ACCA F7 (INT) Financial Reporting - Study text - 2010

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Chapter 3: Accounting for the substance of transactions

(This is why IAS27 introduced a change in the definition of a subsidiary. IAS27

defines a subsidiary by looking at control. This matter will be considered further in

the chapters on consolidated accounts.)

Leasing

Prior to IAS17 Leases, assets leased under a finance lease agreement remained as an

asset in the lessor’s financial statements, even though the risks and rewards

attached to that asset had been transferred to the lessee. A lessee might therefore

have effective control over a large quantity of plant and equipment, without having

to reveal this information in its statement of financial position.

 IAS17 recognises that although legal title may not have passed to the lessee, the

economic reality is that the risks and rewards from ownership have passed to

the lessee. The leased asset should therefore be reported as a non-current asset in

the lessee’s statement of financial position, and not in the lessor’s.

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Recognising and derecognising assets and liabilities

 Determining the substance of a transaction

 Assets and liabilities

 Recognition of an asset or liability

 Derecognition of an asset or liability

2 Recognising and derecognising assets and liabilities

2.1 Determining the substance of a transaction

In many instances the substance and the legal form of a transaction or event are

exactly the same. However in some cases they are not. The substance of a

transaction may be different from its legal form if it has any of the following

features:

 separation of the legal title to an asset from the ability to enjoy the rewards and

benefits of the asset and exposure to the risks of the asset

 a transaction which is linked to others in such a way that the commercial

substance cannot be understood without reference to all the transactions

 the inclusion of options within a transaction whose terms make it highly likely

that the option will be exercised.

2.2 Assets and liabilities

The key issue in deciding how to account for a transaction is whether an asset or a

liability should be recognised in the statement of financial position.

The following definitions, from the IASB Framework, are relevant.

An asset is a resource:

 controlled by the entity

 as a result of past events

 from which economic benefits are expected to flow to the entity.

A liability is:

 a present obligation

 arising from past events

 the settlement of which is expected to result in an outflow of economic benefits.

Both these definitions have been described previously.

Chapter 3: Accounting for the substance of transactions

2.3 Recognition of an asset or liability

An item should only be recognised in the financial statements if:

 it meets the definition of an asset or liability

 there is sufficient evidence of its existence, and

 it can be measured at a monetary amount with sufficient reliability.

2.4 Derecognition of an asset or liability

An entity should cease to recognise an item in the financial statements (‘de-

recognition’) if there has been a transfer to someone else of:

 all significant access to benefits, and

 the exposure to the risks inherent in those benefits.

The guidelines on substance over form, and on the recognition and de-recognition

of assets will now be considered within the context of specific business transactions.

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Examples of specific transactions

 Inventories on sale or return/consignment inventories

 Sale and repurchase agreements

 Factoring of accounts receivable

3 Examples of specific transactions

3.1 Inventories on sale or return/consignment inventories

Inventory might be supplied by a manufacturer to a dealer on a ‘sale or return’

basis. Under such an arrangement, the dealer has the right to return the inventory to

the manufacturer if he does not sell it within a specified period of time. Inventories

are held by the dealer, but legal title remains with the manufacturer until a certain

event occurs or a point in time is reached. This might be at the end of a specified

period, or on sale to a third party.

For example, a car dealer might hold inventories of motor cars that it can return to

the car manufacturer if they are not sold within a specified period of time. Similarly,

book publishers supply books to bookshops on a sale or return basis.

Inventory supplied on this basis may be called ‘consignment inventory’.

The detailed terms of arrangements between manufacturers and dealers can vary.

Only one party, the manufacturer or the dealer, should record the items as

inventory.

Deciding who should record the inventory as an asset depends on whether the

dealer or the manufacturer bears the risks and rewards of ownership. Similarly,

deciding when the item ceases to be an asset of the manufacturer and becomes

inventory of the dealer will also depend on the details of the arrangement.

The details of the business agreement should therefore be studied carefully. The key

factors will be as follows:

 The right of return over inventories. If either party has the right of return it is

unlikely that ownership will pass to the dealer on delivery.

 The price at which the sale is set when ownership eventually passes. If this is

the manufacturer’s price at the date when ownership eventually passes, this will

indicate that the manufacturer has not transferred the key risk of prices falling in

the intervening period.

 Whether or not the dealer has the right to use the inventories. If the dealer can

use the inventories for demonstration purposes then this is likely to trigger

transfer to the dealer.

