CIMA-F2-Financial-Management1

Pension benefits

3 Accounting for pension plans (IAS 19)
Defined contribution plans

The expense of providing pensions in the period is normally the same as the
amount of contributions paid.

• The entity should charge the agreed pension contribution to profit or

loss as an employment expense in each period.

• An asset (prepayment) or liability (accrual) for pensions only arises if

the cash paid does not equal the amount of contributions due.

• IAS 19 requires disclosure of the amount recognised as an expense in

the period.

Example 1

Example 1 answer

Test your understanding 1

J operates a defined contribution scheme on which it pays 6% of
employees gross salaries per annum. At the end of last year, J had
accrued $10,000 for pension contributions due. Gross salaries for the
current year amounted to $650,000 and J had paid contributions totalling
$35,000 into the pension fund during the year.

Required:

What amounts will be recorded in the financial statements for the current
year?

Defined benefit plans: the basic principle

The entity recognises the net figure of the scheme assets less the liability for
future pension payments.

• If the liability exceeds the assets, there is a deficit (the usual situation)

and a liability is reported in the statement of financial position.

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chapter 15

• If the scheme assets exceed the liability, there is a surplus and an asset

is reported in the statement of financial position.

• In simple terms, the pension expense for the period is the difference

between the deficit/surplus at the beginning of the period and the
deficit/surplus at the end of the period.

Measuring the liability and the assets

In practice, the actuary measures the plan assets and liabilities using a
number of estimates and assumptions.

• The plan liability is measured at the present value of the defined benefit

obligation. Discounting is necessary because the liability will be settled
many years in the future and therefore the effect of the time value of
money is material.

• Plan assets are measured at fair value at the reporting date. This is

normally market value.

Recognising the amounts in the financial statements

Explanation of the terms used.

• Current service cost is the increase in the actuarial liability (present

value of the defined benefit obligation) resulting from employee service
in the current period.

• Past service cost is the increase in the actuarial liability relating to

employee service in the previous period but only arising in the current
period. Past service costs usually arise because there has been an
improvement in the benefits being provided under the plan.

• Interest cost is the increase in the pension liability arising from the

unwinding of the discount as the liability is one period nearer to being
settled.

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Pension benefits

• Expected return on assets is the expected return earned from the

pension scheme assets.

• In IAS 19, Curtailments and settlements are the gains and losses

arising when major reductions are made to the number of employees in
the plan or the benefits promised to them.

• Actuarial gains and losses are increases and decreases in the

pension asset or liability that occur either because the actuarial
assumptions have changed or because of differences between the
previous actuarial assumptions and what has actually happened
(experience adjustments). For example, the investment income from the
assets may have been greater than expected.

Effect on profit or loss for the period

The changes in the defined benefit asset/ liability in the period are treated
as follows:

Current service cost Dr Income statement
Cr Pension liability

Interest cost Dr Income statement (finance cost)
Cr Pension liability

Expected return on assets Dr Pension asset
Cr Income statement (investment
income)

Past service costs (if any) Dr Income statement
Cr Pension liability

Curtailments and settlements (if Dr or Cr Income statement
any) Cr or Dr Pension liability

Actuarial gains and losses may also be reported in profit or loss (this is
covered in detail later in the chapter).

Other entries affecting the pension assets and liabilities

There are additional changes in the defined benefit asset/ liability in the
period affecting only the statement of financial position:

Contributions (from the employer) Dr Pension asset
Cr Bank

Benefits paid Dr Pension liability
Cr Pension asset

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Example 2

Example 2 answer

Test your understanding 2 - Alpha

Alpha operates a defined benefit pension scheme.

As at 1 January 20X6, Alpha's statement of financial position showed
pension assets measured at a fair value of $1,400,000 and pension
liabilities measured at a present value of $1,350,000.

The current service cost for the year was estimated at $130,000. The
discount rate used was 8% and the expected rate of return on assets for
the year is 10%.

Alpha paid contributions totalling $120,000 into the scheme during the
year and benefits were paid to scheme members totalling $110,000.

As at 31 December 20X6, the pension fund assets have been valued at
$1,765,000 and the pension fund liabilities at $1,630,000.

