Application and Impact of Financial Reporting Standard 5 - Essay Example

 CURRENT ISSUES IN FINANCIAL REPORTING Executive Summary Introduction: Financial Reporting Standard 5 (FRS 5) talks about “Reporting the Substance of the Transactions”. Here, the emphasis is on reporting the base of the transactions entered into by the business entity. This FRS sets a guideline as to how the substance of a particular transaction is to be decided and also includes the effect of the transaction on the liabilities and assets of the business. Apart from Balance Sheet, It also includes provisions regarding the way the reporting should be done in the profit and loss account as well as in cash flow statements. The major significance of this standard is in understanding that reporting the substance of the transaction forms the core of financial reporting. Moreover, the best advantage is that this FRS does not affect a majority of transactions; however, it has an effect on complex transactions whose substance is not very apparent. Objective: The aim of Financial Reporting Standard 5 is to make sure that the substance of the transactions of the business is reflected clearly in the financial statements. Moreover, it intends to cover the honest representation of the commercial impacts of the transactions on the profits, losses, liabilities as well as assets of the business so that the accounting statements do not just consider the legal form of a specific transaction but also its commercial form. Recognition and Identification Principles: A chief point in concluding on the substance of the transaction is to note whether the transaction has resulted in any increase or decrease in liabilities or assets of the business. The definition of assets and liabilities has been clarified in the FRS 5. Once the identification of a liability or asset is done, the inclusion needs to happen in the balance sheet subject to the condition that there is adequate evidence of the existence of the liability or the assets. Moreover, the monetary value of these should be measureable. The asset or liability respectively should be included only if the transaction does not significantly alter rights of the benefits to the entity or its exposure of risks. If the transaction does not do so, it is appropriate to make amendments in the monetary value of the asset/liability. The FRS takes into consideration several transactions and gives a detailed disclosure and measurement guideline regarding transactions with specific features including consignment stock, repurchase contracts, loan transfer, securitisation, factoring, revenue recognition, and private finance initiatives. Presentation and Disclosure FRS 5 takes a view of the problems of financing off balance sheet items. The problem of understatement is solved due to the presentation and disclosure guidelines of FRS 5. A specific type of presentation known as “linked presentation” is suggested for finance arrangements that are non-recourse in nature. Such a presentation shows the deductions of finance from the gross amount of the particular item that is financed. Sufficient disclosure is vital for the transaction for having a clear idea of the commercial effect of the same. The disclosure requires detailed explanation when the recognition of the asset or liability is different from that found under the related headings in balance sheet. (FRS 5, Accounting Standard Board) Thus, FRS 5 has a clear and structured approach for reporting the substance of the transactions. Application and Impact of FRS 5 on Financial Statements The FRS 5 has a noteworthy effect on the reporting of financial statements. However, it is clarified that it does not affect a vast majority of transaction, but certainly has an impact on complex transactions. Here, we take into consideration the impact and application of FRS 5 on various transactions. A. Accounting and Disclosure for Quasi Subsidiaries When the liabilities and assets of a business are put in a particular entity, while the entity cannot be called a subsidiary, it is termed as a quasi subsidiary. Here, the impact on the reporting organisation in commercial terms applies just as in the case of an actual subsidiary. Here, the profits and losses as well as the liabilities and assets of this quasi subsidiary are to be reported and included as a part of the consolidated financial statements and these should also be disclosed in the group financials in a similar manner as it would be done for a subsidiary. However, there are some exclusions to this and are explained in detail in FRS 5. B. Application of FRS 5 on consignment stock We shall be taking an example of consignment, where the transaction is between a dealer and a manufacturer and the ownership of the stock is with the manufacturer, whereas the possession is with the dealer for the purpose of sale. Here, though the asset is legally owned by the seller, the benefits of possession of the asset like safeguard from rising transfer price, demonstration of the item and benefits from sale lie with the dealer. Moreover, the dealer also is exposed to risks of obsolence and slow movement. Hence, the commercial view by FRS 5 requires the asset to be reported in the balance sheet of the dealer