Background:
The principle of substance
over legal form is central to the faithful representation and reliability of
information contained in the financial statements. The responsibility on the
preparers of financial statements is to actively consider the economic reality
of transactions and events to be reflected in the financial statements. And
more importantly, account for them in a manner that does fairly reflect the
substance of the transaction (and situation). This is because, preparers
understand the commercial reality best and also the reason why the legal form
was considered appropriate to a particular set of transactions.
In the same way, it is
important for accountants and auditors whose responsibility it is to review
financial statements that they obtain the commercial reality and substance of
the transactions from the preparers to serve the overall objective of “faithful
representation” which represents one of the two ‘Fundamental Characteristics’
and components of the Conceptual Framework for financial reporting.
What is critical to both
the preparer and the reviewer is that ‘substance over form’ does not mean that
we ignore ‘Form’ …. in that case, the entire edifice on which Ind AS 115 on
Revenue Recognition where the contract with the customer is fundamental to
revenue recognition, would collapse! What is meant is, we focus on the
commercial substance and reality of the transaction(s) in its entirety.
Accordingly, this article
does not seek to judge the legality of transactions from the narrow prism of a
reviewer. Instead, it focuses on working together as preparers and reviewers to
reflect the substance of transactions in the financial statements.
1. Introduction:
1.1 We are all aware that an entity’s financial
statements should report the substance of the transactions that it has entered
into. Normally, transactions are such that the substance and form do not differ
and therefore, do not require any further inquiry. However, some of these would:
a. The
party that gains the principal benefits from the transaction is not the legal
owner of the asset;
b. There
are a set of transactions that we know are all inter-linked in such manner that
the commercial substance can be determined only by putting together all these
transactions, treating them as “interlinked”;
c. An
option is included on terms that make its exercise highly likely;
1.2 Let us
now look at a couple of transactions:
a. A
finance company buys a huge item of plant & machinery that it will not use
and plans to sell it to the previous owner? Is this a sale transaction or a
financing arrangement is what we may need to establish.
b. An auto
manufacturing company appoints dealers through whom it sells cars on the
condition that it will transfer the cars at a fixed price, will bear the cost
of price fluctuations and the risk of obsolescence… in effect, the auto maker
bears all the significant risks and this could be a significant indicator
whether the company needs to derecognise the asset.
2. Substance of transactions and the standard setters…
2.1 There has been a fair amount of understanding
and consensus among various authorities and accounting standard setters that
except for certain circumstances and reasons, “substance should follow
form“, although, it is not necessary that transactions should not
follow form.
2.2 Very
recently, Tax Authorities introduced General Anti Avoidance Regulations (GAAR)
to deal with certain set of transactions entered into by entities, with the
sole objective of reducing or shifting the tax base, etc to the detriment of
the Exchequer. The net effect of the GAAR provisions (to put them
simply) is to disregard the legal form of these transactions and look
only at the substance, that is the “Commercial Reality” and tax the entity
accordingly. Obviously, these relate to a specific set of transactions entered
into with the only significant objective of reducing tax liability.
2.3 Financial
markets have been developing products and solutions around financial
reengineering, segregating risks between parties and selling these products.
Lease financing, Securitisation, Derivative instruments, the creation of SPVs,
are part of innovative products that were developed to help finance companies.
Regulators and accounting bodies have been putting together their collective
wisdom and market knowledge to address these complexities.
Sale and Lease back arrangements were an accepted tax planning devise
until GAAR came in and so were financial leases on the basis of which an entire
industry came into being. Financial instruments became more complex with the
issue of complex derivative products, securitisation etc. The introduction of
convertible securities raised issues regarding the nature and classification of
capital and debt.
3. The response of the IASB
There is no
specific international financial standard that deals with the topic of
substance over form. Unless specifically governed by specific standards, the
terms of transactions will be scrutinised to determine how the transaction
should be recorded.
It was only
around 1985 that the Institute of England and Wales issued the first
authoritative document on Off Balance Sheet Financing with a view to
determining the accounting treatment of transactions and their economic
substance rather than their mere legal form.
The IASB
came up over a period of time with a fairly comprehensive Financial Reporting
Framework that formed the basis and context for standard setters across the
world. Notwithstanding that, substance over matter forms an all-pervading
aspect of financial accounting; its reference was omitted from the Framework
for the Preparation and Presentation of Financial Statements because it was
considered “redundant” to be presented as a separate component of “Faithful
Representation”. Except for FRS 5 which sets out the principles that
will apply to all transactions where we need to inquire into the basic
principles for identifying and recognising the substance of transactions,
none of the accounting bodies devote a separate standard to deal with the
complexities arising out of “substance over form”.
