Chapter 3 Substance of Transactions

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Objectives
Understand the meaning of substance of transactions. Understand and apply the principle of substance over form.
S u b sta n c e & ver F o rm

% e n e ral rin c ip le s

S p e c i f ic ! $ a m p le s

C o n sig n m e n t In v e n to rie s

S a le a n d R e p u rc h a se A g r e e m e n ts

F a c to rin g o f R e c e iv a b l e s

S p e c ia l u rp o se ! n titie s

S e c u ritised A ssets

" o in t # e n tu re s

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Introduction
'oth the ()IC A*s frame+or, and ()AS 1 state that transactions and events should be accounted for and presented in accordance +ith their substance and economic reality- and not merely their legal form. As yet the ()IC A does not have one standard that brings together all aspects of substance over form. (o+ever- many e$isting standards base their accounting treatment on the concept of substance over form. /he basic thrust is that the substance of a transaction should be determined by identifying all aspects and implications and giving priority to those more li,ely to have a commercial effect in practice. /his usually means considering the effect of the transaction on the assets and liabilities of the enterprise. /herefore- it is important to be clear on e$actly +hat is meant by the term 0asset1 and +hat is meant by the term 0liability1.

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3.

Off Balance Sheet Finance ( )

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(A) ..1

The advantages perceived from schemes of off balance sheet finance Definition &ff balance finance is the organi4ation of transactions such that financial commitments are not included in the statement of financial position of a company or a group.

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/he perceived benefits include the follo+ing5 6i7 erceived lo+er level of gearing. 6ii7 /here may be a breach of loan covenants if further liabilities are recorded on balance sheet. 6iii7 In most cases- off balance sheet finance schemes result in assets also being reduced. /herefore a higher R&C! may result. 6iv7 Specialised activities- e.g. leasing and financial services 6+hich have high gearing7 can be removed from a group balance sheet. The principle of substance over form Definition Substance over form 6 7 re8uires that transactions and other events should be accounted for and presented in accordance +ith their substance and financial reality and not merely with their legal form 6 7.

(B) ...

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/his principle prevents off balance sheet finance because if the commercial reality is that the company has a financial commitment- that commitment should be included on the statement of financial position. /he first ma;or area +here an accounting standard introduced a change from legal form to substance +as ()AS 1< 0=eases1. /his standard is e$amined in detail in the ne$t chapter. Common forms of off balance sheet finance ?ays in +hich companies have tried to ,eep items off the balance sheet in the past include the follo+ing. 6i7 =easing of assets
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(C) ..>

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rior to the issue of ()AS 1< leases +ere not capitali4ed- i.e. the asset and its related financial commitment +ere not sho+n on the lessee*s statement of financial position. Controlled non3subsidiaries Under previous defective definitions of a subsidiary- companies could control other companies but- as they +ere not technically subsidiariesthey +ere not consolidated in the group accounts. ?e +ill cover consolidated accounts later. /he effect of non3consolidation is that the assets and liabilities of the subsidiary +ere not included +ithin the total assets and liabilities of the group. Since the issue of ()AS 2<- companies have had to be more ingenious in arranging their affairs so that off balance sheet arrangements continue to occur in entities +hich are not classified as subsidiaries under the definitions in the standard. Innovations in the financial mar,ets A number of 6often comple$7 arrangements have been developed- often involving comple$ financial instruments- for +hich the accounting entries +ere not immediately obvious. /he ()IC A is addressing such problems by issuing standards such as ()AS .2 0Financial Instruments5 resentation1- ()AS .@ 0Financial Instruments5 Recognition and Aeasurement1 and ()FRS < 0Financial Instruments5 Bisclosure1 +hich have more detailed re8uirements.

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4.

Reflectin the Substance of !ransactions in Financial State"ents

/he ()IC A*s approach to reporting the substance of transactions involves several separate strands5 6i7 the Frame+or, document 6ii7 ()AS 1 to lay do+n the general principle 6iii7 specific ()ASs for particular areas 6a7 ()AS 1< for accounting for leases 6b7 ()AS 29 for related party disclosures 6c7 ()AS .1 for interests in ;oint ventures 6d7 ()AS .2 for the disclosure and presentation of financial statements.

