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Initial and subsequent measurement of debt instruments
Extract from FRS 102 Section 11.12-11.20
11.12 An entity shall recognise a financial asset or a financial liability only when the entity becomes a party to the contractual provisions of the instrument.
11.13 When a financial asset or financial liability is recognised initially, an entity shall measure it at the transaction price (including transaction costs except in the initial measurement of financial assets and liabilities that are measured at fair value through profit or loss) unless the arrangement constitutes, in effect, a financing transaction. A financing transaction may take place in connection with the sale of goods or services, for example, if payment is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate. If the arrangement constitutes a financing transaction, the entity shall measure the financial asset or financial liability at the present value of the future payments discounted at a market rate of interest for a similar debt instrument.
Examples – financial assets
1) For a long-term loan at a market rate of interest made to another entity, a receivable is recognised at the amount of the cash advanced to that entity plus transaction costs incurred by the entity (see the example following paragraph 11.20).
2) For goods sold to a customer on short-term credit, a receivable is recognised at the undiscounted amount of cash receivable from that entity, which is normally the invoice price.
3) For an item sold to a customer on two-years interest-free credit, a receivable is recognised at the current cash sale price for that item (in financing transactions conducted on an arm’s length basis the cash sales price would normally approximate to the present value). If the current cash sale price is not known, it may be estimated as the present value of the cash receivable discounted using the prevailing market rate(s) of interest for a similar receivable.
4) For a cash purchase of another entity’s ordinary shares, the investment is recognised at the amount of cash paid to acquire the shares.
Examples – financial liabilities
1) For a loan received from a bank at a market rate of interest, a payable is recognised initially at the amount of the cash received from the bank less separately incurred transaction costs.
2) For goods purchased from a supplier on short-term credit, a payable is recognised at the undiscounted amount owed to the supplier, which is normally the invoice price.
Subsequent measurement
11.14 At the end of each reporting period, an entity shall measure financial instruments as follows, without any deduction for transaction costs the entity may incur on sale or other disposal:
(a) Debt instruments that meet the conditions in paragraph 11.8(b) shall be measured at amortised cost using the effective interest method. Paragraphs 11.15 to 11.20 provide guidance on determining amortised cost using the effective interest method. Debt instruments that are payable or receivable within one year shall be measured at the undiscounted amount of the cash or other consideration expected to be paid or received (ie net of impairment—see paragraphs 11.21 to 11.26) unless the arrangement constitutes, in effect, a financing transaction (see paragraph 11.13). If the arrangement constitutes a financing transaction, the entity shall measure the debt instrument at the present value of the future payments discounted at a market rate of interest for a similar debt instrument.
(b) Debt instruments that meet the conditions in paragraph 11.8(b) and commitments to receive a loan and to make a loan to another entity that meet the conditions in paragraph 11.8(c) may upon their initial recognition be designated by the entity as at fair value through profit or loss (paragraphs 11.27 to 11.32 provide guidance on fair value) provided doing so results in more relevant information, because either:
(i) it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or debt instruments or recognising the gains and losses on them on different bases; or
(ii) a group of debt instruments or financial assets and debt instruments is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel (as defined in Section 33 Related Party Disclosures, paragraph 33.6), for example members of the entity’s board of directors and its chief executive officer.
(c) Commitments to receive a loan and to make a loan to another entity that meet the conditions in paragraph 11.8(c) shall be measured at cost (which sometimes is nil) less impairment.
(d) Investments in non-convertible preference shares and non-puttable ordinary shares or preference shares shall be measured as follows (paragraphs 11.27 to 11.32 provide guidance on fair value):
(i) if the shares are publicly traded or their fair value can otherwise be measured reliably, the investment shall be measured at fair value with changes in fair value recognised in profit or loss; and
(ii) all other such investments shall be measured at cost less impairment.
Impairment or uncollectability must be assessed for financial assets in (a), (c) and (d)(ii) above. Paragraphs 11.21 to 11.26 provide guidance.
