is close to zero.
Are they sufficient to cover the loan? And – very important – are there any other more senior loans that DEF would need to repay before it can pay to ABC?
Let’s say that the borrower’s bank account shows the balance of CU 11 million – which is great as the loan from ABC is CU 10 million.
However, if the borrower took a bank loan amounting to CU 5 million that has priority, then only CU 6 million is left to repay the loan from ABC – which is not that great.
Also, look at any restrictions on cash and cash equivalent and if there are any, do not count restricted cash as your highly liquid asset.
Scenario 2: The borrower has no sufficient liquid assets
In this case, there will be some ECL, because probability of default is NOT zero.
The reason is that if the lender requires immediate repayment, then the borrower simply cannot repay at that moment due to insufficient funds.
OK, so in this case, we need to calculate ECL using one of the acceptable approaches. In this article I outlined one formula of calculating ECL:
So, even if probability of default is more than zero, you still need to evaluate LGD (loss given default) and EAD (exposure at default).
EAD is clear – it is simply the balance of the loan outstanding at the reporting date.
What about LGD?
Here, you need to assess different scenarios of possible recovery of the loan.
Especially, look to the assets of the borrower and try to estimate their net realizable value – which is about the amount that the lender will be able to get from the borrower if the borrower is forced to sell all assets NOW.
In our example, the borrower is involved in real estate development and therefore it is probable, that it will have some assets with possible net realizable value greater than zero.
Imagine a different situation. Let’s say that the borrower is involved in some research with very uncertain outcome.
In this case it is quite possible that the borrower would have spent a lot of cash on research activities (i.e. expenses in profit or loss) and no assets have been generated – here, LGD would be much greater.
Except for available assets of the borrower, you should assess the following:
- Are there any more senior loans or other liabilities in the borrower’s accounts that would have to be repaid prior lender’s loan?
- Will the lender require immediate repayment? Or, will the lender grant the borrower some time sell the assets over time?
- What would be the expected cash flows from the loan in the case of over-time sale?
… just to name a few things.
Then you would need to set up a cash flow table, discount it, calculate the expected credit loss you get the point.
However, here’s the shortcut: if the borrower’s assets or expected net cash flows from their realization cover the outstanding balance of the loan, then there is probably no ECL (or immaterial ECL).
IFRS 9 indeed requires recognizing a provision on all loans, including intercompany loans.
However, as you read here, it does not need to be a big deal, especially if the loan is interest-free and repayable on demand.
You still have to perform some exercise and document it, but it could be simple and easy.
One last remark – all lenders having intercompany loan receivable in their books MUST assess these loans for any impairment, even it there is NO intention to require immediate repayment of the loan.
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