QUESTIONS (IAS 18)

1 Sale and leaseback or sale and repurchase arrangements can be used to

disguise the substance of loan transactions by taking them 'off balance sheet'.
In this case the legal position is that the asset has been sold but the
substance is that the seller still retains the benefits of ownership. Which one
of the following is not a feature which suggests that the substance of a
transaction differs from its legal form?
A The seller of an asset retains the ability to use the asset.
B The seller has no further exposure to the risks of ownership
C The asset has been transferred at a price substantially above or below its
fair value.
D The 'sold' asset remains on the sellers premises.
2 Tourmalet sold an item of plant for $50 million on 1 April 20X4. The plant
had a carrying amount of $40 million at the date of sale, which was charged to
cost of sales. On the same date, Tourmalet entered into an agreement to
lease back the plant for the next five years (being the estimated remaining life
of the plant) at a cost of $14 million per annum payable annually in arrears. An
arrangement of this type is normally deemed to have a financing cost of 10%
per annum. What amount will be shown as income from this transaction in the
statement of profit or loss for the year ended 30 September 20X4?
A $10 million
B $2 million
C $1 million
D Nil
3 Dexon's statement of profit or loss for the year ended 31 March 20X8
includes $8 million of revenue for credit sales made on a 'sale or return' basis.
At 31 March 20X8 customers who had not yet paid had the right to return
goods to the value of $2.6 million. Dexon applied a mark-up on cost of 30%
on all of these sales. Dexon's customers have in the past returned goods
under this type of agreement.
By what amount should Dexon's profit for the year ended 31 March 20X8 be
reduced in respect of this?
A $2,600,000
B $780,000
C $600,000
D $2,400,000
4 Consignment inventory is an arrangement whereby inventory is held by one
party but owned by another party. It is common in the motor trade.
Which of the following indicate that the inventory in question is consignment
inventory?
(i) Manufacturer can require dealer to return the inventory
(ii) Dealer has no right of return of the inventory
(iii) Manufacturer bears obsolescence risk
(iv) Dealer bears slow movement risk
A (i) and (ii)
B (i) and (iii)
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C (ii) and (iv)

D (ii), (iii) and (iv)
5 Newmarket's revenue as shown in its draft statement of profit or loss for the
year ended 31 December 20X9 is $27 million. This includes:
(i) $8 million for a consignment of goods sold on 31 December 20X9 on which
Newmarket will incur ongoing service and support costs for two years after the
sale. The cost of providing service and support is estimated at $800,000 per
annum. Newmarket applies a 30% mark-up to all service costs.
(ii) $4 million collected on behalf of Aintree. Newmarket acts as an agent for
Aintree and receives a 10% commission on all sales.
At what amount should revenue be shown in the statement of profit or loss of
Newmarket for the year ended 31 December 20X9? (Ignore the time value of
money.)
A $22,920,000
B $21,800,000
C $20,520,000
D $21,320,000
6 Derringdo
Derringdo acquired an item of plant at a gross cost of $800,000 on 1 October
20X2. The plant has an estimated life of ten years with a residual value equal
to 15% of its gross cost. Derringdo uses straight-line depreciation on a time
apportioned basis. The company received a government grant of 30% of its
cost price at the time of its purchase.
The terms of the grant are that if the company retains the asset for four years
or more, then no repayment liability will be incurred. If the plant is sold within
four years a repayment on a sliding scale would be applicable. The repayment
is 75% if sold within the first year of purchase and this amount decreases by
25% per annum. Derringdo has no intention to sell the plant within the first
four years. Derringdo's accounting policy for capital-based government grants
is to treat them as deferred credits and release them to income over the life of
the asset to which they relate.
Required
(a) Discuss whether the company's policy for the treatment of government
grants meets the definition of a liability in the IASB's Conceptual Framework.
(b) Prepare extracts of Derringdo's financial statements for the year to 31
March 20X3 in respect of the plant and the related grant:
Applying the company's policy
In compliance with the definition of a liability in the Conceptual Framework.
Your answer should consider whether the sliding scale repayment should be
used in determining the deferred credit for the grant.
7 Wardle
(a) An important aspect of the International Accounting Standards Board's
Conceptual Framework for Financial Reporting is that transactions should be
faithfully represented. Implicit in this is the requirement that they 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.
(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 20X0 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 20X3. On 1 April
20X0 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 20X3 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
statement of profit or loss of Wardle for the three years to 31 March 20X3 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 is not required.
(c) Comment on the effect the two treatments have on the statements of profit
or loss and the statements of financial position and how this may affect an
assessment of Wardle's performance.