Amortised cost and effective interest method
11.15 The amortised cost of a financial asset or financial liability at each reporting date is the net of the following amounts:
(a) the amount at which the financial asset or financial liability is measured at initial recognition;
(b) minus any repayments of the principal;
(c) plus or minus the cumulative amortisation using the effective interest method of any difference between the amount at initial recognition and the maturity amount;
(d) minus, in the case of a financial asset, any reduction (directly or through the use of an allowance account) for impairment or uncollectability.
Financial assets and financial liabilities that have no stated interest rate (and do not constitute a financing transaction) and are classified as payable or receivable within one year are initially measured at an undiscounted amount in accordance with paragraph 11.14(a). Therefore, (c) above does not apply to them.
11.16 The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability (or a group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period, to the carrying amount of the financial asset or financial liability. The effective interest rate is determined on the basis of the carrying amount of the financial asset or liability at initial recognition. Under the effective interest method:
(a) the amortised cost of a financial asset (liability) is the present value of future cash receipts (payments) discounted at the effective interest rate; and
(b) the interest expense (income) in a period equals the carrying amount of the financial liability (asset) at the beginning of a period multiplied by the effective interest rate for the period.
11.17 When calculating the effective interest rate, an entity shall estimate cash flows considering all contractual terms of the financial instrument (e.g. prepayment, call and similar options) and known credit losses that have been incurred, but it shall not consider possible future credit losses not yet incurred.
11.18 When calculating the effective interest rate, an entity shall amortise any related fees, finance charges paid or received (such as ‘points’), transaction costs and other premiums or discounts over the expected life of the instrument, except as follows. The entity shall use a shorter period if that is the period to which the fees, finance charges paid or received, transaction costs, premiums or discounts relate. This will be the case when the variable to which the fees, finance charges paid or received, transaction costs, premiums or discounts relate is repriced to market rates before the expected maturity of the instrument. In such a case, the appropriate amortisation period is the period to the next such repricing date.
11.19 For variable rate financial assets and variable rate financial liabilities, periodic re-estimation of cash flows to reflect changes in market rates of interest alters the effective interest rate. If a variable rate financial asset or variable rate financial liability is recognised initially at an amount equal to the principal receivable or payable at maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or liability.
11.20 If an entity revises its estimates of payments or receipts, the entity shall adjust the carrying amount of the financial asset or financial liability (or group of financial instruments) to reflect actual and revised estimated cash flows. The entity shall recalculate the carrying amount by computing the present value of estimated future cash flows at the financial instrument’s original effective interest rate. The entity shall recognise the adjustment as income or expense in profit or loss at the date of the revision.
OmniPro comment
A basic financial instrument is recognised at the transaction price including transaction costs with the exception of financial asset and liabilities which are required to be fair valued i.e. investments in shares where ownership is less than 20% (or where significant influence as defined in Section 14 is not obtained) or where debt instruments meet the definition in 11.14 (b).
The standard allows short term receivables or payables i.e. repayable/payable within one year to be carried at the undiscounted rate which is normally the invoice price. However where a financing arrangement exists it may need to be carried based on present value depending on materiality.
Transaction costs are incidental costs directly attributable to the acquisition, issue or disposal of the financial asset or liability. They are usually:
- the arrangement fees,
- commitment fees, or
- facility fees.
These costs are added to the amount originally received where it is an asset or deducted from a liability and included in the calculation of amortised cost using the effective interest rate method. The transactions costs are usually released over the life of the instrument unless there is a market repricing element in the contract in which case the transaction price is released up to the date of market repricing. The only exception is where the financial asset or liability is calculated at fair value in which case they are expensed as incurred (i.e. an investment in non-puttable ordinary or preference shares or where a debt instrument meets the definition of 11.14 (b) where measuring the debt instrument at amortised cost creates a measurement inconsistency.
Transaction costs do not include:
- debt premium or discounts;
- finance costs; or
- internal administration costs.