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!ach of these strands is no+ briefly e$amined. (A) 9.2 The ramewor! /he ()IC A ramewor! for the preparation and presentation of financial statements identifies substance over form as a necessary part of the reliability characteristic. If information is to represent faithfully the transactions and other events that it purports 6 7 to represent- it is necessary that they are accounted for and presented in accordance +ith their substance and economic reality and not merely their legal form. (o+ever- the contents of the Frame+or, are not mandatory standards- so it is necessary to repeat the substance over form principle in ()AS 1. Determining the substance of a transaction Common features of transactions +hose substance is not readily apparent are 6i7 the separation of the legal title to an item from the ability to en;oy the principal benefits and e$posure to the principal ris,s associated +ith it 6ii7 the lin,ing of a transaction +ith one or more others in such a +ay that the commercial effect cannot be understood +ithout reference to the series as a +hole- and 6iii7 the inclusion in a transaction of one or more options +hose terms ma,e it highly li,ely that the option +ill be e$ercised. "ey #oint A ,ey step in determining the substance of a transaction is to identify its effect on the assets and liabilities of the entity. 9.< $is! often indicates +hich party has an asset. Ris, is important- as the party +hich has access to benefits 6and hence an asset7 +ill usually also be the one to suffer or gain if the benefits ultimately differ from those e$pected.

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(B) 9.:

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$%%l&in the Substance over For" 'rinci%le

/he follo+ing e$amples illustrate ho+ these theories are applied in practive. 6i7 consignment inventories and goods on sale3or3return
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6ii7 6iii7 6iv7 (A) :.2

sale and repurchase agreements factoring of receivables special purpose entities

Consignment inventory ( ) Consignment inventory is inventory held by one party but legally o+ned by another- on terms +hich give the holder the right to sell the inventory in the normal course of his business- or at his option to return it unsold to the legal o+ner. &ther terms of such arrangements include a re8uirement for the dealer to pay a deposit- and responsibility for insurance. /he arrangement should be analysed to determine +hether the dealer has in substance ac8uired the inventory before the date of transfer of legal title. "ey #oint /he ,ey point +ill be who bears the ris! of slow moving inventory . /he ris, involved is the cost of financing the inventory for the period it is held.

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In a simple arrangement +here inventory is supplied for a fi$ed price that +ill be charged +henever the title is transferred and there is no deposit- the manufacturer bears the slo+ movement ris,. If- ho+ever- the price to be paid increases by a factor that varies +ith interest rates and the time the inventory is held- then the dealer bears the ris,. ?hoever bears the slow movement ris! should recogni4e the inventory on the balance sheet. %&A'#(% ) &n 1 "anuary 2CCD %illingham- a manufacturer- entered into an agreement to provide Canterbury- a retailer- +ith machines for resale. Under the terms of the agreement Canterbury pays a fi$ed rental per month for each machine that it holds and also pays the cost of insuring and maintaining the machines. /he company can display the machines in its sho+rooms and use them as demonstration models. ?hen a machine is sold to a customer- Canterbury pays %illingham the factory

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price at the time the machine +as originally delivered. All machines remaining unsold si$ months after their original delivery must be purchased by Canterbury at the factory price at the time of deliver. %illingham can re8uire Canterbury to return the machines at any time +ithin the si$ month period. In practice- this right has never been e$ercised. Canterbury can return unsold machines to %illingham at any time during the si$ month period- +ithout penalty. In practice- this has never happened. At 3) December *++, the agreement is still in force and Canterbury holds several machines which were delivered less than si- months earlier. /ow would these machines be treated in the accounts for the year ended 3) December *++,0 S1(2T3145 /he ,ey issue is +hether Canterbury has purchased the machines from %illingham or +hether they are merely on loan. It is necessary to determine whether Canterbury has the benefits of holding the machines and is e-posed to the ris!s inherent in those benefits. %illingham can demand the return of the machines and Canterbury is able to return them +ithout paying a penalty. /his suggests that Canterbury does not have the automatic right to retain or to use them. Canterbury pays a rental charge for the machines- despite the fact that it may eventually purchase them outright. /his suggests a financing arrangement as the rental could be seen as loan interest on the purchase price. Canterbury also incurs the costs normally associated +ith holding inventories. /he purchase price is the price at the date the machines +ere first delivered. /his suggests that the sale actually ta,es place at the delivery date. Canterbury has to purchase any items still held si$ months after delivery. /herefore- the company is e$posed to slo+ payment and obsolescence ris,s. 'ecause Canterbury can return the items before that time- this e$posure is limited.

