ACCA paper f 7 financial reoirting F7FR session03 d08

1.2 Recognition of assets and liabilities Ü The key issue underlying the treatment of a transaction is whether an asset or liability should be shown in the statement of financial positi

OVERVIEW

Objective

Ü To explain the need for substance over form accounting

Ü To describe the issues to be addressed in assessing the commercial form of a transaction

Ü To cover the analysis of certain common substance over form examples

WHY SUBSTANCE MATTERS

REPORTING THE SUBSTANCE OF TRANSACTIONS

EXAMPLES

Ü Introduction

Ü Recognition of assets and liabilities

Ü Creative accounting

Ü Objective

Ü Recognition and derecognition

Ü Consignment inventory

Ü Sale and repurchase agreements

Ü Special purpose vehicle (entity)

Ü Factoring of debts

1 WHY SUBSTANCE MATTERS

1.1 Introduction

Ü Financial statements must reflect the true substance of transactions if they are to show a true and fair view

Ü Ultimately financial statements must follow the Framework which states that if

information reflects substance it has the characteristic of reliability

Ü Usually substance (i.e commercial effect) = legal form For more complex transactions this may not be the case

1.2 Recognition of assets and liabilities

Ü The key issue underlying the treatment of a transaction is whether an asset or liability should be shown in the statement of financial position

Ü In recent years some companies have devised increasingly sophisticated “off balance sheet financing” schemes whereby it was possible for them to hold assets and liabilities which did not actually appear on the statement of financial position according to the local GAAP This is one of the most important issues in financial reporting Some

countries have issued accounting standards to address this point specifically

Ü The concept of substance over form has existed as a concept in IAS for many years If companies had been following IAS some of the reporting problems which have

occurred would not have arisen

Ü The release of IAS 39 Financial Instruments: Recognition and Measurement will greatly

improve accounting for financial instruments and complex hedging arrangements

1.3 Creative accounting

Ü Over the past 40 years companies have tried to be creative in the way they account for certain transaction, this has led to there being abuses of the accounting entries recording these transactions and the financial statements not reflecting the economic reality of the situation Listed below are some of the main areas in which management have been creative in their accounting treatment

1.3.1 Off balance sheet financing

Ü This is where a company has a present obligation to make a payment but has been able

to keep the obligation (debt) off the statement of financial position A sale and

repurchase transaction, if accounted under its legal form, is an example of off balance sheet financing

1.3.2 Profit manipulation or smoothing

1.3.3 Window dressing

Ü This is where the financial statements are made pretty for one moment in time,

normally the year end Many ratios are formed by using figures from the statement of financial position, if these figures can be made to look good then it will improve the related ratios and put the company in a much better light Settling trade payables on the last day of the year, only to re-instigate them the very next day, is an example of this abuse

2.1 Objective

Ü To ensure that financial statements reflect the substance of transactions

2.2 Recognition and derecognition

Ü Recognise item only if

̌ it meets definition of asset/liability, and

̌ monetary amount can be measured with sufficient reliability

Ü Cease to recognise an asset only if

̌ all significant access to benefits, and

̌ all significant exposure to risks inherent in those benefits have been transferred to others

3.1 Consignment inventory

Ü This is very common in the car industry Consignment inventory is held by the dealer but legally owned by the manufacturer

Ü The issue is who should record the inventory as an asset?

Ü This will depend on whether it is the dealer or the manufacturer who bears the risks and benefits from the rewards of ownership

Ü Treatment – Is the inventory an asset of the dealer at delivery?

̌ If yes – the dealer recognises the inventory on the statement of financial position

with the corresponding liability to the manufacturer

̌ If no – do not recognise inventory on statement of financial position until transfer

of title has crystallised (manufacturer recognises inventory until then)

Illustration 1

David Wickes, a car dealer buys cars from FMC (a large multi-national car

manufacturer) on the following terms

Ü Legal title passes on sale to the public or when the car is used for

demonstration

Ü The car is paid for when legal title passes The price to David is

determined at the date of delivery

Ü David must pay interest at 10% on cost for the period from delivery to

payment

Ü David has the right to return the cars to FMC This right has never been

exercised in 10 years of trading

David’s year end is 31 December

Required:

Using as an example a car delivered to David on 30 September and still held at

the year end explain how David should account for the transaction

Solution

(1) Have the risks and rewards of ownership passed to David on delivery?

Risk/reward Factors passed?

