Under the IASB’s Conceptual Framework for Financial Reporting, certain qualitative characteristics of useful financial information are identified. These are subdivided into characteristics considered fundamental and those considered to be enhancing. The two fundamental characteristics identified by the framework are ‘relevance’ and ‘faithful representation’. In order for financial transactions to be represented faithfully in the financial statements, the principle of ‘substance over form’ should be applied. This means that wherever there is a difference between the legal form of a transaction and its economic substance, the financial statements should reflect the economic substance.
Required:
i) Discuss the importance of the concept ‘substance over form’. (4 marks)
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- Economic Reality is more important: In substance over form principle the economic reality of transaction is more important than legal form of the transaction. Thus the transaction are not recorded merely on the bases of legal reality and economic reality is more relevant for accounting for the transaction. This is an important characteristic of this principle.
- Portray Real Nature of Transaction: Another important characteristic of Substance over form principle is portraying the real picture of the transactions. This approach discourages the hiding the actual nature of transaction. This concept has been explained with few examples.
- Achieve Faithful Representation: Application of prudence concept helps in achieving the faithful representation of
financial statements. Faithful representation of financial statements is an important accounting principle. - It has become clear that any hard rule can be creatively circumvented by contriving transactions appropriately. This is because transactions are necessarily structured between parties as they wish, and to suit their business needs. Regulators cannot anticipate the needs of transacting parties, and rules by their nature always lag behind the transactions themselves. In other words, as regulators see a transaction that is not covered by the existing rules, they seek to “plug the gap”. This is not a satisfactory way to ensure that financial statements reflect truth and fairness. (2 valid points for 4 marks)
ii) Describe FOUR (4) features of a transaction that suggest that its economic substance may differ from its legal form. (6 marks)
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There are some key tell-tale indicators that should alert the accountant to the possibility that substance and form issues may exist. Some of these are:
- If two or more transactions are executed together, and the combined effect of both taken together is different from the effect of each individually, this is worth investigating. For example a sale transaction selling an asset (possibly at a price in excess of market) and an agreement to lease back that same asset (possibly at an inflated rental).
- Business arrangements entered into which seem to disproportionately advantage one party over another. There is nothing legally wrong with entering into an arrangement that is not in your best interests, but rational business people tend not to do so unless there is a benefit elsewhere.
- Contrived option arrangements that serve to divert risk from where it might otherwise lie.
- Unusual terms in business agreements that might affect our assessment of the timing of revenues and costs.
- Transactions that may be structured to manipulate the reported results, for example by misreporting expenses as assets, or liabilities as revenue. (Any 4)