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It appears that both parties e$perience the ris,s and benefits. (o+everalthough the agreement provides for the return of the machines- in practice this has never happened. Conclusion5 the machines are assets of Canterbury and should be included in the balance sheet. :.D %&%$C3S% ) /aurus- a motor car manufacturer- supplies cars to 2orthern Aotors- a car dealership- on a consignment basis. /he terms of the agreement are5 617 2orthern pay for the cars at the earlier of5 /hree months after deliveryE or ?hen the cars are sold. /he price paid by the dealer is the +holesale price as at the date of payment. 2orthern must pay /aurus a rent of F:C per month for each car until they have been paid for in full. If after three months the car is unsold then 2orthern have t+o options5 ay for the car in fullE or Return it to /aurus. /aurus +ill charge a fee of F@: to cover administration and transport if the car is returned. /aurus may re8uest the return of any unsold car. /hey might +ant to do this to deliver it to another supplier +ho is short of inventory.

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/he average +holesale price of these cars is F12-CCC- and the average mar,et rate of interest for car dealerships is 12G p.a. $e6uired5 (o+ should this agreement be accounted for in the boo,s of 2orthern Aotors and /aurusH Solution5

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(B) :.@

Sale and repurchase agreements Sale and $epurchase Arrangements Sale and repurchase arrangements are arrangements under +hich assets are sold by one party to another on terms that provide for the seller to repurchase the assets in certain circumstances.

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/ypical arrangements +ould cover the follo+ing points5 6i7 /he vendor sells an item at5 6a7 mar,et priceE or 6b7 an agreed price. 6ii7 /he vendor may repurchase the item at5 6a7 the mar,et price at the date of repurchaseE or 6b7 a price +hich varies +ith time 6 to ta,e into account the time value of money7E or 6c7 an agreed price. 6iii7 /he vendor may have an option to repurchase 6a call option7E or 6iv7 /he purchaser may have an option to demand repurchase 6a put option7. "ey #oint Iou need to identify if a sale and re3purchase agreement is5 a genuine saleE or a secured loan.

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A secured loan transaction +ill usually have the follo+ing features5 6i7 the seller +ill secure access to all future benefits inherent in the assetoften through call optionsE 6ii7 the buyer +ill secure ade8uate return on the purchase 6interest on the loan- often through ad;ustment of the repurchase price7 and appropriate protection against loss in value of the asset bought 6often through put option7. Sale and repurchase arrangements are common in property development and in maturing +his,y inventories. %&%$C3S% * == is a +holesaler of high 8uality hard+ood. /he +ood is stored for many years before it is properly seasoned and ready for use. &n 1 "anuary 2CCC they sold a ne+ consignment of hard+ood to =ehman 'an,. /he +ood had cost == F2m- and the proceeds of sale +ere F.m. It +ill be ten years before this +ood is ready for use. == +ill be responsible for the seasoning process. ?hen the +ood is ready it +ill

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have a mar,et price of F12 m. == has an option to repurchase the timber in ten years time 6on 1 "anuary 2C1C7 for F<-<D1-22<7.

$e6uired5 6a7 6b7 repare e$tracts from the financial statements of == that +ill report the legal form of this transaction. Critically appraise the truthfulness of these financial statements. In particular comment on the +ay in +hich assets- liabilities- income and e$penditure have 6or have not7 been recogni4ed. repare e$tracts from the financial statement for == for 2CCC- 2CC12CC@ and 2C1C reporting the commercial substance of these transactions.

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Additional information5 Assume that == repurchases the timber in 2C1C and immediately resells it at the e$pected mar,et price of F12m. /he prevailing mar,et rate of interest for pro;ects of this nature is 1CG. Solution5

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(C) :.1:

actoring receivables ( ) Bebt factoring is a fairly common method for businesses to improve their cash flo+. ?hat normally happens is that the finance company to +hom the debts are legally sold pay a fi$ed percentage of the debt*s value- say @CG- at the date of legal transfer- +ith the balance payable- less an appropriate charge- if and +hen the debtor pays the factor. Usually- the debts are factored with recourse 6 7. /his means that- if the debtor doesn*t pay- then the finance company can receive repayment of the sums advanced to the seller. If debt factoring is +ith recourse it is usually the case that the original seller has retained the ris!s and rewards of o+nership of the debts- and the factoring proceeds are in reality a form of financing from the factoring agency. Bebt factoring is a common e$ample of a transaction +here lin!ed presentation is sometimes appropriate. "ey #oint actored debts can only be derecognised if all the related ris,s and re+ards have been disposed of.

