Session 3

Substance Over Form

FOCUS
This session covers the following content from the ACCA Study Guide.

B. Accounting for Transactions in Financial

Statements
10. Revenue
b) Explain the importance of recording the commercial substance rather than
the legal form of transactionsgive examples where recording the legal
form of transactions may be misleading.
c) Describe the features which may indicate that the substance of
transactions differs from their legal form.
d) Apply the principle of substance over form to the recognition and
derecognition of assets and liabilities.
e) Recognise the substance of transactions in general, and specifically
account for the following types of transaction:
i) goods sold on sale or return/consignment inventory
ii) sale and repurchase/leaseback agreements
iii) factoring of receivables.

C. Analysing and Interpreting Financial Statements

1. Limitations of financial statements
b) Discuss how financial statements may be manipulated to produce a desired
effect (creative accounting, window dressing).

Session 3 Guidance
Understand the substance-over-form concept; it derives from the Framework and is a very important
topic in its own right (s.1).
Appreciate the effect on the financial statements of accounting for the economic substance of a
transaction rather than the legal form (including the nature of off balance sheet financing) (s.1.3).

(continued on next page)

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VISUAL OVERVIEW
Objective: To understand why economic substance matters and the issues which arise
when assessing commercial transactions, and to apply the substance matters concept to
specific examples.

WHY SUBSTANCE MATTERS

Introduction
Recognition of Assets and Liabilities
Creative Accounting

REPORTING THE SUBSTANCE

OF TRANSACTIONS
Objective
Recognition and Derecognition

EXAMPLES
Consignment Inventory
Sale and Repurchase Agreements
Factoring of Debts

Session 3 Guidance
Work your way carefully through the Illustrations given in the session, as these are common
transactions which regularly feature in an exam (s.3).
Revisit this session when you have completed Session 6 to appreciate how revenue recognition is
linked with substance over form.

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Session 3 Substance Over Form F7 Financial Reporting

1 Why Substance Matters

1.1 Introduction

Financial statements must reflect the economic substance of

transactions if they are to show a true and fair view.

Ultimately financial statements must follow the Framework,

which states that if information reflects substance it has the
characteristic of reliability.
Usually substance (i.e. commercial effect) equates to legal
form. However, especially for more complex transactions, this
may not be the case.

1.2 Recognition of Assets and Liabilities

The key issue underlying the treatment of a transaction is whether

an asset or liability should be shown in the statement of financial
position.

In recent years, some companies have devised increasingly

sophisticated "off balance sheet financing" schemes whereby
it was possible for them to hold assets and liabilities which
did not actually appear on the statement of financial position
according to the local GAAP. This is one of the most important
issues in financial reporting. Some countries have issued
accounting standards to address this point specifically.
The concept of substance over form has existed as a concept
in IFRS for many years. If companies had been following
IFRS, some of the reporting problems which have occurred
would not have arisen.
The release of IAS 39 Financial Instruments: Recognition
and Measurement greatly improved accounting for financial
instruments and complex hedging arrangements.

1.3 Creative Accounting

Over the past 40 years, companies have tried to be creative in
the way they account for certain transactions. This has led to
abuses of the accounting entries recording these transactions
and the financial statements not reflecting the economic
reality of the situation. The following are some of the main
areas in which management have been creative in their
accounting treatment.

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F7 Financial Reporting Session 3 Substance Over Form

1.3.1 Off Balance Sheet Financing

This is where a company has a present obligation to make a
payment but has been able to keep the obligation (debt) off
the statement of financial position. A sale and repurchase
transaction, if accounted under its legal form, is an example of
off balance sheet financing.

1.3.2 Profit Manipulation or Smoothing

Management prefer profits to be increasing at a steady rate,
not going up and down each year in an uncontrolled manner.
Management will change revenue and cost recognition in order
to smooth out the profits. Examples of abuse in this area
include early recognition of revenue and incorrect recognition
of provisions.

