Chapter 3 Substance of Transactions

1.      Objectives

1.1       Understand the meaning of substance of transactions.
1.2       Understand and apply the principle of substance over form.

2.      Introduction

2.1       Both the HKICPA’s framework and HKAS 1 state that transactions and events should be accounted for and presented in accordance with their substance and economic reality, and not merely their legal form.
2.2       As yet the HKICPA does not have one standard that brings together all aspects of substance over form. However, many existing standards base their accounting treatment on the concept of substance over form.
2.3       The basic thrust 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. This usually means considering the effect of the transaction on the assets and liabilities of the enterprise. Therefore, it is important to be clear on exactly what is meant by the term “asset” and what is meant by the term “liability”.

 

3.      Off Balance Sheet Finance (不入帳的融資)

(A)      The advantages perceived from schemes of off balance sheet finance

3.1	Definition
	Off balance finance is the organization of transactions such that financial commitments are not included in the statement of financial position of a company or a group.

3.2       The perceived benefits include the following:
(i)         Perceived lower level of gearing.
(ii)        There may be a breach of loan covenants if further liabilities are recorded on balance sheet.
(iii)       In most cases, off balance sheet finance schemes result in assets also being reduced. Therefore a higher ROCE may result.
(iv)       Specialised activities, e.g. leasing and financial services (which have high gearing) can be removed from a group balance sheet.

(B)       The principle of substance over form

3.3	Definition
	Substance over form (實質重於形式) requires that transactions and other events should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form (交易和其他事項應按它們的實質和財務現實而不只是按它們的法律形式進行核算和反映。).

3.4       This principle prevents off balance sheet finance because if the commercial reality is that the company has a financial commitment, that commitment should be included on the statement of financial position.
3.5       The first major area where an accounting standard introduced a change from legal form to substance was HKAS 17 “Leases”. This standard is examined in detail in the next chapter.

(C)      Common forms of off balance sheet finance

3.6       Ways in which companies have tried to keep items off the balance sheet in the past include the following.
(i)         Leasing of assets
Prior to the issue of HKAS 17 leases were not capitalized, i.e. the asset and its related financial commitment were not shown on the lessee’s statement of financial position.
(ii)        Controlled non-subsidiaries
Under previous defective definitions of a subsidiary, companies could control other companies but, as they were not technically subsidiaries, they were not consolidated in the group accounts. We will cover consolidated accounts later. The effect of non-consolidation is that the assets and liabilities of the subsidiary were not included within the total assets and liabilities of the group.

Since the issue of HKAS 27, companies have had to be more ingenious in arranging their affairs so that off balance sheet arrangements continue to occur in entities which are not classified as subsidiaries under the definitions in the standard.
(iii)       Innovations in the financial markets
A number of (often complex) arrangements have been developed, often involving complex financial instruments, for which the accounting entries were not immediately obvious. The HKICPA is addressing such problems by issuing standards such as HKAS 32 “Financial Instruments: Presentation”, HKAS 39 “Financial Instruments: Recognition and Measurement” and HKFRS 7 “Financial Instruments: Disclosure” which have more detailed requirements.

4.       Reflecting the Substance of Transactions in Financial Statements

4.1       The HKICPA’s approach to reporting the substance of transactions involves several separate strands:
(i)         the Framework document
(ii)        HKAS 1 to lay down the general principle
(iii)       specific HKASs for particular areas
(a)        HKAS 17 for accounting for leases
(b)        HKAS 24 for related party disclosures
(c)        HKAS 31 for interests in joint ventures
(d)        HKAS 32 for the disclosure and presentation of financial statements.

Each of these strands is now briefly examined.

(A)      The Framework

4.2       The HKICPA Framework for the preparation and presentation of financial statements identifies substance over form as a necessary part of the reliability characteristic.
4.3       If information is to represent faithfully the transactions and other events that it purports (聲稱) to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.
4.4       However, the contents of the Framework are not mandatory standards, so it is necessary to repeat the substance over form principle in HKAS 1.

(B)       Determining the substance of a transaction

4.5       Common features of transactions whose substance is not readily apparent are
(i)         the separation of the legal title to an item from the ability to enjoy the principal benefits and exposure to the principal risks associated with it
(ii)        the linking of a transaction with one or more others in such a way that the commercial effect cannot be understood without reference to the series as a whole, and
(iii)       the inclusion in a transaction of one or more options whose terms make it highly likely that the option will be exercised.