Required:

Calculate the actuarial gains/losses arising in the year ended 31
December 20X6.

4 Recognition of actuarial gains/ losses

IAS 19 permits several methods of dealing with actuarial gains or losses:

• They may be recognised immediately in profit or loss.
• They may be recognised immediately as other comprehensive income

and recorded in equity.

• If they fall within certain size limits, they may be carried forward on the

statement of financial position to be spread over future periods - the
10% corridor approach. An unrecognised actuarial gain is added to the
plan liability (to increase the liability) and an unrecognised actuarial loss
is deducted from the plan liability (to reduce the liability).

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Pension benefits

The ‘10% corridor’

Where actuarial gains and losses are carried forward in the statement of
financial position (not recognised in one of the performance statements),
IAS 19 states that if the net cumulative unrecognised actuarial gains and
losses at the end of the previous period exceed the greater of:

• 10% of the present value of the opening plan obligation; or
• 10% of the fair value of opening plan assets

the excess must be recognised in profit or loss.

• The whole of the gain or loss need not be recognised immediately, it

may be spread over the expected average remaining working lives of
the employees.

• Other methods of spreading the gains and losses may be used

provided that:
– the alternative method results in a faster recognition of actuarial

gains and losses
– the same basis is applied to both gains and losses
– the basis is applied consistently from period to period.

Example 3

Example 3 answer

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chapter 15

Test your understanding 3 - Alpha continued

As at 1 January 20X6, actuarial gains totalling $200,000 had arisen in
previous accounting periods.

Required:

Using the above information from TYU 2, prepare extracts from the
income statement, statement of comprehensive income and statement
of financial position for the year ended 31 December 20X6, using each
of the following options for the recognition of actuarial gains/losses:

(a) Recognise immediately in the income statement.
(b) Take directly to reserves.
(c) Using the 10% corridor approach. You may assume the average

remaining working life of scheme members is 15 years and that all
previous actuarial gains are unrecognised at the beginning of 20X6.

Test your understanding 4

The following data relates to a defined benefit scheme for the year
ended 20X4.

Expected return on plan assets $000
Discount rate 12% per annum
Pension liabilities at start of year 10% per annum
Pension asset at start of year
Current service costs 1,030
Past service costs 1,010
Curtailment costs
Benefits paid out 140
Contributions paid in 35
Pension liability at year end 15
Pension asset at year end
105
110
1,240
1,280

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Pension benefits

Cumulative unrecognised actuarial gains at the start of the period
amount to $133,000. The estimated average remaining working life of
scheme members is ten years.

Required:

Extracts from the financial statements, assuming actuarial gains or
losses are to be recognised in accordance with the 10% corridor
approach.

Test your understanding 5

The following data relates to a defined benefit scheme for the next year

ended 20X5:

$000

Expected return on assets 10% per annum

Discount rate 6.6% per annum

Pension liabilities at start of year 1,240

Pension asset at start of year 1,280

Current service costs 150

Benefits paid out 100

Contributions paid in 130

Pension liability at year end 1,610

Pension asset at year end 1,500

Cumulative unrecognised actuarial gains at the start of the period
amount to $252,000. The estimated average remaining working life of
scheme members is still ten years.

Required:

Extracts from the financial statements, assuming actuarial gains or
losses are to be recognised in accordance with the 10% corridor
approach.

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5 Chapter summary

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Pension benefits

Test your understanding answers

Test your understanding 1
Statement of financial position
Current liabilities
Accrued pension contributions (10,000 + 39,000 – 35,000) $14,000

Income statement $39,000
Pension contributions (6% × 650,000)

Test your understanding 2 - Alpha

Brought forward Assets Liabilities Net
Return on assets (10% × 1,400) $000 $000 $000
Current service cost 1,400 1,350
Interest cost (8% × 1,350) 140 50
Contributions 130 140
Benefits 120 108 (130)
(110) (108)
Actuarial gain/loss – balance ––––– (110) 120
1,550 –––––
Carried forward Gain 215 1,478 –
––––– Loss 152 –––––
1,765 –––––
––––– 1,630 72
––––– Gain 63

