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Reporting the substance of transactions

by John Richard Edwards

Underlying principles and environmental context
Most people regard the purpose of financial reporting as being to provide user groups with neutral and objective measurements of business performance. Someone reading the information contained in published accounts would, in such circumstances, expect to be fairly and accurately informed of corporate performance during the period under review. The process of communication may be shown as in Diagram 1.

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:

  1. The process of manipulating accounting figures so as to exploit choices available, within existing accounting regulations and generally accepted accounting procedures, in relation to measurement and disclosure practices.
  2. The process of structuring a transaction in such a way that, if reported in accordance with its legal form, the apparent position differs from the underlying economic reality.

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.

Environmental context
The potential significance of the problem was brought starkly to the attention of the business community and the regulators as early as 1974 when the package holiday business, Court Line Ltd, collapsed. The directors of Court Line had leased aircraft to operate the company’s package holiday business, and the investigation of its affairs following collapse showed there to be undisclosed obligations relating to leased assets of £40 million.

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”.

Diagram 1


Figure 1


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:

  • 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 recognised 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 recognise assets and liabilities (derecognition) are the converse of the above.

Reporting the substance of transactions
The transactions at which FRS 5 directs attention are often extremely complex and the key matter to be kept in mind when examining such arrangements is their purpose. It is necessary to decide whether the reporting entity has created new assets or liabilities as the result of the transaction, or whether it has changed any of its existing assets or liabilities. It is therefore necessary to look at the relationship between the entities involved in a transaction and consider what is likely to have been the object of the arrangement. If first examination of the formal details of the transaction suggest that its purpose is something other than the common sense conclusion, the likelihood is that one needs to dig more deeply in order to discover features of the arrangement which would produce the common sense conclusion.

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.

  1. 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.
  2. The linking of a transaction with others in such a way that the commercial effect can be understood only by considering the series of transactions as a whole.
  3. The inclusion of options or conditions on terms that makes it highly likely that the option will be exercised or the conditions fulfilled.

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
The essential feature of a sale and repurchase agreement is that the company which purports to have sold the asset in question has not relinquished all the risks and rewards associated with that asset in a manner which one would expect in the case of a normal sale. See Example 1.

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 nature of the asset – it is perhaps unlikely that a bank would want to retain ownership of a stock of whisky but the position might be different, and the appropriate accounting treatment would then be different, in the case of property.
  • The nature of the repurchase provision – is there an unconditional commitment by both parties or does either or both possess options concerning repurchase arrangements?
  • The initial sale price and the repurchase price – do these look like artificial prices designed to operationalise a financing arrangement or are they the actual market prices at one or both dates? If the figures used at each date are market prices, the arrangement begin to look more like a normal sale in which risks and rewards are transferred, particularly if either or both parties enjoy appropriate options, e.g. the ‘purchaser’ has the option to retain the asset rather than resell it to the initial vendor.
  • The location of the asset and the right of the seller to use the asset whilst it is owned by the buyer. Where the asset remains on the vendor’s premises or the vendor retains a right of access to the asset, the transaction would appear not to possess the characteristics of a normal sale.
Example 1
A whisky blending company contracts to sell part of its stock of whisky to a bank for £10 million on 1 January 20X1. The agreement makes provision for the whisky company to buy back the whisky two years later for £12.1 million. The whisky remains located at the whisky blending company’s premises.

The market rate of interest for an advance to a whisky blending company is known to be 10%.

Explain the substance of this transaction and how it should be accounted for in the books and accounts of the whisky company.

An examination of the purpose of this transaction reveals it to be a financing arrangement rather than a normal sale. The whisky company has transferred no risks and rewards of ownership to the bank and has merely borrowed money on the security of an appreciating asset.

The stock should remain in the balance sheet of the whisky blending company, at the date of the initial advance (1 January 20X1) at £10 million, with the cash received from the bank shown as a liability.

In the accounts for 20X1, there should appear in the profit and loss account a finance charge of £1 million, representing 10% of the amount of the effective advance. The amount of the ‘loan’ will be shown in the balance sheet for 31 December 20X1 at £11 million – £10 million initial advance and £1 million interest accrued and unpaid.

For 20X2, the finance charge should be £1.1 million; the original advance was £10 million and the interest for year 1 of £1 million has not yet been paid and so the total advance for the duration of year 2 is £11 million (therefore, £11 million x 10% = £1.1 million interest). The recorded value of the advance is increased to £12.1 million and will be deleted from the balance sheet when repayment is made on 1 January 20X3.

Had the transaction instead been accounted for as a normal sale, stock would have been reduced by £10 million and cash would have been increased by £10 million in the whisky blending company’s balance sheet at 1 January 19X1. In such a case the financing arrangement would remain off balance sheet and the assets of the company would also be understated.

This article 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. The accountant then observes the economic event and records and reports its financial effects. We have seen above, however, that 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 – in this case off-balance sheet finance. It then becomes the job of the regulators to counter such opportunistic behaviour on the part of management.

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