What Auditors Look for in Directors’ Loans

Directors’ loans – transactions between a company and its directors – are a common feature in SMEs and group companies. However, they are also high-risk areas that attract significant scrutiny during audits. From legal compliance to financial reporting and tax implications, auditors carefully evaluate every aspect of these loans to ensure transparency, compliance, and accuracy.

Mismanagement or non-compliance can lead to serious legal and financial consequences. To simplify the audit process, here’s a combined overview of what auditors look for and how they assess directors’ loans.

Key Audit Areas and Procedures for Directors’ Loans

Auditors follow a structured process to assess directors’ loans, focusing on the following critical areas:

1. Legal Compliance (e.g., Companies Act)
   • What Auditors Look For: Compliance with company laws, such as the Companies Act, to ensure the loan is authorized and doesn’t exceed legal limits. They check whether the loan was approved by the board or shareholders and flag unauthorized or fraudulent loans.
   • What Auditors Do: Review loan agreements for proper documentation, board/shareholder approvals, and compliance with legal restrictions.
2. Purpose and Nature of the Loan
   • What Auditors Look For: Whether the loan serves a legitimate business purpose or if it could be considered a disguised remuneration or personal benefit for the director.
   • What Auditors Do: Inquire about the loan’s purpose and ensure it aligns with the company’s objectives while assessing the director’s financial position to confirm repayment ability.
3. Repayment Terms and Financial Viability
   • What Auditors Look For: The director’s ability to repay the loan, especially for loans repayable on demand. Auditors evaluate whether the loan is at risk of default based on the director’s liquidity and financial health.
   • What Auditors Do: Assess repayment terms and the director’s financial position to ensure the loan is recoverable.
4. Recording and Measurement
   • What Auditors Look For: Accurate initial recognition of the loan at fair value and subsequent measurement at amortized cost. For interest-free or subsidized loans, auditors ensure proper adjustments for benefits such as below-market interest rates.
   • What Auditors Do: Verify that the loan is recorded correctly, applying the effective interest rate method for subsidized loans and testing for accurate amortization over time.
5. Impairment and Credit Risk
   • What Auditors Look For: Whether the loan is impaired and if provisions for expected credit losses (ECL) are necessary. For loans repayable on demand, auditors evaluate the director’s financial capacity to determine default risk.
   • What Auditors Do: Apply the ECL model to assess impairment and ensure potential losses are accounted for.
6. Tax Implications
   • What Auditors Look For: Whether interest-free or below-market loans are treated as taxable benefits for the director and if forgiven loans are taxed as income or exempt, depending on the director’s role.
   • What Auditors Do: Review tax records and calculations to ensure consistency with financial reporting and compliance with tax laws.
7. Disclosure in Financial Statements
   • What Auditors Look For: Transparent disclosure of the loan as a related party transaction, including all relevant details such as terms, fair value adjustments, and benefits.
   • What Auditors Do: Confirm that related party disclosures comply with financial reporting standards, enhancing transparency and accountability.

Prepare for a Smooth Audit of Directors’ Loans

To ensure your directors’ loans are audit-ready, follow these steps:

1. Maintain Proper Documentation
   • Have formal loan agreements with clearly defined repayment terms, interest rates, and conditions.
   • Record fair value calculations, impairment assessments, and interest income adjustments.
2. Ensure Legal Compliance
   • Obtain necessary board or shareholder approvals for the loan, as required by the Companies Act.
   • Review loans regularly to ensure they remain compliant with legal limits.
3. Be Transparent
   • Clearly explain the loan’s purpose and provide evidence of the director’s ability to repay.
   • Disclose all details in financial statements as related party transactions.
4. Plan for Tax Implications
   • Calculate and report taxable benefits for interest-free or below-market loans.
   • Ensure consistency between financial statements and tax filings.

By understanding auditors’ expectations and following these steps, companies can avoid common pitfalls such as undocumented loans, unauthorized approvals, or incomplete disclosures.

Common Mistakes to Avoid

Here are some frequent issues auditors encounter during directors’ loan audits:

• No Formal Loan Agreement: Failing to establish repayment terms, interest rates, or the purpose of the loan.
• Lack of Approval: Providing loans without proper board or shareholder approval.
• Missing Repayment Terms: Undefined repayment schedules or unclear repayment conditions.
• Below-Market Interest Rates: Offering interest-free or subsidized loans without proper fair value adjustments.
• Misclassification: Incorrectly recording loans as advances, dividends, or remuneration.
• Failure to Assess Repayment Ability: Overlooking the director’s financial position.
• Neglecting Disclosures: Omitting related party transactions in financial statements.
• Improper Loan Forgiveness: Forgiving loans without proper accounting treatment or disclosure.
• Ignoring Tax Implications: Overlooking taxable benefits, leading to penalties.
• Poor Record-Keeping: Inadequate documentation of loan agreements, fair value calculations, and approvals.

Conclusion

Auditing directors’ loans is essential to ensure transparency, compliance, and accurate financial reporting. Auditors focus on verifying legal, financial, and tax compliance while assessing the loan’s purpose, terms, and repayment ability.

Reminder: Always consult your auditors and corporate secretary before giving out a directors’ loan. Their guidance ensures the loan is compliant, well-documented, and properly disclosed, reducing risks for your organization.

For management, preparation is key. By maintaining proper documentation, adhering to regulations, and being transparent with auditors, companies can avoid legal risks, tax penalties, and material misstatements.

Need Expert Support with Directors’ Loans and Audit Assurance?

At S C Mohan PAC, we specialize in audit assurance services for SMEs and group companies. With extensive experience, our team can help you manage directors’ loans, ensuring compliance and reducing risks.

📞 Call us today: +65 9144 1840
📧 Email us: accounts_1@scmohan.com.sg or office@scmohan.com.sg

Feel free to contact us for any enquiries – we’re happy to assist at no charge.

Let us handle your audit and compliance needs so you can focus on growing your business. Reach out to us today!