Chapter 3: Accounting for the substance of transactions

Example

Entity C, a car dealer, obtains its inventory from Entity D, a car manufacturer, on a

consignment basis. The agreement between the entities requires Entity C to

purchase cars from Entity D on the earlier of:

 sale to a third party

 the end of a three month period

Entity C will pay for the cars at the factory price on delivery.

Entity C has no right to return cars to Entity D during the three-month period and

has to insure the cars once they are on its premises.

Required

Consider who has the risks and rewards of ownership, and therefore which entity

should recognise an asset for the inventory (the cars) in its financial statements.

Answer

The key risks of ownership appear pass to Entity C on delivery of cars from Entity

D. This is because Entity C:

 has no right to return cars to Entity D (and so bears the risk of obsolescence and

slow-moving inventories)

 pays the factory price on delivery, regardless of when the purchase is made (and

therefore Entity D has transferred the risk of falling prices to Entity C)

 is obliged to insure the cars once they have been delivered (which is another risk

of ownership).

Therefore Entity C should recognise cars in its statement of financial position (as

inventories) from the time of delivery. At delivery, the manufacturer/supplier should

account for the items as receivables.

3.2 Sale and repurchase agreements

A sale and repurchase agreement is an agreement between two parties, X and Y, in

which Y sells an item to Y ‘now’ at one price and at the same time agrees to

repurchase the item at a future date, probably at a different price.

For example, art dealer X may sell a painting to Art Gallery Y. The sale price is

$500,000, but the art dealer has the right (a call option) to buy back the painting in

one year’s time for $550,000.

With a sale and repurchase agreement the question is whether (between the original

sale and the subsequent repurchase) the entity that has ‘sold’ an asset has in fact

given up all of the risks and rewards associated with that asset.

 If so, then a sale should be recorded.

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 If not, then the asset in question should remain in the statement of financial

position of the entity that has ‘sold’ it with the buy-back option.

Two common forms of this type of arrangement are considered below.

Sale with an option to repurchase

Here, an asset is sold by Entity A to Entity B on terms such that Entity A

repurchases the asset in certain circumstances. This could be under a call option (i.e.

at Entity A’s option) or a put option (i.e. at Entity B’s option).

The key question in each arrangement is whether, in substance, a sale has taken

place, or whether the arrangement is a financing one.

Example

Entity E sells goods for $30,000 to Entity F on 1 July Year 1. Entity E and Entity F

have call and put options respectively for 1 July Year 2 for $32,000.

In other words, Entity E has the right to repurchase the goods on 1 July Year 2 for

$32,000 and Entity F also has the right to require Entity E to repurchase the goods

for $32,000 at that date.

Required

Consider whether, in substance, a sale has taken place and how Entity E should

record the transaction.

Answer

The risks and rewards of ownership have not passed to Entity F:

If prices rise beyond $32,000, Entity E will exercise its call option, buy the goods

back from Entity F, and resell the goods at a higher profit. Entity E therefore retains

the right to economic benefits.

If prices fall below $32,000, Entity F will exercise its put option and sell the goods

back to Entity E. Entity F may then purchase the goods for a cheaper price. Entity E

therefore also remains exposed to the risk of falling prices.

Therefore, in substance, there has been no ‘sale’.

 No sale should be recorded by Entity E.

 The receipt of the $30,000 should be recorded by Entity E as a secured loan from

Entity F.

Chapter 3: Accounting for the substance of transactions

Sale and leaseback

There is a section in IAS17: Leases dealing with sale and leaseback agreements. In a

sale and leaseback agreement Entity G sells an asset to Entity H, but then

immediately leases that asset back from Entity H.

Typically, a company may own and use a large building, which it then sells to

another party (say, a property company) and immediately leases back the building,

paying an annual rent and continuing to use the building in the same way as before.

The treatment of the ‘sale’ depends on whether the resultant lease is classified as a

finance lease or an operating lease.

 If the lease is a finance lease then the risks and rewards of ownership pass to the

lessee. Since the lessee is the original owner of the asset, the risks and rewards of

ownership have never left it, and therefore, in substance, there has been no sale.

The asset remains in the ‘seller’s’ statement of financial position at its original

value. A lease liability is created for the amount received on the sale.

 If the lease is an operating lease then the risks and rewards of ownership do not

pass to the lessee. Therefore the risks and rewards of ownership have passed

from the seller to the lessor, and the sale of the asset has taken place. The profit

or loss on sale is recognised in the income statement. IAS17 sets out rules for

whether this is recognised immediately or over the term of the lease agreement.