4. Let us look at some of the accounting
standards that specifically address the issue of substance over form in greater detail:
a. Ind AS 115 the new Revenue Recognition
Standard that replaces Ind AS 11: Construction Contracts and Ind AS 18:
Revenue specifically to deal with the complexities and changes that have been
taking place in the structuring of business transactions of various types and
in several sectors such as Information Technology, Infrastructure and Real
Estate, etc. by focusing on Revenue Recognition from the customer’s
point of view.
b. Ind AS 17
Leases where Operating Leases have also come within the ambit of the
Standard.
c. Ind AS 110 that deals
with Consolidated and Separate Financial Statements. The standard deals with
various scenario which emphasises on reflecting the substance in determination
of control such as de-facto control, assessment of participating rights
vs. protective rights, analysing the rights and obligation assumed by the
shareholders irrespective of their legal shareholding in the entity.
d. Ind AS 32 on Financial
Instruments: Presentation specifically deals with the classification of
debt instruments into debt and equity in certain cases, like for example
Convertible Debentures that are broken based on a fair valuation into equity
and debt. This standard also covers a situation where in a financial instrument
would classify as equity instruments but if the other members of the group
assumed any obligation or provided any guarantee to the holder of the
instrument, then such additional terms and conditions would need to be
considered for the determination such instrument as equity or financial
liability.
5. Illustrative “Principles” that could
apply to most transactions:
i. UK GAAP deals with the concept of
“substance over form” through FRS 5 that lays down the general principles that could apply to
transactions. It adopts a strictly Balance Sheet strategy namely, settle the
assets and liabilities and let the profit and loss entry emerge. One simple
governing principle is when determining the nature of transactions, one needs
to decide whether, as a result of the transaction, the reporting entity has
created new assets or liabilities or whether it has changed any of its assets
and liabilities. The Standard emphasises the need to focus on the commercial
logic of the (set of) transactions of the respective parties. And, if this does
not make sense, probably, all aspects of the transaction or all parties to the
transaction(s) have not been identified.
ii.
Complex transactions have certain common features that we need to look out for,
such as:
a. Where the legal title to an item is separated
from the ability to enjoy the principle benefits and exposure to the principle
risks associated with it; the main issue here is the identification of assets
and liabilities and tests to ascertain whether the asset or liability should be
recognised in the balance sheet
b. The tying up of all related transactions to
make sense of the commercial reality or substance;
c. The inclusion in the transaction of option
whose terms make it highly likely that the option will be exercised;
d.
Situations where the relationship between the two entities is that of parent
and subsidiary; the concept of ‘control’ becomes very critical here;
iii. The
identification and recognition of the substance of transaction is to identify
whether it has resulted in complete alienation of the asset or the liability or
whether, it has given rise to new assets or liabilities for the entity or
whether it has increased the existing assets or liabilities of the entity. The
transaction may result in the entity losing control over the future economic
benefits of the asset.
iv.
Transactions may result in the creation of new obligations where the entity is
unable to avoid the outflow of benefits. If that be so, the liability is
recognised!
v.
Complexities arise when there are subsequent transactions that result in
affecting these rights or obligations. Where the transaction does not
significantly alter the entity’s rights to benefits or its exposure to risks,
the entity should continue to maintain “status quo”. When significant
variations occur, it may be necessary to vary the valuation of the asset or the
liability. For example, through a series of transactions, an entity hands over
the economic benefits from a financial asset in part (one specific revenue
stream is parted with), there is no complete alienation, in which case, it may
be necessary to recognise the variation in the books.
In this
context, it may help revisit some of the key definitions to get to the
substance of the transactions and these are: Assets, Liabilities, Common Control, Options, etc.
6. Looking at Illustrative Case Studies to demystify some of the complexity:
A small
list of illustrations to better understand this principle….
A. Ind AS 115: Revenue Recognition
Consignment Sales:
This is a case of Principal vs
Agent. In this case, the Consignor sends goods to the consignee to the
specifications of the ultimate customer and is responsible for any deviations.
The Consignee sells the stock in the normal course and returns the unsold goods
to the Consignor.
Some of
the key or significant risks for consideration that would determine whose asset
or obligation it is would be:
… does
the Principal take primary responsibility for fulfilling the terms of the
contract on acceptability of the product and its specifications (that is,
meeting with customer specifications)
… who bears the Inventory risk:
this comprises of two components that is, whom bears the risk of slow moving
inventory and second, the risk of inventory after it reaches the customer (that
is, where the customer has the right of return)
… is the stock
transferred at a price fixed by the entity.