Right to return inventory No

(but it has never been exercised

so for all intents and purposes the risk/reward actually does pass on delivery)

interest charge varying with time (∴

slow movement risk)

Conclusion

On balance the risks and rewards of ownership pass to David on delivery The transaction

should be treated as a purchase of inventory on credit

(2) Journal entries

On receipt of car Dr Purchases

Cr Payables

Up to date of earlier sale to third party or use as a demonstator

Dr Interest payable

Cr Payables (accrued interest)

3.2 Sale and repurchase agreements

Ü Here, an asset is sold by A to B on terms such that A repurchases the asset in certain circumstances

Ü The issue is to decide whether the substance of the transaction is

̌ a sale, or

̌ raising of finance on an asset still held

Ü Treatment in A’s accounts

Was there in substance a sale?

A On “sale”

On “repurchase”

Recognise sale and any profit

Recognise purchase, including any i

payable, as cost of sales

Leave asset in statement

of financial position

Record proceeds as a liability Accrue for any interest payable

Settle liability and accrued payable

Effect Effect

Finance cost recognised on repurchase (as part of cost of sales)

Finance is off balance sheet

Finance cost recognised

on “sale” (as interest payable)

Finance is on balance sheet

Ü

Ü

Ü

Ü

Yes No

Illustration 2

Christov is a vodka manufacturer The company manufactures vodka out of

the finest wheat grain The manufacturing process involves a maturing period

of 3 years The vodka is sold at cost + 200%

On the first day of its accounting period Christov sold 100,000 litres of 1 year

old vodka to Watnest plc, a bank, on the following terms

Ü Sale price $500,000 (cost)

Ü Christov has the option to repurchase the vodka at any time over the next

2 years at cost + a mark up

Ü The mark up is based on an annual rate of interest of 12% and will be

prorated

Ü Watnest has the option to sell the vodka to Christov in 2 years time at a

price based on a similar formula

Required:

Explain how Christov should account for this transaction at inception and at

the year end

Solution

(1) Has there in substance been a sale?

Is the repurchase likely to happen? If so it is not a real sale and the legal form should be set aside

Factors

Sale is unusual – sale at cost/to a bank – indicates that it is not a real sale

A mirror image put and call option means that the repurchase is bound to occur

Christov is paying a borrowers return

Therefore the sale is not a real sale but a financing arrangement

(2) Journal entries

At year end Dr Profit or loss 60,000

Commentary

If in substance there had been a sale

$ $

On “sale” Dr Cash 500,000

Cr Revenue 500,000

On “repurchase” Dr Cost of sales 627,200

Cr Cash 627,200

3.3 Special purpose vehicle (entity)

A controlled undertaking

but not a legal subsidiary

Benefit and risk source

equivalent to a subsidiary

Consolidate as a subsidiary

Illustration 3

A hotel company, Company H, sells some of its hotels to Company B, the

subsidiary of a bank B is financed by loans from the bank at normal interest

rates H and B enter into a management contract whereby H undertakes the

complete management of the hotels It is remunerated for this service by a

management charge which is set at a level which absorbs all the profits of B

after paying the interest on its loan finance There are also arrangements

which give H control over the sale of any of the hotels by B, and any gain or

loss on such sales also reverts to it through adjustment of the management

charge

Required:

Giving reasons, show how H should record the above

Solution

In these circumstances, it is clear that the bank’s legal ownership of B is of little relevance All the profits of B go to H, and the bank’s return is limited to that of a secured lender In substance, H holds the equity interest in both B and the hotels that it owns B will therefore

be regarded as a special purpose vehicle of H and will be consolidated by it As a result, all transactions between the two companies will be eliminated from the group accounts of H, and the group statement of financial position will show the hotels as an asset and the bank loans as a liability The group statement of comprehensive income will show the full trading results of the hotels and the interest charged by the bank on its loans, while the

inter-company management charge will be eliminated on consolidation

3.4 Factoring of debts

Ü The “seller” transfers debts to a “factor” for an agreed % of the value of the debts Again, the key issue is the extent to which the risks and rewards of ownership have been transferred

Ü Possible treatments

̌ debts no longer an asset of the seller → derecognition

̌ debts remain an asset of the seller → separate presentation

FOCUS

You should now be able to:

Ü demonstrate the role of the principle of substance over form in relation to recognising sales revenue;

Ü explain the importance of recording the commercial substance rather than the legal form – give examples of previous abuses in this area;

Ü describe the features that may indicate that the substance of transactions differs from their legal form;

Ü discuss how financial statements may be manipulated to produce a desired effect

(creative accounting, window dressing);

Ü apply the principle of substance over form to the recognition and derecognition of assets and liabilities;

Ü recognise the substance of transactions in general, and specifically account for the following types of transactions: