Substance of a transaction - Essay Example

Substance over Form Substance of a Transaction According to any international standard, financial ments should present fairly the financial position, financial performance and cash flows of an entity. The substance of a transaction typically means the reality of an actual event that has taken place which needs to be accounted for. If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. It is, therefore, of absolute importance that the actual substance of the transaction is accounted for in order to meet international regulatory requirements for financial reporting as well as achieve fair presentation standards and a higher level of transparency in the books of accounts to avoid any audit objections. GAAP-Substance over form The generally accepted accounting principles, more commonly known as GAAP, have evolved as an important term in accounting and signifies all the rules, from whatever source, which govern accounting. These principles may derive from sources like local company legislation, national and international accounting standards, statutory requirements and stock listing requirements yet they are based on the foundations of common principles, namely the going concern assumption, accrual basis of accounting, materiality and substance over form. The GAAP which lays down the concept of substance of transactions is called "substance over form". The underlying principle is that although substance of a transaction may be the same as its legal form, for a number of transactions, the legal form does not indicate the true substance of a transaction and must make economic sense in the financial statements reflecting the reality of an actual event that has taken place. Such may be the case in various sales purchase agreements, leasing, insurance etc. As an example, some transactions may have the form of an outright purchase of capital equipment, whereas in fact the substance of the transactions is a lease of (or perhaps an option to purchase) the equipment. Such transaction also attract audit attention and are important from taxation point of view. Thus we always consider the real substance of a transaction instead of its legal form. In this manner, the concept of substance over form plays a dominant role. Accordingly, it delivers the fact whether the financial statements reflect the financial reality of the entity rather than mere legal form of the transactions and events which bring them about. The underlying principle is relevant to management's contentions that the financial statement items are complete, valid and accurate, and in particular that the financial statement items are exact as to presentation and disclosure. The FASB considered that substance over form was redundant because without it have representational faithfulness cannot be achieved. From auditor's point of view, transactions where the substance of the transaction differs significantly from the form are considered vigilantly. In simpler words, auditors try to find a transaction or groups of transactions that do not make economic sense or emerge as they have been made to change the way in which an account balance appears in the financial statements, rather than reflect the reality of an actual event that has taken place. These transactions are commonly recorded around balance date and often appear overly complex. "A well-known example from the past was Enron group's use of over 3000 Special Purpose Entities (SPEs) structured in such a way as to enable the company to avoid including extensive debt in the consolidated financial statements of the group. This has led to suggested/actual revisions to various accounting standards throughout the world. These revisions require SPEs (such as trusts, partnerships and non incorporated entities) to be consolidated when the substance of the relationship between an entity and the SPE indicates that the SPE is controlled by that entity." ABREMA: glossary: substance over form http://www.abrema.net/abrema/sof_g.html (Accessed February 26, 2006). Adhering to these principles can truly ensure that the substance of a transaction is accounted for. Substance over form captures the essence of faithful representation of financial information. There should be correspondence or agreement between the accounting measures or descriptions in financial reports and the economic phenomena they purport to represent. Representations are faithful when the measures and descriptions are verifiable, and the measuring or describing is done in a neutral manner. Therefore, faithful representation requires completeness, not subordinating substance to form, verifiability, and neutrality. Consequently, the common framework should drop the widely misinterpreted term reliability from the qualitative characteristics, replacing it with faithful representation. In the IASB framework, reliability is comprised of faithful representation, substance over form, neutrality, prudence, and completeness. Many components connect reliability primarily with verifiability, not representational faithfulness. It is for these reasons that signify the concept of substance over form. "Jim Leisenring thought that representational faithfulness should replace reliability as the over-arching term. However, he thought: "To drop substance over form would be as misleading as leaving it in." John Smith took the view that the term had too much baggage with it. Wayne Upton remarked that representational faithfulness gave a more precise target. There will be more debate before this is settled, but the sense of this meeting was that representational faithfulness should replace reliability as a central characteristic, and would be defined as including substance over form." What's in a name http://www.accaglobal.com/ifrs/directarticles/2428122 (Accessed February 26, 2006). Now considering the UK definition of assets, we see that assets are "rights or other access to future economic benefits controlled by an entity as a result of past transactions or events" Convergence of UK GAAP to IAS: Part 1 http://www.accaglobal.com/publications/studentaccountant/568644 (Accessed February 26, 2006). The above definition clearly signifies that ownership is not required when it is states about "rights or other access". This is very important when considering the substance of a transaction. IAS, FRS and Substance over form IAS 1 covers very generally presentation and preparation of financial statements and inclusion of assets and liabilities in the balance sheet. A general guideline is furnished which requires that management should develop policies so as to ensure the reliability of information presented in the financial statements reflecting the economic substance of events and transactions and not merely their form. However, no international standard delivers firmly the guidelines as provided under the UK standard FRS 5: Reporting the Substance of Transactions. This standard is the key to off balance sheet financing and other forms of creative accounting practice. IAS 18 also need to be changed to reflect the on the balance sheet elements and should be linked with FRS 5 covering 'substance over form'. This will enable gains on such items as sale and repurchase agreements to be covered in addition to the more obvious revenue generating activities, in a single statement. Examples Given the concept of substance over form, the cases are presented in the following manner: (i) Under the first case, Apont plc is selling the land to the investment company at a lower than market rate. Even though the way Apont plc has accounted for this transaction depicts its legal form, yet it ignores the true substance of the transaction. A buyback option is also available to Apont plc which also hold a cost of 2% of the original selling price. In case Apont plc buys back the land at the end of the fifth year, it will pay 44 million which is still lower than the current market value. If the investment company undertakes any development activities, it will add up to the appreciation of value the land is expected to have above the current market value of 55 million over these 5 years. The true transfer of ownership can only be determined at the end of this period when the buyback option is closed. All of these facts are over and above the sale transaction recorded. Even though the current event only indicates a conventional sale, the facts annexed to it indicate terms more similar to a lease. Apont plc should either diverge from the current treatment and account it similar to lease or provide additional disclosures to the transaction presenting very clearly and fairly the facts relevant to the nature of transaction so as to depict its true substance. (ii) Similar to the first case, a transaction of sale is recorded. Still it is probable that future economic benefits will flow to the enterprise while its cost can be measured reliably. However, Apont plc accounts for the storage cost as a receivable from Dingdong Ltd which does not illustrate the true state of affairs. Storage cost is a receivable only when there is no repurchase clause attached to the agreement. The true treatment is to account for it as a cost until maturity at a cost of 300,000 per annum. In case Apont plc decide not to repurchase until maturity, the cost should then be debited to receivable from Dingdong Ltd with an amount of 900,000. It is, consequently, of unconditional significance that the real substance of the transaction is considered so as to not only cater the changing international regulatory requirements for financial reporting but also achieve fairer representation of financial information rendered to key users of that information. References ABREMA: glossary: substance over form http://www.abrema.net/abrema/sof_g.html (Accessed February 26, 2006). Convergence of UK GAAP to IAS: Part 1 http://www.accaglobal.com/publications/studentaccountant/568644 (Accessed February 26, 2006). What's in a name http://www.accaglobal.com/ifrs/directarticles/2428122 (Accessed February 26, 2006). Read More