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%-ercise 3 An entity has an outstanding receivables balance +ith a ma;or customer amounting to F12 million and this +as factored to Finance Co on 1 September 2C1C. /he terms of the factoring +ere5

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Finance Co +ill pay DCG of the gross receivable outstanding account to the entity immediately. /he balance +ill be paid 6less the charges belo+7 +hen the debt is collected in full. Any amount of the debt outstanding after four months +ill be transferred bac, to the entity at its full boo, value. Finance Co +ill charge 1.CG per month of the net amount o+ing from the entity at the beginning of each month. Finance Co had not collected any of the factored receivable amount by the year3end. /he entity debited the cash from Finance Co to its ban, account and removed the receivable from its accounts. It has prudently charged the difference as an administration cost.

(o+ should this arrangement be accounted for in the financial statements for the year ended .C September 2C1CH

Solution5

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(D) :.1@

Special purpose entities (S#%s) S !s are legally independent entities that are used to ta,e on the loans or liabilities of another enterprise. An enterprise 6often referred to as the sponsor7 +ill sell assets to the S !- but retain the right to use the asset and gain from any future increase in its value. /he S ! normally has no assets or capital of its o+n. It +ill borro+ the money needed to buy the asset from a Jcapital provider*. "ey #oint The purpose of S#%s is to remove assets and liabilities from the statement of financial position of the sponsor. This has the effect of improving the return on capital employed and gearing of the sponsor.

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S !s are also ,no+n as vehicles and 6uasi7subsidiaries. ()AS K Int 12 0Consolidation K Special urpose !ntities1 states that an enterprise should consolidate an S ! if it controls that S !. A reporting enterprise probably has control over an S ! if5 6i7 It benefits from the S !*s activities. /he S ! may be providing long3 term finance or essential goods and services. 6ii7 It has decision3ma,ing po+ers over the S !. /his can be achieved directly or by delegating decision ma,ing under an autopilot mechanism. 6iii7 It has rights to the ma;ority of the S !*s economic benefits. /he S !*s capital providers normally receive a lender*s return- but nothing more. 6iv7 It is e$posed to the S !*s ris,s. /he capital providers in an S ! normally have limited e$posure to an S !*s losses. %&%$C3S% 8 Bavies plc is a publicly 8uoted o+ner and operator of lu$ury hotels. &n 1 "anuary 2CC< Bavies plc sold some of its hotels to eters =td- a subsidiary of ?ilson*s 'an,. /hese hotels had a boo, value of FD:C million in the boo,s of Bavies. /hey +ere sold to eters for F1-2DC million- +hich +as their open mar,et value. eters =td is financed by one F1 &rdinary Share 6held by ?ilson*s 'an,7 and a

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F1-:CC million 1.G loan supplied by ?ilson*s 'an, on normal commercial terms. Bavies and eters have entered into the follo+ing management contract for the hotels5 Bavies +ill be paid a fee in e$change for the complete management of the hotels. /he fee +ill be set at 1CCG of the profits of eters =td after paying the interest on the loans from ?ilson*s 'an,. If any of the hotels are sold then the profits +ill be assigned to Bavies plc. 'oth companies have a .1 Becember year end. /heir financial statements for 2CC< are noted belo+. /hey have been dra+n up on the basis of legal form. $e6uired5 6a7 6b7 !$plain +hy Bavies plc should consolidate eters =td. repare the consolidated accounts for the Bavies %roup. /he hotels should be stated at their open mar,et value- giving rise to a revaluation reserve. Biscuss the effect that these consolidated accounts +ill have on investors in Bavies plc compared +ith the original company accounts. Statements of comprehensive income for *++9 Bavies Fm :CC 6.:C7 1:C 61DC7 .CC 2<C 9.C 3 <CC eters Fm 1-@CC 61-12:7 <<: 62DC7 6.CC7 1@: 3 61@:7 3