–––––
135

–––––

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chapter 15

Test your understanding 3 - Alpha continued
Income statement (extracts) for the year ended 31 December 20X6

Current service cost (a) (b) (c)
Interest cost $000 $000 $000
Return on assets (130) (130) (130)
Recognised actuarial gains (108) (108) (108)
140 140 140
Total cost
63 – 4
–––– –––– ––––
(35) (98) (94)

Statement of comprehensive income for the year ended 31
December 20X6

Profit for the year (a) (b) (c)
Other comprehensive income $000 $000 $000
Actuarial gains on defined benefit pension (35) (98) (94)

Total comprehensive income for the year 63
–––– –––– ––––
(35) (35) (94)

Statement of financial position (extracts) as at 31 December 20X6

Pension fund assets (a) (b) (c)
Pension fund liabilities $000 $000 $000
1,765 1,765 1,765
Net pension asset (1,630) (1,630) (1,630)
Unrecognised gains (W1) ––––– ––––– –––––

Net pension liability 135 135 135
– – (259)
–––––
(124)
–––––

Equity – – 259
Pension reserve

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Pension benefits

Workings
10% corridor = higher of:

10% of opening fund assets 10% × 1,400 = 140
10% of opening fund liabilities 10% × 1,350 = 135

10% corridor 140
Opening gains 200
–––
Excess
Recognise in IS over 15 years (60/15 yrs) 60
4
Unrecognised gains carried forward in statement of
financial position 200
(4)
Opening actuarial gains 63
Transferred to income statement
Gains in year –––
259
Closing actuarial gains

Test your understanding 4
Statement of financial position (extracts) as at 31 December 20X4

Fair value of plan assets $000
Present value of obligation 1,280
(1,240)
Net pension asset
Unrecognised actuarial gains (133 – 3 (W2) + 122 (W1)) –––––––

Net pension liability 40
(252)

–––––––

(212)

–––––––

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chapter 15

Income statement (extracts) for the year ended 31 December 20X4

Service costs (140 + 35 + 15) $000
Interest cost (190)
Expected return on plan assets (103)
Recognised actuarial gain for year (W2) 121

Expense recognised in income statement 3

––––––

(169)

––––––

Workings Assets Liabilities Net

(W1) Actuarial gain/loss for year $000 $000 $000

Opening net assets 1,010 1,030 (20)
Expected return at 12%
Benefits paid out 121 121
Contributions paid in
Finance costs at 10% (105) (105) −
Current service cost
Past service cost 110 110
Curtailment cost
103 (103)
Actuarial gain/ loss (balance)
140 (140)
Closing net assets
35 (35)

–––––– 15 (15)

–––––– ––––––

1,136 1,218 (82)

Gain 144 Loss 22 Gain 122

–––––– –––––– ––––––

1,280 1,240 40

––––––

(W2) 10% Corridor calculation

10% of opening plan liabilities 103
10% of opening plan assets 101
Corridor (higher of the above)
103

Net cumulative unrecognised actuarial gains 133
Corridor 103

Excess –––––

Spread over ten-year remaining life 30

–––––

3

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Pension benefits

Test your understanding 5
Statement of financial position (extracts) as at 31 December 20X5

Fair value of plan assets $000
Present value of obligations 1,500
(1,610)
Net pension liability –––––
Unrecognised actuarial gains (252 – 12 (W2) – 176 (W1)) (110)

Net pension liability (64)
–––––
(174)
–––––

Income statement (extracts) for the year ended 31 December 20X5

Service costs $000
Interest cost (150)
Expected return on plan assets
Recognised actuarial loss for year (W2) (82)
128
Expense recognised in income statement
12
Workings ––––
(92)
––––

(W1) Actuarial gain/loss for year Assets Liabilities Net
$000
Opening net assets $000 $000
Expected return at 10%
Benefits paid out 1,280 1,240 40
Contributions paid in
Finance costs at 6.6% 128 (100) 128
Current service cost (100) −
130
Actuarial gain/ loss (balance) 130

Closing net assets ––––– 82 (82)
150 (150)

