What does applying “substance over form” mean?

  • February 1, 2022
  • Posted by: Julianne Vissie
  • Category: Blog
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Understanding what applying “economic substance over legal form” – at a conceptual level – means knowing why we prepare financial statements and the basic principles  that we should use to prepare them. Information in the financial statements should demonstrate certain characteristics.

We prepare financial statements so that those that provide resources to public sector entities and those that benefit from government services can (a) hold entities accountable, and (b) make economic decisions at  year-end and into the future. Information in the financial statements should be relevant to users’ economic and accounting decisions, faithfully represent the economic characteristics underlying events and transactions, be verifiable, comparable, and be timely enough to allow appropriate action to be taken.

Faithfully representing the economic characteristics underlying events and transactions means that information is complete, neutral, and represents the economic substance and not the legal form of transactions or events. Representing the economic substance of transactions and events rather than their legal characteristics is critical to the preparation of financial statements.

There are several examples where substance over form is applied in the suite of Standards.

Area Substance over form
Assets Recognition of assets

Assets are recognised based on control of the economic benefits or service potential of an asset and not solely on the legal title or legal ownership.

Arrangements to use assets for a specified period in return for a series of payments, i.e., leases, depending on the circumstances, may result in the acquisition of an asset along with a liability.
  Classification of assets

Assets are classified based on their use for accounting purposes rather than their “legal” classification. For example, assets need not be designated as heritage items in legislation to be classified as heritage assets in the financial statements.
Liabilities Liabilities can arise from legal obligations as well as constructive obligations. Constructive obligations arise from past practices or past behaviour.
Equity (residual interests) Equity instruments (e.g., shares) or a component of equity instruments could be liabilities instead of equity (residual interests). For example:

·     Dividends payable on preference shares.

·     Shares issued by an entity that are required to be  bought back on request of the holder.
  Arrangements called “loans” but with no explicit requirement to pay cash to another entity are classified as equity (residual interests) rather than liabilities.
Classification of arrangements Principal-agent relationships

While there is broad consistency between the legal principles of principals and agents and Standards of GRAP, the following may arise when considering substance over form:

·      An agreement might not specifically identify a “principal-agent arrangement” – the definition and principles in the Standards should be applied to determine the existence of such arrangements.

·      An arrangement might identify the “principal” and the “agent” – the principles in the Standards are applied to determine whether the arrangement is a principal-agent arrangement and which party is the principal and agent.
  Parent-subsidiary relationships

Legislation, contracts, or equivalent may indicate that one entity controls, or is a subsidiary to, another entity. “Control” over another entity depends on the existence of powers over and the rights to benefit from those entities.

The table above highlights some typical examples, but more exist. Legal rights and obligations are not the only factors considered in accounting for events and transactions. Preparers should review arrangements carefully and apply the specific principles in the Standards of GRAP to account for those transactions.

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