1.3.3 Window Dressing

This is where the financial statements are made pretty for
one moment in time, normally the year end. Many ratios
are calculated using figures from the statement of financial
position. If these figures can be made to look good then it
will improve the related ratios and put the company in a much
better light. Settling trade payables on the last day of the
year only to re-instigate them the next day is an example of
such abuse.

2 Reporting the Substance of Transactions

2.1 Objective
To ensure that financial statements reflect the substance of
transactions.

2.2 Recognition and Derecognition

Recognise the item only if:
it
meets the definition of asset/liability; and
themonetary amount can be measured with sufficient
reliability.
Cease to recognise an asset only if:
all significant access to benefits has been transferred to
others; and
all significant exposure to risks inherent in those benefits
has been transferred to others.

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Session 3 Substance Over Form F7 Financial Reporting

3 Example Transactions

3.1 Consignment Inventory

This is common in the car industry. Consignment inventory is
held by the dealer but legally owned by the manufacturer.
The issue is, who should record the inventory as an asset?
This will depend on whether it is the dealer or the
manufacturer who bears the risks and benefits from the
rewards of ownership.
Treatmentis the inventory an asset of the dealer at delivery?
If yesthe dealer recognises the inventory on the
statement of financial position with the corresponding
liability to the manufacturer.
If nothe dealer does not recognise inventory on the
statement of financial position until transfer of title has
crystallised (manufacturer recognises inventory until then).

Illustration 1 Consignment Inventory

David Wickes, a car dealer, buys cars from FMC (a large multinational car manufacturer) on the
following terms:
Legal title passes on sale to the public or when the car is used for demonstration.
The car is paid for when legal title passes. The price to David is determined at the date of
delivery.
David must pay interest at 10% on cost for the period from delivery to payment.
David has the right to return the cars to FMC. This right has never been exercised in 10 years
of trading.
David's year end is 31 December.

Required:
Using as an example a car delivered to David on 30 September and still held at the year
end, explain how David should account for the transaction.

Solution
(1) Have the risks and rewards of ownership passed to David on delivery?

Factors Risk/reward passed?

Right to return inventory No
(but it has never been exercised so for all intents
and purposes the risk/reward actually does pass
on delivery)
Price reflects an interest charge varying Yes
with time ( slow movement risk)

Conclusion
On balance, the risks and rewards of ownership pass to David on delivery. The transaction should
be treated as a purchase of inventory on credit.
(2) Journal entries

On receipt of car Dr Purchases

Cr Payables
Up to date of earlier sale to third party or use as a demonstator
Dr Interest payable
Cr Payables (accrued interest)

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F7 Financial Reporting Session 3 Substance Over Form

3.2 Sale and Repurchase Agreements

Under these agreements, the two parties enter into an
agreement where the seller may repurchase the goods at
some later date. For example:
as the result of an explicit agreement;
where the seller has a call option to repurchase the goods;
or
where the buyer has a put option to require the seller to
repurchase the goods.
Revenue is recognised according to the substance of the
transaction:
if, in substance, the seller has transferred the risks and
rewards of ownership to the buyer, revenue is recognised;
or
if, in substance, the seller retains the risks and rewards of
ownership (even if legal title is transferred), the transaction
is a financing arrangement and does not give rise to
revenue.
Here, an asset is sold by A to B on terms such that A
repurchases the asset in certain circumstances.
The issue is to decide whether the substance of the
transaction is:
a sale; or
raising of finance on an asset still held.
Treatment in A's accounts:

Yes No
On "sale" Recognise sale and any profit Leave asset in statement of financial
position. Record proceeds as a liability.
Accrue for any interest payable
On "repurchase" Recognise purchase, including any Settle liability and accrued payable
payable, as cost of sales

Effect Effect
Finance cost recognised on Finance cost recognised on "sale"
repurchase (as part of cost of sales) (as interest payable)
Finance is "off balance sheet" Finance is "on balance sheet"

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Session 3 Substance Over Form F7 Financial Reporting

Illustration 2 Sale and Repurchase Agreement

Christov is a vodka manufacturer. The company manufactures vodka from the finest wheat
grain. The manufacturing process involves a maturing period of three years. The vodka is sold
at cost + 200%.
On the first day of its accounting period, Christov sold 100,000 litres of one-year-old vodka to
Watnest plc, a bank, on the following terms:
Sale price of $500,000 (cost).
Christov has the option to repurchase the vodka at any time over the next two years at cost
plus a mark-up.
The mark-up is based on an annual compounded rate of interest of 12% and will be prorated.
Watnest has the option to sell the vodka to Christov in two years' time at a price based on a
similar formula.

