Accountants are often faced with the question of what is more critical, substance or form. This question can be applied to many aspects of life. Still, in the accounting world, it typically refers to financial statement items.
The philosophical basis is that accountants need to focus on the natural, underlying substance of a transaction rather than on its legal form. This concept is one of the underlying accounting principles of the IASB's conceptual framework.
History of substance over form
The concept of substance over form was initially identified in the early 1980s. It emerged due to how entities were financing their operations. It became apparent that financing transactions were becoming more complex.
This complexity often led to separating the legal title to an asset from access to its economic benefits and risk. Specific financing arrangements were being entered into, which, in some instances, were deliberately engineered to achieve the desired outcome (to keep financing arrangements off the balance sheet).
This practice was coined 'off-balance-sheet finance', and the concept is still as much a problem today as it was back in the early 1980s.
The problem with off-balance sheet finance is that not only can it have a significant effect on a company's balance sheet, but it can also have a significant effect on a company's reported profit (or loss).
To address these and many more such issues, the accounting bodies introduced the concept of substance over form accounting.
What is substance over form in accounting?
Substance over form concept is a notion that underlies the concept of reliability, one of the qualitative characteristics detailed in the IASB's Framework.
In essence, substance over form in accounting refers to the concept that transactions recorded in a company's financial statements and its disclosures must reflect their economic substance rather than their legal form.
This means that whoever prepares the financial reports for a company needs to use their judgement to derive the business sense from the transactions and events to present them in a manner that best reflects their true essence.
Let's take an example of this principle with the definition of an asset. A liability should be recognized in the balance sheet.
An asset is a resource controlled by the reporting entity that derives economic benefit for the entity itself. The point to emphasize where assets are concerned is the concept of 'control'. To meet the definition of an asset, an entity must have control over that asset.
Conversely, a liability is an obligation on the part of the entity that creates an expectation that the entity will experience an outflow of funds (or depletions of other assets) to settle the obligation.
In assessing whether an asset or a liability has been created, the characteristics of the transaction should be scrutinized, not simply the legal form. The term' risks and rewards' are often cited when determining the substance of business transactions, and some factors that may be considered are as follows.
Some of the applications of substance over form accounting in IFRS.
- An undertaking may dispose of an asset to another party so that the document purports to pass legal ownership to that party. Nevertheless, agreements may ensure that the undertaking continues enjoying the asset's benefits. This may be done to raise finance, using the asset as collateral. In such circumstances, the reporting of a sale would not represent the transaction faithfully.
- Leases as per IFRS 16 are accounted for following their substance and financial reality and not merely with the legal form. The lessee may acquire no legal title to the leased asset in a finance lease. The lessee obtains the benefits of the leased asset for most of its economic life, controlling the asset for the lease period in return for paying the asset's value and the related interest charge. IFRS 16 on leases, therefore, requires the lease to be shown as an asset on the lessee's balance sheet.
- IAS 32 requires capital instruments to be classified as debt or equity, whichever represents the substance
Criticism of substance over form
- Substance over form principle can lead to complex accounting standards and disclosures, making it difficult for investors and others to understand a company's financial statements.
- Application of the substance over form principle increases subjectivity in accounting. It is primarily determined by the accountant doing professional judgment and their moral and ethical qualities.