Limited recourse loans: Key accounting insights

Limited recourse loans are common arrangements where a company provides a loan, usually to employees, for the purpose of acquiring shares in the company.  

Typically, a limited recourse loan arrangement is one in which the company loans an employee money which can only be used for the purchase of its shares. However, the loan is “limited recourse”, meaning that in the event of non-repayment of the loan, the company’s only recourse is to take back the shares issued.

Errors in accounting for limited recourse loans are frequently observed in financial reporting under Australian Accounting Standards. Limited recourse loans are often incorrectly recognised as “loan receivables” in companies’ financial statements on issue of the shares. This is not the appropriate accounting treatment as it does not reflect the substance of the transaction.  

This article addresses some of the common accounting issues related to limited recourse loans under the requirements of Australian Accounting Standards.

Overview of the accounting treatment

Limited recourse loans should be recognised and measured in line with the requirements of AASB 2 Share-based payment, representing the overall substance of the transaction.

The substance of the loan transaction can be viewed in this way: 

The limited-recourse nature of the arrangement means that an employee could reasonably be expected to repay the loan on the repayment date if the value of the shares is higher than the loan amount payable.  However, if the value of the shares issued is lower than the amount payable, the employee would reasonably be expected not to repay the loan, and instead to surrender the shares back to the company.

The nature of the arrangement means that employees are not exposed to any risk of loss resultant of any downturn in share price performance during the term of the loan.  Conversely, if the Company’s share price increases  employees are likely to repay the loan and benefit from acquiring the shares at less than market value.

The result is that employees are effectively granted “options” to acquire the Company’s shares, allowing them to decide whether to exercise the options based on future movements in the Company’s share price.

Recognising a limited recourse loan as a loan receivable is therefore not appropriate. The company has no contractual rights to receive any cash in return for the issued shares. Instead, the issue of a limited recourse loan should be accounted for as if the Company granted share options to employees, and the options are deemed to be exercised upon the employee choosing to repay the loan.

This treatment was confirmed by the International Financial Reporting Interpretations Committee in November 2005.

Full recourse loan vs. Limited recourse loan

It is important to note that the accounting treatment of a full recourse loans is different and does not fall within the scope of AASB 2 Share Based Payment. We have outlined the key differences between full and limited recourse loans below:

• Full recourse loan: A full recourse loan grants the lender the contractual obligation to recover the loan from any and all of the assets from the borrower in the event of non-payment of the loan.
• Limited recourse loan: In the event of non-payment, the lender’s recovery is limited solely to the shares issued, with no recourse to any other assets of the borrower.

If a full recourse loan is issued to employees for the purpose of acquiring the Company’s shares the loan should be recognised as a loan receivable, as the Company has the contractual right to receive cash loan repayments. Like any receivable, the company would have to consider the extent to which any provision for an expected credit loss is necessary.

Accounting for limited recourse loans

Since the substance of a limited recourse loan is effectively the issuance of options to employees to acquire shares at a defined value, the transaction should be accounted for in accordance with of AASB 2 Share-based payment.

AASB 2 requires the Company to measure the fair value of the share options at the grant date. The fair value of the options is measured using any option valuation models that are permitted under the accounting standards, considering the price of the Company’s shares, the exercise price of the options, the expected life of the options, expected volatility, expected dividends and the risk-free interest rate. 

Following is an illustrative example to demonstrate the accounting treatment of limited recourse loan transactions:

Company A provides a limited-recourse loan of $1M to a key employee. The terms of the loan agreement state the employee must use the loan to buy 200,000 shares at $5 each.

The shares are to be held in the Trust for three years, after which the employee must either repay the loan or forfeit the shares.

The shares are automatically forfeited if the employee ceases employment before three years after the grant date.

As the substance of the agreement is that of an effective issue of share options to the employee, management measured the fair value of the options to be $3 each at the grant date.

Question 1 - How should Company A account for limited recourse loan under AASB 2 Share-based payment?

Under AASB 2, this arrangement would be treated as the issue of 200,000 options with a vesting period of three years, and an exercise price of $5.

The options would be fair valued on the grant date (i.e., $600,000), and the fair value would be recognised as an expense over a three-year vesting period representing the employee’s service requirement obtain the shares held in trust.

The probability of the vesting condition being met is required to be assessed for each reporting period.

Question 2 - What about the actual issued shares that are funded via a limited recourse loan, how should Company A account for the issued shares?

The total fair value of the options is $600,000, being 200,000 options, at fair value $3 each measured on the grant date. The total value of issued shares is $1M, being 200,000 shares, issued at $5 per share. 

The effect of the arrangement is equivalent to granting the option to purchase shares (See the accounting treatment listed in Question 1 for details).

Since the shares are issued on a limited recourse basis and are accounted for as options under AASB 2, neither the “loan” nor the shares issued are recorded in the financial statements until the loan is repaid.

No accounting entries are required to recognise the issuance of shares from accounting perspective.

The accounting entries for Year 1 would be as below (with the assumption that probability of meeting the vesting condition is 100% in Year 1).

Question 3 - What is the accounting treatment when the loan is fully repaid after the vesting service conditions are met?

During the vesting period (i.e., 3 years), the fair value would be recognised as an expense, with the corresponding accounting entries being credit to equity account – a total of $600,000 in this example. 

When a limited recourse loan is repaid, the share “option” is considered to be exercised for accounting purposes.

When the limited recourse loan is repaid, the issue of shares are recorded as follows:

For the amounts previously recognised in the share-based payment reserve during the vesting period, the Company can choose to transfer these amounts to issued capital at the time when the loan is repaid, although this is not required by IFRS.

Question 4 - How should Company A account for employees who leave the Company before reaching the vesting period? 

If the employee leaves the Company before reaching the vesting period, without settling the repayment associated with the limited recourse loan, the issued shares would be cancelled by the Company due to its limited recourse loan nature.

Under AASB 2, the service vesting condition is categorised as a non-market condition. The company is required to assess the probability of non-market conditions being met at each reporting period. If the employee leaves, the Company would reverse any expense previously recognised in relation to the options that have not vested. The accounting entry would be a debit to equity and a credit to the income statements to reverse expenses from previous periods.

In some cases, if the employee is not required to provide future service (for example, the employee can repay the “loan” at any time and keep the shares), an entity should recognise the total fair value of the options on the grant date, rather than over the term of the loan.

The accounting treatment of limited recourse loans is just one example of the complexities that can occur when accounting for share based payments.  

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For further information, please contact Ralph Martin or Nicky Kaindlbauer or your local RSM office.