When calculating the effective interest rate, consideration needs to be given to any put or call options, and at each reporting date a determination as to whether it is likely any party will take action on the put and call options so that the life over the financial instrument can be determined. If initially the calculations were completed based on the option not been triggered which then it subsequently does, then the financial asset/liability would have to be adjusted to reflect the actual and revised estimated cash flows. The adjustment is recognised prospectively as income or expenses at the date of the revision.
NOTE: where there are no transaction costs and no financing arrangement exists then the amortised cost is the same as the actual amount received or paid, the effective interest rate is the rate stated in the agreement.
See diagram on next page for the way in which a basic financial instrument should be accounted for on initial and subsequent measurement.
Where a financing arrangement exists i.e. sales/purchases made at non-standard terms or where loans are provided at non market rates then the financing element needs to be separated and posted as a finance income or expense using the effective interest rate method.
The standard is silent on how the difference between the transaction price paid or received and the present value of future payments of the future cash flows should be accounted for however example 15 to example 18 would be indicative of how these can be accounted for.
Where a debt instrument is repayable on demand, then the amortised cost is effectively equal to the value of the money received or paid and any transaction costs are expensed as incurred as this represents the present value as it is repayable on demand.
Example 13: loan at market rates with transaction costs
Company A obtains a loan from the bank for CU100,000 on 1 January 2015. Arrangement fees of CU10,000 was charged by the bank. The loan carries a market rate of interest of 5% per annum which is charged annually. It is repayable after 5 years. Entity A would calculate the amortised cost and effective interest rate in the following way:
Step 1: Assess whether the instrument meets the definition of a basic instrument and the category it falls into
As this loan meets the definition of a debt instrument where there is no unusual interest rates, then this meets the definition of a basic debt instrument.
Step 2: Determine the method in which the debt instrument should be measured (does section 11.14 (b) apply
As using the amortised cost basis does not create a measurement inconsistency and as this is not a group managed debt instrument where the performance of the group is evaluated on a fair value basis, then it is correct to use the amortised cost basis
Step 3: Assess if there is a financing transaction within the arrangement i.e. is the transaction at non market rates; is unusual extended credit terms provided?
Here the loan is at market rates, therefore there is no financing transaction.
Step 4: Determine amount to be recognised on initial recognition.
The amount to be recognised is the total value of the loan received of CU100,000 less the transaction costs of CU10,000 i.e. CU90,000
Step 5: Determine the effective interest rate and determine the carrying amount on subsequent measurement
The effective interest rate is the rate of interest that exactly discounts the estimated future cash flows through the expected life. In this case the rate is 7.469%. This 7.469% can be determined through trial and error or through the use of a mathematical formula in Microsoft Excel.
Step 6: Decide the journals to be posted at each period end
The journals to be posted in 2015 excluding the payment of the interest are as detailed below such that the amortised cost at 31/12/15 is CU91,708. This will be continued year on year:
|
|
CU |
CU |
|
Dr Loan Liability |
10,000 |
|
|
Cr Bank |
|
10,000 |
Being journal to recognise the arrangement fee charged
|
|
CU |
CU |
|
Dr Interest Expense |
CU6,722 |
|
|
Cr Loan Liability |
|
CU6,722 |
Being journal to recognise effective interest charge for 2015. The effective interest charge will be posted in each of the 5 years as detailed above. The CU5,000 will be set against the liability as it is paid.
Changes in cash flow estimates
Section 11.20 states the entity shall adjust the carrying amount of the financial asset or financial liability to reflect actual and revised estimated cash flows. The entity shall recalculate the carrying amount by computing the present value of estimated future cash flows at the financial instrument’s original effective interest rate. The entity shall recognise the adjustment as income or expense in profit or loss at the date of the revision. See example
Example 13a: change in estimate
If we take example 13 and assume that a repayment of CU10,000 was made at the end of year 2 (i.e. 31/12/16). Therefore the new principal to be repaid at 31/12/19 is CU90,000 and the new interest charge is CU4,500 (i.e. CU90,000*5%) for 2017 to 2019.
Calculate the net present value of estimated future cash flows as per below.