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Revenues Cost of sales %ross profit !$penses Aanagement fee &perating profit rofit on disposal of hotels Interest payable rofit before ta$ Statement of financial position for *++9

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Assets 2on3current assets Current assets /otal assets %6uity and liabilities Share capital and reserves Share capital Retained profits Revaluation reserve 2on3current liabilities Current liabilities /otal e8uity and liabilities

Bavies Fm 9CC @CC 1-.CC

eters Fm 1-2DC 9CC 1->DC

:C D:C 1CC 1-CCC 3 .CC 1-.CC

3 3 3 3 1-:CC 1DC 1->DC

Solution5

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%-amination Style :uestions

:uestion ) /he overriding re8uirement of a company*s financial statements is that they should represent faithfully the underlying transactions and other events that have occurred. /o achieve this transactions have to be accounted for in terms of their 0substance1 or economic reality rather than their legal form. /his principle is included in the ()IC A*s 0Frame+or, for the reparation and resentation of Financial Statements1and is also used in many standards- in particular ()AS 1< 0=eases1 and ()AS 1D 0Revenue1. $e6uired5 6a7 Bescribe +hy it is important that substance rather than legal form is used to account for transactions- and describe ho+ financial statements can be adversely affected if the substance of transactions is not recorded. 6: mar,s7 Bescribe- using an e$ample- ho+ the follo+ing features may indicate that the substance of a transaction is different from its legal form5 6i7 separation of o+nership from beneficial useE 6ii7 the lin,ing of transactions including the use of option clausesE 6iii7 +hen an asset is sold at a price that differs to its fair value. 6@ mar,s7 &n 1 April 2CCD Forest had an inventory of cut seasoning timber +hich had cost F12 million t+o years ago. Bue to shortages of this 8uality of timber its value at 1 April 2CCD had risen to F2C million. It +ill be a further three years before this timber is sold to a manufacturer of high3class furniture. &n 1 April 2CCD Forest entered into an arrangement to sell 'arret 'an, the timber for F1: million. Forest has an option to buy bac, the timber at any time +ithin the ne$t three years at a cost of F1: million plus accumulated interest at 2G per annum above the base rate. /his +ill be charged from the date of the original sale. /he base rate for the period of the transactions is e$pected to be DG. Forest intends to buy bac, the timber on .1 Aarch 2C11 and sell it the same day for an e$pected price of F2: million. 2ote5 Ignore any storage costs and capitalisation of interest that may relate to inventories. $e6uired5
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Assuming the above transactions ta,e place as e$pected- prepare e$tracts to reflect the transactions in the statement of comprehensive income for the years to .1 Aarch 2CC@- 2C1C and 2C11 and the statement of financial position 6ignore cash7 at those year ends5 6i7 6ii7 if Forest treated the transactions in their legal formE and if the substance of the transactions is recorded. 611 mar,s7 62: mar,s7

Comment briefly on your ans+er to 6c7 above.

:uestion * Revenue recognition is the process by +hich companies decide +hen and ho+ much income should be included in the income statement. It is a topical area of great debate in the accounting profession. /he ()IC A loo,s at revenue recognition from conceptual and substance points of vie+. /here are occasions +here a more traditional approach to revenue recognition does not entirely conform to the ()IC A guidanceE indeed neither do some (ong )ong Accounting Standards. $e6uired5 6a7 !$plain the implications that the ()IC ALs Frame+or, for the reparation and resentation of Financial Statements 6Frame+or,7 and the application of substance over form have on the recognition of income. %ive e$amples of ho+ this may conflict +ith traditional practice and some accounting standards. 6> mar,s7 Berringdo sells goods supplied by %ungho. /he goods are classed as A grade 6perfect 8uality7 or ' grade- having slight faults. Berringdo sells the A grade goods acting as an agent for %ungho at a fi$ed price calculated to yield a gross profit margin of :CG. Berringdo receives a commission of 12M:G of the sales it achieves for these goods. /he arrangement for ' grade goods is that they are sold by %ungho to Berringdo and Berringdo sells them at a gross profit margin of 2:G. /he follo+ing information has been obtained from BerringdoLs financial records5 FCCC 2-9CC

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Inventory held on premises 1 April 2CC2

