by John Richard Edwards
Underlying principles and environmental context
In practice, financial reporting is not a neutral and unproblematic process. The interests and objectives of the suppliers of accounting information, the directors of a limited company for example, may well not coincide with those of external stakeholders such as shareholders and lenders. In such circumstances, the directors may manipulate either the way in which the economic activity is legally structured (A) or the way it is measured (B) in order to influence user perception (C) through, for example, publication of an artificially high earnings figure or low measure of gearing.
More specifically, such manipulations – “creative accounting” as it is often described – may be defined as:
In either case, the aim is to transform financial statements from what they should contain into what suppliers of such information would prefer to see reported.
Manipulation type 1 involves exploiting choices available e.g. depreciation methods, techniques of stock valuation and ways of accounting for development expenditure.
Manipulation type 2, dealt with here, covers the potential conflict between economic substance and legal form as the appropriate basis for financial reporting.
In most cases, it is a straightforward matter to report the economic substance of transactions in a company’s accounts because it coincides also with the legal form of the transaction.
Company A purchases stock on credit from an unrelated company, Company B. Company A will enter (recognise) the stock in its balance sheet as an asset, stock-in-trade, and also as a liability, the amount due to Company B. Company A will remove (derecognise) the asset when it is sold to another unrelated company (say Company C) and instead recognise in its balance sheet the cash received from Company C, or the debt due from Company C.
This clear-cut position became clouded over the years, as the result of the development of numerous artificial transactions intended to make the financial position of an entity look better than it actually was.
This was of course over a quarter of a century ago and the magnitude of this undisclosed financial obligation is demonstrated by the fact that it dwarfed the figure for shareholders’ equity of £18 million reported in the last balance sheet published before the company collapsed. Both the shareholders and the creditors whose debts were reported in the balance sheet were astonished and dismayed to discover that the generally accepted accounting procedures of the day permitted the omission of vast liabilities from the balance sheet and, moreover, that such a company could get a clean audit report. Following their investigation of Court Line’s affairs, the Department of Trade and Industry’s inspectors reported that “the amounts involved were material and should have been disclosed”.
The fact was, however, that the financial reporting procedures followed by Court Line were entirely justified on a strict legal interpretation of its leasing agreements. The lessors were the owners of the aircraft, not Court Line. However, the substance of the arrangement was that Court Line had acquired the aircraft for its exclusive use with finance provided by the lessor; an arrangement which, in commercial terms, was no different from Court Line buying the aircraft outright on credit terms. In other words, there was a discrepancy between the legal form and the economic substance of the transaction, with Court Line choosing to comply with the former and ignore the latter.
It is an indication of the complexity of the topic and probably also effective lobbying from the leasing industry that it was not until ten years later in 1984, that the problem was addressed through the issue of SSAP 21, Accounting for leases and hire purchase contracts.
In the free-wheeling Thatcherite economy of the late 1980s company directors, faced with one avenue for deception, succeeded in devising (in conjunction with their business advisors) a wide range of alternative schemes capable of achieving exactly the same effect. These developments raised fundamental questions about the nature of assets and liabilities and whether they should be included in the accounts. Although the most widely recognised effect of such arrangements is the omission of liabilities from the balance sheet, it must be remembered that such schemes also involve the omission from the balance sheet of the assets ‘acquired’ with off-balance sheet finance with the result that both the resources of the entity and its financing are understated.
These experiences demonstrated the need for a regulatory initiative that tackled the general problem – the widespread failure to account for the economic substance rather then the legal form of business transactions – not merely a specific manifestation of the problem, the finance lease.
The ASB tackled the matter in two stages: the establishment of a conceptual framework in the form of the Statement of Principles; and the issue of a broad-based financial reporting standard, FRS 5, Reporting the substance of transactions. The Statement of Principles was not issued until after the publication of FRS 5, of course, but the initial version had already been drafted and undoubtedly provided the theoretical framework for the ASB’s thinking on the matter.
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:
Chapter 5 states that new assets and liabilities or changes in assets and liabilities should be recognised and reported in the accounts if:
The criteria for ceasing to recognise assets and liabilities (derecognition) are the converse of the above.
Reporting the substance of transactions
The nature of assets and liabilities, as defined by FRS 5, is entirely consistent with the Statement of Principles as set out above. The conditions which must be met for recognition (i.e. inclusion in the accounts) – evidence of existence and measurement with sufficient reliability – are also identical.
The transactions to which these principles needed to be applied with care were the variety of complex arrangements that became labelled “special purpose transactions” (SPTs). An SPT is a transaction organised in such a way that, when reported in accordance with its precise legal form, its apparent effect differs significantly from the underlying commercial reality. As with finance leases, also with SPT’s in general, their principal objective is to create off-balance sheet finance in circumstances where a company requires loan capital but does not want to show a higher level of gearing in its balance sheet.
The SPT, if effective, succeeds in excluding the asset and its related finance from one company’s balance sheet (Company A) by arranging ownership through a second company (Company B) in such a way that Company A nevertheless enjoys effective control over the use of the asset.
The general position where ownership is separated from use and benefit in this way is shown in Figure 1.
To determine the appropriate accounting treatment, the key task is to decide where the ‘risks and rewards’ reside. Normally, of course, these attach to the owner of an asset. For example, a company buys an asset on the expectation that it will produce future financial benefits. In terms of the labels 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.
In the case of an SPT, 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.
FRS 5 therefore sets out general principles but, in response to the demand also for guidance in difficult areas, it deals specifically with quasi-subsidiaries and contains ‘application notes’ that explore 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; securitised assets; private finance intiatives and loan transfers.
Each of the above three ‘broad areas’ can, of course, be incorporated into arrangements concerning quasi-subsidiaries or those falling into any of the six categories covered by the application notes. The greater the extent to which the three provisions are contained in a particular arrangement, the more complex the scheme becomes and the more difficult it is, sometimes, to identify the substance of the transaction. The significance of the three ‘broad areas’ is illustrated, below, by reference to the sale and repurchase agreement.
Sale and repurchase agreement
This is a straightforward financing arrangement but additional provisions may be included which make it less easy to determine the substance of the transaction.
The results of empirical research suggest that it will continue to prove very difficult for the standard setters to develop definitions that are sufficiently watertight to overcome the problem of off balance sheet finance. For example, the fact that the value of the operating leasing industry has increased dramatically since SSAP 21 came into effect is entirely consistent with this conclusion. A study of a sample of over 200 companies by Goodacre and Beattie showed payments due within one year under operating leases to have increased from approximately £0.5 million in 1984 to over £9 million ten years later. As Whittred and Zimmer put it: “If study of this topic does nothing else, it shows how difficult it is for regulation to obviate opportunistic behaviour by contracting parties”(Financial Accounting).
John Richard Edwards is Professor and Head of Accounting at the Cardiff Business School