Substance of a transaction Essay Example | Topics and Well Written Essays - 1250 words

Substance of a transaction - Essay Example According to any international standard,financial statements should present fairly the financial position and cash flows of an entity.The substance of a transaction means the reality of an actual event that has taken place which needs to be accounted for. If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.It is, therefore, of absolute importance that the actual substance of the transaction is accounted for in order to meet international regulatory requirements for financial reporting as well as achieve fair presentation standards and a higher level of transparency in the books of accounts to avoid any audit objections.The generally accepted accounting principles, more commonly known as GAAP, have evolved as an important term in accounting and signifies all the rules, from whatever sour ce, which govern accounting. These principles may derive from sources like local company legislation, national and international accounting standards, statutory requirements and stock listing requirements yet they are based on the foundations of common principles, namely the going concern assumption, accrual basis of accounting, materiality and substance over form. The GAAP which lays down the concept of substance of transactions is called "substance over form". The underlying principle is that although substance of a transaction may be the same as its legal form, for a number of transactions, the legal form does not indicate the true substance of a transaction and must make economic sense in the financial statements reflecting the reality of an actual event that has taken place. Such may be the case in various sales purchase agreements, leasing, insurance etc. As an example, some transactions may have the form of an outright purchase of capital equipment, whereas in fact the substa nce of the transactions is a lease of (or perhaps an option to purchase) the equipment. Such transaction also attract audit attention and are important from taxation point of view. Thus we always consider the real substance of a transaction instead of its legal form. In this manner, the concept of substance over form plays a dominant role. Accordingly, it delivers the fact whether the financial statements reflect the financial reality of the entity rather than mere legal form of the transactions and events which bring them about. The underlying principle is relevant to management's contentions that the financial statement items are complete, valid and accurate, and in particular that the financial statement items are exact as to presentation and disclosure. The FASB considered that substance over form was redundant because without it have representational faithfulness cannot be achieved. From auditor's point of view, transactions where the substance of the transaction differs significantly from the form are considered vigilantly. In simpler words, auditors try to find a transaction or groups of transactions that do not make economic sense or emerge as they have been made to change the way in which an account balance appears in the financial statements, rather than reflect the reality of an actual event that has taken place. These transactions are commonly recorded around balance date and often appear overly complex. "A well-known example from the past was Enron group's use of over 3000 Special Purpose Entities (SPEs) structured in such a way as to enable the company to avoid including extensive debt in the consolidated financial statements of the group. This has led to suggested/actual revisions to various accounting standards throughout the world. These revisions require SPEs (such as trusts, partnerships and non incorporated entities) to be consolidated when the substance of the relationship between an entity and the SPE indicates