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Financial Management | June 2014

RESOURCE

STudy & tech notes/the institute/events

study
notes

In this issue
Paper C03 Fundamentals of
Business Mathematics, p46
Paper F3 Financial
Strategy, p48

Papers F1 and F2
Financial Operations and
Financial Management
The economic substance of assets and liabilities, rather than their legal
form, is what an accountant must focus on when deciding how to record
them in the financial statements, but this is not always straightforward
By Jayne Howson

he term substance over

form is fundamental to
our understanding of
how financial state
ments are produced. Its
essential for students
studying for the papers t esting financial
reporting principles to understand the
concept and how to apply it.
The term means that an entitys trans
actions are recognised according to their
economic substance rather than their
legal form in order to present a true and
fair view of the performance and position

of that entity. Those preparing accounts

will have to use their judgement in order
to show the business sense from the
transactions and to present them in a
way that best reflects their true essence.
The syllabus for both F1 and F2 refers
to the understanding of substance over
form and the concepts application to a
range of situations. Students should be
able to define and apply the principle to
determine the correct accounting treat
ment in exam scenarios.
In any question requiring you to de
termine the substance of the transaction,

the starting point will be the elements

of financial statements in particular,
the definition of assets and liabilities
given by the International Accounting
Standards Board (IASB). If one side of
the transaction meets the definition, the
presentation, recognition and measure
ment of that transaction will be estab
lished in accordance with its substance.
An asset is defined as a resource con
trolled by an entity as a result of past
events and from which future economic
benefits are expected to flow to the
entity. Note that there is no mention of
ownership. The term controlled sug
gests that the entity may use the asset
as it pleases, but does not have legal title.
A liability is defined as a present
obligation arising from past events, the
settlement of which is expected to result
in an outflow from the entity of resour
ces embodying economic benefits. It
may take one of the two following forms:
l Legal ie, meeting a contractual com
mitment such as a loan repayment.
l Constructive ie, the entity creates an
expectation that it will meet an obli
gation because of its reputation. For
example, if a company renowned for

44

its environmentally friendly policies

were to pollute a river with chemical
waste, there would be an expectation
that it would make good the damage.
The next stage is to consider some sit
uations where the substance over form
concept should be applied. Both F1 and
F2 may require candidates to record a
transaction in the preparation of finan
cial statements for a single company or
a group. In F2 in particular, a journal
entry may be required in order to pro
vide some explanation of the principles
behind the treatment.
Lets look at the five topics that are
examined most frequently in this area:
finance versus operation leases; redeem
able preference shares; consignment
stock; sale and repurchase agreements;
and debt factoring.

Finance versus operation leases

A finance lease is one that transfers the

risks and rewards of ownership of an
asset from the lessor to the lessee. This
may be demonstrated by the lessee con
tracting to lease the asset for most of its
useful economic life and to pay for any
maintenance and insurance. One that
does not meet these criteria is an oper
ating lease.
With regard to the legal form, the asset
belongs to the lessor in either case.
With regard to substance:
l Under a finance lease the definition of
an asset is met. The lessee controls the
asset. The transaction will be recorded
in the lessees books as the acquisition
of an asset with a corresponding obliga
tion to pay the lessor. The journal would
measure the transaction at the lower of
the fair value and the present value of
the minimum lease payments (Dr: Asset
and Cr: Finance lease liability).
l Under an operating lease there is no
control of the asset, so the cash paid to
the lessor will be treated as an expense
with no obligation.

Redeemable preference shares

This aspect is often examined and its

acommon form of off balance sheet
financing watch out for it in the 25mark group accounts question in F2.
In legal terms, a redeemable prefer
ence share usually provides the holder
with a fixed annual dividend calculated
as a percentage of the nominal value.
The term redeemable means that the
capital, with or without a premium, will

Financial
Financial
Management
Management
| September
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2013

be repaid to the shareholder at a set date.

This makes its substance that of a loan,
because there is an obligation to repay
the equivalent of principal and interest.
On initial recognition, the transaction
is valued at proceeds received (Dr: Cash
and Cr: Liability). Subsequently the loan
is measured at amortised cost using
theeffective interest rate. This means
that dividend payments are treated
likeinterest for a loan and the amounts
payable, along with any other servicing
expenses, are recorded in the income
statement as finance costs.

Consignment stock

Consignment stock is inventory legally

owned by one company (the manufac
turer) but kept on the premises of an
other (the dealer). In past papers this has
been examined using the case of a car
maker transferring stock to a dealer. The
question is: in substance, whose inven
tory is this? You will need to reconsider
the definition of an asset and establish
where the risks and rewards of owner
ship lie. Numerous questions need to be
asked here, some of which are as follows:
l Are insurance, servicing and repairs
the responsibility of the dealer?
l When the dealer eventually buys the
asset, has it fixed the price at the point

Test your understanding

The following question is an edited
extract from November 2011s F2 paper.
A model answer will be published in the
version of this article that will appear in
Junes FM app, which can be downloaded
free to most mobile devices.
On 31 May 2011 DRT sold land to a provider
oflong-term finance called NKL for
$1,600,000. The lands carrying value on the
sale date was $1,310,000 (its original cost).
DRT can buy it back within four years for
between $1,660,000 and $1,800,000,
depending on the repurchase date. NKL
cant use the land for any purpose without
DRTs consent. It must be repurchased for
$1,800,000 after four years if the option is
not taken before then. DRT has derecognised
the land and recorded the gain within its
profit for the year ended 31 May 2011.
You are required to: discuss how the
sale of the land should be accounted for
inaccordance with the principles of IAS 18;
and prepare any accounting adjustments
required to DRTs financial statements for
the year to 31 May 2011 (five marks).

of delivery so that any price movements

are the risk of the dealer?
l Is the dealer unlikely to return the asset
to the manufacturer on demand or at
itsdiscretion?
If the answer to any of these questions
is positive, the inventory is deemed to
be that of the dealer on d
elivery to its
premises. At this point the manufactur
er is deemed to have made a correspond
ing sale (Dr: Asset and Cr: Liability).

Sale and repurchase agreements

Under these deals, an entity that requires

finance transfers the legal ownership of
an asset to a finance provider in return
for cash and a promise to buy the asset
back at a set date. This may apply to land
and buildings or inventory that requires
time to mature before it can be sold.
The asset legally belongs to the finance
provider until the money has been re
funded. If its highly probable that the
asset will be repurchased, this is a s ecured
liability in substance, because the risks
and rewards of the asset will continue to
rest with the entity. The accounting treat
ment is to keep the asset in the books of
the entity (Dr: Cash and Cr: Liability).

Debt factoring

This method of raising finance occurs

when an entity transfers the responsibil
ity for collecting receivables to a finance
provider in exchange for cash. Such deals
may vary widely in practice, but F1 and
F2 examine the following two forms:
l With recourse where the finance pro
vider has the right to ask the entity to
compensate it for any receivables that
its unable to collect.
l Without recourse where the finance
provider takes full responsibility for the
collection of receivables from day one.
In legal terms the receivables are the
responsibility of the finance provider in
both situations. But in substance the
with recourse variant means that the
entity carries the risks of non-payment
by customers. Therefore the asset re
mains in the entitys accounts until the
finance provider releases the obligation
to refund the shortfall. The cash trans
ferred is treated initially as a loan and
the journal entries would be as for a sale
and repurchase agreement.
Jayne Howson is a freelance lecturer
specialising in financial management, reporting and taxation