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K A grade

%oods from %ungho year to .1 Aarch 2CC. Inventory held on premises .1 Aarch 2CC. $e6uired5

K ' grade K A grade K ' grade K A grade K ' grade

1-CCC 1D-CCC D-DCC 2-CCC 1-2:C

repare the income statement e$tracts for Berringdo for the year to .1 Aarch 2CC. reflecting the above information. 6: mar,s7 6ACCA 2.: 6()%7 Financial Reporting "une 2CC. N. 6a7 O 6b77 :uestion 3 /he principle of recording the substance or economic reality of transactions rather than their legal form lies at the heart of the Frame+or, for reparation and resentation of Financial Statements* 6Frame+or,7 and several (ong )ong Financial Reporting Standards. /he development of this principle +as partly in reaction to a minority of public interest companies entering into certain comple$ transactions. /hese transactions sometimes led to accusations that company directors +ere involved in Jcreative accounting*. $e6uired5 6a7 6i7 6ii7 !$plain- +ith relevant e$amples- +hat is generally meant by the term Jcreative accounting*E 6: mar,s7 !$plain +hy it is important to record the substance rather than the legal form of transactions and describe the features that may indicate that the substance of a transaction is different from its legal form. 6: mar,s7 At,ins*s operations involve selling cars to the public through a chain of retail car sho+rooms. It buys most of its ne+ vehicles directly from the manufacturer on the follo+ing terms5 At,ins +ill pay the manufacturer for the cars on the date they are sold to a customer or si$ months after they are delivered to its sho+rooms +hichever is the sooner. /he price paid +ill be DCG of the retail list price as set by the manufacturer at the date that the goods are delivered. At,ins +ill pay the manufacturer 1M:G per month 6of the cost price to At,ins7 as a Jdisplay charge* until the goods are paid for.
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At,ins may return the cars to the manufacturer any time up until the date the cars are due to be paid for. At,ins +ill incur the freight cost of any such returns. At,ins has never ta,en advantage of this right of return. /he manufacturer can recall the cars or re8uest them to be transferred to another retailer any time up until the time they are paid for by At,ins. $e6uired5 Biscuss +hich party bears the ris,s and re+ards in the above arrangement and come to a conclusion on ho+ the transactions should be treated by each party. 6> mar,s7 6ii7 At,ins bought five identical plots of development land for F2 million in 1@@@. &n 1 &ctober 2CC1 At,ins sold three of the plots of land to an investment company- =andban,- for a total of F2M9 million. /his price +as based on <:G of the fair mar,et value of F.M2 million as determined by an independent surveyor at the date of sale. /he terms of the sale contained t+o clauses5 At,ins can re3purchase the plots of land for the full fair value of F.M2 million 6the value determined at the date of sale7 any time until .C September 2CC9E and &n 1 &ctober 2CC9- =andban, has the option to re8uire At,ins to re3 purchase the properties for F.M2 million. Iou may assume that =andban, see,s a return on its investments of 1CG per annum.

$e6uired5 Biscuss the substance of the above transactionsE and 6. mar,s7

repare e$tracts of the income statement and balance sheet 6ignore cash7 of At,ins for the year to .C September 2CC25 62 mar,s7 if the plots of land are considered as sold to =andban,E and 69 mar,s7 reflecting the substance of the above transactions. 62: mar,s7 6ACCA 2.: 6()%7 Financial Reporting Becember 2CC2 N.7 :uestion 8
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Recording the substance of transactions- rather than their legal form- is an important principle in financial accounting. Abuse of this principle can lead to profit manipulation- non3recognition of assets and substantial debt not being recorded on the statement of financial position. $e6uired5 Bescribe ho+ the use of off balance sheet financing can mislead users of financial statements. 2ote5 your ans+er should refer to specific user groups and include e$amples +here recording the legal form of transactions may mislead them. 6@ mar,s7

