You are the management accountant of Tree plc, a listed company that prepares consolidated financial statements. Your Managing Director, who is not an accountant, has recently attended a seminar at which key financial reporting issues were discussed. She remembers being told that:
- financial statements of an entity should reflect the substance of its transactions;
- the way to determine the substance of a transaction is to consider its effect on the assets and liabilities of the entity carrying out the transaction.
The year end of Tree plc is 31 August. In the year to 31 August 2001, the company entered into the following transactions:
Transaction 1:
On 1 March 2001, Tree plc sold a property to a bank for £5 million. The market value of the property at the date of the sale was £10 million. Tree plc continues to occupy the property rentfree. Tree plc has the option to buy the property back from the bank at the end of every month from 31 March 2001 until 28 February 2006. Tree plc has not yet exercised this option. The repurchase price will be £5 million plus £50,000 for every complete month that has elapsed from the date of sale to the date of repurchase. The bank cannot require Tree plc to repurchase the property and the facility lapses after 28 February 2006. The directors of Tree plc expect property prices to rise at around 5% each year for the foreseeable future.
Transaction 2:
On 1 September 2000, Tree plc sold one of its branches to Vehicle Ltd for £8 million. The net assets of the branch in the financial statements of Tree plc immediately before the sale were £7 million. Vehicle Ltd is a subsidiary of a bank and was specifically incorporated to carry out the purchase - it has no other business operations. Vehicle Ltd received the £8 mil- lion to finance this project from its parent in the form of a loan.
Tree plc continues to control the operations of the branch and receives an annual oper- ating fee from Vehicle Ltd. The annual fee is the operating profit of the branch for the 12 months to the previous 31 August less the interest payable on the loan taken out by Vehicle Ltd for the 12 months to the previous 31 August. If this amount is negative, then Tree plc must pay the negative amount to Vehicle Ltd.
Any payments to or by Tree plc must be made by 30 September following the end of the relevant period. In the year to 31 August 2001, the branch made an operating profit of
£2 000 000. Interest payable by Vehicle Ltd on the loan for this period was £800 000.
Required
(a) Evaluate the extent to which the advice given to the Managing Director at the seminar is in accordance with generally accepted accounting principles.
(b) Explain how the transactions described above will be dealt with in the consolidated financial statements (balance sheet and profit and loss account) of Tree plc for the year ended 31 August 2001.