––––– –––––

1,438 1,372 66

Gain 62 Loss 238 Loss (176)

––––– ––––– –––––

1,500 1,610 (110)
–––––

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(W2) 10% corridor calculation chapter 15

10% of opening plan liabilities 124
10% of opening plan assets 128
Corridor (higher of the above)
128
Net cumulative unrecognised actuarial gains
Corridor 252
128
Excess ––––
124
Spread over ten-year remaining life ––––

12

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Pension benefits

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chapter

16

Substance over form

Chapter learning objectives

On completion of their studies students should be able to:

• Discuss the principle of substance over form applied to a range

of transactions.

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Substance over form

1 Session content

2 Reporting the substance of transactions
Introduction
IAS 1 requires that financial statements:

• must represent faithfully the transactions that have been carried out
• must reflect the economic substance of events and transactions and not

merely their legal form.

Examples of accounts reflecting economic or commercial substance which
we have already met are:

• the production of consolidated accounts (chapter 3)
• the capitalisation of a finance lease (F1).

Determining the substance of a transaction

Common features of transactions whose substance is not readily apparent
are:

• the legal title to an asset may be separated from the principal benefits

and risks associated with the asset

• a transaction may be linked with other transactions which means that

the commercial effect of the individual transaction cannot be understood
without an understanding of all of the transactions

• options may be included in a transaction where the terms of the option

make it highly likely that the option will be exercised.

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chapter 16

Identifying assets and liabilities

Key to determining the substance of a transaction is to identify whether
assets and liabilities arise subsequent to that transaction by considering:

• who enjoys the benefits of any asset
• who is exposed to the principal risks of any asset.

Assets are defined in the IASB Framework as resources controlled by the
entity as a result of past events and from which future economic benefits are
expected to flow to the entity.

Liabilities are defined in the IASB Framework as present obligations of the
entity arising from past events, the settlement of which is expected to result
in an outflow of resources from the entity.

Recognition and derecognition of assets/liabilities

3 IAS 18 Revenue

IAS 18 states that revenue from the sale of goods should be recognised
when the entity has transferred to the buyer the significant risks and rewards
of ownership.

Therefore when the entity transfers the risks and rewards the asset should
be derecognised i.e. removed from the books and revenue from the sale
should be recorded.

4 Examples where substance and form may differ

Examples of areas where substance and form may differ include:

• factoring of receivables
• sale and repurchase agreements
• sale and leaseback agreements
• consignment inventory and goods on sale-or-return

5 Factored receivables

Factoring of receivables is where a company transfers its receivables
balances to another organisation (a factor) for management and collection
and receives an advance on the value of those receivables in return.

The receivables are legally "sold" to the factor.

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Substance over form

The factor advances the company cash, e.g. 90% of receivables.

The factor collects receivables balance from the customer and may advance
further sums to the company.

Factors to consider:

• Has the company transferred the risks and benefits of the receivable to

the factor?

• Will the company have to pay back the cash to the factor if the customer

does not pay?

• If the company only has to pay back a fixed amount, are they still facing

the majority of the risk of the bad debt?

• who bears the risk (of slow payment and irrecoverable debts)?

Example 1

Example 1 answer

Test your understanding 1

An entity has an outstanding receivables balance with a major customer
amounting to $12 million and this was factored to FinanceCo on 1
September 20X7. The terms of the factoring were:

FinanceCo 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.

• FinanceCo will charge 1.0% per month of the net amount owing

from the entity at the beginning of each month. FinanceCo had not
collected any of the factored receivable amount by the year-end.

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chapter 16

• the entity debited the cash from FinanceCo to its bank account and

removed the receivable from its accounts. It has prudently charged
the difference as an administration cost.

Required:

How should this arrangement be accounted for in the financial
statements for the year ended 30 September 20X7?

6 Sale and repurchase transactions

Sale and repurchase agreements are situations where an asset is sold by
one party to another. The terms of the sale provide for the seller to
repurchase the asset in certain circumstances at some point in the future.

Sale and repurchase agreements are common in property developments
and in maturing whisky stocks.

