Accounting for shareholders’ loans
It is common in South Africa to finance private companies and subsidiaries of listed companies by means of shareholders loans, because it is easier and cheaper to distribute profits from loan accounts than it is by repaying share capital or share premium or by declaring dividends, which have secondary tax on companies’ implications. These shareholders’ loan accounts invariably pay no interest and have no fixed or determinable repayment dates. The issue addressed here is how to account for such a shareholder’s loan account acquired as part of a business combination in the books of the investor.
Under the pre-2005 statement on financial instruments there were six categories of financial assets:
1. Derivatives (clearly this loan did not fall into this category).
2. Financial assets held for trading (ditto).
3. Held to maturity investments (such a loan could not fall into this category as there are no fixed or determinable payments and fixed maturity).
4. Originated loans and receivables (such a loan could not fall into this category as it was a purchased loan).
5. Available for sale financial assets, the default category (as this loan did not fall into any of the previous categories, it ended up in this one, unless one argued that it fell into category (6) below).
6. Financial assets that do not have a quoted market price in an active market and whose fair value cannot be reliably measured.
Paragraph 70 of the previous AC 133 stated that after initial recognition an enterprise (now entity) measured its financial assets at fair value, without any deduction for transaction costs, except for financial assets falling into categories 3, 4 or 6 above. Paragraph 72 stated that there is a presumption that fair value can be reliably determined for most financial assets classified as available for sale or held for trading financial instruments.
Fair value was, and still is, defined as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. The big question is: “How does one arrive at the value of a loan that pays no interest, has no fixed or determinable repayments and has no fixed maturity date?”
Such a loan has no value as a stand-alone asset. A suggestion I heard is to assume that the loan could be called up immediately and value it at par. The practicality is that the funds are invariably tied up in property, plant and equipment and working capital so they are not available for distribution to the loan holders immediately. And in many cases some equity shareholders do not hold the loans in the same proportions as their equity holdings so could be penalised by giving the loan holders a call option on the loan capital.
This loan only has value to someone who buys an equity stake in the company together with the loan account. The loan account should, therefore, be valued in the light of such an acquisition. To do this one would value the loan account and the equity as one and then deduct the par value of the loan to get the value of the equity on the basis that the acquirer will have the ability to demand a fair interest rate on the loan, thereby penalising the value of the equity.
The new standard on financial instruments has changed the definition of loans and receivables to include acquired loans.
However, it has introduced a new restriction limiting such instruments to those with fixed or determinable payments. So a shareholder’s loan of the type being discussed cannot fall into this category and, under the new standard, it also ends up as an available for sale financial asset. The new standard does not permit revaluations of available for sale financial assets to be taken to profit or loss, i.e. this option has been deleted. Any gain or loss must now be taken to equity.
The new standard has also changed category 6 above from “Financial assets that do not…” to “Equity instruments that do not …”, i.e. this category now only applies to “equity instruments” and not to “financial instruments” generally.
A listed company called Argent acquired various subsidiaries that were “technically insolvent” at the acquisition date, i.e. the liabilities including the shareholders’ loans exceeded the values of the assets. It acquired these loans at a substantial discount (R67m). Over the years the subsidiaries made profits and at the 2002 year-end the subsidiaries were solvent. The company revalued the loan accounts to par through a non-distributable reserve, an option permitted by the old AC 133 at the time and now required by the new standard. It then republished restated financial statements in which the loan accounts were written down to cost. It would be fascinating to know why it did this when it complied with AC 133 in the first place.
Charles Hattingh, Chartered Financial Analyst CA(SA)
Copyright South African Institute of Chartered Accountants Mar 2005
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