Accounting for the Substance of Transactions - Essay Example

114376 Question Evaluate whether generally accepted accounting principles and practice ensure transactions are accounted for according to their substance. (1300 words) People expect Financial Reports based on various accounting measurements to furnish the users neutral and objective measurements of the economic activity and performance of the organization. However, in reality, the financial reporting is not that neutral, objective and easy process. Though giving an account of the economic summary of the activities of the organization is a straightforward job, generally, an effort is made to give better perception of the organization to be presentable to the Shareholders and other stakeholders by inflating the earnings or assets or deflating the liabilities or losses or manipulation of depreciation methods, stock valuation and accounting development expenditure. Here, two factors influence the presentation. The legal provisions and accounting provisions. The presentation which is correct in legal angle may not be founded on sound accounting principles and may vary from the underlying economic reality. The managements, may, therefore, sometimes choose the best and most advantageous of these two options to present the economic substance of the transactions according to their wishes. Certain artificial transactions/combination of transactions undertaken by the organization are such that it is very difficult to assess the net effect the entire exercise. The assessment of net effect of such various activities of the enterprise may be captioned as "substance" of a transaction. Assessment of the substance of the transactions is found necessary to provide reliable, fair and accurate information about corporate performance and to ascertain the actual state of affairs of the business organization. The need is felt very seriously as the various distortions in Financial statements are on the increase, among other things, defining the nature of assets and liabilities and inclusion or non-inclusion of such assets and liabilities in Books of Accounts. Such events not only distort the substance of the economic activity of the organization but also fail to project the actual problems faced by the organization, depriving the organization to initiate remedial steps to address the real problems. Accounting reforms comprising provisions for reporting of substance of transactions are therefore, found necessary. Statement of principles of Accounting prescribe the activities that should be reported on in financial statements, the various dimensions of those activities that should be prominently furnished, the features that information should have if it is to be mentioned in the financial statements. The main role of the Statement of principles is to provide conceptual input into the ASB's work on the development and review of accounting standards. The Statement is not, therefore, neither an accounting standard nor does it contain any requirements on how financial statements are to be prepared. The prominent among the principles for reporting the Substance of the Transactions is definition of assets and liabilities, accounting for subsidiary undertakings, and the activities to be excluded from the business organization's financial statements and those to be included, thus setting standards for presentation of Financial statements. Factors like legal requirements, cost-benefit considerations, industry-specific issues, and the desirability of evolutionary change and implementation issues are also covered. Reporting the Substance of Transactions' implies the addition of Application Note G 'Revenue Recognition'. This clears the ambiguity regarding the treatment of revenue and, in particular, the treatment of turnover (as a subset of revenue). This Application Note deals with revenue recognition from the supply of goods or services by a seller to its customers. It sets out basic principles of revenue recognition which should be applied in all cases. It also provides specific guidance for long-term contractual performance, separation and linking of contractual arrangements; bill and hold arrangements; sales with rights of return; and. presentation of turnover as principal or as agent. The relevant chapters of the Statement are chapter 4 entitled 'The elements of financial statements' and chapter 5 entitled 'Recognition in financial statements' Chapter 4 defines: Assets as rights or other access to future economic benefits controlled by an entity as the result of past transactions or events; and liabilities as: Obligations of an entity to transfer economic benefits as a result of past transactions or events. Chapter 5 states that new assets and liabilities or changes in assets and liabilities should be recognized and reported in the accounts if: There is sufficient evidence of their existence, and the item can be measured at a monetary amount with sufficient reliability. The criteria for ceasing to recognize assets and liabilities (de-recognition) are the converse of the above. The Special Purpose Transactions, if takes place properly, results in excluding the asset and its related finance from one company's balance sheet (Company 1) by arranging ownership through a second company (Company 2) in such a way that Company 1 nevertheless enjoys effective control over the use of the asset. To decide the appropriate accounting treatment, the main task is to decide where the 'risks and rewards' reside. Naturally, of course, these attach to the owner of an asset. For example, a company may buy an asset on the hope that it will generate future financial gains. In terms of the titles employed in the Statement of Principles, the expectation is that 'value in use' (the discounted present value of the future cash flows generated from the use of the asset) will exceed the fair value of the asset at acquisition date. If these expectations are fulfilled, the rewards of ownership accrue to the owner. However, if the acquisition proves to have been a mistake - e.g. the market for the product disappears immediately the asset is acquired - the risks and related loss are suffered by the owner. In an extreme case, the loss incurred will be equal to the entire cost of the asset. Thus, a transaction involving an item previously recognized as an asset is in substance a financing arrangement. The accountant observes the economic event and records and reports its financial effects. Business persons do not necessarily engage in commercial transactions unaware or unconcerned with its financial reporting implications. The result is that business arrangements are sometimes structured in a manner intended to achieve desired financial reporting objectives - like off-balance sheet finance. It then becomes the job of the regulators to counter such opportunistic behaviour on the part of management. In the case of an Special purpose transactions, however, the risks and rewards normally associated with ownership are transferred from the legal owner to the user of the asset. For example, the contract relating to a finance lease may stipulate that, if the lessor wishes to end the leasing arrangement prematurely, there must be paid, as a penalty, a sum of money equal to the amount of the lease rentals outstanding. FRS 5 (Para. 47) sets out three broad areas which require consideration in order to decide where the risks and rewards reside in relation to what might be an extremely complex contractual arrangement. The separation of legal title to an item from the rights or other access to the principal future economic benefits associated with it. Also, exposure to the principal risks inherent in those benefits. FRS 5 explores the issues surrounding six categories of complex transaction and provides advice concerning their appropriate treatment. The six categories are: sale and repurchase agreements; consignment stock; factoring of debts; securitized assets; private finance initiatives and loan transfers. Treatment of transactions in as per FRS5 ensures reporting the substance of transactions. Thus, the basic thrust of FRS is that the substance of a transaction should be determined by identifying all aspects and implications and giving priority to those more likely to have a commercial effect in practice. Therefore, it is important to be clear on exactly what is meant by the term 'Asset' and what is meant by the term 'Liability'. Question No.2. Determine the substance of the transaction and explain how the transaction should be treated in A Plc's financial statements. Solution An examination of the purpose of this transaction reveals it to be a financing arrangement rather than a normal sale. The A Plc has transferred no risks and rewards of ownership to the B Ltd and has merely borrowed money on the security of an appreciating asset. The stock should remain in the balance sheet of the A Plc, at the date of the initial advance (1st April 2006) at 5,000,000, with the cash received from the B Ltd shown as a liability. In the accounts for 2007, there should appear in the profit and loss account an interest charge of 10% of the amount of the effective advance. The amount of the 'loan' will be shown in the balance sheet for 31 March 2007 at 5,500,000 that is, 5,000,000+10% interest thereon, which is not paid. The same procedure should be followed till the transaction is brought to finality or 31.3.2009, whichever is earlier. Had the transaction instead been accounted for as a normal sale, stock would have been reduced by 5,000,000 and cash would have been increased by 5,000,000 in the A Plc's balance sheet at 1 April 2006. Analysis This example has shown how the usual relationship between the occurrence of an economic event and accounting for the event can be reversed. The usual situation is that a transaction is undertaken independently of its accounting significance Reference: http://www.asb.org.uk/ Read More