Skip to main content

Difference between the legal form of the transactions and their substance

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


"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 ?


Santosh Puthran
Post a Comment

Popular posts from this blog

Learning Curve Theory

Learning Curve Theory is concerned with the idea that when a new job, process or activity commences for the first time it is likely that the workforce involved will not achieve maximum efficiency immediately. Repetition of the task is likely to make the people more confident and knowledgeable and will eventually result in a more efficient and rapid operation. Eventually the learning process will stop after continually repeating the job. As a consequence the time to complete a task will initially decline and then stabilise once efficient working is achieved. The cumulative average time per unit is assumed to decrease by a constant percentage every time that output doubles. Cumulative average time refers to the average time per unit for all units produced so far, from and including the first one made.

Major areas within management accounting where learning curve theory is likely to have consequences and suggest potential limitations of this theory.

Areas of consequence:
A Standard Costing

Throughput Accounting

Throughput accounting (TA) is an alternative to cost accounting proposed by Eliyahu M. Goldratt. It is not based on Standard Costing or Activity Based Costing (ABC). Throughput Accounting is not costing and it does not allocate costs to products and services. It can be viewed as business intelligence for profit maximization. Conceptually throughput accounting seeks to increase the velocity at which products move through an organization by eliminiating bottlenecks within the organization.

Cost (or Management) accounting is an organization's internal method used to measure efficiency. Since no one outside the organization uses such internal accounts for investment or other decisions, any methods that an organization finds helpful can be used.

Throughput accounting improves profit performance with better management decisions by using measurements that more closely reflect the effect of decisions on three critical monetary variables (throughput, inventory, and operating expense — defin…

Resistence to Change - Approaches of Kotter and Schlesinger

The Six (6) Change Approaches of Kotter and Schlesinger is a model to prevent, decrease or minimize resistance to change in organizations.
According to Kotter and Schlesinger (1979), there are four reasons that certain people are resisting change: Parochial self-interest (some people are concerned with the implication of the change for themselves ad how it may effect their own interests, rather than considering the effects for the success of the business)Misunderstanding(communication problems; inadequate information)Low tolerance to change (certain people are very keen on security and stability in their work)Different assessments of the situation (some employees may disagree on the reasons for the change and on the advantages and disadvantages of the change process) Kotter and Schlesinger set out the following six (6) change approaches to deal with this resistance to change: Education and Communication - Where there is a lack…