Required:
Explain how Christov should account for this transaction at inception and at the year
end.

Solution
(1) Has there in substance been a sale?
Is the repurchase likely to happen? If so, it is not a real sale and the legal form should be set
aside.

Factors:
Sale is unusualsale at cost/to a bankindicates that it is not a real sale.
A mirror image put and call option means that the repurchase is bound to occur.
Christov is paying a borrowers return.
Therefore the sale is not a real sale but a financing arrangement.*

(2) Journal entries*

$ $
On "sale" Dr Cash 500,000
Cr Payables 500,000
At year end Dr Profit or loss 60,000
Cr Payables 60,000
On "repurchase" Dr Payables 627,200
Cr Cash 627,200

*It may be possible to Dr the asset if it meets the definition of a

qualifying asset. This assumes that repurchase is at the end of the
year.
*If in substance there had been a sale:
$ $
On "sales" Dr Cash 500,000
Cr Revenue 500,000
On "repurchase" Dr Cost of sales 627,200
Cr Cash 627,200

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F7 Financial Reporting Session 3 Substance Over Form

3.3 Factoring of Debts

The "seller" transfers debts to a "factor" for an agreed
percentage of the value of the debts. Again, the key issue is
the extent to which the risks and rewards of ownership have
been transferred.
Possible treatments:
debts are no longer an asset of the seller derecognition;
or
debts remain an asset of the seller separate presentation.

Illustration 3 Factoring

Impact LTD has a portfolio of receivables totalling $100,000. It wishes to raise funds and so is
looking into two options to sell the receivables and raise cash.
Option (i) would be to sell to a factor and receive $50,000 today and a further $42,000 in two
months' time. The factor would bear all risks associated with the receivables.
Option (ii) would be to sell the receivables to a factor for $97,000. The contract states that
the factor can return the receivable to Impact if they have not recovered the funds within three
months.

Accounting:
Option (i)the risks have been transferred and so the receivables should be derecognised with a
separate receivable due from the factor for $42,000 recognised.
Dr Cash $50,000
Dr Factor Receivable $42,000
Dr Profit or loss $8,000
Cr Trade receivables $100,000
Option (ii)the risks are retained by Impact and so the receivables should not be derecognised; a
liability to the factor should be recognised.
Dr Cash $97,000
Cr Liability $97,000
Any finance costs will be accrued over the three-month period.

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 Summary
Financial statements must reflect the true substance of transactions if they are to show a
true and fair view.
The key issue underlying the treatment of a transaction is whether an asset or liability
should be shown in the statement of financial position.
In the past, companies have tried to be creative in the way they account for certain
transaction, leading to abuses of the accounting entries recording these transactions and
the financial statements not reflecting the economic reality of the situation.
Recognise an item only if it meets the definition of asset/liability, and the monetary amount
can be measured with sufficient reliability.
Cease to recognise an asset only if all significant access to benefits, and all significant
exposure to risks inherent in those benefits, have been transferred to others.

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 Session 3

Session 3 Quiz
Estimated time: 15 minutes

1. Explain why the substance of the transaction matters. (1)

2. Describe what is meant by "off balance sheet financing". (1.3)
3. Describe other forms which creative accounting may take. (1.3)
4. List the characteristics of a sale and repurchase agreement. (3.2)
5. Explain why companies sell (factor) their trade receivables and how the sale should be
accounted for. (3.3)

Study Question Bank

Estimated time: 50 minutes

Priority Estimated Time Completed

MCQs - Session 3 25 minutes

Q9 Hughes and Custom cars 25 minutes

Additional
Q8 Substance over form

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