The actual carrying amount at 31/12/16 as per the amortised cost table above in example 14 was CU93,573. If we then take account of the additional payment of CU10,000 made on 31/12/16, the carrying amount in the financial statements is CU83,573. The difference of CU645 (CU83,573-CU84,218) is debited to the interest cost in the profit and loss account at 31/12/16.
The remaining difference of CU5,782 (CU90,000-CU84,218) is then charged to the profit and loss account over the remaining life as follows (assuming there is not a substantial modification as discussed further below):
Non market loans- inter-company loan / director’s loans
Section 11 requires all such loans to be stated at the amortised cost. In reality for a lot of intercompany loans which are between related parties, there may be a favourable interest rate or no interest charged on the loan. In this particular case section 11 deems this to be akin to a financing arrangement and therefore requires:
- an inputted rate to be charged on these loans; and
- for the loan to be recognised at the present value of the future cash flows discounted at a market rate of interest for similar debt instrument.
The inputted rate is the interest rate that would be charged by a bank if the entity had to obtain external loan financing. Even where interest is charged on the loan but it is not at market rates, the difference between the market rate and the rate charged is used to determine the amortised cost.
Although the standard does not specify where the difference between the amount initially recognised and the amount received is to be posted in the P&L, depending on the circumstances the below accounting treatment may be used:
- Where the loan is received from a parent company, in the receiving company; the difference is posted as a capital contribution to equity and the other side of the transaction is posted to the loan liability. The posting to equity reflects the fact that the parent company has provided a gift i.e. an interest free loan or a non-market interest rate loan to its subsidiary.
In the parent company financial statements, the difference is posted as an investment i.e. credit to bank, debit to investment and debit to debtors on initial recognition. A review would have to be performed to ensure the amount stated including this adjustment does not result in the carrying amount of the investment being in excess of its recoverable amount.
- Where the loan is received from a non-group company or a group company that is not its parent or a shareholder/director, then the difference is posted as a debit to interest expense in the books of the receiver (or potentially equity where it is deemed to be a distribution) and a credit to interest income in the books of the giver where applicable.
Example 14: Intercompany loan from a parent company
Company A is a subsidiary of Parent B. Parent B provides a loan to Company A for 5 years for CU200,000 on 01/01/2015. No interest is charged on the amount loaned. The market rate of interest that would be charged on this loan by a third party i.e. a bank would be 5%. In the analysis below we have assumed the answers to steps one and two are as per example 13 above. (Step 1 Asses whether the instrument meets the definition of a basic instrument and the category it falls into. Step 2 Determine the method in which the debt instrument should be measured (does section 11.14 (b) apply). Under Section 11, the following accounting transactions will be required in the books of the parent and the subsidiary:
Step 3: Assess if there is a financing transaction within the arrangement i.e. is the transaction at non market rates; is unusual extended credit terms provided?
Step 4: Determine amount to be recognised on initial recognition and subsequent measurement
Given that a financing arrangement exists, there is a need to determine the present value of the future payments using the inputted market rate. Therefore the amount to be recognised initially is:
CU200,000 / (1.05)^5 = CU156,705
Therefore the journals to post in Company A’s TB are:
|
|
CU |
CU |
|
Dr Bank |
200,000 |
|
|
Cr Interco Loan |
|
200,000 |
Being journal to recognise receipt of the loan
|
|
CU |
CU |
|
Dr Interco Loan (CU200,000- CU156,705) |
43,295 |
|
|
Cr Equity/Capital Contribution |
|
43,295 |
Being journal to reflect deemed gift from the parent for the fact that the loan was given interest free.
In the parent company financial statements the journals on initial recognition would be:
|
|
CU |
CU |
|
Dr Interco Loan |
200,000 |
|
|
Cr Bank |
|
200,000 |
Being journal to recognise provision of the loan
|
|
CU |
CU |
|
Dr Investment |
43,295 |
|
|
Cr Interco Loan (CU200,000-CU156,705) |
|
43,295 |
Being journal to recognise the deemed investment in Company as a result of providing a favourable loan
Step 5: Determine the effective interest rate
The effective interest rate is the rate of interest that exactly discounts the estimated future cash flows through the expected life. In this case the rate is 5% which is the same as the market interest rate as there was no transaction costs.
