UNDERSTANDING SUBSTANCE OVER FORM

Both the IASB's Framework and IAS 1 Presentation of financial statements state that transactions and events should be accounted for and presented in accordance with their substance and economic reality, and not merely their legal form.

However, there is no standard that brings together all the requirements of substance over form. Certain standards do include the principles of substance over form, for example IAS 17 Leases on lease transactions requires the substance of the transaction to be recognised when finance leases are capitalised in the financial statements.

The substance of a transaction can be determined by looking at its effect on assets and liabilities in the statement of financial position. More specifically, does the transaction require that assets and liabilities are recognised or derecognised? The way to deal with this is to look at the assets and liabilities before and after the transaction.

A problem arises when the risks and rewards attached to an asset are shared between two parties, making it difficult to decide if the seller should derecognise it.

International standards only provide rules for the derecognition of financial assets, and so these will have to be used as guidelines for other assets.

IAS 39 Financial instruments: recognition and measurement states that a company should derecognise a financial asset when either of the following has occurred:

• The asset has been sold so that the risks and rewards of ownership have been transferred; or
• The contractual rights to the cash flows of the financial asset have expired.

In general, an asset cannot be derecognised if the entity is still exposed to the risks and rewards of owning the asset. For example, the risk of a receivable being uncollectible or inventory becoming obsolete.

The following characteristics suggest that a transaction's commercial substance may be different from its legal form:

• Separation of the legal title to an item from its risks and rewards. For example, an entity may sell an asset to a third party but retain the right to use the asset and the risks attached to it.
• Linking two or more transactions together. Often, the commercial effect can only be understood when the series of transactions is considered as a whole.
• Including options in a transaction.

Examples of transactions where the substance is different from its legal form include:

1. Consignment inventory - inventory is held by one party but legally owned by another. This is common in the motor trade.
2. Sale and repurchase agreements - assets are sold with an option to repurchase them at a future date for a price that includes some element of interest.
3. Factoring of accounts receivable - the receivables are sold to a factor, who then collects the cash from the customers. The factor makes a profit either by charging a fee, charging interests or paying below face value for the receivables.
4. Special purpose entities (SPEs) - these are legally independent entities that are used to take on the loans or liabilities of another entity. The purpose of SPEs is to remove assets and liabilities from the statement of financial position of the sponsor.