4.6	Key Point
	A key step in determining the substance of a transaction is to identify its effect on the assets and liabilities of the entity.

4.7       Risk often indicates which party has an asset. Risk is important, as the party which has access to benefits (and hence an asset) will usually also be the one to suffer or gain if the benefits ultimately differ from those expected.

5.      Applying the Substance over Form Principle

5.1       The following examples illustrate how these theories are applied in practive.
(i)         consignment inventories and goods on sale-or-return
(ii)        sale and repurchase agreements
(iii)       factoring of receivables
(iv)       special purpose entities

(A)      Consignment inventory (寄售存貨)

5.2       Consignment inventory is inventory held by one party but legally owned by another, on terms which give the holder the right to sell the inventory in the normal course of his business, or at his option to return it unsold to the legal owner.
5.3       Other terms of such arrangements include a requirement for the dealer to pay a deposit, and responsibility for insurance. The arrangement should be analysed to determine whether the dealer has in substance acquired the inventory before the date of transfer of legal title.

5.4	Key Point
	The key point will be who bears the risk of slow moving inventory. The risk involved is the cost of financing the inventory for the period it is held.

5.5       In a simple arrangement where inventory is supplied for a fixed price that will be charged whenever the title is transferred and there is no deposit, the manufacturer bears the slow movement risk.
5.6       If, however, the price to be paid increases by a factor that varies with interest rates and the time the inventory is held, then the dealer bears the risk. Whoever bears the slow movement risk should recognize the inventory on the balance sheet.

5.7

EXAMPLE 1

On 1 January 2008 Gillingham, a manufacturer, entered into an agreement to provide Canterbury, a retailer, with machines for resale. Under the terms of the agreement Canterbury pays a fixed rental per month for each machine that it holds and also pays the cost of insuring and maintaining the machines. The company can display the machines in its showrooms and use them as demonstration models. When a machine is sold to a customer, Canterbury pays Gillingham the factory price at the time the machine was originally delivered. All machines remaining unsold six months after their original delivery must be purchased by Canterbury at the factory price at the time of deliver. Gillingham can require Canterbury to return the machines at any time within the six month period. In practice, this right has never been exercised. Canterbury can return unsold machines to Gillingham at any time during the six month period, without penalty. In practice, this has never happened. At 31 December 2008 the agreement is still in force and Canterbury holds several machines which were delivered less than six months earlier. How would these machines be treated in the accounts for the year ended 31 December 2008?   SOLUTION: The key issue is whether Canterbury has purchased the machines from Gillingham or whether they are merely on loan. It is necessary to determine whether Canterbury has the benefits of holding the machines and is exposed to the risks inherent in those benefits. Gillingham can demand the return of the machines and Canterbury is able to return them without paying a penalty. This suggests that Canterbury does not have the automatic right to retain or to use them. Canterbury pays a rental charge for the machines, despite the fact that it may eventually purchase them outright. This suggests a financing arrangement as the rental could be seen as loan interest on the purchase price. Canterbury also incurs the costs normally associated with holding inventories. The purchase price is the price at the date the machines were first delivered. This suggests that the sale actually takes place at the delivery date. Canterbury has to purchase any items still held six months after delivery. Therefore, the company is exposed to slow payment and obsolescence risks. Because Canterbury can return the items before that time, this exposure is limited. It appears that both parties experience the risks and benefits. However, although the agreement provides for the return of the machines, in practice this has never happened. Conclusion: the machines are assets of Canterbury and should be included in the balance sheet.

5.8

EXERCISE 1

Taurus, a motor car manufacturer, supplies cars to Northern Motors, a car dealership, on a consignment basis. The terms of the agreement are: (1)       Northern pay for the cars at the earlier of: Three months after delivery; or When the cars are sold. (2)        The price paid by the dealer is the wholesale price as at the date of payment. (3)        Northern must pay Taurus a rent of $50 per month for each car until they have been paid for in full. (4)        If after three months the car is unsold then Northern have two options: Pay for the car in full; or Return it to Taurus. Taurus will charge a fee of $95 to cover administration and transport if the car is returned. (5)        Taurus may request the return of any unsold car. They might want to do this to deliver it to another supplier who is short of inventory. The average wholesale price of these cars is $12,000, and the average market rate of interest for car dealerships is 12% p.a. Required: How should this agreement be accounted for in the books of Northern Motors and Taurus?

(B)       Sale and repurchase agreements

5.9	Sale and Repurchase Arrangements
	Sale and repurchase arrangements are arrangements under which assets are sold by one party to another on terms that provide for the seller to repurchase the assets in certain circumstances.

