PSAB Matters Article – When Loans Are Really Grants
Public sector entities lend money primarily to achieve policy objectives (for example, to support regional development or give economic assistance). In some cases, public sector entities make loans and provide the borrower with future funding to repay the loan. In other cases, public sector entities provide loans with concessionary terms or forgiveness clauses. Finally, a public sector entity could simply forgive the loan.
A loan receivable is a financial asset of a lender, represented by a promise by a borrower to repay a specific amount, at a specified time or times, or on demand, usually with interest. By definition, financial assets provide resources to discharge existing liabilities or finance future operations. When a loan or part thereof does not provide the lender resources that could be used to discharge existing liabilities or finance future operations, it is more in the nature of a grant.
Section PS 3050, Loans Receivable, establishes standards on how to account for and report loans receivable in the financial statements of public sector entities.
How to Account for Loans to be Repaid through Future Funding to Borrowers
The portion of a loan that is expected to be repaid through the lender’s future funding to the borrower is a grant and should be accounted by the lender as an expense when a direct relationship can be established between the loan repayment and the lender’s funding to the borrower.
A direct relationship between the loan repayment and lender’s funding can be established if the lender changes its assistance to the borrower (for example, by providing specific repayment grants or increasing existing assistance to the borrower). On its own, a borrower’s financial dependence on the lender does not represent “a direct relationship” if there is no change in the funding from the lender as a result of the loan. If a lender provides new funding to a borrower and the new funding is consistent with that provided to similar organizations that did not have a loan, “a direct relationship” also does not exist.
How to Account for Loans with Significant Concessionary Terms
Loans with significant concessionary terms include loans with an interest rate significantly below the government’s average borrowing rate and extended repayment terms. When the terms of a loan are so concessionary, all or part of the loan is, in substance, a grant.
The grant portion of the loan should be recognized as an expense by the lender when the loan is made. The grant portion is the difference between the face value of the loan and its present value, discounted at the lender’s average borrowing rate. The lender should record the loans receivable at the date of issuance at its present value. The loan discount should be amortized to revenue and the loans receivable in a rational and systematic manner over the term of the loan.
How to Account for Forgivable Loans
A loan may contain conditions under which the principal and any accrued interest would be forgiven. A forgivable loan should be accounted for as a grant unless it meets the definition of a loan receivable and there is sufficient evidence of a reasonable expectation of its recovery.
If the lender expects to be repaid except under specific conditions, the lender has a loan receivable until the loan is forgiven. Evidence of the lender’s expectation of repayment may include terms in the loan agreement that specifies that interest is payable on the amounts outstanding, and/or the repayment due dates. If interest and repayments are not due unless the borrower fails to meet certain conditions, the loan is of the nature of a grant. The lender does not have a loan receivable until the specified conditions occur.
How to Account for a Loan Receivable
A loan receivable should be recognized by the lender when:
- it assumes the risks associated with, and acquires the right to receive, repayment of principal and related payments of interest; and
- the amount of the loan can be reliably measured.
In most cases, the lender assumes the risks and acquires the rights associated with a loan when it disburses the funds to the borrower, exchanges other assets, or assumes liabilities. At that point, it has the contractual right to receive cash from the borrower at a future date.
A loan receivable should be removed from the lender’s statement of financial position when:
- it has been repaid in accordance with the terms of the loan agreement;
- the risks and rewards associated with the loan have been transferred in a sale or exchange;
- the right to repayment has expired;
- the right to repayment has been waived;
- the borrower of a forgivable loan meets the forgiveness conditions; or
- it is written off.
A lender should report its loans receivable at the lower of cost and net recoverable value. This is achieved by:
- adjusting the cost of the loans initially recognized for repayments received, amortization of loan discounts, write-downs or forgiveness; and
- reporting the adjusted cost net of valuation allowances.
Except for loans with significant concessionary terms and loans to be repaid through future funding to borrowers, loans receivable should be initially reported on the lender’s statement of financial position at cost (i.e., the cash or other assets given up, or liabilities assumed in the loan transaction).
Valuation allowances should be used to reflect a loan’s collectability and risk of loss, and to reflect a provision for expected forgiveness of an individual loan or a particular class of loans. They should be determined using the best estimates available considering past events, current conditions and all circumstances known (including the experience with similar types of loans) as well as the following:
- recent principal and interest collection experience for the loan;
- recent financial performance of the borrower;
- security held for the loan;
- factors known at the time of reporting that are likely to affect the borrower’s ability to repay the loan in the future;
- economic conditions in the country or region in which the borrower operates; and
- conditions in the industry in which the borrower operates.
Changes in valuation allowances should be recognized in expenses. If a loan loss is provided for in a valuation allowance and recovery of the loan is subsequently assessed as likely, the valuation allowance for the loan may be reduced.
When the amount of a loan loss is known with sufficient precision and there is no realistic prospect of recovery, the loan receivable should be reduced by the amount of that loss. Approval for write-downs or write-offs of a loan is generally required and may take time to accomplish. The net financial position of recognizing a loan loss by writing off the loan or by providing a valuation allowance is the same. The valuation allowance gives the lender a practical solution to properly report its financial position while waiting for a loan to be formally written off.
How to Account for Interest Revenue
Interest revenue on a loan receivable is earned over the term of a loan and should be recognized when earned. The total revenue on a loan with significant concessionary terms is the contractual interest earned plus the amortization of the loan discount. Both interest revenue and amortization of the loan discount should cease to be accrued when the collectability of either the principal or interest of the loan is not reasonably assured.
When collectability of the principal and interest of a loan is not reasonably assured, any previously accrued but uncollected interest, to the extent that its collection is doubtful, should either be provided for through a valuation allowance or written off. Reasonable assurance of collectability means that there is sufficient and appropriate evidence that the loan will be recovered.
How to Account for Loan Restructuring
A loan agreement may be restructured before the end of its term (for example, when the borrower is having trouble meeting the terms in the agreement). It may involve:
- forgiveness of a portion of the principal or interest in arrears;
- deferral of interest payments;
- an extension of the term of the loan;
- capitalization of interest, or
- a reduction in the interest rate.
A loan restructuring is, in substance, a settlement of the original loan and replacement of a new loan. Any related costs, such as the cost of any concessions relating to principal or interest previously accrued, should be recognized as expenses at the time of a loan restructuring. Interest should not be capitalized unless its recovery over the term of the restructured loan is reasonably assured.
What Information Is Disclosed
An entity should disclose its accounting policies regarding:
- the basis of initial valuation of loans receivable;
- the policy related to valuation allowances, write-offs and recoveries; and
- the policy for the recognition of interest revenue.
An entity should disclose the nature and terms of significant classes of loans receivable, including:
- the recorded cost, the related valuation allowance and the net recoverable value;
- general terms and conditions of the loans receivable such as:
- repayment terms;
- interest terms;
- a description of forgiveness and other conditions attached to the loans; and
- security held for the class of loans; and
- the amount and the currencies of loans receivable outstanding in foreign currencies, the Canadian dollar equivalents and the basis of translation.
Lydia So, CPA, CA
Principal, Public Sector Accounting Board
Phone: +1 (416) 204-3281