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Explain what you understand by the term 'substance over form'. Is it appropriate that this concept should be used as a guide in setting accounting standards?

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Introduction

Explain what you understand by the term 'substance over form'. Is it appropriate that this concept should be used as a guide in setting accounting standards? Introduction The overriding requirement of a company's financial statements is that they should present a true and fair view, and represent faithfully the underlying transactions and other events that have occurred. To achieve this, transactions are required to be accounted for in terms of their 'substance' or commercial reality rather than their legal form. This principle is introduced in the Accounting Standard Board 'Statement of Principle for Financial Reporting', and also in many standards, in particular Financial Reporting Standard No. 5 (FRS 5), "Reporting the Substance of Transactions" and SSAP 21 'Accounting for Leases and Hire Purchase Contracts'. To understand the term 'substance over form' (henceforth SOF) properly, this essay firstly describes briefly what is mean by the 'substance' of a transaction and how to determine 'substance'. It secondly explains the importance of SOF. This point is illustrated by analysing an example of the treatment of 'consignment stock' and MicroStrategy case. Thirdly, it discusses some debates over the 'SOF' methodology, and argues it would not be enforced as a standard but used to develop individual and specific standards to deal with particular areas. Finally, it concludes this essay. Part 1 The Substance of the Transaction 'Substance' can be viewed as the 'reality' or commercial substance of a transaction or an event, whereas 'Form' can be viewed as the strict 'legal' interpretation ...read more.

Middle

However, title to the stock does not pass to the dealer at the time when the stock was delivered. It means that the dealership in fact has not yet bought the stock and so should not yet include the stock, or any liability to pay for it, in its financial statement. So what treatment should be used for the dealer? Determining if the stock should be classified as an asset of the dealer, involves assessing what the commercial substance of the transaction is. If only the legal form of the transaction was assessed, it might appear that the stock is an asset of the manufacturer. However, according to FRS 5, the substance of the transaction is determined by assessing where the greatest benefit and risk lies.6 If the manufacturer cannot require the dealer to return the stock, the dealer has no right to return the stock. Consequently, the dealer bears the obsolescence risk and slow movement risk. This indicates that the stock is in substance an asset of the dealer. On the other side of the argument, if the dealer has the legal right to return the unsold stock without incurring an obsolescence risk and a slow movement risk, then the dealer does not have an asset. Therefore, the substance of transaction should be reflected faithfully in its financial statements not merely the legal form of the transaction, particularly if the legal form of the transaction would present a misleading view of the financial position or results of operations of an entity.7 2.2 What would happen if we instead took 'Form over Substance'? ...read more.

Conclusion

These would enable the substance of transactions and other evens to be identified directly. It is likely to be able to successfully deal with new challenges facing financial accounts, including the emergency of new financial instruments and grey leasing. It seems that the principle of SOF has indicators set to be an accounting standard. But, perhaps the biggest problem of SOF when coupled with the true and fair view, is that it then depends heavily on the accounting profession's ability to interpret sensibly commercial reality, in many different situations, while still following consistent conventions and tenets. Therefore, the framework of the principle of SOF would not be enforced as a standard but used to develop individual and specific standards to deal with particular areas.11 It would consume far more resources, but would produce treatments that were consistent and respond adequately to novel transaction and other event. Specific standards would also be easier to enforce than general guidance as to the identification of the substance of transaction and other events.12 Conclusion In conclusion, We have provided the meaning of SOF, and examined the determinants of the substance of transactions. Then, we have explained why the SOF was so important in accounting through a discussion of the treatment of consignment stock. At the same time, we have illustrated how financial statements can be adversely affected if the company emphasises 'Form' of the transactions rather than 'Substance' of the transactions. We have also discussed the debates over SOF, and finally, we have argued how the principle of SOF would be used as a guide in setting accounting standards. ...read more.

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