IFRS 9 Financial Instruments requires all financial instruments to be initially recognised at fair value.
The fair value of a financial instrument at initial recognition is normally the transaction price (i.e. the fair value of the consideration given or received). However, if part of the consideration given or received is for something other than the financial instrument, an entity shall measure the fair value of the financial instrument.
IFRS 9, paragraph B5.1.1 provides guidance on determining the fair value of a long-term loan or receivable that carries no interest. Such loans can be measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating.
Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type of asset.
Parent Co advances a $100,000 interest-free loan to its subsidiary, Company X. The term of the loan is 10 years, with the loan principal to be repaid in full at the end of the loan term.
Company X will use the loan to fund promotional activities and it does not have any assets that can be used to secure the loan. If Company X were to borrow funds in the market for promotional activities, repaying the principal in full at the end of a ten-year loan term, it would be charged interest at 15% per annum.
Fair value is determined by calculating the fair value of the loan’s cash flows, discounted at a market interest rate (which is 15%).
The table below provides the calculation of the loan’s fair value:
| 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | |
|---|---|---|---|---|---|---|---|---|---|---|
Cash flow | - | - | - | - | - | - | - | - | - | $ 100,000 |
Discount factor | 4.045558 | |||||||||
Present value | $ 24,718.47 |
The only cash flow (return of the principal) occurs in year ten. The present value of that cash flow is calculated using the following formula:
The discount rate is the amount that would be charged in the market (15%) and ^year means to the power of the year.
This means that the formula for the only cash flow, at the end of year ten, is $100,000/1.1510 = $24,718.47.
At the loan’s inception, Parent Co processes the following journal entry:
| Dr ($) | Cr ($) |
|---|---|---|
Dr Loan advanced (asset) at fair value | $24,718 | |
Dr Investment in subsidiary | $75,282 | |
Cr Bank (face value of amount advanced) | $100,000 |
The carrying amount of the investment in subsidiary, Company X then may need to be assessed for impairment under IAS 36 Impairment of Assets.
Parent Co advances a $100,000 loan to its subsidiary, Company Y. Interest is charged at 5% per annum, payable annually.
The term of the loan is 10 years, with the loan principal to be repaid in full at the end of the loan term.
Company Y will use the loan to fund the purchase of a piece of equipment that it needs to expand its production line and the piece of equipment will be used as security for the loan.
If Company Y were to borrow funds in the market to purchase the item of equipment, using the equipment as security for the loan and repaying the principal in full at the end of a ten-year loan term, it would be charged interest at 12% per annum.
As with example one, fair value is determined by calculating the fair value of the loan’s cash flows, discounted at a market interest rate (which is 12%).
The table below provides the calculation of the loan’s fair value:
| Year | Cash flow | Present value |
|---|---|---|
| 1 | $ 5,000.00 | $ 4,464.29 |
| 2 | $ 5,000.00 | $ 3,985.97 |
| 3 | $ 5,000.00 | $ 3,558.90 |
| 4 | $ 5,000.00 | $ 3,177.59 |
| 5 | $ 5,000.00 | $ 2,837.13 |
| 6 | $ 5,000.00 | $ 2,533.16 |
| 7 | $ 5,000.00 | $ 2,261.75 |
| 8 | $ 5,000.00 | $ 2,019.42 |
| 9 | $ 5,000.00 | $ 1,803.05 |
| 10 | $ 105,000.00 | $ 33,807.19 |
| Total | $ 60,448.44 |
The cash flow in periods one to nine is $5,000 (5% interest x $100,000 principal). In year 10, the cash flow is $105,000 ($5,000 interest + $100,000 principal).
For each period, present value is calculated using the following formula:
The discount rate is the amount that would be charged in the market (12%) and ^year means to the power of the year.
So, as an example, in year eight the present value calculation is $5,000/1.128 = $2,019.42.
The fair value is the sum of the present values of the cash flows of each year ($60,448.44).
At the loan’s inception, Parent Co processes the following journal entry:
| Dr ($) | Cr ($) | |
|---|---|---|
| Dr Loan advanced (asset) at fair value | $60,448 | |
| Dr Investment in subsidiary | $39,552 | |
| Cr Bank (face value of amount advanced) | $100,000 |
The carrying amount of the investment in subsidiary then may need to be assessed for impairment under IAS 36 Impairment of Assets.
Parent Co advances a $100,000 loan to its subsidiary, Company Z. Interest is charged at the following rates:
Years one and two – 13%
Years three to six – 11%
Years seven to ten – 9%.
The term of the loan is 10 years, with the loan principal to be repaid in full at the end of the loan term.
Company Z will use the loan to fund the purchase of machinery that will replace outdated existing machinery. The new machinery will be used as security for the loan.
The terms and conditions of the loan, including the interest rates charged, are the same as would be offered to Company Z in the market.
In this instance, the fair value of the loan at inception is $100,000, because the loan is advanced on market terms.
At the loan’s inception, Parent Co processes the following journal entry:
| Dr ($) | Cr ($) | |
|---|---|---|
| Dr Loan advanced (asset) at fair value | $100,000 | |
| Cr Bank (face value of amount advanced) | $100,000 |
When initially recognising an intercompany loan, it is important to ensure that fair value is determined in accordance with the requirements of IFRS 9. Discounting must be done at a market rate; that market rate must be determined by considering all relevant factors, including the creditworthiness of the borrower, the term of the loan, the repayment profile and the security available. This requires the application of considerable professional judgement.