5.10     Typical arrangements would cover the following points:
(i)         The vendor sells an item at:
(a)        market price; or
(b)        an agreed price.
(ii)        The vendor may repurchase  the item at:
(a)        the market price at the date of repurchase; or
(b)        a price which varies with time ( to take into account the time value of money); or
(c)        an agreed price.
(iii)       The vendor may have an option to repurchase (a call option); or
(iv)       The purchaser may have an option to demand repurchase (a put option).

5.11	Key Point
	You need to identify if a sale and re-purchase agreement is: a genuine sale; or a secured loan.

5.12     A secured loan transaction will usually have the following features:
(i)         the seller will secure access to all future benefits inherent in the asset, often through call options;
(ii)        the buyer will secure adequate return on the purchase (interest on the loan, often through adjustment of the repurchase price) and appropriate protection against loss in value of the asset bought (often through put option).
5.13     Sale and repurchase arrangements are common in property development and in maturing whisky inventories.

5.14

EXERCISE 2

LLP is a wholesaler of high quality hardwood. The wood is stored for many years before it is properly seasoned and ready for use. On 1 January 2000 they sold a new consignment of hardwood to Lehman Bank. The wood had cost LLP $2m, and the proceeds of sale were $3m. It will be ten years before this wood is ready for use. LLP will be responsible for the seasoning process. When the wood is ready it will have a market price of $12 m. LLP has an option to repurchase the timber in ten years time (on 1 January 2010) for $7,781,227). Required: (a)        Prepare extracts from the financial statements of LLP that will report the legal form of this transaction. (b)       Critically appraise the truthfulness of these financial statements. In particular comment on the way in which assets, liabilities, income and expenditure have (or have not) been recognized. (c)        Prepare extracts from the financial statement for LLP for 2000, 2001, 2009 and 2010 reporting the commercial substance of these transactions. Additional information: Assume that LLP repurchases the timber in 2010 and immediately resells it at the expected market price of $12m. The prevailing market rate of interest for projects of this nature is 10%.

 

(C)      Factoring receivables (應收賬款出售)

5.15     Debt factoring is a fairly common method for businesses to improve their cash flow. What normally happens is that the finance company to whom the debts are legally sold pay a fixed percentage of the debt’s value, say 90%, at the date of legal transfer, with the balance payable, less an appropriate charge, if and when the debtor pays the factor.
5.16     Usually, the debts are factored with recourse (帶追索權). This means that, if the debtor doesn’t pay, then the finance company can receive repayment of the sums advanced to the seller. If debt factoring is with recourse it is usually the case that the original seller has retained the risks and rewards of ownership of the debts, and the factoring proceeds are in reality a form of financing from the factoring agency. Debt factoring is a common example of a transaction where linked presentation is sometimes appropriate.

5.17	Key Point
	Factored debts can only be derecognised if all the related risks and rewards have been disposed of.

5.18

Exercise 3

An entity has an outstanding receivables balance with a major customer amounting to $12 million and this was factored to Finance Co on 1 September 2010. The terms of the factoring were: Finance Co will pay 80% of the gross receivable outstanding account to the entity immediately. The balance will be paid (less the charges below) when the debt is collected in full. Any amount of the debt outstanding after four months will be transferred back to the entity at its full book value. Finance Co will charge 1.0% per month of the net amount owing from the entity at the beginning of each month. Finance Co had not collected any of the factored receivable amount by the year-end. The entity debited the cash from Finance Co to its bank account and removed the receivable from its accounts. It has prudently charged the difference as an administration cost.   How should this arrangement be accounted for in the financial statements for the year ended 30 September 2010?

 

 

(D)       Special purpose entities (SPEs)

5.19     SPEs are legally independent entities that are used to take on the loans or liabilities of another enterprise. An enterprise (often referred to as the sponsor) will sell assets to the SPE, but retain the right to use the asset and gain from any future increase in its value. The SPE normally has no assets or capital of its own. It will borrow the money needed to buy the asset from a ‘capital provider’.

5.20	Key Point
	The purpose of SPEs is to remove assets and liabilities from the statement of financial position of the sponsor. This has the effect of improving the return on capital employed and gearing of the sponsor.

