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Revise lecture 24

Revise lecture 24. Substance over form. Substance over form. The meaning of substance over form In many types of transactions there is a difference between the commercial substance and the legal form:. Substance over form. The meaning of substance over form

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Revise lecture 24

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  1. Revise lecture 24

  2. Substance over form

  3. Substance over form The meaning of substance over form • In many types of transactions there is a difference between the commercial substance and the legal form:

  4. Substance over form The meaning of substance over form • Commercial substance reflects the financial reality of the transaction • Legal form is the legal reality of the transaction • Accounts are generally required to reflect commercial substance rather than legal form.

  5. Substance over form with a finance lease • When an asset is leased under a finance lease there is a difference between the legal form of that transaction and its commercial substance: Legal form: The asset remains legally owned by the party leasing it out (the lessor)

  6. Substance over form with a finance lease Commercial substance: The party making the lease payments (the lessee) has the use of the asset for most or all of its useful life. The lessee has effectively purchased the asset by taking out a loan (the finance lease commitments).

  7. Accounting treatment of the commercial substance of a lease As the commercial substance of finance leases is that the lessee is the effective owner of the asset the required accounting treatment is to: • Record the asset as a non-current asset in the lessee’s statement of financial position. • Record a liability for the lease payments payable to the lessor.

  8. Lease and the definition of an asset IAS 17 is mainly concerned with regulating the accounting for finance leases. The IAS 17 treatment follows the definition of an asset in the IASB Framework for the preparation and presentation of financial statements: ‘an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’ Ownership is not necessary, control is the essential feature.

  9. Lease and the definition of an asset IAS 17 thus argues that an asset leased under a finance lease must be recorded as an asset and a corresponding liability in the lessee’s accounting records.

  10. Accounting for a finance lease There are 2 main methods of allocating the finance charge each period: • Actuarial method • Sum of the digits method • The actuarial method is used mostly in practice

  11. Accounting for a finance lease The actuarial method • The actuarial method allocates interest to each period: • At a constant rate on the outstanding amount. • Using the interest rate implicit in the lease.

  12. Recording a finance lease Initial recording At the start of the lease: • The fair value (or, if lower, the present value of the MLP’s) should be included as a non-current asset, subject to depreciation. • The same amount (being the obligation to pay rentals) should be included as a loan, i.e. a liability.

  13. Recording a finance lease Initial recording • In practice, the fair value of the asset or its cash price will often be a sufficiently close approximation to the present value of the MLPs and therefore can be used instead.

  14. Reporting the substance of transactions

  15. Reporting the substance of transactions IAS 1 requires that financial statements: • Must represent faithfully the transactions that have been carried out. • Must reflect the economic substance of events and transactions and not merely their legal form. Examples of accounts reflecting economic or commercial substance are: • The capitalisation of a finance lease • The production of consolidated accounts

  16. Reporting the substance of transactions The historical problem • Historically, many companies tried to keep items off the statement of financial position by ignoring their real substances.

  17. Reporting the substance of transactions Examples • Leasing assets, prior to the issue of IAS 17, leases were not capitalised, i.e. the assets and its related financial commitment were not shown on the lessee’s statement of financial position.

  18. Reporting the substance of transactions Examples • Controlled non- subsidiaries, under the definitions of a subsidiary prior to IAS27, companies could control other companies by legal arrangements under which technically they were not subsidiaries, so they were not consolidated in the group.

  19. Off balance sheet finance • Why companies might wish to keep financing liabilities off their statement of financial position?

  20. Off balance sheet finance Answer There are number of reasons why companies might wish to avoid showing financing liabilities on their statement of financial position: • To maintain a level of gearing similar to their counterparts in other countries. • To maintain the share price on the basis that the market would place a lower value on a company whose borrowings are considered by the analysts to be high.

  21. Off balance sheet finance Answer 3. To maintain ROCE by keeping the asset and the related liability out of the statement of financial statement until the asset starts to produce income. 4. In groups of companies to keep activities which have different characteristics (e.g. high gearing ratio) separate by keeping them off the SFP in order not to distort the financial ratios of the remainder of the group.

  22. Determining the substance of a transaction Key to determining the substance of a transaction is to identify whether assets and liabilities arises subsequent to that transaction by considering: • Who enjoys the benefits of any asset? • Who is exposed to the principal risks of any asset?

  23. Determining the substance of a transaction Assets and liabilities should be recognisedin the statement of financial position where: • It is probable that any future economic benefit associated with the item will flow to or from the entity. • The item has a cost or value that can be measured with reliability. • When either of these criteria are not met the item should be derecognised.

  24. Examples where substance and form may differ Examples of areas where substance and form may differ include: • Consignment inventory and goods on sale return • Sale and repurchase agreements • Sale and leaseback agreements • Factoring of receivables

  25. Examples where substance and form may differ Factors to consider are: • Who bears the risks of the inventory? • Who has the benefits or rewards of the inventory?

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