There is considerable ambiguity in Pakistan regarding the proper treatment of director’s loans, particularly in cases where individuals initially register their companies with minimal paid-up capital. Subsequently, they deposit additional amounts and categorize these as investments, often labeling them as director’s loans in the long-term liability section of financial statements.
This practice is notably prevalent among companies with paid-up capital below 1 million, and it introduces uncertainty in the appropriate accounting treatment of such transactions.
In the scenario of a contractual interest-free director’s loan with a predetermined repayment date, a director may extend a loan to an entity without interest. However, the loan agreement specifies a fixed date for repayment. Recognizing the contractual obligation to provide cash, this transaction is recorded as a financial liability.
According to IAS 39, the entity must initially measure this financial liability at its fair value. Given that the loan carries no interest, the consideration exchanged (such as the face amount) does not represent the financial instrument’s fair value entirely. Consequently, the loan is initially recognized at its fair value, estimated as the present value of future payments discounted at a market rate of return/interest for a similar debt instrument.
Any difference between the cash paid and present value upon initial recognition is acknowledged as an addition to equity, reflecting the economic substance of the interest-free element as a capital contribution. In subsequent periods, interest is recognized using the effective interest method, representing the unwinding of the difference between the present value on initial recognition and the cash received.
Regarding contractual director’s loans that are both interest-free and repayable on-demand, a director might provide such a loan to an entity. In this case, although the loan carries no interest, the loan agreement stipulates that the lent amount is repayable on-demand. Recognized as a financial instrument, a loan due on-demand is not discounted upon initial recognition, as it lacks a specific term and can be demanded at any time.
Consequently, it is acknowledged at the full amount receivable, equivalent to its face value. Despite being a financing transaction with a non-market rate of interest, the ability of the director to demand payment at any time eliminates the impact of discounting from the first date when the payment could be required.
In the case of a contractual director’s loan that is both interest-free and repayable at the discretion of the entity, the loan does not meet the liability test and is recorded as equity at face value. This classification is not subject to subsequent re-measurement. If the entity decides in the future to deliver cash or any other financial asset to settle the director’s loan, it would result in a direct debit to equity.
When dealing with director’s loans or financing lacking written contractual terms or ongoing interest charges, a director may provide financing to an entity without specifying repayment terms or interest charges in a written contract. In the absence of explicit terms, the entity must assess any implied contractual terms.
Without written evidence characterizing the financing as a loan or a capital contribution, the substance is likely to be treated as an on-demand loan. The accounting treatment aligns with that of a contractual director’s loan that is interest-free/low-interest and repayable on-demand.