In order to determine whether an asset or liability has been created, it is necessary to examine the economic substance of the transaction, and not only the legal form of the transaction. The term “risks and opportunities” is often used to determine the content of business transactions, and some factors that may be taken into account are the following. It seems that the concept of substance rather than form should, in my view, be the only accounting practice. The article compares this to the purely legal form of accounting. Thank you for giving a clear example of this concept. The explanation is in one word The philosophical basis is that auditors should focus on the natural and underlying substance of a transaction and not on its legal form. This concept is one of the underlying accounting policies of the IASB`s conceptual framework. The concept of substance over form is easy to understand, but many stakeholders find it strange because this particular concept questions the legal form of a transaction and replaces it with the economic form. However, it is applied to increase fairness in a company`s business, which is ultimately reflected in its financial statements. This concept means that transactions should be considered according to their economic or financial reality rather than their legal form in order to promote a more objective picture of transactions and events. Since at times the “legal form” of a transaction may not give a true and fair view, and in addition to the fact that the legal form is of great importance, it may be neglected in order to present more relevant knowledge to users of financial statements. This area of accounting is somehow critical and subjective and involves the point of view of the creator.

The concept can be critical in terms of actions and agreements, but it simply requires you to present the true intentions behind a deal so that users are not misled. For example, in leases, ownership and use belong to another party, but the risk and reward always rests with the owner of the asset. It is therefore not necessary to follow economic substance instead of legal status. However, with leasing, the risks and rewards are essentially passed on to the lessee, so the lessor (who is also the owner of the asset) is not responsible for the risks and opportunities. Here, economic substance is preferred and the asset is recorded in the lessee`s financial statements, even if he is not the owner. Relevance means that a financial transaction has an impact on the business. For example, costs paid for assets a few years ago should not be included in replacement decisions. The price originally paid is unlikely to be repeated.

Therefore, accountants should not include the information in the reports to make a new purchase. Another example of relevance of content to form is when costs are different for different alternatives. Only the envisaged alternative has relevant costs. @David09 – I am shocked to read that some accountants, as the article says, “sacrifice the accuracy” of their financial statements by using substance rather than forms accounting. Substance versus form in accounting refers to a concept that transactions recorded in an entity`s financial statements and accompanying disclosures should reflect their economic substance rather than their legal form. At times, the “legal form” of a transaction may not give its true image. While legal form can be important, it can be ignored in order to provide users with more relevant financial information that should not be misled. I believe that in cases where accuracy is sacrificed to meet deadlines, these future financial statements would correct previous deficiencies in reporting. At least, that`s how I would cover myself. We are confused because Mr.

ABC is the owner of the car, which is why it should appear in his books. But on the other hand, Mr. XYZ uses the car and all income (rewards) and losses (risks) of the car are with Mr. XYZ and for this reason, Mr. XYZ`s financial statements should have this asset. Well, according to the legal form of the transaction says that these machines belong to Mr. A. And the economic substance says that the economic benefits (rewards) and losses (risks) associated with the machine are with the owner of the machine, i.e. Mr. A, that is, the income obtained from the sale of biscuits is appreciated by Mr.

A and also, if something happens to the machines, Mr. A will bear the losses. The legal form, on the other hand, refers to the legal status of the transaction. Finally, “economic substance” should not be confused with “possession” or “use”. There are many examples where ownership of the asset belongs to a party other than the owner, and yet we do not apply this concept. The reason for this is that economic substance is not a question of ownership and/or use, but of risks and opportunities. With this concept, we check whether the risks and opportunities lie with which party and then decide accordingly what the accounting treatment will look like. If you want to better understand IFRS, read our IFRS blogs or take an IFRS review course with Eduyush. Although the asset is sold to Bank XYZ and the bank is legally the new owner, Mr. A`s risks and rewards are still exactly the same as before the sale, as the asset is returned to Mr.

A under a 10-year finance lease. However, the problem I see with the substance over form method is that determining things like relevance could, in my opinion, be open to subjectivity. Thank you for simplifying the concept. As for me, I am very satisfied with the examples used and do not hesitate to explain it to my classmates. I can see how a pure legal form would be misleading and could distort an investor`s interpretation of a company`s performance. Therefore, the concept of substance is applied on form and the transaction is not a sale transaction, but a secured credit transaction, so that the asset remains in Mr. A`s books and any money Mr. A receives from Bank XYZ is recorded as a long-term liability. Quite amazing with clear explanations. Substance rather than form is a particular concern under generally accepted accounting principles (GAAP), as GAAP is largely rules-based, creating specific hurdles that must be overcome in order to capture a transaction in a particular way.

Therefore, someone who wants to hide the true intent of a transaction could structure it in such a way that it barely meets GAAP rules, allowing that person to record the transaction in a way that hides their true intent. Conversely, International Financial Reporting Standards (IFRS) are more principles-based, making it more difficult for an individual to reasonably conceal the intent of a transaction when using the IFRS framework to prepare financial statements. To learn more about the variance of fixed overhead volume, contact GoCardless` financial experts. Find out how GoCardless can help you with one-time or recurring payments. When a small adventure company in Cornwall buys a fleet of vans with a lease from a bank, they pay a portion of the initial costs and the remaining amount for the vans over a five-year period. While the company legally owns the vans from an “economic standpoint,” it will not be recognized as the “rightful owner” until it pays the final installment at the end of the fifth year. The concept of substance over form involves the use of judgment by financial statement preparers so that they can infer business acumen from transactions and events and present them in a manner that best reflects their true nature. Although the legal aspects of transactions and events are of great importance, they sometimes need to be neglected in order to provide more useful and relevant information to users of financial statements.

In some cases, accountants may sacrifice accuracy when preparing financial statements. Completeness and relevance make more sense in substance than in form. While accountants should strive to be accurate at all times, too many hours on a project can lead to delays in completion. Other activities can also suffer if accountants fall behind due to time-related issues. For example, tax reports or public filing deadlines may not be met by a company. A transaction is an instance of an event that can change the financial situation of a business entity. This is usually a contract between a buyer and seller that results in an asset for one business and/or a liability for the other company. Selling stocks, buying raw materials, entering into legal agreements and obtaining a bank loan are examples of business transactions. GoCardless is used by more than 70,000 companies worldwide.

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