Accounting for something in accordance with its legal form, instead of its economic substance, does not result in a faithful representation.
- accounting for something in accordance with its legal form (even with appropriate disclosures) cannot result in a faithful representation if the economic substance of the item is different; and
- substance over form is an aspect of reliability. Substance of contractual rights and contractual obligations
Substance over form is the concept that the financial statements and accompanying disclosures of a business should reflect the underlying realities of accounting transactions. Conversely, the information appearing in the financial statements should not merely comply with the legal form in which they appear. The key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent of the transaction, which would mislead the readers of a company’s financial statements.
Substance over form is a particular concern under Generally Accepted Accounting Principles (GAAP), since GAAP is largely rules-based, and so creates specific hurdles that must be achieved in order to record a transaction in a certain way. Thus, someone intent on hiding the true intent of a transaction could structure it to just barely meet GAAP rules, which would allow that person to record the transaction in a manner that hides its true intent. Conversely, International Financial Reporting Standards (IFRS) are more principles-based, so it is more difficult for someone to justifiably hide the intent of a transaction if they are using the IFRS framework.
Thus far, the substance over form argument assumes that someone is attempting to deliberately hide the true intent of a transaction – but it may also arise simply because a transaction is extremely complex, which makes it quite difficult to ascertain what the substance of the transaction is – even for a law-abiding accountant.
Examples of substance over form issues are:
- Company A is essentially an agent for Company B, and so should only record a sale on behalf of Company B in the amount of the related commission. However, Company A wants its sales to appear larger, so it records the entire amount of a sale as revenue.
- Company C hides debt liabilities in related entities, so that the debt does not appear on its balance sheet.
- Company D creates bill and hold paperwork to legitimize the sale of goods to customers where the goods have not yet left the premises of Company D.
The Conceptual Framework explains ‘substance of contractual rights and contractual obligations‘ along some essential features captured in the following subjects:
1. Substance over the legal form of transaction(s) Substance of contractual rights and contractual obligations
The terms of a contract create rights and obligations for an entity that is a party to that contract. To represent those rights and obligations faithfully, financial statements report their substance (see Faithful representation). In some cases, the substance of the rights and obligations is clear from the legal form of the contract. In other cases, the terms of the contract or a group or series of contracts require analysis to identify the substance of the rights and obligations.
Substance over form concept entails the use of judgment on the part of the preparers of the financial statements in order for them to derive the business sense from the transactions and events and to present them in a manner that best reflects their true essence. Whereas legal aspects of transactions and events are of great importance, they may have to be disregarded at times in order to provide more useful and relevant information to the users of financial statements.
2. Explicit and implicit terms in a contract Substance of contractual rights and contractual obligations
All terms in a contract—whether explicit or implicit—are considered unless they have no substance. Implicit terms could include, for example, obligations imposed by statute, such as statutory warranty obligations imposed on entities that enter into contracts to sell goods to customers.
Implied contract terms are items that a court will assume are intended to be included in a contract, even though they are not expressly stated. Businesses and professionals generally do not want to rely upon a court’s interpretation of implied terms. Their contracts will often be very extensive so that as many material items as possible are included in the contract. When it is not possible to cover every possible detail, a lawyer may appeal that such terms were implied in order to give force to the intent of the contract.
3. Terms having no substance Substance of contractual rights and contractual obligations
Terms that have no substance are disregarded. A term has no substance if it has no discernible effect on the economics of the contract. Terms that have no substance could include, for example:
(a) terms that bind neither party; or
(b) rights, including options, that the holder will not have the practical ability to exercise in any circumstances.
If a term has no substance and as a result has no noticeable effect on the outcome of a contract it makes sense that it is disregarded.
4. Group or series of contracts Substance of contractual rights and contractual obligations
A group or series of contracts may achieve or be designed to achieve an overall commercial effect. To report the substance of such contracts, it may be necessary to treat rights and obligations arising from that group or series of contracts as a single unit of account. For example, if the rights or obligations in one contract merely nullify all the rights or obligations in another contract entered into at the same time with the same counterparty, the combined effect is that the two contracts create no rights or obligations. Conversely, if a single contract creates two or more sets of rights or obligations that could have been created through two or more separate contracts, an entity may need to account for each set as if it arose from separate contracts in order to faithfully represent the rights and obligations (see unit of account).
Just some more explanations on different ways substance over form needs to address reporting transactions in financial reporting as a separate unit or combined unit of account, with faithful representation as the most important qualitative characteristics.