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Good day tutor,
Question 1a:
Could you please explain why the following transaction does not qualify as a repurchase agreement?June 2012: Question 1:
“Immediately prior to the year end, Robby sold land to a third party at a price of $16 million with an option to purchase the land back on 1 July 2012 for $16 million plus a premium of 3%. The market value of the land is $25 million on 31 May 2012 and the carrying amount was $12 million. Robby accounted for the sale, consequently eliminating the bank overdraft at 31 May 2012.”Answer:
“The sale of land should not be recognised in the financial statements as the risks and rewards of ownership have not been transferred. The land can be repurchased at the sale price plus a premium, which represents effectively an interest payment. It is effectively manipulating the financial statements in order to show a better cash position. The land should be reinstated at its carrying amount before the transaction, so $12 million, a current liability recognised of $16 million and the profit on disposal of $4 million that was recorded reversed.”While I was attempting this question I took a look at the BPP study text for the treatment of Repurchase Agreements. Applying the treatment suggested by BPP, I had classified this transaction as a call option, as the repurchase price ($16.48m) is > than the original selling price ($16m). My entries were:
Dr Land 12m
Dr P/L $4m
Dr Finance cost $0.48m
Cr loan – repo $16.48mThis was sadly incorrect when compared to the examiner’s solution. Why is that so?
Treatment for call option as per BPP study text:
A financing arrangement should be accounted for. The entity continues to recognise the asset and recognises the cash received as a financial liability. The difference between the original selling price and the repurchase price is recognised as interest expense.Question 1b:
The scenario also mentioned that the market value of the land was $25m and the carrying amount was $12m. Should we not have revalued the land upwards by $13m and credited it to OCE?Looking forward to your reply, thanks 🙂
Hi,
Your answer is the same as the one in the model answer, except that you’ve recognised the interest immediately when it should be spread over time.
On your other point, there isn’t anything in the question that says the company uses the revaluation model.
I’ll answer your other question in the other thread later in the week when I have my materials with me. I’m currently away from home and not back until the weekend.
Thanks
Hello tutor, thank you so much for answering my doubts.
For “interest should be spread over time”, does it mean that interest expense should only be recognised at 30 June 2012 (as this is the duration of the repo) and added to the carrying amount of the repo loan?
Entries will hence be:
Dr Finance cost 0.48m;
Cr Repo Loan 0.48m
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