4 FRS 5 – Reporting the Substance of Transactions – requires that a reporting entity’s financial statements should report the substance of the transactions into which it has entered. FRS 5 states that in order to determine the substance of a transaction it is necessary to identify whether the transaction has given rise to new assets or liabilities for the reporting entity and whether it has changed the entity’s existing assets or liabilities.
You are the management accountant of D Ltd which has three principal activities. These are the sale of motor vehicles (both new and second-hand), the provision of spare parts for motor vehicles and the servicing of motor vehicles.
During the financial year ended 31 August 1996, the company has entered into a type of business transaction not previously undertaken. With effect from 1 January 1996, D Ltd entered into an agreement whereby it received motor vehicles on a consignment basis from E plc, a large manufacturer. The terms of the arrangement were as follows:
(i) On delivery, the stock of vehicles remains the legal property of E plc.
(ii) Legal title to a vehicle passes to D Ltd either when D Ltd enters into a binding arrangement to sell the vehicle to a third party or six months after the date of delivery by E plc to D Ltd.
(iii) At the date legal title passes, E plc invoices D Ltd for the sale of the vehicles. The price payable by D Ltd is the normal selling price of E plc at the date of delivery, increased by 1% for every complete month the vehicles are held on consignment by
D Ltd. Any change in E plc’s normal selling price between the date of delivery and the date legal title to the goods passes to D Ltd does not change the amount payable by
D Ltd to E plc.
(iv) At any time between the date of delivery and the date legal title passes to D Ltd, the company (D Ltd) has the right to return the vehicles to E plc provided they are not damaged or obsolete. D Ltd does not have the right to return damaged or obsolete vehicles. If D Ltd exercises this right of return then a return penalty is payable by
D Ltd as follows:
* i.e. the price that would otherwise be payable by D Ltd if legal title to the vehicles had passed at the date of return.
(v) E plc has no right to demand return of vehicles on consignment to D Ltd unless D Ltd becomes insolvent.
The managing director suggests that the vehicles should be shown as an asset of D Ltd only when title passes, and the purchase price becomes legally payable.
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