Comments:
The crucial tests are:
i. Consignment revenues are
not recognised when the goods are delivered to the consignee because control is
not transferred. Revenue is generally recognised on sale to the customer.
ii. Revenue recognition
upon transfer of ‘control’ is different from the ‘risk and rewards model’ under
Ind AS 18. Per Ind AS 115, ‘control of an asset refers to the ability to direct
the use of an obtaining substantially all of the remaining benefits from the
asset.
Sale & Repurchase:
A is a Developer in the
Real Estate business, he also possesses significant land banks. He enters into
an agreement with ABC Bank to sell some of the land based on:
i) Sale price on date of
sale will be decided by the seller who will appoint his own valuer;
ii) A gets the right to
develop the land during any time commencing within the next three years during
ABC’s ownership. Given A’s credentials in the sector, ABC will not unreasonably
withhold any of the development plans. However, ABC will bear all the outgoings
during this entire period including taxes etc. ABC will also charge an addition
fee of 10% of costs incurred that will cover its administration costs;
iii) The bank will maintain
a “Memorandum” account to which all costs incurred will be debited
and should A re-acquire the land, all these costs will be recovered including
interest calculated at the average of the last three years;
iv. The Bank grants A an
option to buy the land anytime within the next 5 years at the price that is
determined on the date of the repurchase, except that the Bank will deduct all
expenses it incurred during the period of its holding.
v. The Bank also has an option to sell the land
at the same price as determined in the Memorandum to any third party, except
that A will be given the first right of refusal. In the event of the land being
sold to a third party, all proceeds net of incidental costs including brokerage
etc. will be deducted by the bank and made good to A.
Comments:
The substance of the transaction appears clearly as a secured loan because, A
continues to control possession of the land, control’s its development, bearing
all costs and acknowledging all the obligations relating to ownership and use.
The right to first refusal virtually ensures that the return of the asset is
controlled fairly through the entire transaction.
Real
Estate Transactions: Performance obligation relating to the provision of common
amenities:
One area of significant
judgment is with regard to performance obligations made by the builder. It is
common, builders are able to sell individual apartments whereas common
facilities forming part of the performance obligations, remain incomplete.
1. Hypothetically, a builder had launched a
project of five buildings, out of which, he has completed three of them in
full. Under RERA, all the five buildings were considered as one project. The
builder has completed all necessary steps with regard to the individual
apartments sold, viz:
– The builder has a present
right for full payment from the respective owners
– Legal title has been
transferred for each of the apartments
– Physical possession has
been completed.
2. Significant risks and
rewards of ownership have been transferred to the individual owners and
– The owner has accepted
the apartment.
3. Common facilities such
as sports complex and social function halls;
4.These were all part of
the performance obligations of the builder.
The builder says that
Occupancy Certificate is pending and therefore, the builder’s contention is
that they do not propose to recognise any revenue on the completed units. The
alternate view is as under:
i. Revenue should be recognised
on the units actually sold; the amenities represent implicit obligations
because they are not ‘distinct’ from the project and real estate has been sold
without completion of these facilities;
ii. The individual units
are ready and the builder has actually been advised that they can apply for an
OC for the completed part because it is completed in every which way, however,
the builder has been postponing
this process.
Comments:
In the case above: This is an area of complexity and responses will differ upon
circumstances of the case:
i. There is a valid contract (whose attributes
meet with the conditions specified in Ind AS 115) that has been entered into
with the owners;
ii. Individual performance level obligations have
been met except that obligations that are implied such as sports complex and
function halls are yet valid expectations and therefore, obligations that
remain unfulfilled yet; however, the contract states that these areas are
scheduled to be complete by the time the other two buildings are completed.
iii. Given the fact that the three residential
buildings are complete in every which manner, the only question that remains
unanswered is whether the builder is in a position to apply for the OC
immediately; that would require him to confirm several matters including
mainly, an affirmation that all aspects of the three buildings have been
completed for survey by the Authorities. If the builder is in a position to do
so, Revenue should be recognised in respect of every apartment sold, which
meets the criteria set out in Ind AS 115 and para I above that is, there should
be a valid contract, individual (apartment) performance level obligations have
been met, legal title has been transferred for each of the apartments, physical
possession has been completed, significant risks and rewards of ownership have
been transferred to the individual owners and the owner has accepted the
apartment.
B. Ind AS 109: Financial
Instruments
Factoring of Debts:
Factoring is a common
practice to raise money’s especially in cases where a company wishes to remove
the factored debts from the balance sheet and preferably, show no liability for
payments made by the Factor.