The asset has been ‘legally’ sold, but there is either a commitment or an
option to repurchase the asset at a later date.

Factors to consider:

• Has the company transferred the risks and benefits of the asset?

e.g. Can the company still use the asset? Does the company bear costs
associated with the asset?

• Was the asset "sold" at a price different to market value?

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Substance over form

• Is the company obliged to repurchase the asset?
• If the company has the option to repurchase the asset are they likely to

exercise this option?

Example 2

Example 2 answer

Test your understanding 2

On 1 April 20X4 Triangle sold maturing inventory that had a carrying
value of $3 million (at cost) to Factorall, a finance house, for $5 million.

Its estimated market value at this date was in excess of $5 million and is
expected to be $8.5 million as at 31 March 20X8.

The inventory will not be ready for sale until 31 March 20X8 and will
remain on Triangle's premises until this date.

The sale contract includes a clause allowing Triangle to repurchase the
inventory at any time up to 31 March 20X8 at a price of $5 million plus
interest at 10% per annum compounded from 1 April 20X4.

The inventory will incur storage costs estimated at $200,000 per annum
until maturity. If Triangle chooses not to repurchase the stock, Factorall
will pay the accumulated storage costs on 31 March 20X8.

The proceeds of the sale have been debited to the bank and the sale
has been included in Triangle's turnover.

Required:

Explain how the above should be treated in Triangle's financial
statements for the year to 31 March 20X5.

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7 Sale and leaseback transactions

A sale and repurchase agreement can be in the form of a sale and
leaseback.

• Under a sale and leaseback transaction, an entity sells one of its own

assets and immediately leases the asset back.

• This is a common way of raising finance whilst retaining the use of the

related assets. The buyer / lessor is normally a bank.

• The leaseback is classified as finance or operating in accordance with

the usual IAS 17 criteria.

Terminology:

A sells non-current asset to B

(Seller) (Buyer)

Then

A leases the non-current asset back from B

(Lessee) (Lessor)

Factors to consider:

• What type of lease is the asset being leased back under?

• Under an operating lease, the risks and benefits lie with the lessor i.e.

the buyer. Therefore the entity has transferred the risks and benefits to
the buyer and the asset should be derecognised.

• Under a finance lease, the risks and benefits lie with the lessee i.e. the

seller. Therefore the entity has not transferred the risks and benefits. In
this case IAS 17 says to record the sale but to bring the asset back in
under a finance lease.

• If the asset is leased back under an operating lease but the "sale

proceeds" are greater or less than the market value of the asset, the
excess profit or loss may need to be deferred.

Under an operating lease record the operating lease rentals through the
income statement on a straight line basis.

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Substance over form

Example 3

Example 3 answer

Test your understanding 3

S enters into a sale and leaseback arrangement which results in an
operating leaseback for 5 years from 1 January 20X7. Details at 1
January 20X7 are as follows:

Carrying amount of non-current asset $m
Sale proceeds 6.0
Fair value of non-current asset 8.0
7.2

The lease rentals are $4m per year.
Required:

What will be the effect on S's income statement for the year ended 31
December 20X7?

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chapter 16

8 Consignment inventory
Consignment inventory is inventory which:

• is legally owned by one party

• is held by another party, on terms which give the holder the right to sell

the inventory in the normal course of business or, at the holder’s option,
to return it to the legal owner.

This type of arrangement is common in the motor trade.

The manufacturer delivers inventory to the dealer which the dealer can then
sell on to a customer.

Manufacturer → Dealer

Inventory is legally owned by the manufacturer until:

• Dealer sells inventory onto a third party; or
• Dealer’s right to return expires and the inventory is still held

However, the inventory is actually held by the dealer.
Accounting issue

When does the manufacturer record a
sale?

Factors to consider:

• Can the dealer return the goods to the manufacturer at any point in time

without penalty?

• Is the price that the dealer pays to the manufacturer based on prices at

the date of delivery?

• Does the dealer have to pay the manufacturer a display charge that

increases over time?

• Can the manufacturer request the dealer to return the goods?
• Can the dealer use the goods e.g. for demonstration purposes?
• Who bears costs associated with the goods e.g. insurance?