5.21     SPEs are also known as vehicles and quasi-subsidiaries.
5.22     HKAS – Int 12 “Consolidation – Special Purpose Entities” states that an enterprise should consolidate an SPE if it controls that SPE. A reporting enterprise probably has control over an SPE if:
(i)         It benefits from the SPE’s activities. The SPE may be providing long-term finance or essential goods and services.
(ii)        It has decision-making powers over the SPE. This can be achieved directly or by delegating decision making under an autopilot mechanism.
(iii)       It has rights to the majority of the SPE’s economic benefits. The SPE’s capital providers normally receive a lender’s return, but nothing more.
(iv)       It is exposed to the SPE’s risks. The capital providers in an SPE normally have limited exposure to an SPE’s losses.

5.23

EXERCISE 4

Davies plc is a publicly quoted owner and operator of luxury hotels. On 1 January 2007 Davies plc sold some of its hotels to Peters Ltd, a subsidiary of Wilson’s Bank. These hotels had a book value of $850 million in the books of Davies. They were sold to Peters for $1,280 million, which was their open market value. Peters Ltd is financed by one $1 Ordinary Share (held by Wilson’s Bank) and a $1,500 million 13% loan supplied by Wilson’s Bank on normal commercial terms. Davies and Peters have entered into the following management contract for the hotels: Davies will be paid a fee in exchange for the complete management of the hotels. The fee will be set at 100% of the profits of Peters Ltd after paying the interest on the loans from Wilson’s Bank. If any of the hotels are sold then the profits will be assigned to Davies plc. Both companies have a 31 December year end. Their financial statements for 2007 are noted below. They have been drawn up on the basis of legal form. Required: (a)        Explain why Davies plc should consolidate Peters Ltd. (b)        Prepare the consolidated accounts for the Davies Group. The hotels should be stated at their open market value, giving rise to a revaluation reserve. (c)        Discuss the effect that these consolidated accounts will have on investors in Davies plc compared with the original company accounts. Statements of comprehensive income for 2007   Davies Peters   $m $m Revenues 500 1,900 Cost of sales (350) (1,125) Gross profit 150 775 Expenses (180) (280) Management fee 300 (300) Operating profit 270 195 Profit on disposal of hotels 430 - Interest payable - (195) Profit before tax 700 - Statement of financial position for 2007   Davies Peters Assets $m $m Non-current assets 400 1,280 Current assets 900 400 Total assets 1,300 1,680       Equity and liabilities     Share capital and reserves     Share capital 50 - Retained profits 850 - Revaluation reserve 100 -   1,000 - Non-current liabilities - 1,500 Current liabilities 300 180 Total equity and liabilities 1,300 1,680

 

Examination Style Questions

Question 1
The overriding requirement of a company’s financial statements is that they should represent faithfully the underlying transactions and other events that have occurred. To achieve this transactions have to be accounted for in terms of their “substance” or economic reality rather than their legal form. This principle is included in the HKICPA’s “Framework for the Preparation and Presentation of Financial Statements”, and is also used in many standards, in particular HKAS 17 “Leases” and HKAS 18 “Revenue”.

Required:

(a)     Describe why it is important that substance rather than legal form is used to account for transactions, and describe how financial statements can be adversely affected if the substance of transactions is not recorded.                                                                                                                  (5 marks)
(b)     Describe, using an example, how the following features may indicate that the substance of a transaction is different from its legal form:
(i)      separation of ownership from beneficial use;
(ii)     the linking of transactions including the use of option clauses;
(iii)    when an asset is sold at a price that differs to its fair value.
(9 marks)
(c)     On 1 April 2008 Forest had an inventory of cut seasoning timber which had cost $12 million two years ago. Due to shortages of this quality of timber its value at 1 April 2008 had risen to $20 million. It will be a further three years before this timber is sold to a manufacturer of high-class furniture. On 1 April 2008 Forest entered into an arrangement to sell Barret Bank the timber for $15 million. Forest has an option to buy back the timber at any time within the next three years at a cost of $15 million plus accumulated interest at 2% per annum above the base rate. This will be charged from the date of the original sale. The base rate for the period of the transactions is expected to be 8%. Forest intends to buy back the timber on 31 March 2011 and sell it the same day for an expected price of $25 million.

Note: Ignore any storage costs and capitalisation of interest that may relate to inventories.

Required:

Assuming the above transactions take place as expected, prepare extracts to reflect the transactions in the statement of comprehensive income for the years to 31 March 2009, 2010 and 2011 and the statement of financial position (ignore cash) at those year ends:

(i)      if Forest treated the transactions in their legal form; and
(ii)     if the substance of the transactions is recorded.