Factoring: a Case Study:
A company with a poor
history of collections approaches a “Factor” because a stage has
arrived where the bankers have threatened not to increase working capital
limits to the extent of overdue debts. The company holds a portfolio of Rs.300
million. It enters into a “factoring” arrangement with a reputed
factor with the following key conditions:
i. The company will
transfer the portfolio through an assignment to the Factor for Rs. 275 million
of cash. All debts have been subject to a credit appraisal by an independent
agency to ensure that the portfolio transferred is, ab ignition, not a “troubled” debt. The Factor
will pay the cash of Rs. 275 million “upfront” to the company.
ii. The company will open a
separately nominated account into which it shall deposit all the collections it
makes from its debtors. The Factor will charge a collection fee and this will
be added up to the amounts collected by the company upon settlement and end of
agreement;
iii. Any collections
falling short of Rs.275 million will be to the company’s account and so will
any collections in excess of Rs.275 million: the company takes the upside too;
iv. Upon termination of the
agreement, all outstanding are agreed upon and settled in cash.
The substance of the
transaction is as under:
i. Under the agreement, the
maximum exposure that the company has is to the extent of Rs.275 million that
it has received from the Factor, upfront;
ii. It means, the company
has given a guarantee to the Factor to the extent of the entire Rs.275 million,
that is, for all credit losses;
iii. In addition, the
company is entitled to the upside too;
Comments:
i. This means, the company
has retained both the credit and late payment risks associated with the
portfolio; therefore, the entity has retained substantially all the risks and
rewards of ownership of the receivables and continues to recognise the
receivables.
ii. Such type of
transactions can be a very useful way of raising cash quickly and can be tricky
from accounting perspective. It involves analysing terms of arrangement to
establish the substance of the transaction. Key point here is, understanding
the “ownership” of the receivable in establishing the commercial substance of
the transaction.
iii The company will
therefore need to recognise the consideration received from the broker as a secured
borrowing.
C. Ind AS 110: Consolidation
Case Study: Control
The assessment whether an
investor has control over an investee depends whether the entity has all the
three elements of control over the investee, viz; power over the investee, exposure,
or rights to variable returns and the ability to use its power to influence the
investor’s returns.
It is a simple situation
where control of an investee is held through voting rights; however, it is not
clear whether control of the investee is through voting rights, a critical step
in assessing control is identifying the relevant activities of the investee,
and the way decisions about such activities are made. Relevant activities are
activities that significantly impact the investee’s returns. Power over an
investee is fairly established when an investor who does not have majority
voting rights has power to influence decision making with regard to the
relevant activities that significantly affect the investee’s returns.
Generally, decision making
is controlled by majority voting rights that also give rise to variable
returns. But in certain cases, the investor may be holding less than majority
of the voting rights, in which case, it may not be as straight forward. This is
particularly so in the case of a structured entity (SPV) that is used to
control an investee company and the investor does not have any dominant holding
in the structured entity and voting rights are not the dominant factor in
deciding who controls that structured entity. This is where all factors listed
above (power, exposure to variable returns and ability to use power over
investee) may all be need to be taken into consideration to determine the real
substance behind the structuring.
In cases cited above (that
is, where voting rights are not the dominant factor in deciding control over
the investee), an understanding of the purpose and design of the investee would
help to understand the reasons why the investor is involved with the investee,
what risks was the investee designed to be exposed and which are the key
parties exposed to those risks and variable returns. Such mapping of power with
the ability to use that power to influence the variable returns will be helpful
in determining who has the control.
In certain complex situations
where two or more investors control several relevant activities of the
investee, it is important to ascertain which investor controls the activities
with the most significant returns.
One may
conclude that the substance of the control can be determined by examining where
the decision-making powers resides i.e. seat of power.
To establish the decision making with complex legal structure, it is necessary
to look into framework for assessment of control i.e. i) Assessment of purpose
and design of the investee, ii) Its relevant activities, iii) and how decision
about these relevant activities are made. This involves complete
understanding of the lucidity behind the structure and role of each party.
7. Conclusion:
Given the complexities that
the financial markets are made of and also given the financial structuring
options that businesses have, it is necessary that the Financial Accounting and
Reporting Framework specifically may necessitate separate guidance that deals with ‘Substance
over Form’. While the specific standards such as Leasing, Revenue Recognition
and Consolidation have dealt with several of the complexities, the need for an
independent standard that builds the logic for accountants and auditors to
apply cannot be overemphasised.