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Substance over form

Consignment inventory - further detail

Example 4

Example 4 answer

Test your understanding 4
On 1 January 20X6 Gillingham, a manufacturer, entered into an
agreement to provide Canterbury, a retailer, with machines for resale.
The terms of the agreement are:

• Canterbury pays a fixed rental per month for each machine that it

holds.

• Canterbury pays the cost of insuring and maintaining the machines.
• Canterbury can also display the machines in its showrooms and use

them as demonstration models.

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chapter 16

• 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
delivery.

• 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 20X6 the agreement is still in force and Canterbury
holds several machines which were delivered less than six months
earlier.

Required:

How should these machines be treated in the accounts of Canterbury for
the year ended 31 December 20X6?

9 Linking substance and analysis of financial statements

It is likely in the examination that you will be required to explain the correct
accounting treatment of a transaction and then to deal with the
consequences of any required adjustments.

In order to be able to do this, you must have a sound understanding of the
transactions covered in this and previous chapters:

• Factored receivables
• Sale and repurchase agreements
• Sale and leaseback agreements
• Consignment inventory
• Preference shares
• Convertible debt etc

You also need to be able to prepare the relevant double entries to record the
transactions.

A question may require adjustments to draft financial statements and/ or
recalculation of ratios after the adjustments.

The following TYU is a good example of this type of question and further
examples can be found in the Exam Kit.

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Substance over form

Test your understanding 5 - Expand again

You are the management accountant of Expand – a large group that
seeks to grow by acquisition. The directors of Expand have identified
two potential target entities (A and B) and obtained copies of their
financial statements. Extracts from these financial statements, together
with notes providing additional information, are given below:

Statements of comprehensive income for the year ended 31
December 20X1

Revenue A B
Cost of sales $000 $000
68,000 66,000
Gross profit (42,000) (45,950)
Other operating expenses –––––– ––––––
26,000 20,050
Profit from operations (18,000) (14,000)
Finance cost –––––– ––––––
8,000 6,050
Profit before tax (3,000) (4,000)
Income tax expense –––––– ––––––
5,000 2,050
Net profit for the period (1,500) (1,000)
Other comprehensive income ––––– –––––
Surplus on revaluation of properties 3,500 1,050

Total comprehensive income – 6,000
––––– –––––
3,500 7,050
––––– –––––

Statements of changes in equity for the year ended 31 December
20X1

Balance at 1 January 20X1 A B
Comprehensive income $000 $000
Dividends paid 22,000 16,000
3,500 7,050
Balance at 31 December 20X1 (2,000) (1,000)
–––––– ––––––
23,500 22,050
–––––– ––––––

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chapter 16

Statements of financial position at 31 December 20X1

AB
$000 $000 $000 $000

Non-current assets 32,000 35,050
Property, plant and equipment
–––––– ––––––
Current assets
Inventories 32,000 35,050
Trade receivables
6,000 7,000
Equity
Share capital ($1 shares) 12,000 10,000
Revaluation reserve
Retained earnings –––––– ––––––

Non-current liabilities 18,000 17,000
Long-term borrowings
Current liabilities –––––– ––––––
Trade payables
Income tax 50,000 52,050
Short-term borrowings
–––––– ––––––

16,000 12,000
Nil 5,000
5,050
7,500
–––––– ––––––
23,500 22,050

16,000 18,000

5,000 5,000
1,500 1,000
4,000 6,000
–––––– ––––––

10,500 12,000
–––––– ––––––
50,000 52,050
–––––– ––––––

Notes to the financial statements

(1) Sale by A to X

On 31 December 20X1, A supplied goods, at the normal selling
price of $2.4 million, to another company, X. A's normal selling price
is at a mark up of 60% on cost. X paid for the goods in cash on the
same day. The terms of the selling agreement were that A
repurchase these goods on 30 June 20X2 for $2.5 million. A has
accounted for the transaction as a sale.

