Initial measurement of a no- or low-interest financial instrument
Under Accounting standards for private enterprises (ASPE), the fair value of a financial instrument with a non-market rate of interest is not equal to the cash consideration. In this case, it can be estimated as the present value of all future cash receipts discounted using the prevailing market rates of interest for a similar instrument (similar as to currency, term, type of interest rate, or other factors) with a similar credit rating.
The question is: what discount rate should be used?
In many instances, approximating the interest rate based on an entity’s current loans may be acceptable, if the potential variances are clearly immaterial to the financial statements as a whole.
However, further analysis is required if the amounts in question are significant. Without delving into the specifics of determining interest rates, it should be noted that the interest rate of a financial instrument is directly proportional to the risk to the lender.
Common examples of no- or low-interest loans (other than those resulting from a related party transaction) include:
- The purchase of an asset directly financed by the supplier
- The purchase of a company financed in part by the seller (balance of sale)
- Loans from a government or municipal body
- Employee loans
The risk assumed by the lender differs greatly in all these situations.
FINANCIAL INSTRUMENTS, Section 3856, indicates that the prevailing market rate of interest for a “similar instrument” should be used. To identify a “similar instrument” in a given context and thus determine the rate of return (discount rate), it is appropriate to ask the following question: what would be the most likely financing option for this loan amount?
For example, if the option to purchase equipment directly financed by the supplier (when the equipment is pledged as collateral) is a guaranteed loan with a financial institution, the interest rate should probably be similar to the standard rate the entity’s financial institution charges to finance its other equipment, plus a few basis points since a traditional term loan is seldom used to finance the total cost of equipment.
However, if the option is a subordinated debt or quasi-equity/equity, such as an unsecured loan granted by a government body, the interest rate should probably be similar to the rate of return required by a venture capitalist. Several financing options are in fact available. The model proposed here takes into account the likely need for a financing package. It also considers the risks to the various types of investors involved in the financing package and that weighted averages will need to be calculated to identify the appropriate rate of return (discount rate).
Using an unsecured $100,000 loan from a government body as an example, if the most likely similar financing option includes a subordinated debt of $40,000 and a down-payment (equity) of $60,000 with a required rate of return of 10% and 15% respectively, then the rate of return on a similar financial instrument can be reasonably estimated at 13% ((10% x 40%) + (15% x 60%)).
To determine the interest rate for this type of financing package, it’s important to consider the five (5) key components of a credit analysis (commonly known as the 5 C’s of credit): character (management), cash flow, capital structure, conditions and collateral.
The following are a few considerations about each component to help select a proper interest rate.
Does management have a good reputation and track record? In other words, does it inspire confidence among potential traditional lenders? If the answer is no, the alternative may be equity financing with an equivalent rate of return.
Can the company generate sufficient future cash flows to repay its obligations? The more historical and projected cash flows exceed the debt service requirements given the company’s financial position and industry, the lower the interest rate will be.
How is risk shared between shareholders and creditors? What is the company’s capital structure? The greater the leverage, the higher the rate of return required by creditors. If the percentage of financing is very high, the financial instrument’s purpose may be to supplement the shareholders’ investment. In such a case, the required rate of return on part of the financial instrument may be similar to that required for equity financing.
What are the terms and conditions (e.g. repayment) of the loan? The longer the repayment terms, the higher the interest rate.
What are the covenants? The more control a lender has over the management of the company’s capital, the lower the interest rate.
What disclosures does the lender require? The more closely a lender can monitor the investment, the lower the interest rate.
What was pledged as collateral? Is it good collateral? Is the amount financed commensurate to the realizable value of the assets being financed? Is there a shortage of collateral? The lower the percentage of financing relative to collateral, the lower the interest rate. Conversely, any portion of financing that is used to meet working capital needs or that exceeds the collateral’s realizable value will require a higher return than the collateralized portion.
By identifying the appropriate financing method for a given context, e.g. a term loan, subordinated debt or quasi-equity/equity, it is possible to obtain a rate of return that is in keeping with the market rate for a similar instrument.
Clearly there is no one-size-fits-all approach to this since the process is based on judgment and assumptions. Proper documentation of the above components is certainly the key to success in determining an appropriate estimate.
Jasmin Bilodeau, CPA, CA
Senior Manager, Corporate Financing
Demers Beaulne, LLP
Paul Beauvais, CPA, CA
Partner, Professional Practice
Demers Beaulne, LLP
Member of the technical working group on ASPE - Financial accounting - Part II