ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 11: Financial instruments

ED 2009/7: Classification and measurment

 Introduction

 IFRS 9 – Key features

6 ED 2009/7: Financial instruments: Classification and

measurement (Now IFRS 9)

6.1 Introduction

Many users of financial statements and other interested parties have told the IASB

that the requirements in IAS 39 are difficult to understand, apply and interpret and

have urged the IASB to develop a new, less complex standard for financial reporting

for financial instruments.

The IASB are addressing this issue in several parts which will ultimately result in a

standard (IFRS 9) which will replace IAS 39 in its entirety. The different projects

include:

 Classification and measurement – this resulted in the issue of ED 2009/7:

Classification and measurement which in turn resulted in the issue of IFRS 9.

IFRS 9 currently only contains sections on classification and measurement of

financial assets but further sections will be added in the future.

 Impairment – ED released in 2009. This is not on the list of examinable

documents.

 Hedge accounting – ED is expected in 2010

 Derecognition – ED 2009/3 in issue

6.2 IFRS 9 – Key features

IFRS 9 contains simplified rules on accounting for financial assets.

A financial asset must be measured at amortised cost if both of the following

conditions are met:

 the asset is held within a business model whose objective is to hold assets in

order to collect contractual cash flows.

 the contractual terms of the financial asset give rise on specified dates to cash

flows that are solely payments of principal and interest on the principal amount

outstanding.

All other financial assets are to be carried at fair value through P&L or OCI.

There is no need to separate embedded derivatives from financial assets.

IFRS 9 must be applied to accounting periods beginning on or after 1

January 2013

but earlier application is allowed.

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Paper P2 (INT)

Corporate Reporting

CHAPTER

Leases and substance

over form

Contents

1 Substance over form

2 Recognising and derecognising assets and

liabilities

3 Examples of specific transactions

4 Accounting for leases

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Substance over form

 The problem: finance not reported in the statement of financial position

 Examples of previous ‘abuses’ in this area

1 Substance over form

1.1 The problem: finance not reported in the statement of financial position

The IASB Framework states information should reflect the substance of a

transaction to be reliable.

The substance of a transaction is its commercial effect. Normally this is the same as

its legal form but for complex transactions, this may not be the case. The general

principle that results from The IASB Framework is that where the legal form of the

transaction does not reflect its substance, the legal form should be set aside in order

to reflect substance. This is known as substance over form accounting.

In the past, companies have designed transactions so that by accounting for the

legal form of the transaction they were able to avoid showing a liability in the

statement of financial position. This is sometimes called ‘off balance sheet

financing’. Some companies used it to improve the ‘look’ of the statement of

financial position.

By keeping a liability out of the statement of financial position, companies would be

able to show lower financial gearing (and so lower financial risk). This should make

it easier for the company to raise new debt at lower interest rates.

Assets might also be reduced by ‘off balance sheet’ schemes to keep assets out of the

statement of financial position, because this will generate a higher return on capital

employed for the company (by reducing assets and capital employed).

1.2 Examples of previous ‘abuses’ in this area

The need to account for ‘substance over form’ has been made apparent in the past

by some dubious accounting practices by some companies.

Controlled non-subsidiaries

Prior to IAS 27 Consolidated and separate financial statements, some parent companies

deliberately set up entities that did not meet the definition of a subsidiary entity,

even though the entity was controlled by them. This meant that the parent entity

could avoid consolidation of the ‘subsidiary’ within its group accounts. This meant

that the assets and liabilities of the subsidiary would be excluded from the

consolidated group accounts. This could be useful for parent companies wishing to

‘hide’ certain assets or liabilities.

Chapter 12: Leases and substance over form

(This is why IAS 27 changed the definition of a subsidiary. IAS 27 now defines a

subsidiary by looking at control. This is considered in more detail in the chapters on

consolidated accounts.)

Leasing

Prior to IAS 17 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. IAS 17 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 financial

statements and not in the lessor’s.

Interest expense

Prior to IAS 39 interest might have been recognised on a cash basis. For example if a

company entered into a five year zero coupon bond they might not have recognised

any interest over the life of the bond.

1.3 Substance over form in IFRS

There is no IAS or IFRS that deals in general with accounting for the substance of

transactions. However, guidance based on substance appears in many standards

including:

IAS 17: Leases

 Lease classification

 Finance lease accounting

 Sale and leaseback transactions

IAS 18: Revenue

 Recognition criteria

 Sale and repurchase

IAS 27: Consolidated and separate financial statements

 Definition of subsidiary

IAS 32

 Classification of equity and liabilities

IAS 39: Financial instruments: Recognition and measurement

 Effective interest rate

 Derecognition of financial assets

 Hedge accounting

 Separation of embedded derivatives

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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 other cases they may not be. 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 an option within a transaction whose terms make it highly

likely that the option will be exercised (for example, an option to purchase the

asset at a future date).

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.

Note that IAS 39 contains specific guidance on the recognition and derecognition of

financial assets and liabilities.

