Accounting of Interest free loan or loan at below market rate of interest to employees

Lots of entities provide interest free loan to employees or at interest rate less than market rate of interest. We need to determine how should same be accounted for under Ind AS

Which Ind AS is applicable here Ind AS 19 or Ind AS 109

Any loan provided to anybody meets the definition of a financial instrument under Ind AS 109 Financial Instruments as per para 11 which states

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

A financial asset is any asset that is:

(a) cash;

(b) an equity instrument of another entity;

(c) a contractual right:

(i) to receive cash or another financial asset from another entity; or

(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity; or

(d) a contract that will or may be settled in the entitys own equity instruments and is:

(i) a non derivative for which the entity is or may be obliged to receive a variable number of the entitys own equity instruments; or

(ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entitys own equity instruments. For this purpose the entitys own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entitys own equity instruments.

Therefore, we need to look at the rules for initial and subsequent measurement of financial instruments.

But the transaction has the other side:

Employee loans are provided to a companys employees and maybe they are provided interest free or maybe at lower than market rate

Para 8 Definition of Employee benefit states that Employee benefits are all forms of consideration given by an entity in exchange for service rendered by employees or for the termination of employment

Therefore, we can say that there is some employee benefit involved, falling under the scope of Ind AS 19 Employee Benefits.

Lets understand with a simple example:

On 1 April 20X1, ABC Ltd. provided a loan to its employee Mr. A amounting to Rs.100 000 at interest rate of 1% p.a., repayable in 4 installments of Rs. 25,000 and interest in addition to installment on 31 March 20X1, 31 March 20X2, 31 March 20X3 and 31st March 20X4.

The market interest rate on similar loans is 5%.

How should ABC Ltd. recognize and measure this loan initially and subsequently

Initial recognition and measurement of an employee loan

Loan meets the definition of a financial instrument under Ind AS 109. Standard require measuring the financial assets initially at their fair value (plus the transaction cost in some cases). Lets say that ABC Ltd. classifies the loan at amortized cost under Ind AS 109. If the loan would have been made on market terms, then clearly, its fair value at inception would have equaled the loan amount of Rs. 100,000. Lets check

This proves is NOT the case where fair value equals loan amount. So what is the fair value of the employee loan

In order to determine the fair value of the loan, ABC Ltd. needs to take the following steps:

1. Determine the market interest rate for similar instruments (here: 5% p.a.)

2. Discount all cash flows from the loan with the market interest rate to arrive at their present value.

The present value of all cash flows as determined above is the fair value of the loan. Thus loan will be accounted at 90,917 being its fair value at market rate in terms of its future cash inflow

How to treat the difference between loans fair value and nominal amount

Theres a difference between:

The nominal amount of the loan (or the cash paid to an employee): Rs.100,000, and

The loans fair value of Rs.90,917

Difference = Rs.9,083

Normally, this would be recognized directly in profit or loss, but heres this difference is an employee benefit and ABC Ltd. must recognize it in line with Ind AS 19 rules.

The problem is that Ind AS 19 does NOT provide any direct guidance on accounting for this form of benefits, and therefore we need to apply general principles of Ind AS 19.

Determine the type of the employee benefit

First of all, we need to determine the type of the employee benefit under Ind AS 19 and it depends on the specific terms of the loan agreement. We need answers to the following questions:

What happens when the employee leaves the company 

Can he still keep the loan at favorable conditions and continue paying beneficial interest

Or will he need to start paying the market interest rate

Or will the loan become repayable

If the employee can continue with the loan under the same favorable conditions even after he terminates the employment, it means that the employee benefit has already been earned. This can be understood with the help of para 11of Ind AS 19 which states that

When an employee has rendered service to an entity during an accounting period, the entity shall recognise the undiscounted amount of short-term employee benefits expected to be paid in exchange for that service:

(a) as a liability (accrued expense), after deducting any amount already paid.  If the amount already paid exceeds the undiscounted amount of the benefits, an entity shall recognise that excess as an asset (prepaid expense) to the extent that the prepayment will lead to, for example, a reduction in future payments or a cash refund.

(b) as an expense, unless another IFRS requires or permits the inclusion of the benefits in the cost of an asset (see, for example, IAS 2 Inventories and IAS 16 Property, Plant and Equipment)

Since employee can continue with favorable terms of loan even if he terminates employment means that employee has rendered service related to loan receipt

In practical terms it is recognized straight in profit or loss and the journal entry is:

-Debit Profit or loss Employee benefits: Rs.9,083

-Debit Financial assets Loans: Rs. 90,917

-Credit Cash: Rs.100,000

If the loan will revert to a market interest rate after the employee leaves, then the benefit has not been fully earned and is available only while the employee provides services to the entity. Such benefits are covered under other long term employee benefit as explained under para 153 of Ind AS 19

Other long-term employee benefits include items such as the following, if not expected to be settled wholly before twelve months after the end of the annual reporting period in which the employees render the related service:

(a) long-term paid absences such as long-service or sabbatical leave;

(b) jubilee or other long-service benefits;

(c) long-term disability benefits;

(d) profit-sharing and bonuses; and

(e) deferred remuneration.

In line with Ind AS 19, an expense should be recognized when the employee provides its services, therefore in this case, we cannot recognize the full amount of Rs. 9,083 in profit or loss at the time of making the loan. Such services accounting shall be dealt with as per para 70 of Ind AS 19 which states that

In determining the present value of its defined benefit obligations and the related current service cost and, where applicable, past service cost, an entity shall attribute benefit to periods of service under the plans benefit formula. However, if an employees service in later years will lead to a materially higher level of benefit than in earlier years, an entity shall attribute benefit on a straight-line basis from:

(a) the date when service by the employee first leads to benefits under the plan (whether or not the benefits are conditional on further service) until

(b) the date when further service by the employee will lead to no material amount of further benefits under the plan, other than from further salary increases.

We need to defer the expense and allocate it to the periods when the employee provides services.

The journal entry is:

Debit Prepaid (deferred) expenses for employee benefits: Rs.9083

Debit Financial assets Loans: Rs. 90,917

Credit Cash: Rs.100,000

Amortize the benefit in profit or loss

The amount of Rs.9083 will be straight lined over the period of 4 years i.e. 2271 as under

Debit P/L Employee benefits: Rs.2271

Credit Prepaid (deferred) expenses for employee benefits: Rs.2271

There can be one more method used very frequently. This method looks at the employee benefit as short-term benefit, i.e. settled within 12 months after the employee renders the service. We can estimate the cost of such an employee benefit in each period as the difference between:

The interest income for the period based on the fair value of the loan asset (using effective interest method at the market rate of 5%); and

Actual interest income as paid by the employee

The journal entries at the end of the year 1:

#1 Interest income on the loan using the effective interest method (at 5%):

Debit Financial Assets Loans: Rs. 4546

Credit P/L Interest income: Rs. 4546 (Being 5% of loan amount of Rs.90917)

#2 The 1st installment paid by the employee:

Debit Cash: Rs. 26,000

Credit Financial Assets Loans: Rs.26,000

#3 The employee benefit resulting from the employee loan:

Debit P/L Employee benefits: CU 3456

Credit Prepaid (deferred) expenses for employee benefits: CU 3456

(Being diff between interest income as recognized in 1st year of Rs.4546 and interest actually paid by employee at 1% of Rs.1000)

This seems more appropriate as benefit to employee has been of such amount of interest and the same should be considered to be expense for the entity