FRS 102: The impact on directors’ current accounts
This is the second of two articles which examine the accounting implications of directors’ loans to and from a business under FRS 102. The first in the series looked at the company law aspects and the relevant disclosure requirements.
Loans to or from a director are caught under the rules in FRS 102, Section 11 Basic Financial Instruments.
FRS 102 (March 2018), paragraph 11.13A(a) offers a simplification to small entities to simply recognise loans from a director-shareholder/group of the director’s close family members which contains a shareholder at transaction price.
However, this simplification does not apply to companies outside the small companies regime. FRS 102, paragraph 11.13A was included as part of the Financial Reporting Council’s triennial review amendments.
At the outset, it is worth noting that if a loan is not formalised with loan terms, the loan would be regarded as being repayable on demand and hence would be presented as either a current asset or a current liability in the financial statements ie no discounting would be required.
Similarly, where a market rate of interest is being charged for a loan with formalised terms there would also not be a need to discount the loan using an imputed rate of interest.
Quite often, a company will make a loan to a director which is either at a below-market rate of interest or interest-free (usually the latter). Where such a loan is made to or from a director, it will fall to be treated as a financing transaction and the consequence of this is where the loan is below market rate, a measurement difference will arise where the loan is covered by formal terms and is repayable after more than one year from the balance sheet date. The measurement difference is the difference between the face value of the loan and the present value.
On 1 January 2019, Largeco Ltd makes an interest-free loan to a director who is also a shareholder amounting to £50,000. The loan has been formalised with loan terms which state that the director is to repay this loan on 31 December 2020 and the market rate for a similar loan (ie if the director had gone to the bank for the funds) would be 5.5% per annum. The net present value of the loan is £44,923 (£50,000/1.0552). The measurement difference is the difference between the fair value and the present value which is £5,077 (£50,000 – £44,923).
In the example above, the substance of the arrangement is that the director has benefitted personally by receiving a loan from the company interest-free. If the director had gone to the bank, the director would have had to pay interest at market rate. The measurement difference, therefore, represents a transfer of value from the company to the director-shareholder which must be reflected in the financial statements under FRS 102.
Using the example above, the measurement difference of £5,077 represents a distribution to the director in their capacity as a shareholder (ie because the director-shareholder has benefited from the company providing them with a loan at below-market rates of interest). In this example, we are using the director’s current account to record the loan receivable.
The entity would record the transaction as follows:
The measurement difference has been taken to equity as a distribution because the director is a shareholder. If the director was not a shareholder, it would be taken to payroll expense in the profit and loss account.
The above scenarios were based on a loan TO a director-shareholder. It is commonplace for the reverse to apply ie where the director-shareholder will make a loan to the company.
On 1 January 2019, Sarah, a director of Pastures Ltd, provides an interest-free loan of £50,000 to her business in which she is a shareholder. The market rate of interest for a similar loan is 5.5%. The loan has been formalised with loan terms which state repayment is to be made on 31 December 2020. The loan is material to the financial statements.
Scenario 1: The entity is small, reports under FRS 102, Section 1A and chooses to apply FRS 102, para 11.13A(a)
As the company is small, it can take advantage of the simplification in FRS 102, para 11.13A(a) and simply recognise the loan at transaction price (ie at £50,000). Hence the loan is recorded as follows:
There would be no notional interest charges recognised in profit or loss over the loan term. As the loan is material, it is disclosed as a related party transaction to comply with the requirements in FRS 102, paragraph 1AC.35 because the loan has not been concluded under normal market conditions.
Scenario 2: The entity is medium-sized (or small without taking advantage of para 11.13A(a))
The loan terms state that the loan will be repaid on 31 December 2020. A measurement difference arises amounting to £5,077 (see calculations above).
The measurement difference will be treated as a capital contribution by Sarah because the substance of the arrangement is that the company has benefitted by receiving a loan from her at a rate of interest which is below market rate. Hence the loan is recorded as follows:
The liability will then be measured under the amortised cost method as follows:
In year 1, interest is charged to the profit and loss account of £2,471 and the corresponding credit is taken to the director’s current account. The same applies in year 2.
Small entity becomes medium
But what happens to a loan accounted for using the simplification in FRS 102, para 11.13A(a) on initial recognition when the company becomes medium-sized at a later date?