Chapter 12: Leases and substance over form

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

 Consignment inventory

 Sale and repurchase agreements

 Guidance in other standards

3 Examples of specific transactions

3.1 Consignment inventory

Consignment inventory is inventory held by one party but legally owned by

another. For example, a car manufacturer may allow a car dealer to hold some

inventory in the dealer’s showrooms, in order to attract customers. The dealer then

pays for the cars when they are sold, or possibly after a specified period of time has

passed. During this time the dealer may be able to return the cars to the

manufacturer, or the manufacturer may be allowed to demand the return of cars

that have been supplied.

The question to answer here is: Who should record the inventory – the

manufacturer or the dealer?

Consignment agreements will have different terms and conditions. However,

applying the general principles of substance over form, the inventory should be

recognised as an asset by the party who has the risks and rewards.



Example

Z Cars, a car dealer buys cars from Car Maker Company (CMC) on the following

terms:

 Legal title passes either on sale of a car to the public or when a car is used as a

demonstration model.

 The car is paid for when legal title passes. The price charged to the dealer is the

price at the original date of delivery.

 Z Cars is charged interest at 5% on cost during the period from delivery to

payment.

 Z Cars has the right to return the cars to CMC at any time, but given its record of

successful selling, this rarely happens.

Required

Z Cars has 20 cars in its showroom at the end of a reporting period. Explain the

accounting treatment by applying the principles of substance over form.

Chapter 12: Leases and substance over form



Answer

Although legal title does not transfer until the car is used as a demonstration model or

is sold to a customer of the dealer, the accounting treatment is determined by the

substance of the transaction. It is necessary to establish who has the risks and rewards

attaching to the cars at the time of delivery to Z Cars.

From the information given there are a number of indicators that suggest that Z

Cars bears the risks and rewards:

 The price is based on the manufacturer’s price at the delivery date. This means

that the manufacturer is unable to pass on any subsequent price changes, and so

the cars become an asset of Z Cars at the date of delivery. This is a reward of

ownership for Z Cars.

 Z Cars bears the risk of slow-selling of the cars, as there is a 5% interest charge

based on the time taken to sell the cars. Interest cost on inventory is a risk of

ownership for Z Cars.

An argument against the idea that Z Cars is the ‘owner in substance’ of the cars is

that Z Cars can return cars to CMC at any time, and so has no risk of obsolescence.

However, given that this rarely happens in practice, it seems that on balance Z Cars

should record the purchase and the inventory at the date of delivery.

This also means that CMC should record a sale when cars are delivered to Z Cars,

and will not include the cars in its own inventory.

3.2 Sale and repurchase agreements

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

which A sells goods to B at one price and at the same time agrees to buy back the

goods at a future date, usually at a higher price. The question this time is whether

the initial sale is a genuine sale transaction, or whether the sale and repurchase

agreement really disguises a short-term loan.



Example

A whiskey distiller sells inventory to a bank two weeks before the year end for

$300,000. The company has the option to repurchase the whiskey at any time at cost

plus 10% interest.

Although legally a sale has been made, the transaction appears unusual. Why

would a bank want to purchase whiskey? Clearly the whiskey distiller will want the

whiskey returned in the future so that it can honour commitments to its ‘real’

customers.

The substance of the transaction appears to be that the distiller obtains a secured

loan from the bank when it sells the inventory. The distiller has ‘sold’ the inventory

to the bank in order to raise some short-term finance. It will ‘repurchase’ the

inventory in the future and pay back the loan plus 10% financing costs.

Therefore in this example, a sale should not be recorded. Instead the distiller should

establish a liability (loan) in its statement of financial position. The future

repurchase will be accounted for by cancelling the liability.

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Accounting for leases

 Revision of accounting for finance and operating leases

 Accounting for a finance lease

 Accounting for an operating lease

 Sale and leaseback transactions

 Termination of a lease

 Tax variation clauses

 Evaluating the substance of transactions involving a lease

 IFRIC Interpretation 4: Deciding whether an arrangement contains a lease

 DP 2009/1: Leases

4 Accounting for leases

4.1 Revision of accounting for finance and operating leases

A lease is a contract between two parties where the owner of an asset (the ‘lessor’)

allows the other party (the ‘lessee’) to use the asset for an agreed period of time, in

return for a series of payments. Sometimes, at the end of the lease, legal title to the

asset is transferred to the lessee. In other situations, the leased asset is returned to

the lessor, who may then arrange a new lease with a different lessee or might scrap

the asset.

During the term of the lease, the legal ownership to the asset belongs to the lessor,

but with many leases it is the lessee who has most of the risks and benefits from

most of the rewards. For example an airline company might lease a new aircraft for

a ten-year period from a lessor: the lessee will get most of the economic benefits

from use of the aircraft and will also bear most of the risks (such as costs of

maintenance and repair, costs of insurance and so on).

However, before the issue of IAS 17, the lessee would not have recorded the asset

(or a liability to the lessor) in its statement of financial position. It would simply

have recorded the lease payments as expenses (on an accruals basis) in profit or loss.

IAS 17 was the first IAS to introduce the concept of substance over form in financial

reporting.

Classification of leases: finance and operating leases

IAS 17 divides leases into two types:

 finance leases

 operating leases.

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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