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Angelino has entered into the follo+ing transactions during the year ended .C September 2CC>5 6i7 In September 2CC> Angelino sold 6factored7 some of its trade receivables to &mar- a finance house. &n selected account balances &mar paid Angelino DCG of their boo, value. /he agreement +as that &mar +ould administer the collection of the receivables and remit a residual amount to Angelino depending upon ho+ 8uic,ly individual customers paid. Any balance uncollected by &mar after si$ months +ill be refunded to &mar by Angelino. 6: mar,s7 6ii7 &n 1 &ctober 2CC: Angelino o+ned a freehold building that had a carrying amount of F<.: million and had an estimated remaining life of 2C years. &n this date it sold the building to Finaid for a price of F12 million and entered into an agreement +ith Finaid to rent bac, the building for an annual rental of F1.. million for a period of five years. /he auditors of Angelino have commented that in their opinion the building had a mar,et value of only F1C million at the date of its sale and to rent an e8uivalent building under similar terms to the agreement bet+een Angelino and Finaid +ould only cost FDCC-CCC per annum. Assume any finance costs are 1CG per annum. 6> mar,s7 6iii7 Angelino is a motor car dealer selling vehicles to the public. Aost of its ne+ vehicles are supplied on consignment by t+o manufacturers- Aon4a and Capri- +ho trade on different terms.

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Aon4a supplies cars on terms that allo+ Angelino to display the vehicles for a period of three months from the date of delivery or +hen Angelino sells the cars on to a retail customer if this is less than three months. ?ithin this period Angelino can return the cars to Aon4a or can be as,ed by Aon4a to transfer the cars to another dealership 6both at no cost to Angelino7. Angelino pays the manufacturer*s list price at the end of the three month period 6or at the date of sale if sooner7. In recent years Angelino has returned several cars to Aon4a that +ere not selling very +ell and has also been re8uired to transfer cars to other dealerships at Aon4a*s re8uest. Capri*s terms of supply are that Angelino pays 1CG of the manufacturer*s price at the date of delivery and 1G of the outstanding balance per month as a display charge. After si$ months 6or sooner if Angelino chooses7Angelino must pay the balance of the purchase price or return the cars to Capri. If the cars are returned to the manufacturer- Angelino has to pay for the transportation costs and forfeits the 1CG deposit. 'ecause of this Angelino has only returned vehicles to Capri once in the last three years. 6: mar,s7 $e6uired5 Bescribe ho+ the above transactions and events should be treated in the financial statements of Angelino for the year ended .C September 2CC>. Iour ans+er should e$plain- +here relevant- the difference bet+een the legal form of the transactions and their substance. 2ote5 /he mar, allocation is sho+n against each of the three transactions above. 6/otal 2: mar,s7 6ACCA 2.: 6()%7 Financial Reporting Becember 2CC> N.7 :uestion ; 6a7 An important aspect of the International Accounting Standards 'oard*s Frame+or, for the preparation and presentation of financial statements is that transactions should be recorded on the basis of their substance over their form. $e6uired5

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!$plain +hy it is important that financial statements should reflect the substance of the underlying transactions and describe the features that may indicate that the substance of a transaction may be different from its legal form. 6: mar,s7 ?ardle*s activities include the production of maturing products +hich ta,e a long time before they are ready to retail. Betails of one such product are that on 1 April 2CC@ it had a cost of F: million and a fair value of F< million. /he product +ould not be ready for retail sale until .1 Aarch 2C12. &n 1 April 2CC@ ?ardle entered into an agreement to sell the product to !asyfinance for F> million. /he agreement gave ?ardle the right to repurchase the product at any time up to .1 Aarch 2C12 at a fi$ed price of F<-@D>-CCC- at +hich date ?ardle e$pected the product to retail for F1C million. /he compound interest ?ardle +ould have to pay on a three3year loan of F> million +ould be5 F >CC-CCC >>C-CCC <2>-CCC

Iear 1 Iear 2 Iear . /his interest is e8uivalent to the return re8uired by !asyfinance. $e6uired5

6c7

Assuming the above figures prove to be accurate- prepare e$tracts from the income statement of ?ardle for the three years to .1 Aarch 2C12 in respect of the above transaction5 6i7 Reflecting the legal form of the transactionE 6ii7 Reflecting the substance of the transaction. 2ote5 statement of financial position e$tracts are 2&/ re8uired. /he follo+ing mar, allocation is provided as guidance for this re8uirement5 6i7 2 mar,s 6ii7 . mar,s 6: mar,s7 Comment on the effect the t+o treatments have on the income statements and the statements of financial position and ho+ this may affect an assessment of ?ardle*s performance. 6: mar,s7 6/otal 1: mar,s7 6ACCA F< Financial Reporting "une 2C1C N97
2.329

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