Interest-free loans or loans at below-market interest rate are popular among entities under common control. They can also be a form of a government grant. Recently, such loans became even more popular in response to the COVID-19 pandemic.
According to IFRS 9, a long-term loan or receivable that carries no interest should be recognised at fair value measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (currency, term, etc.) with a similar credit rating. An incremental borrowing rate of the debtor will usually be a great starting point for calculation of the discount rate. Any amount lent/borrowed exceeding the fair value of the loan should be accounted for according to its substance under other applicable IFRS (IFRS 9.B5.1.1).
Example: Loan at below-market interest rate subsidised by government
On 25th September 20X1, Entity A takes out a loan of $900,000 from a bank. Interest rate quoted by the bank for this loan is 5%, however the government will subsidise the loan and Entity A will be charged only 2% p.a. The loan will be repaid after two years and interest will be paid annually.
All calculations presented in this example are available for download in an excel file.
Entity A prepares a schedule of expected cash flows for the loan as presented below. Interest is determined using the subsidised rate of 2% p.a., whereas the discount rate applied to arrive at fair value of the loan is based on the market interest rate for this loan, i.e. 5% p.a.
| Date | Cash flow @ 2% | Discount factor @ 5% | Discounted amount | |
|---|---|---|---|---|
| 20X2-09-25 | 18,000 | 0.9524 | 17,143 | Interest payment |
| 20X3-09-25 | 918,000 | 0.9070 | 832,653 | Repayment of the loan and interest |
| 849,796 | Present value |
The difference between the fair value of the loan liability ($849,796) and cash received from the bank ($900,000) is recognised as government grant (IAS 20.10A):
| DR | CR | |
| Cash | 900,000 | |
| Financial liability (loan) | 849,796 | |
| Government grant | 50,204 |
How exactly do we recognise this government grant? See accounting for government grants.
Subsequently, the loan is measured at amortised cost. The accounting schedule is as follows:
| Opening date | Opening | Interest expense | Payment | Closing | Closing date |
|---|---|---|---|---|---|
| 20X1-09-25 | 849,796 | 11,090 | - | 860,886 | 20X1-12-31 |
| 20X1-12-31 | 860,886 | 31,399 | (18,000) | 874,286 | 20X2-09-25 |
| 20X2-09-25 | 874,286 | 11,410 | - | 885,696 | 20X2-12-31 |
| 20X2-12-31 | 885,696 | 32,304 | (918,000) | - | 20X3-09-25 |
Interest-free loans are not rare among entities under common control. Therefore, strictly speaking, the difference between the fair value of such loan and the proceeds should be recognised as an increase in investment in subsidiary (in separate financial statements of the parent) and an equity contribution (in separate financial statements of the subsidiary). Additionally, such loans can trigger additional tax charges due to violation of transfer pricing laws in some countries.
However, interest-free intra-group loans often come without specified repayment date, which makes it hard to forecast cash flows and determine fair vale. There are two possible approaches to accounting for such loans:
- treat such a loan as short-term and repayable on demand and therefore consider its fair value to equal proceeds received, or
- consider the loan to be in-substance equity contribution from the parent.
Exact treatment will depend on facts and circumstances surrounding the loan, but the first approach is much more common. See also the publication on related company loans by BDO.
On 20th April 20X1, subsidiary ‘S’ receives interest-free loan of $500,000 from parent ‘P’ repayable after one year. Interest rate quoted by a bank for such a loan is 4%. All calculations presented in this example are available for download in an excel file.
Firstly, S discounts the repayment of the loan using market rate (i.e. 4%), which gives a fair value of the liability amounting to $480,769. S recognises the loan as follows:
| DR | CR | |
| Cash | 500,000 | |
| Financial liability (loan) | 480,769 | |
| Equity | 19,231 |
Entries made by P are as follows:
| DR | CR | |
| Cash | 500,000 | |
| Financial asset (loan) | 480,769 | |
| Investment in S | 19,231 |
As we can see, the difference between cash received and fair value of the loan at initial recognition is recognised as an additional contribution of equity by P.
The loan is subsequently accounted for using the amortised cost method:
| Opening date | Opening | Interest in P&L | Payment | Closing | Closing date |
|---|---|---|---|---|---|
| 20X1-04-20 | 480,769 | 13,356 | - | 494,125 | 20X1-12-31 |
| 20X1-12-31 | 494,125 | 5,875 | (500,000) | - | 20X2-04-20 |