and the payable liability under the required head in balance sheet. However, the impact on financial statement changes on the basis of different situations and arrangements between the dealer and the manufacturer. C. Application And Disclosure In Case Of Factoring Transactions In case of factoring transaction, where the debtors of the business are transferred to the factor by way of assignment, the reporting of the transaction can happen in three ways i.e. derecognizing by removing the debtors from the balance sheet and removing the corresponding liabilities too; linked presentation by showing factor finance subtracted from factored debts in the balance sheet or by a separate presentation by showing both creditors or factor finance in liabilities and factored debts as assets. But, the treatment would depend on the wholesome study of the commercial features of the transaction. D. Application and reporting for Repurchase transaction Here, we take an example of a company, which transfers the legal title of the asset and further enters into a repurchase agreement; where the possession of the asset may still lie with the seller and the seller also is able to use it. In this situation, the legal title is with the buyer, however, the economic advantage of the asset is with the seller and the seller is also exposed to risks related with such benefits. As per FRS 5, the assets is to be reported as an assets for the seller in the financial statements in spite of the legal title being transferred and sheet to the extent of selling price of the asset as well as interest there on. This is in view of the commercial effect rather than the legal one. (FRS 5 Application notes) Thus, reporting the substance of the transaction depends widely on the analytical study done by keeping in view the precedence of commercial treatment of the transaction. International Accounting Standards and the Significance of Reporting the Substance We have seen that globalization has paved its way for convergence of accounting standards on a global basis rather than on local basis. Hence, the need arises even to have a structured approach towards international financial reporting. The implications of financial reporting would change in international context. However, the base remains the same. This is because; reporting of economic or rather commercial substance of the transaction becomes important and more significant than mere legal view of the transaction. (The Importance of International Accounting Standards in Promoting Regional Business Growth) The International Accounting Standard Board (IASB) is trying to concentrate on IFRSs (International Financial Reporting Standards) now apart from International Accounting standards (IAS). Moreover, IAS itself has a lot of emphasis on disclosure and appropriate reporting guidelines. It indicates that the company that makes compliance with IFRs shall explicitly mention the same in the notes of the financial statements. Moreover, though there is no reporting standard comparative to FRS 5 issued by IASB, the board understands the importance of economic decision making and the reflection of its true and fair picture of the same in the financial statements to make them much more reliable. The IFRs have laid an emphasis on considering not just the legal form of the transaction, but also the economic substance of the transactions in question. (Compliance with IASB Standards) The significance of such reporting lies in a sound conceptual base with the standards that require a precise matching of expenses and profits in the relevant year in such a way that the accounts represent the correct and realistic position of the business in that particular year. This further helps in decision making. Reporting the substance of a particular transaction holds too much importance in the accounting standards and forms the foundation of the realistic view of items business. This is possible by proper revenue recognition as well as by elimination of items that are off-balance sheet in nature. The primary aim of this is correct recognition of liabilities, assets and gains as well as losses of the business. These standards cover a vast mainstream of the transactions and does not much affect the accounting statements. Nonetheless, there are effects on the accounting treatment given to complex transactions. Thus, substance reporting forms the core of accounting standards not only locally but also in global terms. The IAS is prepared taking into view the above fact and has increasing emphasis on the same with a passage of time. Bibliography Jen Shek Voon, “The Importance of International Accounting Standards in Promoting Regional Business Growth”, Ernst and Young, Singapore, available from http://www.cipe.org/pdf/publications/fs/article6258.pdf, retrieved on 29th August 2007 “Compliance with IASB Standards”, available from http://www.iasplus.com/restruct/whatis.htm, retrieved on 29th August 2007 “Financial reporting standard 5”, available from http://www.frc.org.uk/images/uploaded/documents/FRS%205.pdf, retrieved on 29th August 2007 “Reporting the Substance of Transactions”, available from http://www.frc.org.uk/asb/technical/standards/pub0100.html, , retrieved on 29th August 2007 Read More