Better Form to Report Commercial Substance

by Designing Proper Entry Form to Record Substance and Report Performance

What is Commercial Substance?

Taking catering as an example, a company cannot start catering business without rent or own property. For a catering business which prepares for expansion, it is normally to rent some properties selected from preferred locations. The decision of the expansion is based on an expectation of increasing net present value of net cash flow (Future cash inflow less related cash outflow) of a company.

Taking property investment as a related example, property investment cannot start its business without acquisition of property. For a property owner who wants to maintain stable income to compensate related finance cost, it is usually to lease the property. The decision is based on the expectation of increasing net present value of net cash flow of the property owner.

If the catering company confirm a lease agreement offered by the property owner, the business contract can meet the definition of commercial substance even the resulting net present value of net cash flow is negative.

In an alternative scenario, if a company has two independent business units – Catering and Property Investment. The managers of responsible business units execute a similar transaction without signing any lease agreement; the transaction cannot meet the definition of commercial substance. It is mainly due the transaction is executed by the same company despite both managers they argue that their decision be based on the expectation of increasing net present value of net cash flow of their business unit. For the purpose of effective implementation of performance management, both business unit may insist on considering the transaction can meet the definition of commercial substance. However, it is necessary an elimination adjustment be made before the finalisation of the company account.

In a final scenario, if a holding company has two wholly own subsidiaries – Catering Company and Property Company. Both companies their management prepare to effect a similar transaction as per the first scenario. The business contract can meet the definition of commercial substance for each company. However, it is necessary an elimination adjustment be made before the finalisation of the consolidated financial statements of the holding company.

After your understanding of the commercial substance of the lease transaction between lessor and lessee, you may want to learn more story about Substance Loyalty (本質忠厚) and Form Attractiveness (形式吸引) – an extension of case 005. The academic student Jennifer Brescia (珍妮弗~布雷西亞) has a gathering with the writer; they are sitting at a restaurant of the Hong Kong Disneyland to inform the writer that she has completed a drafted academic paper titled “Better Form to Deliver Substance of Lease Accounting”. Of course, the writer had a good insight of her sharing of the paper.

Why Form Attractiveness Outperforms Her Husband?

As published on case 005, the CFO confirmed the proposal of Form Attractiveness rather than Substance Loyalty because she can provide a comprehensive scenario analysis to indicate that scenario 3 is the best to achieve compliance with IFRS 16 Leases. Form Attractiveness is an expert in project implementation while her husband is an experienced accountant. She outperformed her husband in the project because she wants to help her husband. However, Substance Loyalty wants to take this opportunity to prove his talent in commercial accounting. Form Attractiveness understands the substance of the project is to comply with the IFRS 16 and related system improvement to adopt the new accounting rules.

Use of Mind Map for Project Implementation

Form Attractiveness does not follow traditional practices of project management. Her previous experience is mainly deal with small projects. However, she always prepares and updates mind map for project implementation from project planning to different implementation milestones. Also, she also recommended Jennifer can be one of valuable mind map online platform.

Form Attractiveness suggested that the application of mind map for a project not be an on-off exercise. When there are some changes deviated from the plan, update relevant part of the mind map is necessary.

Form Attractiveness Presented an Advanced Automation

Upon confirmation of the scenario three as the accounting rules for system implementation, the CFO asked both project leaders to submit a proposal of entry forms to support relevant lease accounting. During a series of meeting with user departments, they have finalised a proposal which included two separate scenarios of entry forms. The first scenario is more concern on the adaptability of end-user in respect preparing vouchers by double entry.

The second scenario is more concern on advanced automation while it does not require users to input data by double entry.

After the CFO had reviewed the proposal, a meeting with user departments (i.e. Lease Department and Finance Department) revealed that Finance Department favour for the first scenario but Lease Department support for the second scenario. At the meeting, the CFO tended to appreciate the work of Form Attractiveness because she presented very clearly the advantage of using the second scenario in term of faster financial close and the opportunity to implement management accounting without an extra recurring workforce.

Resignation is Not the End Story

The end of the selection of scenarios, the company has confirmed the first scenario because Form Attractiveness has left the company. Jennifer implied that Form Attractiveness concerned she cannot help her husband effectively because her mind map did not include individual human behaviour consideration. Jennifer said that next month she would contact Form Attractiveness again to learn more about her career plan and related matter. Finally, Jennifer agreed to extend her research to cover issues of the preparation of consolidated financial statements and performance management.


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