Substance over form
The question of substance over form is one that has been asked by accountants for many years.
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.
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- What is substance over form in accounting
- Applications of substance over form
- Criticisms of substance over form
- Video lecture on Substance over form
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 aspect 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.
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.
We have published our video explanation over the concept. do watch the same in case you dont wish to read the entire article below.
In essence, substance over form refers to the accounting concept that transactions recorded in a company's financial statements and its disclosures must reflect their economic reality rather than their legal form.
Let's take an example of this principle with the definition of an asset & a liability as it 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.
As opposed to assets, liabilities are obligations that generate an expectation that the entity will experience an outflow of funds (or depletion of other assets) to settle them.
In assessing whether an asset or a liability has been created, the economic substance of the transaction should be scrutinized, not simply the legal form of transaction. 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.
- Lease agreements 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. In return for paying the asset's value and interest charges, the lessee enjoys the benefits of the leased asset for most of its economic life. 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 to be recorded in the financial statements, whichever represents the substance.
- Derivative instruments: Derivative instruments, such as options or futures contracts, may be structured in a way that obscures their economic substance. In these cases, the accounting treatment of the instruments should be based on their economic substance, rather than their legal form.
Sale and leaseback transactions: A company may sell an asset and then lease it back from the purchaser in a transaction known as a sale and leaseback. If the transaction has the economic substance of a financing arrangement, rather than a sale, the accounting treatment should reflect this substance.
Related party transactions: If a company engages in a transaction with a related party, such as a subsidiary or affiliated company, the accounting treatment of the transaction should be based on its economic substance rather than its legal form or the way it is labelled.
- Off-balance sheet financing: A company may use off-balance sheet financing arrangements, such as unique purpose entities or sale and leaseback transactions, to raise capital or finance assets. If these arrangements have the economic substance of a financing arrangement rather than a sale, the accounting treatment should reflect this substance.
- Revenue recognition: A company may enter into a contract to provide goods or services, but the contract may be structured in a way that obscures the economic substance of the transaction. In these cases, the accounting treatment of the revenue should be based on the substance of the transaction rather than its legal form.
- Business combinations: When two companies merge or one company acquires another, the accounting treatment of the transaction should be based on its economic substance rather than its legal form or the way it is labelled.
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 bias in accounting. It is primarily determined by the accountant doing professional judgment and their moral and ethical qualities.