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.

You are the management accountant of S Ltd. During the most recent financial year (ended 31 August 1998), the company has entered into a debt factoring arrangement with F plc. The main terms of the agreement are as follows:

1 On the first day of every month S Ltd transfers (by assignment) all its trade debts to F plc, subject to credit approval by F plc for each debt transferred by S Ltd.

2 At the time of transfer of the debtors to F plc, S Ltd receives a payment from F plc of 70% of the gross amount of the transferred debts. The payment is debited by F plc to a factoring account which is maintained in the books of F plc.

3 Following transfer of the debts, F plc collects payments from debtors and performs any necessary follow-up work.

4 After collection by F plc, the cash received from the debtor is credited to the factoring account in the books of F plc.

5 F plc handles all aspects of the collection of the debts of S Ltd in return for a monthly charge of 1% of the total value of the debts transferred at the beginning of that month.

The amount is debited to the factoring account in the books of F plc.

6 Any debts not collected by F plc within 90 days of transfer are regarded as bad debts by F plc and re-assigned to S Ltd. The cash previously advanced by F plc in respect of bad debts is recovered from S Ltd. The recovery is only possible out of the proceeds of other debtors which have been assigned to S Ltd. For example, if, in a particular month, S Ltd assigned trade debts having a value of £10 000 and a debt of £500 was identified as bad, then the amounts advanced by F plc to S Ltd would be £6650 [70% × £10 000 – 70% × £500].

7 On a monthly basis, F plc debits the factoring account with an interest charge which is calculated on a daily basis on the balance on the factoring account.

8 At the end of every quarter, F plc pays over to S Ltd a sum representing any credit balance on its factoring account with S Ltd at that time.

Requirement Write a memorandum to the Board of Directors of S Ltd which outlines:

(a) how, under the principles set out in FRS 5, the substance of a transaction should be determined; (10 marks)

(b) how the debt factoring arrangement will be reported in the financial statements of S Ltd. (10 marks)

CIMA, Financial Reporting, November 1998 (20 marks)