Step 6: Decide the journals to be posted at each period end.
In Company A financial statements the journals to be posted at 31/12/2015 are as detailed below such that the amortised cost at 31/12/15 is 164,540. This will be continued year on year:
|
|
CU |
CU |
|
Dr Interest Expense |
7,835 |
|
|
Cr Loan Liability |
|
7,835 |
Being journal to recognise effective interest charge for 2015. The effective interest charge will be posted in each of the 5 years as detailed above assuming no changes in the cash flow occur.
In the parent company financial statements the journals to be posted at 31/12/2015 are as detailed below such that the amortised cost at 31/12/15 is 164,540. This will be continued year on year:
|
|
CU |
CU |
|
Dr Loan Liability |
7,835 |
|
|
Cr Interest Income |
|
7,835 |
Being journal to recognise effective interest charge for 2015. The effective interest charge will be posted in each of the 5 years as detailed above.
NOTE: if the terms of the loan agreement stated that the loan was repayable on demand, the carrying amount on initial recognition would be 200,000 as this is the deemed present value of future payments, therefore no deemed interest would need to be recognised.
Example 15: Loan provided to the company by a director
A shareholder/director provides a loan to Company A for 5 years for CU200,000 on 01/01/2015. Interest of 1% is charged on the amount loaned annually (i.e. CU2,000 per annum). The market rate of interest that would be charged on this loan by a third party i.e. a bank would be 5%. In the analysis below we have assumed the answers to steps one and two are as per above. (Step 1 Asses whether the instrument meets the definition of a basic instrument and the category it falls into. Step 2 Determine the method in which the debt instrument should be measured (does section 11.14 (b) apply). Assure that there are no timing differences for deferred tax purposes. Under Section 11, the following accounting transactions will be required in the books of the Company A:
Step 3: Assess if there is a financing transaction within the arrangement i.e. is the transaction at non market rates; is unusual extended credit terms provided?
Here the loan is at non-market rates as there is no interest charged, therefore there is a financing transaction. The interest rate charged on the loan is 4% (5%-1%) below market rates.
Step 4: Determine amount to be recognised on initial recognition
Given that a financing arrangement exists, there is a need to determine the present value of the future of the future payments using the inputted market rate. Therefore amount to be recognised initially is:
CU200,000 / (1.04)^5 = 164,385
Therefore, the journals to post in Company A’s TB are:
|
|
CU |
CU |
|
Dr Bank |
200,000 |
|
|
Cr Directors Loan |
|
200,000 |
Being journal to recognise receipt of the loan
|
|
CU |
CU |
|
Dr Directors Loan (200,000-164,385) |
35,615 |
|
|
Cr Interest Income |
|
35,615 |
Being journal to reflect the benefit received from the loan being received interest free.
NOTE: if the director was instead a shareholder/director, then there could be an argument to say that the credit should go to equity as opposed to the P&L as the shareholder has in effect given the company the benefit of an interest free loan which is akin to a capital contribution.
Step 5: Determine the effective interest rate
The effective interest rate is the rate of interest that exactly discounts the estimated future cash flows through the expected life. In this case the rate is 5.128%. This rate is determined through trial or error or through the use of a mathematical model in Excel.
Step 6: Decide the journals to be posted at each period end.
The journals to be posted at 31/12/2015 are as detailed below such that the amortised cost at 31/12/15 is CU170,815. This will be continued year on year:
|
|
CU |
CU |
|
Dr Interest Expense |
8,430 |
|
|
Cr Loan Liability |
|
8,430 |
Being journal to recognise effective interest charge for 2015. The effective interest charge will be posted in each of the 5 years as detailed above.
