Difference between the legal form of the transactions and their substance

05 March 2007 |

I came across a case study question on how to treat transaction and event in Financial statements as per UK FRS.

Question:

"On 1 October 2005 Angelino Ltd owned a freehold building that had a carrying amount of £7·5 million and had an estimated remaining life of 20 years. On this date it sold the building to Finaid for a price of £12 million and entered into an agreement with Finaid to rent back the building for an annual rental of £1·3 million for a period of five years. The auditors of Angelino have commented that in their opinion the building had a market value of only £10 million at the date of its sale and to rent an equivalent building under similar terms to the agreement between Angelino and Finaid would only cost £800,000 per annum. Assume any finance costs are 10% per annum.

Describe how the above transactions and events should be treated in the financial statements of Angelino Ltd for the year ended 30 September 2006. Your answer should explain, where relevant, the difference between the legal form of the transactions and their substance."

Answer: (as per UK FRS)

This is an example of a sale and leaseback of a property. Such transactions are part of normal commercial activity, often being used as a way to improve cash flow and liquidity. However, if an asset is sold at an amount that is different to its fair value there is likely to be an underlying reason for this. In this case it appears (based on the opinion of the auditor) that Finaid has paid Angelino £2 million more than the building is worth. No (unconnected) company would do this knowingly without there being some form of ‘compensating’ transaction. This sale is ‘linked’ to the five year rental agreement. The question indicates the rent too is not at a fair value, being £500,000 per annum (£1,300,000 – £800,000) above what a commercial rent for a similar building would be.

It now becomes clear that the excess purchase consideration of £2 million is an ‘in substance’ loan (rather than sales proceeds – the legal form) which is being repaid through the excess (£500,000 per annum) of the rentals. Although this is a sale and leaseback transaction, as the building is freehold and has an estimated remaining life (20 years) that is much longer than the 5 year leaseback period, the lease is not a finance lease and the building should be treated as sold and thus derecognised.

The correct treatment for this item is that the sale of the building should be recorded at its fair value of £10 million, thus the profit on disposal would be £2·5 million (£10 million – £7·5 million). The ‘excess’ of £2 million (£12 million – £10 million) should be treated as a loan (long-term liability). The rental payment of £1·3 million should be split into three elements; £800,000 building rental cost, £200,000 finance cost (10% of £2 million) and the remaining £300,000 is a capital repayment of the loan.


Any ideas... how the above scenario will be treated in Financial Statements/Accounting as per Indian Accounting Standards ?

Regards,

Santosh Puthran
AICWA

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