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Chapter 15

The legal versus the commercial


view of accounting
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Contents

1. Off balance sheet finance


2. Substance over legal form

3. The IASB Framework


4. Common forms of off balance sheet

5. Revenue recognition

Accounting standards
IAS
IAS
IAS
IAS
IAS

11
17
18
24
32

Off balance sheet finance

What is off balance sheet finance?


Off balance sheet finance has been
defined as the funding or refinancing of a
companys operations in such a way that,
under legal requirements and, until
relatively recently, existing accounting
conventions, some or all of the finance may
not be shown on its balance sheet.

Off balance sheet finance


Reasons as to why companies resort to off
balance sheet finance?
To maintain low gearing;
Without it gearing will be high, suggesting
that a right issue is imminent, with an adverse
effect on share price;
Matching borrowings with assets being
developed and effectively removing both from the
balance sheet;
Activities such as leasing and financial
services can give rise to high gearing ratios and
are therefore placed off balance sheet.

Diagram

Off
balance
sheet
finance

To keep
gearing
low

The purpose
of off balance
sheet finance
To stay with
the terms of
loan covenants

Substance over form


What is substance over form?
The principal that transactions and other
events are accounted for and presented in
accordance with their substance and
economic reality and not merely their legal
form (Framework)

It is used to determine accounting treatment in financial statements


and so prevent off balance sheet balance. And the information
provided can better reflect the economic activities.

Substance over form


IAS17 Leases
In IAS17,there is an explicit requirement that if
the lessor transfers substantially all the rewards
and risks of ownership to the lessee then ,even
though the legal title has not necessarily
passed ,the item being leased should be shown
as an assets in the statement of financial position
of the lessee and the amount due to the lessor
should be shown as liability
IAS24 Related party disclosures
It requires that financial statements to disclose
fully any material transactions undertaken with a
related party by the reporting entity ,regardless
of any price charged.

Substance over form


IAS11Consruction contracts
It requires to account for attributable profits on
construction contracts under the accruals
convention.

IAS27 Consolidated and separate


financial statements
IAS27 contains a definition of a subsidiary based
on control rather than just ownership rights ,thus
substantially reducing the effectiveness of this
method of off balance sheet finance.

Substance over form


Control
is the power to govern the financial and operating polices of
an entity so as to obtain benefit from its activities.
The control exists when:
(a) the parent has a majority of the voting rights in the
subsidiary (possibly by agreement with other members)
(b) the parent can appoint or remove a majority of the
board of the subsidiaryor
(c) the parent can direct the operating and financial policies
through a statute or agreement or
(d) the parent can cast the majority of votes at a board
meeting of directors

The IASB Framework


The Framework provides the general
guidance for reporting the substance of
transactions and preventing off balance
sheet finance.
You should consider these items while
studying :
(a) IAS17 leases
(b) IAS32 Financial instruments
(c) IAS27 Consolidated and separate
financial statements
(d) IAS24 Related party disclosures
(e) IAS18 Revenue

Common forms of off balance sheet


finance
Consignment
of inventory

Sale and
purchase
agreements

Common
forms of
off balance
sheet
finance

Factoring of
receivables

Sale and
leaseback
agreements

Factoring
of debts

Common forms of off balance sheet


finance
Consignment inventory
Consignment inventory is an arrangement where
inventory is held by one party (says a
distributor) but is owned by another party (for
example a manufacturer or a finance company).
The following apply where it is concluded that the
inventory is in substance an asset of the dealer.
(a) The inventory should be recognized as such in
the dealers statement of financial position,
corresponding liability to the manufacturer.
(b) Any deposit should be deducted from the
liability and the excess classified as a trade
payable.

Common forms of off balance sheet


finance
Sale and repurchase agreements
These are arrangements under which the
company sells an asset to another person on
terms that allow the company to repurchase the
asset in certain circumstances.
If the seller has the right to the benefits of the
use of the asset ,and the purchase terms are
such that the purchase is likely to take place ,the
transaction should be accounted for as a loan.

Sale and leaseback transactions


A sale and leaseback transaction involves the sale
of the an asset and the leasing back of the same
asset. The lease payment and the sale price are
usually negotiated as a package.

The accounting treatment depends on the types


of lease involved.
If it is a financial lease, then it is in substance a
loan from the lessor to the lessee.
If it is operating lease and the transaction has
been conducted at fair value ,then it can be
regarded as normal sale transaction.

Common forms of off balance sheet


finance
Factoring of receivables /debts
Where debts or receivables are factored, the
original creditor sells the debts to the factor. The
sale price may be fixed at the outset or may be
adjusted later.
If the seller has to pay interest on the difference
between the amounts advanced to him and the
amounts that the factor has received ,and if the
seller bears the risks of non-payments by the
debtor , then the indications would be that the
transaction is, in effect, a loan.

Revenue recognition
Introduction

Accrual accounting is based on the matching of


costs with the revenue they generate.
Revenue is generally recognized as earned at
the point of sale, because at that point four
criteria will generally have been met:
(a) The product or service has been provided to the
seller
(b) The buyer has recognized his liability to pay for
the goods or service provided
(c) The buyer has indicated his willingness to hand
over cash or other assets in settlement of his
liability.
(d) The monetary value of the goods or services has
been established.

Revenue recognition
Revenue from specific types
of transaction or events

IAS 18

Sale of
goods

Rendering
of services

Interests ,
royalties
and dividends

Revenue recognition
Sale of goods
Revenue from the sale of the goods should only be
recognized when all the following are satisfied:
(a) The entity has transferred the significant risks and
rewards of ownership of the goods to the buyer
(b) The entity has no continuing managerial involvement to
the degree usually associated with ownership ,and no
longer has effective control over the goods sold
(c) The amount of revenue can be measured reliably
dIt is probable that the economic benefits associated
with transaction will flow to the entity
(f) The costs incurred in respect of transaction can be
measured reliably

Revenue recognition
Rendering of services

(a)
(b)

(c)
(d)

The associated revenue should be recognized by reference


to the stage of completion of the transaction at the end of
the reporting period. The outcome of a transaction can be
estimated reliably when all the following are satisfied.
The amount of revenue can be measured reliably
It is probable that the economic benefits associated with
transaction at the end of the reporting period can be
measured reliably
The stage of completion of the transaction at the end of
reporting period can be measured reliably
The costs incurred for the transaction and the costs to
complete the transaction can be measured reliably

Revenue recognition
Interest , royalty and dividends
The revenue is recognized on the following bases
aInterest is recognized on a time proportion
basis that take into account the effective yield on
the asset
(b) Royalties are recognized on an accrual basis in
accordance with the substance of relevant
agreement
(c) Dividends are recognized when the share
holders right to receive payment established

Disclosure
The following items should be disclosed.
(a) The accounting polices adopted for the recognition of
revenue, including the methods used t determine the
stage of completion of transactions involving the
rendering of services
(b) The amount of each significant category of revenue
recognized during the period including revenue arising
from:
(i) The sale of goods
(ii) The rendering of service
(iii) Interest
(iv) Royalties
(v) Dividends
(c) The amount of revenue arising from exchange of
goods or services included in each significant category of
revenue

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