ANSWERS
1 B This feature suggests that the transaction is a genuine sale.
If the seller retains the right to use the asset or it remains on his premises,
then the risks and
rewards have not been transferred. If the sale price does not equal market
value, then the transaction is likely to be a secured loan.
2 C This is in substance a secured loan, so the asset will be recognised at its
new carrying amount of $50m and a lease liability will be set up for the same
amount.
The $10m increase in carrying amount will be treated as other income
deferred over the life of the asset. The amount which can be recognised for
the year to 30 September 20X4 is:
($10m / 5) 6/12 = $1m
3 C $2.6m 30 / 130
4 B These both indicate that the manufacturer retains ownership of the
inventory. (i) and (iii) would indicate that the risks and rewards have been
transferred to the dealer.
5D
Revenue per draft profit or loss
Servicing costs (800 2 130%)
Agency collections
Agency commission (4,000 10%)

$000
27,000
(2,080)
(4,000)
400
21,320

6 Derringdo
(a) Liability
There are two issues here:
(i) Should a capital grant be treated as deferred income in the financial
statements?
(ii) Should a liability be recognised for the potential repayment of the grant?
Derringdo has credited the $240,000 grant to a deferred income account
which is shown as a liability in the statement of financial position. It is then
released to profit or loss over the ten year life of the related asset.
However, the Conceptual Framework states that a liability should only be
recognised if there is a probable outflow of economic benefits. This is not true
for a grant; under normal circumstances the grant will not have to be repaid
and so a liability does not exist.
This example is complicated by the possibility of having to repay the grant if
the asset is sold. At the end of the reporting period the asset has not been
sold, and so there is no past event to give rise to a liability. Derringdo intends
to keep the asset for its ten year useful life. Nor can it be classified as a
contingent liability. Under IAS 37 the 'uncertain future event' that creates a
contingent liability must be 'not wholly within the control of the entity'. In this
case Derringdo will make the decision to keep or sell the asset.
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Following on from the above, the Conceptual Framework would not permit the
grant to be shown as a liability. Instead the grant would be claimed as income
in the year that it was received (provided that there was no intention to sell the
asset within the four year claw-back period). However, the treatment of the
grant as deferred income is in accordance with IAS 20 Accounting for
government grants.
(b) Extracts (Company policy complies with one of the two alternatives in IAS
20)
STATEMENT OF PROFIT OR LOSS
$
Operating expenses
Depreciation charge (W1)
34,000
Release of grant (W2)
(12,000)
22,000
STATEMENT OF FINANCIAL POSITION
$
Non-current assets
Property, plant and equipment (W1)
766,000
Non-current liabilities
Deferred income (W2)
204,000
Current liabilities
Deferred income (W2)
24,000
228,000
Workings
1 Property, plant, equipment $
Cost (gross, excluding grant)
Depreciation (10 years straight line, 15% residual value for 6 months
800,000 x 85% x 10% x 6/12)
Carrying value
2 Deferred income $
Grant received ($800,000 X 30%)
Release for this year ($240,000 x 10% x 6/12)
Total balance at year-end
Presentation
Current liability ($240,000 x 10%)
Non-current liability (balance)

800,000
(34,000)
766,000
240,000
(12,000)
228,000
24,000
204,000
228,000

Theoretical approach under the Conceptual Framework

Because the 'deferred' element of the grant cannot be recognised as a
liability, the grant will be claimed in full in the year that it is received. The
repayment clause will not affect this policy because, at the end of the
reporting period, Derringdo has not sold the asset and so no liability exists.
STATEMENT OF PROFIT OR LOSS
$
Operating expenses
Depreciation charge (as before)
Grant received and claimed

34,000
(240,000)
(206,000)

STATEMENT OF FINANCIAL POSITION

$
Non-current assets
Property, plant and equipment

766,000

8 Wardle
(a) It is important that financial statements should reflect the economic
substance of a transaction, where this differs from legal form, because this
provides users with a faithful representation of the transaction.
For instance, if an asset held under a finance lease were treated according to
its legal form it would not appear under non-current assets and the related
lease liability would not be shown. This would make the entitys gearing look
lower than it actually was and probably inflate its ROCE. This treatment is not
allowed under IFRS.
Sale and leaseback or sale and repurchase arrangements can be used to
disguise the substance of loan transactions by taking them off balance sheet.
In this case the legal position is that the asset has been sold, but the
substance of the transaction is that the seller still retains the benefits of
ownership.
Features which suggest that the substance of a transaction may differ from its
legal form are:
The seller of an asset retains the ability to use the asset
The seller remains exposed to the risks of ownership eg maintenance
An asset which has been sold is one that can reasonably only be used by
the seller
A sold asset remains on the sellers premises
An asset has been transferred at a price substantially above or below its fair
value
An asset has been sold under terms which make it very unlikely that it will
not be repurchased
A number of linked transactions have taken place All of these features
suggest that control has been separated from legal ownership and that the
substance of the transaction may not have been correctly represented.
(b) (i) Legal form
Revenue
Cost of sales
Gross profit
Finance costs
Net profit
(ii) Substance
Revenue
Cost of sales
Gross profit
Finance costs
Net profit

31 March: 20X1
$000
6,000
(5,000)
1,000

1,000
31 March: 20X1
$000

(600)
(600)

20X2
$000

20X2
$000

(660)
(660)

20X3
$000
10,000
(7,986)
2,014

2,014
20X3
$000
10,000
(5,000)
5,000
(726)
4,274

Total
$000
16,000
(12,986)
3,014

3,014
Total
$000
10,000
(5,000)
5,000
(1,986)
3,014

(c) While net profit at the end of the three-year period is the same under both
treatments, we can see that under the legal form revenue is much greater,
because of the assumption that Wardle has sold the asset twice.
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This leads to profit being split between two of the three years rather than
shown wholly in year 3, so there is some smoothing effect. Reporting under
the legal form of the transaction removes the finance cost, which will have a
favourable effect on interest cover, and will also have removed the loan from
the statement of financial position, thus making gearing appear lower.
Similarly, under the legal form, the asset will not appear in the statement of
financial position, which will make ROCE appear higher than it would
otherwise have been.