Accounting for loans with below market terms

By Hayley Keagan
Technical Director
19 August 2021
  • Accounting
  • Accounting standards

When a loan occurs it usually attracts a market interest rate, establishment fees and maturity dates. Terms like this are considered normal as they match the risk associated with the money that is being lent. Sometimes loans occur on non-commercial terms and accounting standards are not explicit on the treatment. In these circumstances there needs to be consideration of the commercial substance of the loan, with accounting for any below-market portion as per its substance. 

For example

If a parent entity lends money to a subsidiary entity without interest, then any interest portion not paid would reflect the parent entity’s contribution to the subsidiary. Reason being is that the subsidiary would have otherwise had to pay interest if borrowing those funds under normal market terms.

We would need to determine the fair value of the loan and record that portion as a debt instrument, whereas the remaining portion would be considered a contribution or investment in the subsidiary entity.

The accounting issue

Accounting standards consider all transactions on normal commercial terms.  Therefore, when accounting for a loan under AASB 9: ‘Financial Instruments’ we must recognise it at its fair value. Meaning that the non-commercial portion, or the difference between the transaction price and the fair value of the loan, should be accounted for appropriately. 

Determining the below-market element

The fair value of the transaction must first be determined by using normal market rates comparable for the loan term. Using the market rate, a calculation can be performed to determine the appropriate fair value using a Net Present Value (NPV) technique. This fair value can then be compared to the transaction amount to determine the below market-element.

Examples of below market elements

Type of loan

Below market element

Explanation

Loan provided to an employee

Wages expense

The employee received a benefit of a below market loan for their services

Loan from parent entity to subsidiary entity

Investment in the subsidiary

The parent entity has provided a benefit to the subsidiary that the subsidiary wasn’t otherwise able to access

Loan between fellow subsidiaries

Possible scenarios:

- Services expense (or other relevant expense)

- Investment in entity

Depends on the nature of the loan and should be carefully analysed

Loan from subsidiary to parent

Distribution from subsidiary

The subsidiary has provided a benefit to the parent that the parent only received due to the group relationship

Loan to subsidiaries that are not repayable

Investment in subsidiary

The entire transaction balance should be considered equity if there is no intention for repayment as this takes on the character of equity.

Short-term loans

Often group entities will have high turnover loans which acts as cash sweeping accounts, intended to spread cash across the group. This style of loan usually acts as a bank overdraft or cash balance and are expected to be repaid in the near future. Under these circumstances, the loan amounts (being the transaction values) would likely be similar to the fair value and no adjustment would be needed for a below-market element.

Undocumented loans

Sometimes loans between group entities are poorly documented, with no stated interest rates or repayment terms. In this case, steps will need to be taken to consider the substance of the loans and to document the terms to allow for the above analysis to occur.

For any further guidance, please contact your local PKF audit representative.