3.3 Factoring of accounts receivable

In a factoring agreement, a business entity (the ‘seller’) makes an arrangement with

a ‘factor’. The ‘seller’ transfers its accounts receivable (invoices) to the ‘factor’, and

in return receives an immediate payment of an agreed percentage of the receivables

The factor will agree to make an immediate payment to the entity of (say) up to 80%

of the value of the invoices it has undertaken to collect.

For example, if a company arranges for the factoring of its accounts receivable and

its monthly invoices to customers are $100,000 in total, the factor may agree to pay

the company $80,000 each month as an advance on the money receivable (charging

interest on the advance), with the balance payable, less the factor’s fees, when the

debts are eventually collected.

The key issue in accounting for receivables that are subject to a factoring

arrangement is to decide whether the company should derecognise the receivables

(and remove them from its statement of financial position). This decision should be

based on whether the key risks and rewards of ownership of the receivables have

passed to the factor.

 If they have not passed to the factor, the receivables have not been sold and the

payments from the factor that relate to those receivables should be treated as a

loan.

 If they have passed to the factor, the receivables have been sold and should be

removed from the statement of financial position. Any profit or loss should be

recognised in the income statement.

Paper F7: Financial reporting (International)

The key issue is who bears the risk of bad debts. In a factoring agreement, the terms

of the agreement will specify what happens in the event of bad debts.

 The factor may agree to bear all the risk of bad debt losses. This is a ‘non-

recourse agreement’ for which the factor charges a higher fee.

 The factor may not accept the risk of bad debts, so that any bad debt losses are

incurred by the client company. (This is called a ‘with recourse’ factoring

agreement.)

With a non-recourse factoring agreement, it is appropriate for the client company to

de-recognise its receivables, and account for the cash from the factor as sales income

and for the balance as receivables due from the factor, rather than its original

customers.

Example

Entity G transferred title to its trade receivables of $200,000 at 31 January Year 1, to a

factor. The factor paid 80% of the value of the receivables. The agreement provided

that if less than 80% of the receivables proved to be recoverable Entity G would

have to make good the factor’s losses.

If the factor recovers more than 80% of the value of the receivables, it will keep the

difference.

Required

Consider how this transaction should be dealt with in the books of Entity G.

Answer

The risk of bad debts remains with Entity G because:

 if less than 80% of the receivables prove to be recoverable it will have to pay part

of the $160,000 back to Entity G

 if more than 80% of the receivables prove to be recoverable the excess belongs to

the factor

Therefore, in substance, there has been no ‘sale’. The receivables should remain in

the statement of financial position of Entity G and the $160,000 should be recorded

as a secured loan.

Paper F7 (INT)

Financial reporting

CHAPTER

The regulatory framework

Contents

1 The regulatory framework

2 Constitution and objectives of the IASC

Foundation and the IASB

3 The standard-setting process

4 Specialised, not-for-profit and public sector

entities

Paper F7: Financial reporting (International)

The regulatory framework

 The need for regulation

 Sources of regulation

 Principles and rules

1 The regulatory framework

1.1 The need for regulation

There are several reasons why financial reporting practice should be regulated. The

most obvious one is that without it, an entity would be free to adopt any accounting

treatment that it chose. There are other reasons.

 Persons external to the business are normally dependent on the published

financial statements for information about an entity’s activities. Regulation

ensures that external users of financial statements are provided with information

that is relevant to their decisions and reliable.

 Accounting standards and other forms of regulation help to ensure that entities

adopt similar accounting treatments for similar items and account for similar

transactions in the same way over time. This makes it possible to compare the

financial statements of different entities and to compare an entity’s performance

for the current year with its performance in previous years.

 Without regulation, management would adopt whichever accounting treatment

presented its results and position in the best possible light. Sometimes

management might deliberately mislead users of the financial statements.

1.2 Sources of regulation

The main sources of regulation are:

 accounting standards

 company law

 for listed companies, the listing rules of the relevant Stock Exchange.

Accounting standards are authoritative statements of how particular types of

transaction and event are reflected in the financial statements. In some countries (for

example in the UK) they have legal authority, but in most countries they do not

have the force of law.

Company law varies from country to country, but typically it sets out rules for

determining profits available for distribution, issuing and redeeming share capital,

the reserves that a company must have and the uses to which they can be put. In

some countries, company law prescribes the format of the main financial statements.

These matters are not covered in accounting standards.

There might also be stock market regulations that set out additional the information

which entities must supply as a condition of obtaining access to the stock market for

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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