Substance Over Form-1

Substance over Form
Agenda
• Substance Over Form
• Consignment Stock
• Sale and repurchase Agreements
• Debt Factoring
Substance over Form
“If information is to represent faithfully
the transactions and other events that
it purports to present, it is necessary
that they are accounted for and
presented in accordance with their
substance and economic reality and
not merely their legal form”
IASB Framework, paragraph 35
How do we find out what the
substance of a transaction is?
By asking questions:
• What is the commercial reality? What is likely to
happen in practice?
Remember
• What are the terms of the contract? the
Framework
• Do we have an asset? definitions?
• Do we have a liability?
• Who is exposed to the risks associated with the
asset? Who controls it?
• Who will receive the benefits from assets?
Substance over Form
• IASB – no specific standard on Substance over
Form
• Key references are the Framework definitions:
– Asset
• A resource controlled by an enterprise as a result of past
events and from which future economic benefits are
expected to flow to the enterprise
– Liability
• A present obligation of the enterprise arising from past
events, the settlement of which is expected to result in a
outflow from the enterprise of resources embodying
economic benefits
Legal form and commercial
substance – tell tale signs
• Separation of legal title and the
benefits/risks an asset can confer
• Series of linked transactions
• Use of “put” and “call” options
• Put option
– Right to sell asset at a future date
• Call option
– Right to buy asset at a future date
Treatment of options
• Is there a genuine commercial possibility
that the option will be exercised?
• Yes
– Assume will be exercised
• No
– Assume will not be exercised
• Assume parties will act in their economic
best interests
Substance over Form - Examples
• Consignment stock
• Sale and repurchase agreements
• Debt factoring
Consignment Stock
• Common in motor industry
• Dealer obtains stock on a ‘sale or return’ basis
• Stock held on dealer premises
• Legal title only passes to dealer if:
– Stock sold to third party;
– Dealer acquires vehicle as ‘demonstrator’ model; or
– Specified period of time
• Until then, the asset legally belongs to manufacturer
• What is the commercial substance of the
transaction?
Consignment Stock - example
Producer P Plc supplies leisure caravans to
dealer C Ltd on the following terms:
1. Each party has the option to return the
caravans to the producer
2. C Ltd pays P Plc a rental charge of 1% per
month of the cost price of the caravan for
exhibiting the caravan
3. When the caravan is sold C Ltd pays P Ltd the
lower of:
1. the factory price of the caravan when delivered; or
2. the factory price when sold, less all rentals paid
4. If the caravan is unsold after 6 months, C Ltd
must buy it on these terms
Which company treats the caravans as inventory?
Inventory of P plc?
• P Plc has the option to have the
caravans returned
• C Ltd has the option to return the
caravans
• P Plc receives a rental for the use of
the caravan until it is sold
Inventory of C Ltd?
• C Ltd has to pay for unsold caravans
at the end of 6 months
• Rental charge – could be regarded as
interest on the amount outstanding
• C Ltd should not pay more than the
factory price of the caravan on the
date of delivery
You decide
• The risks and rewards of ownership are shared
• But it is not acceptable to show the caravans
partly on each Statement of Financial Position
• Answer may depend on the detail of the contract
• Does C Ltd have an unrestricted right of return
within 6 months? What happens if the caravans
are damaged?
Sale and repurchase agreements
• Legal title may pass but is it a sale?
• Is it a financing arrangement in
commercial substance?
• Questions to ask?
– Who has physical control of the asset?
– Who has benefits/risks of ownership?
– Is the price set at market value?
Sale and repurchase - example
Redbrick Plc, a company specialising in
building domestic houses sells a
proportion of its landholding (“land bank”)
to a merchant bank for £750,000 on 25
March 20X7. It agrees to repurchase the
land for £940,800 on 24 March 20X9. The
land remains under the control and
supervision of Redbrick plc
Is it really a sale?
Substance
Financing transaction:
• Redbrick plc retains the risks and rewards of
ownership
• Loan on security of the land
• “Profit” of £190,800 after 2 years is 12% p.a.
compound interest
• Land should remain on Redbrick’s Statement of
Financial Position (balance sheet) with £750,000
loan
• Accrue interest of £190,800 charged to the
income statement
Debt factoring
• Sale of debts to third party – often to accelerate
cash flow
• Key Question:
– Is it a genuine sale of the debt or a loan secured on
the debtor balance?
• Look at who bears the risk of the debt going bad
– Without recourse
• Bad debt risk transferred to purchaser – sale
– With recourse
• Risk retained by vendor – financing transaction
How do you determine the
substance of a transaction?
• Contractual documentation
• Related documentation
• What do the parties expect to happen?
• What is the likely commercial outcome?
• Industry practice
Key Point
• These examples focus on whether assets
and liabilities should be recognised on the
balance sheet
• Key test is the asset and liability definitions
in the Framework
• If it meets those definitions – it should be
recognised on the balance sheet
• Account for the commercial substance
regardless of the legal form
Summary
• Substance over Form is an important concept in
dealing with Off Statement of Financial Position
Finance
• Fundamental principle?
• It also often has important practical application
for
– Dealing with a complex and rapidly changing
business reality;
– Being able to effectively interpret financial statements

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