Discuss the importance of recording the substance rather than the legal form of transactions and describe the features that may indicate that the substance of a transaction is different from its legal form?
Substance over form is an accounting principle; it is used to ensure the financial statements give a relevant, accurate picture of the events and the transactions. Through this principle, the entity ensues that the financial statement shows the reality (financially) of the organisation rather than its legal form.
The accounting standard Financial Reporting Standard (FRS) -5 requires the entities to consider the substance of the transactions in financial statement over its legal form. This FRS states that whenever a transaction takes place all its immediate effects i.e. in assets, liabilities, gains and losses should be reflected rather than the legal form of the transactions.
The principle of Substance over legal form ensures reliability and faithful representation of the information contained in the financial statements. The stakeholders and the shareholders of the entities rely on these financial statements for their decision making. This principle places responsibility on the preparers of the financial statement to consider the economic / financial reality of the transactions and event at times of reflecting the same in the financial statement. This principle gives more clarity to the prepares as well to the users about a transaction. The legal form sometimes misrepresents the basic characteristics that are mainly relevant for the users. However, if the accountant is able to determine the substance of the transaction then he should overall its legal form.
For example: In case of finance lease where the asset for the major portion of its economic life is used by the lessee, considering the economic realty in this transaction, the leased asset is accounted by the lessee irrespective of the fact that the legal ownership of the leased asset is still not transferred by the owner of the asset.
The substance form of the transaction is different from its legal form. This is very much evident from the above example. The substance of a transaction is determined by considering its effect on assets and liabilities in the statement of financial position whereas the legal form may or may not have its effects on the assets and liabilities in the statement. The problem comes into picture when the risk and reward attached to a transaction is shared by two different parties. For example, an entity may decide to sell an asset to a third party but decides to retain the right to use the sold asset and the risks attached to it. In this case this principle comes into picture, now based on the economic reality of the transaction, the same needs to be recorded in the books.
- ICAEW, 2015, “FRS 5: Reporting the substance of transactions”; Available at: https://www.icaew.com/en/library/subject-gateways/accounting-standards/uk-frs/frs-05
- Financial Reporting Council, 2003, “FRS 5 Reporting the Substance of Transactions”; Available at: https://frc.org.uk/Our-Work/Codes-Standards/Accounting-and-Reporting-Policy/Standards-in-Issue/FRS-5-Reporting-the-Substance-of-Transactions.aspx
- Accounting Standards Board, 1994, “Financial Reporting Standard 5”; Available at: https://frc.org.uk/Our-Work/Publications/ASB/FRS-5-Reporting-the-Substance-of-Transactions-File.pdf