Comment briefly on your answer to (c) above.                                      (11 marks)
(25 marks)

Question 2
Revenue recognition is the process by which companies decide when and how much income should be included in the income statement. It is a topical area of great debate in the accounting profession. The HKICPA looks at revenue recognition from conceptual and substance points of view. There are occasions where a more traditional approach to revenue recognition does not entirely conform to the HKICPA guidance; indeed neither do some Hong Kong Accounting Standards.

Required:

(a)     Explain the implications that the HKICPA's Framework for the Preparation and Presentation of Financial Statements (Framework) and the application of substance over form have on the recognition of income. Give examples of how this may conflict with traditional practice and some accounting standards.
(6 marks)
(b)     Derringdo sells goods supplied by Gungho. The goods are classed as A grade (perfect quality) or B grade, having slight faults. Derringdo sells the A grade goods acting as an agent for Gungho at a fixed price calculated to yield a gross profit margin of 50%. Derringdo receives a commission of 12·5% of the sales it achieves for these goods. The arrangement for B grade goods is that they are sold by Gungho to Derringdo and Derringdo sells them at a gross profit margin of 25%. The following information has been obtained from Derringdo's financial records:

		$000
Inventory held on premises 1 April 2002	– A grade	2,400
	– B grade	1,000
Goods from Gungho year to 31 March 2003	– A grade	18,000
	– B grade	8,800
Inventory held on premises 31 March 2003	– A grade	2,000
	– B grade	1,250

Required:

Prepare the income statement extracts for Derringdo for the year to 31 March 2003 reflecting the above information.                                                                                              (5 marks)
(ACCA 2.5 (HKG) Financial Reporting June 2003 Q3 (a) & (b))

Question 3
The principle of recording the substance or economic reality of transactions rather than their legal form lies at the heart of the Framework for Preparation and Presentation of Financial Statements’ (Framework) and several Hong Kong Financial Reporting Standards. The development of this principle was partly in reaction to a minority of public interest companies entering into certain complex transactions. These transactions sometimes led to accusations that company directors were involved in ‘creative accounting’.

Required:

(a)     (i)      Explain, with relevant examples, what is generally meant by the term ‘creative accounting’;                                                                                                         (5 marks)
(ii)     Explain why it is important to record the substance rather than the legal form of transactions and describe the features that may indicate that the substance of a transaction is different from its legal form.                                                                                                (5 marks)
(b)     (i)      Atkins’s operations involve selling cars to the public through a chain of retail car showrooms. It buys most of its new vehicles directly from the manufacturer on the following terms:

• Atkins will pay the manufacturer for the cars on the date they are sold to a customer or six months after they are delivered to its showrooms whichever is the sooner.
• The price paid will be 80% of the retail list price as set by the manufacturer at the date that the goods are delivered.
• Atkins will pay the manufacturer 1·5% per month (of the cost price to Atkins) as a ‘display charge’ until the goods are paid for.
• Atkins may return the cars to the manufacturer any time up until the date the cars are due to be paid for. Atkins will incur the freight cost of any such returns. Atkins has never taken advantage of this right of return.
• The manufacturer can recall the cars or request them to be transferred to another retailer any time up until the time they are paid for by Atkins.

Required:

Discuss which party bears the risks and rewards in the above arrangement and come to a conclusion on how the transactions should be treated by each party.
(6 marks)
(ii)     Atkins bought five identical plots of development land for $2 million in 1999. On 1 October 2001 Atkins sold three of the plots of land to an investment company, Landbank, for a total of $2·4 million. This price was based on 75% of the fair market value of $3·2 million as determined by an independent surveyor at the date of sale. The terms of the sale contained two clauses:

• Atkins can re-purchase the plots of land for the full fair value of $3·2 million (the value determined at the date of sale) any time until 30 September 2004; and
• On 1 October 2004, Landbank has the option to require Atkins to re-purchase the properties for $3·2 million. You may assume that Landbank seeks a return on its investments of 10% per annum.

 

Required:

Discuss the substance of the above transactions; and                              (3 marks)

Prepare extracts of the income statement and balance sheet (ignore cash) of Atkins for the year to 30 September 2002:
– if the plots of land are considered as sold to Landbank; and                (2 marks)
– reflecting the substance of the above transactions.                               (4 marks)
(25 marks)
(ACCA 2.5 (HKG) Financial Reporting December 2002 Q3)

Question 4
(a)     Recording the substance of transactions, rather than their legal form, is an important principle in financial accounting. Abuse of this principle can lead to profit manipulation, non-recognition of assets and substantial debt not being recorded on the statement of financial position.