Some small companies may eventually outgrow the small companies regime and become medium-sized. Where the company has applied the optional simplification in FRS 102, paragraph 11.13A to measure the loan at transaction price but then becomes medium-sized, it will no longer be able to continue measuring the loan at transaction price because this option is only available to small entities.
FRS 102, para 11.13B states:
An entity taking advantage of the exemption in paragraph 11.13A(a) that subsequently ceases to be a small entity may, when remeasuring the financial liability to present value prospectively from the first reporting date after it ceases to be a small entity, determine the present value on the basis of the facts and circumstances existing at that time or at the date the financing arrangement was entered into.
On 1 January 2016 Jason, a director-shareholder in Rapidco Ltd, provides an interest-free loan to the business of £50,000 which is repayable on 31 December 2021. The loan is formalised with written terms and the company applied the exemption in FRS 102, para 11.13A(a) on initial recognition of the loan. The company has now become medium-sized for the first time for the year ended 31 December 2019. No changes to the loan terms/circumstances have arisen since the loan was entered into.
For the year ended 31 December 2019, Rapidco Ltd cannot continue to record the loan at transaction price because this exemption is only available to small entities. The loan needs to be restated to the present value of future cash flows using a market rate of interest. The market rate of interest for the purposes of this example is 5.5%.
The present value of a two-year loan at 5.5% is £44,923 (£50,000 / 1.0552). The journals to restate this as at 31 December 2019 are:
As the company has grown from a small company to a medium-sized company, it would be required (not encouraged) to present a statement of changes in equity and this would show the capital contribution for the year ended 31 December 2019.
Notional interest would be charged to the profit and loss account over the remaining two-year life of the loan using the amortised cost method as follows:
For the year ended 31 December 2020, the journal would be:
On repayment, the journals would be to credit bank £50,000 and debit director’s current account.
Medium-sized entity becomes small
It may be the case that a medium-sized entity contracts and becomes eligible to apply the small companies regime. If the entity has received a loan from a director-shareholder/group of close family members which contains at least one shareholder, the entity can choose to continue to measure the loan at present value. Alternatively, it can apply the exemption in paragraph 11.13A(a) but it must apply the exemption retrospectively (FRS 102, para 11.13C).
|On 1 January 2016 Sharon, a director-shareholder of Glastonbury Ltd, provided a seven-year interest-free loan to the business for £50,000. The company prepares financial statements to 31 December each year. A market rate of interest is 5.5% and the present value of the loan on initial recognition was £34,372 (£50,000 / 1.0557).On initial recognition of the loan, it was profiled as follows:
On initial recognition, the balance on the capital contribution reserve is £15,628 (£50,000 less £34,372).
At the end of 2019, the company becomes small and becomes eligible to apply the exemption in FRS 102, para 11.13A(a) which it wishes to do. Therefore, a retrospective restatement is needed because this is a change in accounting policy.
The exemption is applied as far back as the date of transition (the start date of the comparative period reported in the financial statements), which in this case will be 1 January 2018. At this date, the loan has a carrying amount of £38,256 and £40,360 at the end of the comparative year ended 31 December 2018. The value of the capital contribution reserve as at 1 January 2018 is £11,744, reconciled as follows:
Equity as at 1 January 2018
Equity (retained earnings) is increased by £11,744 which is also the difference between the face value of the loan of £50,000 and the carrying value of £38,256 and therefore removes the capital contribution reserve as at this date, i.e.:
Profit and loss account for prior year ended 31 December 2018
The profit and loss account is restated to remove the notional interest charge of £2,104 as follows:
The loan will then be carried in the financial statements at its transaction price as at 31 December 2019 and there is no notional interest charge in the profit and loss account. The entity must also disclose the change in accounting policy and the effect this has had on the financial statements.
This article has examined the accounting aspects of FRS 102 in respect of directors’ loans. Take care with directors’ loans under FRS 102 because it may be the case that the company is small and can apply the simplification in FRS 102, paragraph 11.13A and measure the loan at transaction price.
However, where the loan is material do not forget that it will be caught under the related party rules in FRS 102, Section 1A, paragraph 1AC.35.