Example 16: Intercompany loan from a related party or a fellow subsidiary
If we take the same facts as example 15 but assume this time the loan was provided by a fellow subsidiary or another company which is owned by the same shareholders as Company A. Assume there are no timing differences for deferred tax purposes. The journals in this particular instance for each entity are:
Journals on initial recognition in Company A
|
|
CU |
CU |
|
Dr Bank |
200,000 |
|
|
Cr Related Party Loan Liability |
|
200,000 |
|
Dr Related Party Loan Liability (CU200,000-CU164,385) |
35,615 |
|
|
Cr Interest Income |
|
35,615 |
Being journal to recognise the receipt of the loan and the adjustments to show the loan at its present value of future payments
The journals for subsequent years will be the same as included in example 15 above
Journals on initial recognition in the fellow subsidiary/related party company
|
|
CU |
CU |
|
Dr Related Party Loan Asset |
200,000 |
|
|
Cr Bank |
|
200,000 |
|
Cr Related Party Loan Asset |
|
35,615 |
|
Dr Interest Expense |
35,615 |
|
Being journal to recognise the provision of the loan and the adjustments to show the loan at its present value of future receipts
On subsequent measurement the journals would be to credit interest income and debit related party loan asset so as to show the correct amortised cost amount as calculated above. It may also be possible to argue that the debit can be posted to other reserves and treated as a distribution.
In an instance where Company A provided a loan to the directors, the accounting treatment in Company A’s books would be the same as the journals for the related party entity above.
Example 16a: Sale with unusual credit terms
Company A sold goods worth CU50,000 with unusual credit terms on 01/12/13. The credit provided is for a period of up to 31/12/15. The normal cash price for these goods would be CU35,000. The difference of CU15,000 is determined to be a financing transaction. The effective interest rate is calculated at 18.62% as per below. The effective interest rate is determined so as to write the deemed interest into the P&L over the life of the transaction. The effective interest rate is determined through trial and error or through the use of Excel.
The adjustments required to accounted for this are as follows:
|
|
CU |
CU |
|
Dr Trade Debtors |
50,000 |
|
|
Cr Sales |
|
50,000 |
Being journal to recognise the sale
|
|
CU |
CU |
|
Dr Sales (CU50,000-CU35,000) |
15,000 |
|
|
Credit Trade Debtors |
|
15,000 |
Being journal to reflect the deemed financing element of the sale so as to show the correct amortised cost
|
|
CU |
CU |
|
Dr trade debtors |
536 |
|
|
Cr Finance Income in P&L (so that the carrying amount is now CU35,536) |
|
536 |
Being journal reflect the deemed interest income in the profit and loss for the year for one month. The same type of journal is posted for the other two years.
Example 16b: Purchase with unusual credit terms
If we take example 16A, and show the accounting for the purchaser in this case. For the purchasing company the journals to post are:
|
|
CU |
CU |
|
Dr Inventory |
50,000 |
|
|
Cr Trade Creditors |
|
50,000 |
Being journal to reflect purchase of stock
|
|
CU |
CU |
|
Dr Trade Creditors |
15,000 |
|
|
Cr Inventory |
|
15,000 |
Being journal to reflect the deemed financing element of the sale so as to show the correct amortised cost
|
|
CU |
CU |
|
Dr Finance Expense in P&L (so that the carrying amount is now CU35,536) |
536 |
|
|
Cr Trade Creditors |
|
536 |
Being journal reflect the deemed interest income in the profit and loss for the year for one month. The same type of journal is posted for the other two years.
Example 17: Employee loan
If this loan was to an employee the answer would be the same as example 16 as it is irrelevant who the loan is to. Instead of the amount being posted to interest expense it would be posted to employee compensation.
Loans repayable on demand
Where the terms of the loan are such that it is repayable on demand, even where no interest rate is charged, the present value of the loan is the amount received which therefore equates to its amortised cost. Therefore, the calculations performed in the examples above would not be required as the value of the loan received is the carrying amount it should be shown at in the financial statements. If the above example were all repayable on demand then all of the aforementioned steps would not be required.
Example 17a: Loans repayable on demand
Company A received a loan of CU100,000 from Company B. Transaction fees of CU1,000 were incurred. No interest is charged on this loan. The loan is repayable on demand. In this case as this loan is repayable on demand, the CU1,000 transaction fees are expensed as incurred and the fair value of the loan is CU100,000 which is the amount to be recognised in the financial statements.
