The term substance over form is an accounting concept that ensures financial statements are true and fair, rather than focusing on the legal forms of business transactions. Financial reports are prepared based on their substance. That is, the true and fair intent of the event.
What you should know?
Substance over form means accountants should record business transactions by considering their substance rather than the form. When a business records transactions based on its legal form, it means that the financial statement will not be presented fairly. To avoid this, accountants focus on the substance of the transaction.
To explain it, consider a business whose activities is to act as an agent for another business in selling a product. In business law, the agent does not have ownership (also called title) to the goods. Therefore, according to the law, the implication of not having title to the goods, is that such goods should not go into the agent’s book of accounts.
However, this does not reflect the substance of the transactions. The principal of the product sends the goods to the agent. Therefore, such goods should be recorded in a consignment account in the agent's book. This will enable transparency and tracking of the product and the commission the agent earned.
Applying the substance over form principles
There are three areas where the principle of substance over form is applicable.
1. Business operations
In business operations, substance over form is applied in agent and principal relationships, lease, sales and leaseback, and financial assets impairment loss.
2. Taxation
For taxation, the tax man needs to know if the business is reporting the substance of its transactions or only reporting a few that it wants the tax authority to know. In Nigeria, the FIRS has begun the implementation of e-invoicing. All businesses are expected to connect their business to this platform. This will enable the FIRS to easily understand the substance of the business transactions and its reduced tax audit process.
3. Auditing
In auditing, auditors are expected to give an opinion on the true and fair view of the financial statements. An auditor will not give an unqualified opinion if he/she believes the company does not report the complete business substance.
Applying the principle to the Lease agreement
In a finance lease, the legal form is that the lessee does not have ownership of the leased asset. If this legality is followed, the book of accounts cannot contain the lease asset. But examining the substance of the transaction reveals that the lessee is responsible for the maintenance of the non-current assets and will also benefit from using them in the form of cash inflow.
Since the risk and reward go to the lessee, the substance of the event means recording the leased assets in their accounts. This is also true with operating leases, where the Right to use the asset is recorded in the financials and in sales and lease-back.
Impairment of financial assets
Financial assets such as accounts receivable and loans in commercial banks may not be paid by the borrower. If the legal form is followed, the company will recognize the default when it occurs, as in the case of reporting non-performing loans to the Central Bank of Nigeria.
However, to comply with the substance over form, an impairment loss is computed immediately the loan sum has passed to the customer. This will ensure that the company provides for the future occurrence of default loans and that the financial report is fairly presented to users.
Post a Comment