KAPLAN PUBLISHING 515

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Substance over form

(2) Revaluation of non-current assets by B

B revalued its non-current assets for the first time on 1 January
20X1. The non-current assets of A are very similar in age and type
to the non-current assets of B. However, A has a policy of
maintaining all its non-current assets at depreciated historical cost.
Both companies charge depreciation of non-current assets to cost
of sales. B has transferred the excess depreciation for the year of
$1 million on the revalued assets from the revaluation reserve to
retained earnings.

Expand uses ratio analysis to appraise potential investment
opportunities. It is normal practice to base the appraisal on four key
ratios:

• return on capital employed
• gross profit margin
• asset utilisation
• gearing (debt / debt + equity)

For the purposes of the ratio analysis, Expand compute

• capital employed as capital and reserves plus borrowings;
• borrowings as long-term borrowings plus short-term borrowings.

Your assistant has computed the four key ratios for the two enterprises
from the financial statements provided and the results are summarised
below:

Ratio A B
Return on capital employed 18.4% 13.1%
Gross profit margin 38.2% 30.4%
Asset utilisation
Gearing 1.6 1.4
46.0% 52.1%

Your assistant has informed you that, on the basis of the ratios
calculated, the performance of A is superior to that of B in all respects.
Therefore, Expand should carry out a more detailed review of A with a
view to making a bid to acquire it. However, you are unsure whether this
is necessarily the correct conclusion given the information provided in
Notes 1 and 2.

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chapter 16

Required:

(a) Explain and compute the adjustments that would be appropriate in
respect of Notes 1 and 2 so as to make the financial statements of
A and B comparable for analysis.

(12 marks)

(b) Recalculate the four key ratios mentioned in the question for both A
and B AFTER making the adjustments you have recommended in
your answer to part (a). You should provide appropriate workings to
support your calculations.

(6 marks)

(c) In the light of the work that you have carried out in answer to parts (a)
and (b), evaluate your assistant's conclusion that a more detailed
review of A should be carried out, with a view to making a bid to
acquire it.

(7 marks)

(Total: 25 marks)

KAPLAN PUBLISHING 517

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Substance over form
10 Chapter summary

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chapter 16

Test your understanding answers

Test your understanding 1

As the entity still bears the risk of slow payment and irrecoverable debts,
the substance of the factoring is that of a loan on which finance charges
will be made. The receivable should not have been derecognised nor
should all of the difference between the gross receivable and the amount
received from the factor have been treated as an administration cost.
The required adjustments can be summarised as follows:

Receivables Dr Cr
Loan from factor (80% x 12,000) $000 $000
Administration (12,000 – 9,600) 12,000
Finance costs: accrued interest (9,600 x 1%)
Accruals 9,600
2,400
96

96
–––––– ––––––
12,096 12,096
–––––– ––––––

Test your understanding 2

• There is a clause allowing Triangle to repurchase the inventory,

indicating a sale and repurchase agreement.

Triangle can repurchase the inventory at $8,120,500 at 31 March
20X8 i.e.$5 million × 1.14 = $7,302,500 plus $800,000 storage
costs. Since the market value is expected to be $8.5 million at this
time it is likely that Triangle will repurchase the stock.

• Triangle have received proceeds of $5 million when the current

market value is in excess of this amount. This would indicate that a
sale has not taken place in reality.

• Furthermore, since the goods remain on Triangle's premises during

the 4 years it does not appear that any reward has been transferred
to Factorall.

The above factors indicate therefore that Triangle has not sold the
inventory but has simply taken out a loan of $5 million with interest at
10% per annum that is secured on the inventory.

KAPLAN PUBLISHING 519

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Substance over form

Therefore Triangle should not have recorded a sale, but instead should
have recorded a loan of $5 million with a finance cost of 10% per annum.
The goods should remain in inventory at their cost of $3 million.

To correct the entries Triangle recorded in error:

Dr Revenue (to reverse the sale) $m
Cr Liability 5
5

Reinstate the closing inventory:

Dr Closing inventory (SFP) $m
Cr Closing inventory (IS) 3
3

Record the interest for the year at 10% x $5m = $0.5m:

Dr Finance cost $m
Cr Liability 0.5
0.5

Test your understanding 3

As the sale proceeds exceed the fair value of the non-current asset, the
excess profit must be deferred over the lease term.