Variable interest rate over the life of the loan
Where a variable interest rate is charged on a loan and no transaction costs are incurred, then the amount that this will be carried at is the actual amount received/paid as the interest rate will be charged to the P&L as incurred which is based on a market interest rate at that time.
Where on the other hand, a variable interest rate loan is issued by a group company which is below market rates, the variable interest rate to be used in the amortised cost calculation is the expected variable interest rate over the life of the loan (unless there is a repricing element within it in which case it would be up until the date of the repricing).
Issues surrounding directors or intra-group loans
In the majority of cases it is likely that there may be no formal signed agreements in place in relation to these loans. If this is the case, each loan should be looked at separately to assess if there are any implied contractual terms. An assessment has to be made as to whether under the terms that repayment was not likely to have been required in the near future.
Consideration would also need to be given as to whether the loans were shown as repayable within one year under old GAAP or whether they were included in the financial statements as being payable/repayable after more than one year. If it is felt that the substance is that it is akin to a capital contribution which may never have to be paid, it is no longer in Section 11 scope and instead comes within the remit of Section 22.
Where the substance of the loan based on the facts and circumstances indicate that it is repayable on demand and therefore the amount received/paid is what the financial asset/liability will be carried at, auditors will need to assess where a letter of support is required, if this letter of support from the parent company contradicts the repayable on demand concept in relation to that loan. If the wording in the letter of support contradicts the repayable on demand concept then the entity will have to carry out the detailed exercise to ascertain the amortised cost, the market rate of interest when the loan was received/advanced etc.
Therefore care needs to be taken when the parent company provides a letter of support. The parent company should ensure that the letter of support does not evidence the contractual terms of intra group financing or that use the incorrect wording. In reality the letter of support should state that the parent will only provide support if the subsidiary is unable to meet its debts as they fall due.
Factors that indicate a related party loan is not at a market rates
Factors which indicate a loan has been provided/advanced at non market rates are:
- It is interest free or the interest rate is excessively high or low
- The interest charged is not in line with what has been charged by third parties in the past or presently and the loan advanced is riskier than what the third party advanced but yet the interest rate is lower.
- Transfer pricing adjustments being made to reflect market rates.
Fair valuing investments for debt instruments and non-puttable/non-convertible ordinary and preference shares within the scope of section 11
Extract from FRS 102 Section 11.27-11.32
11.27 Paragraph 11.14(b) and other sections of this FRS make reference to the fair value guidance in paragraphs 11.27 to 11.32, including Section 9 Consolidated and Separate Financial Statements, Section 12 Other Financial Instruments Issues, Section 13 Inventories, Section 14 Investments in Associates, Section 15 Investments in Joint Ventures, Section 16 Investment Property, Section 17 Property, Plant and Equipment, Section 18 Intangible Assets other than Goodwill, Section 27 Impairment of Assets, Section 28 Employee Benefits (in relation to plan assets) and Section 34 Specialised Activities. In applying the fair value guidance to assets or liabilities accounted for in accordance with those sections, the reference to ordinary shares or preference shares in these paragraphs should be read to include the types of assets and liabilities addressed in those sections.
Paragraph 11.14(d)(i) requires an investment in non-convertible preference shares and non-puttable ordinary shares or preference shares to be measured at fair value if the shares are publicly traded or if their fair value can otherwise be measured reliably.
An entity shall use the following hierarchy to estimate the fair value of the shares:
(a) The best evidence of fair value is a quoted price for an identical asset in an active market. Quoted in an active market in this context means quoted prices are readily and regularly available and those prices represent actual and regularly occurring market transactions on an arm’s length basis. The quoted price is usually the current bid price.
(b) When quoted prices are unavailable, the price of a recent transaction for an identical asset provides evidence of fair value as long as there has not been a significant change in economic circumstances or a significant lapse of time since the transaction took place. If the entity can demonstrate that the last transaction price is not a good estimate of fair value (eg because it reflects the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distress sale), that price is adjusted.
