What it means
Many businesses are funded in part by people close to them. An owner may lend the company money, a parent may fund a subsidiary through an intercompany loan, or an employee may be owed unpaid wages or expenses, and each of these creates a claim against the company's assets.
In normal times these balances are recorded like any other liability, though they often carry softer terms, such as no fixed repayment date or little or no interest. Auditors usually require them to be labelled separately as related-party balances so that readers of the accounts can see them.
When a group prepares consolidated accounts, intercompany claims between group members are cancelled out, because the group cannot owe money to itself. Only claims on parties outside the group appear in the combined balance sheet.
In insolvency the ranking of internal claims becomes crucial. Depending on local law and the circumstances, loans from owners or connected parties can be pushed behind outside creditors, a treatment known as subordination, so they may recover little or nothing until others are paid in full.
Lenders sometimes require owners to agree to this ranking in writing before granting a new loan. For managers the practical lesson is to document insider loans carefully, with signed agreements, repayment terms and interest where appropriate.
A well-documented claim stands a better chance of being treated properly, while a vague one can be challenged by a liquidator. The nuance is that the phrase is used loosely.
Some writers use it to mean intercompany balances, others mean owner loans, and others mean claims by employees, so it is wise to confirm which meaning applies in a given document.
In practice
Real-world examples.
Example
A founder lends her bakery business $80,000 during its first year without a written agreement. When the business later closes, the liquidator questions whether the loan was a genuine debt or an extra capital contribution. Poor paperwork weakens her claim, and she recovers less than she expected.
Example
A logistics group has a parent company that funds its subsidiaries. At year end, the finance team eliminates the $5,000,000 owed between two group companies in the consolidated balance sheet. Each company's separate accounts still show the balance.
Example
A restaurant owes a former chef $12,000 in unpaid wages and the owner $30,000 for a director's loan. In a wind-up, the wage claim often receives priority treatment under local law, whereas the owner's loan is ranked behind outside creditors.
Formula
Calculation
Recovery rate = Assets available to the class of claims / Total claims in that class
Suppose an insolvent company has $600,000 available for unsecured creditors. Outside unsecured creditors are owed $1,500,000 and the owner's loan, an internal claim, is $500,000, so total claims are $2,000,000. If both rank equally, the recovery rate is 600,000 / 2,000,000 = 30%, so the owner receives 500,000 x 0.30 = $150,000. If the owner's loan is subordinated, outside creditors are paid first, and their recovery rate is 600,000 / 1,500,000 = 40%, while the owner receives nothing.Case study
Seen in the real world.
This is an illustrative story about a fictional manufacturer, Sandstone Components Ltd, owned by two brothers. Over several years they lent the company a total of $400,000 to buy machinery, recording the amounts in a single director's loan account with no interest or repayment schedule.
When a major customer failed, Sandstone could not pay its bank and suppliers, and an insolvency practitioner was appointed. The practitioner treated the brothers' loans as internal claims and placed them behind the external creditors, who recovered a portion of what they were owed.
The brothers received nothing from their loans. The illustrative lesson is that insider funding can feel safe, but without clear terms, security or ranking, it is often the first money lost when the business fails. Had the brothers instead put the money in as formal, registered loans on clear terms, their position would have been far easier to defend.
Watch out
Common mistakes.
- Assuming an owner's loan is repaid before outside creditors. In many jurisdictions it ranks behind them, and may be treated like equity.
- Leaving insider loans undocumented. Without a written agreement, the claim is easier to challenge or reclassify.
- Forgetting to eliminate intercompany balances in consolidation. Leaving them in overstates both the group's assets and its liabilities.
Questions
People also ask.
Is an internal claim the same as an intercompany balance?
Sometimes. An intercompany balance is one type of internal claim, but the phrase can also cover owner and employee claims.
Can an internal claim earn interest?
Yes, if the agreement says so, though related-party interest may be reviewed by tax authorities to ensure it is at a fair market rate.
Why do auditors ask about related-party balances?
Because transactions with insiders may not be on arm's-length terms, and readers of the accounts need to know about them.
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