Friday, May 27, 2022

IFRS 9: Staff loans and Staff advances

 


Welcome to IFRS is easy's flash term for the week

Understanding the difference between Staff loans and Staff advance

Many companies use these two words interchangeably and they wonder why auditors keep asking them for details on what constitutes their staff loan or staff advance, or whichever name they have chosen to call them.

The reason for this curious questioning is not far-fetched. This is because each of these is expected to be treated differently regardless of what name the Company may have called it.

Before we kick off into the accounting bit of it. Let's take a look at the meaning of each and why it is significant to get it right.

Staff loan is a loan or salary advance given to an employee for the purpose of the employee’s personal use with an agreement to pay back the loan to the company at an interest.

Okay, don't get it twisted, not all staff loans are given at an interest. In fact, some companies are generous that they give their employees loans at zero interest or sometimes at an interest rate below the market rate. But this creates an accounting issue which we will see how to account for it very soon.

Now let's talk about the staff advance.

Staff advance is an employee advance or expense advance given to an employee for the purpose of meeting business needs to prevent employees from paying out of their own pocket.

Did you notice the difference between both definitions above? Simply, the difference between staff loans and staff advances is that staff loans are for the employees' personal use while staff advances are to be spent by the employee for the purpose of the business. 

Now that we understand the difference, let's look at the accounting implication. How to account for staff loans under IFRS and how to account for staff advances.

Financial assets or non-financial assets?

Staff loans are financial assets

IFRS 9 paragraph 11 defines a financial asset as any asset that is cash, an equity instrument of another entity, a contractual right to receive cash or another financial asset from another entity.

Simply put, the end result of a financial asset is that you are expecting cash as a result of holding it.

When the company gives out staff loans, even if it is at zero interest, the company expects that the staff should pay back the loan in cash. This implies that staff loans will be measured in accordance with the requirements of IFRS 9 Financial Instruments. 

Staff advances are non-financial assets

Staff advances are similar to a prepayment for service. For those in consulting that enjoy going to work on client sites and sometimes get lodged in a hotel during the period of work, they often get an advance from the firm to cater for their travel, meals, and accommodation expenses. 

When such an advance is given to an employee, it is for the purpose of meeting an expense. What the company expects in return is a service, not cash. Even though cash comes back sometimes when the staff does not spend it all. But the intent is what gives it away. At the point when the company released the cash, the expectation is that the staff will spend everything for the associated expense need which is solely for the business.

You may have experienced a situation where you prepaid for a service but the service could not be delivered and you got a refund. You'd have been happy to get the service rather than a refund right? It's all about the intent.

Note that because many companies use different names for these two items and sometimes even use them interchangeably, it is important that you understand them beyond the name so as to address them appropriately.

Now let's look at how we account for staff loans and staff advances.

Accounting recognition

Staff loans are often measured at amortized cost and tested for impairment

When a company gives a staff loan to its employee with the expectation of receiving cash over a given period of time, such staff loan is measured at amortized cost. 

According to IFRS 9 paragraph 5.1.1, the company will measure the staff loan at its fair value. This simply means that the company will discount to present value, all the expected cash flows that relate to the loan using a market interest rate on similar loans (as though the company does not have a relationship with the staff at all, just the way a bank will give out a loan and charge interest). Note that it does not matter whether the company gave out the loan to the staff at an interest rate or not. It is the market interest rate that will be used to discount.  

Let's try our hands on the scenario below.

Practical scenario

At the beginning of the year 2022, Company A gave out $5,000 staff loan at 2% interest rate. The frequency of payment by the staff for both principal and interest is on an annual basis over 5 years, with the principal paid evenly across the 5 years starting from the end of year 2022. The market rate for a similar loan would have been 5%. The company's year-end is 31 December.

Let's list out the fact of the arrangement to help us determine our computation and how the Company A (the holder of the financial asset) will treat this in its books.

  • Loan origination date - 1 January
  • Year end of the Company - 31 December
  • Maturity date - 5 years' time
  • Loan amount - $5,000
  • Contractual rate - 2%
  • Market rate - 5%
  • Frequency of principal repayment - Annually
  • Frequency of interest repayment - Annually

Now let's go back to what IFRS 9 told us to do. It says that we are to determine the fair value of the loan using the market rate of a similar loan. This rate has been established as 5%. We are to discount the $5,000 principal and the expected interest to be received from the staff over 5 years.

The below schedule shows the discounting process.


At the end of each year, the interest received is calculated as 2% of the opening balance for each year. This is because payment is made at the end of the year which means that the interest will be calculated on the amount outstanding since the beginning of the year.

Remember that the fair value is the present value (PV) of the total cash flows (principal and interest), as such, for 31 December 2022, the total cash flow per year is discounted at the market rate using the discount factor  (1+r)^-n where "r" is the 5% and "n" is the number of years from loan origination.

So for 31 December 2022, the PV of cash flows is as calculated below:

Principal received + Interest received = Total cash flows from staff
1,000 + 100 = 1,100

Discount factor = (1+r)^-n
(1+5%)^-1 = 0.9524

PV of cashflows for 31 December 2022 = Total cash flows from staff * Discount factor
1,100 * 0.9524 = 1,048

Apply the same approach for each year from 2022 to 2026 and sum up the resulting PV of cash flows to get the fair value of $4,598

You will notice that after discounting the cash flows, the fair value is lower than the actual loan amount given to the staff of $5,000. This is because the difference is a cost borne by Company A on behalf of the staff by giving out the loan at 2% instead of 5%. This difference is an employee cost to Company A and will be capitalized as a prepayment which will be amortized systematically over the period of the staff loan.

See the schedule below.


In accordance with IFRS 9 paragraph 5.5.1, because the staff loan is a financial asset measured at amortized cost, it should be subjected to an impairment assessment for determining its expected credit loss to cater for a situation where the staff is unable to pay back (may default on the staff loan).

At initial recognition, Company A will raise the below journal entries:

When the cash is released to the staff

DR Staff loan    $5,000

CR Bank           $5,000

To recognize the transaction cost borne by the company

DR Prepayment    $402

CR Staff loan        $402

Download the excel file (showing the computation, journal entries, and reconciliation movement) for the above by clicking on the link in the description box of the YouTube video below. 

To gain a classroom understanding of the difference between Staff loans and Staff advances and how to raise accounting journal entries and disclosures required on staff loans, watch the YouTube video below.


Alright, so let's wrap up our discussion.


Staff advances are measured at historical cost

No interest is expected in a staff advance and the amount released to the staff is treated as a prepayment until the expense is incurred. Two major accounting journals arise on these.

When cash is released to the staff:

DR Staff advance
CR Bank

When the staff spends the cash on business expenses:

DR Expense
CR Staff advance

Yes! You made it to the end.

I will be happy to receive any questions you may have that are not addressed in the article/video.

What name does your company use for its staff loan or staff advance? Share in the comment section for others to learn and identify.

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Written by:

Adedamola Otun

For: IFRS IS EASY

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