| Substance over form - when to apply it? |
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| Over the last few months we have focused on explaining substance over form – what it means and when it should be applied. We continue the discussion on what it means to apply economic substance over legal form, and when it would, or would not, be applied. |
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| Why do we apply substance over form? |
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The financial statements present information about the economic and other phenomena. This means that the focus is on the economic characteristics of items and what this means for a reporting entity. The legal characteristics may provide information about how economic characteristics arise, but following a purely legal classification of transactions, events and economic phenomena in the financial statements is inappropriate.
Substance over form is a fundamental principle in The Conceptual Framework for General Purpose Financial Reporting. One of the qualitative characteristics that information in the financial statements should represent is “faithful representation”. The Conceptual Framework describes “faithful representation” as follows: “To be useful in financial reporting, information must be a faithful representation of the economic and other phenomena that it purports to represent. ….Information that faithfully represents an economic or other phenomenon depicts the substance of the underlying transaction, other event, activity or circumstance ― which is not necessarily always the same as its legal form.”
In classifying transactions, events or other phenomena as assets, liabilities, revenue, expenses, equity or something else, economic substance is considered and not just legal form, e.g. recognising assets based on control rather than legal title only. Substance over legal form is also important when assessing relationships between parties for accounting purposes, e.g. control relationships, principal-agent arrangements, and service concession arrangements.
Questions have been asked about whether “economic substance over legal form” is applied in all situations, particularly the presentation and measurement of revenue, expenses, assets, liabilities and equity. The Standards often discuss whether the contractual or other legal terms of arrangements or management’s intention should be used in, for example, measuring and presenting transactions or events. The Standards provide clear guidance on when substance over form (including management intent) should be applied. Two examples are outlined below. The rights to extend the repayment of debt and how it affects the classification of liabilities
If an entity exercises its contractual discretion to refinance an obligation for at least twelve months after the reporting date under an existing loan facility, it classifies the obligation as non-current even if it would otherwise be due within a shorter period. However, when refinancing or rolling over the obligation is not at the discretion of the entity (for example there is no agreement to refinance), the potential to refinance is not considered and the obligation is classified as current.
The reason for relying on the contractual rights (i.e. legal form) for presentation, is because the classification should be based on what rights exist and can be exercised at year end. If intention was used, entities would be able to alter debt from current to non-current and potentially improve their financial position.
Calculating the impairment of receivables
In the Standard of GRAP on Financial Instruments (Revised in 2019) an entity is required to identify impairment losses based on what it believes its exposure to credit losses will be over a period of time. The expected losses are calculated based on the cash flows that an entity expects to receive and when it expects to receive them. While there are a number of assumptions that management makes about the receipt of cash flows, the underlying cash flows used in the calculation are based on what is contractually agreed. Also, the period over which the cash flows are calculated cannot exceed the contractual period of the instrument.
As with the first example, it is important that, for example, that contractual cash flows are used (i.e. legal form) as this reflects the money the entity is entitled to. Assumptions are then applied to assess how much of these cash flows will be received and when. Using other amounts would enable the entity to manipulate its financial position and financial performance. The two examples illustrate the importance of reading and understanding the Conceptual Framework as well as the requirements of the individual Standards of GRAP. |
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