Profit now: 7.2 – 6.0 = $1.2m

Profit to be deferred over 5 years:

8.0 – 7.2 = $0.8m

$0.8m /5 years = $0.16m p.a.

Income statement for year ended 31 December 20X7

Operating lease rentals $m
(4.00)
Profit up to fair value recognised
immediately 1.20
Release of deferred profit
0.16
––––
2.64

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chapter 16

Test your understanding 4

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 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 inventory still held six months after
delivery. Therefore the company is exposed to slow payment and
obsolescence risks. Because Canterbury can return the inventory 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 their statement of financial position.

KAPLAN PUBLISHING 521

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Substance over form

Test your understanding 5 - Expand again

(a) Adjustments
Note 1 The substance of this transaction is not a sale but a loan.
Therefore the following adjustments are necessary to reverse
the effect of the sale:

Dr Revenue $2,400,000
Cr Loan $2,400,000
Cr Cost of sales $1,500,000
Dr Inventories (2,400,000 x 100/160) $1,500,000

Note 2 Expand needs to be able to make meaningful comparisons
between the accounts of A and B. As far as possible, both
sets of accounts should be based on the same accounting
policies. The only practical way of achieving this is to restate
the accounts of B so that both sets of properties are stated at
historic cost:

Dr Revaluation reserve $5,000,000
Cr Tangible non-current assets $5,000,000
Dr Retained earnings (excess depreciation) $1,000,000
Cr Cost of sales $1,000,000

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chapter 16

These adjustments affect the accounts as follows:

Before Adjustment After
$000
$000 $000

Company A 68,000 (2,400) 65,600
Revenue (42,000) 1,500 (40,500)
Cost of sales
–––––––– ––––––––
Gross profit
26,000 (900) 25,100
Profit from operations
–––––––– ––––––––
Borrowings (4,000 + 16,000)
Capital and reserves 8,000 (900) 7,100

Capital employed –––––––– ––––––––

Company B 20,000 2,400 22,400
Revenue 23,500 (900) 22,600
Cost of sales
–––––––– ––––––––
Gross profit
43,500 45,000
Profit from operations
–––––––– ––––––––
Borrowings (6,000 + 18,000)
Capital and reserves 66,000 66,000
(45,950) 1,000 (44,950)
Capital employed
–––––––– ––––––––

20,050 1,000 21,050

–––––––– ––––––––

6,050 1,000 7,050

–––––––– ––––––––

24,000 24,000
22,050 (5,000) 17,050

–––––––– ––––––––

46,050 41,050

–––––––– ––––––––

KAPLAN PUBLISHING 523

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Substance over form

(b) Ratios

AB

Return on capital employed

Profit from operations 7,100 7,050
––––––––––––––––
Capital Employed –––––– = 15.8% –––––– = 17.2%

45,000 41,050

Gross profit margin

Gross profit 25,100 21,050
––––––––
Revenue –––––– = 38.3% –––––– = 31.9%

65,600 66,000

Turnover of capital employed

Revenue 65,600 66,000
––––––––––––– –––––– = 1.5 –––––– = 1.6
Capital Employed 45,000 41,050

Leverage (gearing) 24,000
–––––– = 58.5%
Total borrowings 22,400 41,050
––––––––––––– –––––– = 49.8%
Capital Employed 45,000

(c) Evaluation

The ratios based on the adjusted accounts show that A is not
necessarily the better acquisition.

The adjustments have had the effect of reducing the profits of A and
slightly improving the profits of B. Although A still clearly has the
better gross profit margin, B now has the better return on capital
employed. There appear to be two reasons for this:
– the turnover of capital employed ratio shows that B is slightly

better at generating sales revenue from its capital base than A;
and

– A has operating expenses of $4 million more than B, although
both companies have similar levels of revenue.

For these reasons B may be the better company to acquire,
particularly if the operating expenses of A cannot be reduced. B has
significantly higher leverage (gearing) than A, but this may not be a
critical factor if Expand can change the capital structure or provide
the company with additional finance.

524 KAPLAN PUBLISHING

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