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Friday, December 24, 2010

Accounting for Substance

Substance over form

The principle of substance over form was introduced in international accounting standards.
International accounting standards refers to three fundamental accounting assumptions:

  1. Going concern
  2. Consistency
  3. Accrual

International accounting standards further refers to three considerations that should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form.

Substance over form is defined as follows: “transactions and other events should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form”.

Accounting for substance

The concept of substance over form has now been replaced by the concept of accounting for substance. The incidence of so-called “creative accounting” has added increased urgency to the need to develop this concept.

That can be defined as follows: “accounting for transaction in accordance with its substance requires that its accounting treatment should fairly reflect its commercial effect”.

Reporting the substance of transaction proposes that “a reporting entity’s financial statements should report the substance of the transactions into which it has entered”.

Examples of accounting for substance

  • Goods sold subject to reservation of title: legal title does not pass to the purchaser until the goods have been paid for. Nevertheless accounts are drawn up including the goods in stock with a corresponding creditor, in accordance with the commercial substance of the transaction.
  • Fixed assets acquired under hire purchase contracts: legal title does not pass until the final installment is paid. Nevertheless the fixed asset is included in the balance sheet right from the start together with a corresponding creditor. Again this reflects the commercial substance of the transaction.
  • Finance leases: a lessee may obtain the use of a fixed asset over its useful economic life by means of a financial lease contract. Although the lessee never actual obtains legal title the lessee has rights and obligation similar to those of an outright purchaser.

Further considerations

One particular point about the types of transactions that are caught within the accounting for substance was also referred to as follows:

Many transactions are straightforward and embody a number of standard rights and obligations with the result that the commercial effect and consequent accounting treatment are well known.
Some transactions, on the other hand, combine or divide up rights and obligations in ways that make it difficult to discuss their effect on the enterprise’s assets and liabilities.

The following are common features of transactions that combine or divide up rights and obligations:

  • Severance of legal title to an item from the ability to enjoy the principle benefits and exposure to the principle risks associated therewith;
  • Linkage of a transaction with one or more others in such a way that the commercial effect cannot be understood without reference to the series as a whole;
  • Inclusion in the terms of a transaction of one or more options or conditions whose terms make it reasonably probable that the option will be exercised or the condition fulfilled.

Some more examples for accounting for substance

  • Sale of goods with a commitment to repurchase: at first sight, a sale of goods might appear to be a trading transaction, with stock replaced by cash. However, the commercial effect is that the transaction is a financing transaction. The cash received should be regarded as receipt of a loan, not as sale of goods.
  • Sale and leaseback: a sale and leaseback which involves a finance lease is effectively a financing transaction and both the asset and liability should appear on the balance sheet.
  • Consignment stock: consignment stock arrangements are particularly common in the motor trade. Consignment stock is held by one party but legally owned by another on terms which give the holder the right to sell the stock in the normal course of his business or, at his option, to return it unsold to the legal owner.


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