Required:

Describe how the use of off balance sheet financing can mislead users of financial statements.

Note: your answer should refer to specific user groups and include examples where recording the legal form of transactions may mislead them.                                                  (9 marks)

(b)     Angelino has entered into the following transactions during the year ended 30 September 2006:

(i)      In September 2006 Angelino sold (factored) some of its trade receivables to Omar, a finance house. On selected account balances Omar paid Angelino 80% of their book value. The agreement was that Omar would administer the collection of the receivables and remit a residual amount to Angelino depending upon how quickly individual customers paid. Any balance uncollected by Omar after six months will be refunded to Omar by Angelino.                              (5 marks)
(ii)     On 1 October 2005 Angelino owned a freehold building that had a carrying amount of $7.5 million and had an estimated remaining life of 20 years. On this date it sold the building to Finaid for a price of $12 million and entered into an agreement with Finaid to rent back the building for an annual rental of $1.3 million for a period of five years. The auditors of Angelino have commented that in their opinion the building had a market value of only $10 million at the date of its sale and to rent an equivalent building under similar terms to the agreement between Angelino and Finaid would only cost $800,000 per annum. Assume any finance costs are 10% per annum.
(6 marks)
(iii)    Angelino is a motor car dealer selling vehicles to the public. Most of its new vehicles are supplied on consignment by two manufacturers, Monza and Capri, who trade on different terms.

Monza supplies cars on terms that allow Angelino to display the vehicles for a period of three months from the date of delivery or when Angelino sells the cars on to a retail customer if this is less than three months. Within this period Angelino can return the cars to Monza or can be asked by Monza to transfer the cars to another dealership (both at no cost to Angelino). Angelino pays the manufacturer’s list price at the end of the three month period (or at the date of sale if sooner). In recent years Angelino has returned several cars to Monza that were not selling very well and has also been required to transfer cars to other dealerships at Monza’s request.

Capri’s terms of supply are that Angelino pays 10% of the manufacturer’s price at the date of delivery and 1% of the outstanding balance per month as a display charge. After six months (or sooner if Angelino chooses), Angelino must pay the balance of the purchase price or return the cars to Capri. If the cars are returned to the manufacturer, Angelino has to pay for the transportation costs and forfeits the 10% deposit. Because of this Angelino has only returned vehicles to Capri once in the last three years.
(5 marks)
Required:

Describe how the above transactions and events should be treated in the financial statements of Angelino for the year ended 30 September 2006. Your answer should explain, where relevant, the difference between the legal form of the transactions and their substance.

Note: The mark allocation is shown against each of the three transactions above.
(Total 25 marks)
(ACCA 2.5 (HKG) Financial Reporting December 2006 Q3)

Question 5
(a)     An important aspect of the International Accounting Standards Board’s Framework for the preparation and presentation of financial statements is that transactions should be recorded on the basis of their substance over their form.

Required:

Explain why it is important that financial statements should reflect the substance of the underlying transactions and describe the features that may indicate that the substance of a transaction may be different from its legal form.                                                                                   (5 marks)
(b)     Wardle’s activities include the production of maturing products which take a long time before they are ready to retail. Details of one such product are that on 1 April 2009 it had a cost of $5 million and a fair value of $7 million. The product would not be ready for retail sale until 31 March 2012.

On 1 April 2009 Wardle entered into an agreement to sell the product to Easyfinance for $6 million. The agreement gave Wardle the right to repurchase the product at any time up to 31 March 2012 at a fixed price of $7,986,000, at which date Wardle expected the product to retail for $10 million. The compound interest Wardle would have to pay on a three-year loan of $6 million would be:

	$
Year 1	600,000
Year 2	660,000
Year 3	726,000

This interest is equivalent to the return required by Easyfinance.

Required:

Assuming the above figures prove to be accurate, prepare extracts from the income statement of Wardle for the three years to 31 March 2012 in respect of the above transaction:
(i)      Reflecting the legal form of the transaction;
(ii)     Reflecting the substance of the transaction.
Note: statement of financial position extracts are NOT required.
The following mark allocation is provided as guidance for this requirement:
(i)      2 marks
(ii)     3 marks
(5 marks)
(c)     Comment on the effect the two treatments have on the income statements and the statements of financial position and how this may affect an assessment of Wardle’s performance. (5 marks)
(Total 15 marks)
(ACCA F7 Financial Reporting June 2010 Q4)