Substance Over Form
Substance over form means the accounting record must reflect with transaction’s economic substance rather than the legal form. Economic substance refers to the true intention behind the transactions. Legal form refers to the clarification of transactions in accordance with the applicable law, regulation, or accounting standard. The financial statement must be present a true and fair view to the readers. The company should not use the regulation as the cover to mislead the financial statements
Substance over form concept does not want us to break the law or regulation but must ensure the true nature of transaction is taken into account. The company must measure the economic impact of the event instead of the legal form. The principle is to make sure that financial information true and faithful representation so the reader will fully understand. They are not missing any pieces of information which can impact their decision.
Substance over form is very subjective in some countries where they use rule base accounting (e.g. GAAP). Accountants must comply with accounting rule, thus they can manage to hide real intention by preparing a barely meet financial report. However, it will very hard for the company that follow the principle base accounting.
Substance Over Form Example
For example, Company A withdraws a large amount of cash at bank to keep in the vault, and they record the movement of cash from bank to cash on hand. The huge balance of cash on hand remains the same for several months before it was deposited back to bank right before the year-end. Accountant records the movement from cash on hand to cash at bank.
Based on the form, it just a movement of cash from bank to vault to support operation and so on. And it was put back into the bank at year-end, external auditor can check bank statement or send bank confirmation to ensure if the balance is correct or not.
However, there are reasons for this unusual cash movement. Company A’s owner has taken the cash to help company B which almost goes bankrupt. At the year-end, company B still not doing well, so the owner decides to borrow cash from a loan shark and put it back into the bank account.
Company A’s financial statements do not include the balance lend to company B and liability from a loan shark.
Company X sells some inventory to Company Y, the goods are transferred and the payment has been made. After several months, the same inventories are sold back at a slightly higher price. Company Y transfer back the inventory and company X settle full payment. Both company record sales and purchase as normal business transactions.
These transactions seem strange, however, they are fully complied. They have proof of payments made by bank. There are supporting documents of goods being transported from seller to buyer. And yes the goods really move from seller’s warehouse to buyer’s warehous and vice versa.
However, these are not the sale and purchase transactions, but the loan transactions. Company X borrows cash from Company Y and uses the inventory as the collateral. Company X agrees to pay back the principal plus interest on the maturity date. That’s why we see the price of inventory increase when they buyback. They do not want to record these as a loan because company X has a high gearing ratio which will impact their financial statements.
Impact of Substance Over Form to External Auditor
External auditor has to be aware of this issue and make sure the company does not hide true economic substance under the required regulation. Auditor must be skeptical to the strange, unusual, and complicated transaction as these are the areas that company want to play around. We should know the company’s financial condition in order to determine what could go wrong. So that audit team will pay more attention to those areas.
External Auditors are required to specifically check the company’s financial statements if they are complying with substance over form concept.