The objective of FRS 5 – Reporting the substance of transactions, is to ensure that a reporting entity’s financial statements report the substance of the transactions into which it has entered.

You are the management accountant of BLFB plc. BLFB plc imports timber which it uses to manufacture and sell a large range of furniture products. BLFB plc makes up financial statements to 30 June each year.

On 1 June 1999, BLFB plc purchased for £40 million a large quantity of timber from an overseas supplier. The timber was intended to be used in the manufacture of a large quantity of high-quality furniture. Before manufacturing such furniture, it is necessary to keep the new timber in controlled conditions for at least five years from the date of purchase.

On 1 July 1999, BLFB plc sold the timber to Southland Bank plc for £45 million. The timber was physically retained by BLFB plc under the controlled conditions that were necessary to render the timber suitable for use. At the date of the sale on 1 July 1999, BLFB plc signed an agreement to re-purchase the timber from Southland Bank plc on 30 June 2004 for a price of £66.12 million. Responsibility for the security and condition of the timber remained with BLFB plc.

Your assistant, who is responsible for preparing the draft financial statements for the year ended 30 June 2000, has shown the transaction as a sale of £45 million and recorded a profit of £5 million.

Requirements

(a) Write a memorandum to your assistant that:

(i) describes what is meant by the ‘substance’ of a transaction and how to determine

‘substance’; (5 marks)

(ii) explains why FRS 5 requires transactions to be accounted for according to their substance. (5 marks)

(b) (i) Prepare all the journal entries that should have been made in the financial statements of BLFB plc for the year ended 30 June 2000 in order to account correctly for the sale of timber to Southland Bank plc. (4 marks)

(ii) Explain fully how the entries you have made comply with the relevant provisions of FRS 5. You should also explain why the treatment suggested by your assistant is incorrect. (6 marks)

CIMA, Financial Reporting, November 2000 (20 marks)