(c) If the market for the asset is not active and recent transactions of an identical asset on their own are not a good estimate of fair value, an entity estimates the fair value by using a valuation technique. The objective of using a valuation technique is to estimate what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations.
Valuation Technique
11.28 Valuation techniques include using recent arm’s length market transactions for an identical asset between knowledgeable, willing parties, if available, reference to the current fair value of another asset that is substantially the same as the asset being measured, discounted cash flow analysis and option pricing models. If there is a valuation technique commonly used by market participants to price the asset and that technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, the entity uses that technique.
11.29 The objective of using a valuation technique is to establish what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations. Fair value is estimated on the basis of the results of a valuation technique that makes maximum use of market inputs, and relies as little as possible on entity-determined inputs. A valuation technique would be expected to arrive at a reliable estimate of the fair value if:
(a) it reasonably reflects how the market could be expected to price the asset; and
(b) the inputs to the valuation technique reasonably represent market expectations and measures of the risk return factors inherent in the asset.
No active market
11.30 The fair value of ordinary shares or preference shares that do not have a quoted market price in an active market is reliably measurable if:
(a) the variability in the range of reasonable fair value estimates is not significant for that asset; or
(b) the probabilities of the various estimates within the range can be reasonably assessed and used in estimating fair value.
11.31 There are many situations in which the variability in the range of reasonable fair value estimates of assets that do not have a quoted market price is likely not to be significant. Normally it is possible to estimate the fair value of ordinary shares or preference shares that an entity has acquired from an outside party. However, if the range of reasonable fair value estimates is significant and the probabilities of the various estimates cannot be reasonably assessed, an entity is precluded from measuring the ordinary shares or preference shares at fair value.
11.32 If a reliable measure of fair value is no longer available for an asset measured at fair value (e.g. ordinary shares or preference shares measured at fair value through profit or loss), its carrying amount at the last date the asset was reliably measurable becomes its new cost. The entity shall measure the ordinary shares or preference shares at this cost amount less impairment until a reliable measure of fair value becomes available.
OmniPro comment
Investments in non-convertible preference shares and non-puttable ordinary shares (the investment is not an associate, joint venture or subsidiary i.e. <20% investment or where significant influence is not achieved) to be measured at fair value if the shares are publically traded or they can otherwise be measured reliably. Section 11.27 above provides the hierarchy for determining market value.
Where they cannot be measured reliably and they are not publically traded they should be stated at cost less impairment at each reporting date as stated in Section 11.30 above.
Example 18: non-convertible preference shares and non-puttable ordinary shares – traded price or can be reliably measured
A company purchased 200 shares which were publically quoted at a price of CU10 per share plus acquisition costs of CU100. At year end, the bid price of each share was CU15.
Therefore, as the shares are publically traded on initial recognition the amount to be recognised was CU2,000. The CU100 is ignored and is expensed. Therefore the movement between the date of acquisition and year end of CU1,000 should be posted as a credit to the P&L so that the year-end value reflects its fair value. Deferred tax will also need to be recognised on the movement which is posted to the tax line in the profit and loss account. The tax rate to be used is the sales tax (CGT) rate.
If the fair value can no longer be reliably measured then the value stated at that date is deemed to be its original cost.
Example 19: non-convertible preference shares and non-puttable ordinary shares – not traded or cannot be reliably measured
A company purchased 200 shares which were not publically quoted at a price of CU10 per share plus acquisition costs of CU100. The fair value of these shares cannot be reliably measured.
Therefore, on initial recognition the amount to be recognised is CU2,100. The subsequent carrying amount at each year end will be the cost of CU2,100 less any impairment.
If a reliable measurement can be obtained, it must be fair valued, there is no choice. For non-traded investments it is usually still possible to determine the fair value using valuation models which are utilised within the industry. However where the range of reasonable fair value estimates are significantly wide and the probabilities of the various estimates cannot be reasonably assessed, then the entity cannot use fair value. It is not permissible to measure the instrument at fair value by arbitrarily picking an estimate within a wide range.
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