Peeling away financial reporting issues one layer at a time

The Death and Transfiguration of “Substance Over Form” in U.S. GAAP

Over the years, the notion of accounting for "substance over form" has been trumpeted in IFRS circles as the apotheosis of principles-based accounting. From a practical standpoint, something like it is absolutely necessary for filling in the large gaps in specific guidance and the paucity of application examples.

This is what the IASB's Conceptual Framework said about "substance over form" until pretty recently (more on the change later):

"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. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, an entity may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the entity continues to enjoy the future economic benefits embodied in the asset. In such circumstances, the reporting of a sale would not represent faithfully the transaction entered into (if indeed there was a transaction). [¶35, emphasis added]

In stark contrast, the FASB firmly rejected the notion more than 30 years ago:

"Substance over form is an idea that also has its proponents, but it is not included [in the hierarchy of accounting qualities] because it would be redundant. The quality of reliability and, in particular, of representational faithfulness leaves no room for accounting representations that subordinate substance to form. Substance over form is, in any case, a rather vague idea that defies precise definition." [Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information, ¶160, 1980; emphasis added]

The example in the quotation from the IFRS concepts document, on legal ownership versus economic benefits, feeds right into an anecdote a good friend and trusted source related to me recently. I'll call him George.*

George was attending a conference where he asked a German accountant about the criteria that was used in his country for distinguishing between an operating and a capital lease under IAS 17. "If ze lease term ist greater than 70% of ze remaining economic life of ze asset, zen vee capitalize ze lease," said the German.

"Why 70 and not 75%?" asked George.

"Because 75% ist zee American standard," responded the German. He walked away without further explanation.

George asked a French accountant in attendance the same lease capitalization question. His answer was 90%; and when George asked him why, he too just shrugged and walked away.

That's the reality of the application of substance over form. Whatever "substance" might mean to the accounting standards setters, we all know that's not the way the pros play the game.

Under IFRS, "substance over form" can be more than a gap filler. It has even been used to trump specific accounting rules. In 2008, Société Générale chose to shove losses incurred on their account by a rogue trader into 2007's income statement, thus netting them with his gains of the previous year. There is no disputing that the losses occurred in 2008, yet the company's position is that application of specific IFRS rules (very simply, marking standalone derivatives to market with the result gains/losses going to income) would, for reasons unstated, result in a failure of the financial statements to present a "true and fair view" – i.e., substance over form. You might also be interested to know that the financial statements of French companies are opined on by not just one, but two, auditors. How could both be wrong about the "substance" of those losses? C'est imposible.

Bringing Back the Dead

If IFRS were to converge with U.S. GAAP, then it was imperative that "substance over form" be resurrected. The deed was done through the joint project to converge conceptual frameworks and hidden the basis for conclusion section in CON 8:

"Substance over form is not considered a separate component of faithful representation because it would be redundant. Faithful representation means that financial information represents the substance of an economic phenomenon rather than merely representing its legal form. Representing a legal form that differs from the economic substance of the underlying economic phenomenon could not result in a faithful representation." [¶BC3.26]

The positions of the IASB and FASB are now identical, because the same language was incorporated into the IASB's framework. The new language in CON 8 is eerily similar to old CON 2, but there are two important differences. First, the last sentence of CON 2 on the vagueness of the "substance over form" notion is conveniently omitted. Second and relatedly, the next two sentences make out "substance over form" and "faithful representation" (now one of the two "fundamental" qualitative characteristics of financial information). to be one and the same. That's pretty convenient since "representational faithfulness" doesn't seem to mean anything more or less than telling the truth. Effectively, CON 8 now says, 'The two fundamental qualitative characteristics of financial information are relevance and being truthful.' Wow, that's deep.

Does it matter that for U.S. GAAP "substance over form" has been resurrected and transfigured into "representational faithfulness"? Yes. If you are looking for example of the ways in which convergence with IFRS has diminsihed the quality of U.S. GAAP, I would make bringing back "substance over form" Case in Point No. 1. Three examples of recent consequence come to mind.

First, the AICPA has proposed to make "substance over form" a key component of its proposed accounting framework for SMEs:

"The substance of transactions and events may not always be consistent with the substance apparent from their legal or other form. To determine the substance of a transaction or event, it may be necessary to consider a group of related transactions and events as a whole. The determination of the substance of a transaction or event will be a matter of professional judgment in the circumstances." [¶1.13, emphasis added]

That last sentence is just another way of acknowledging the FASB's concern expressed in CON 2 (and which has magically disappeared): that no one knows what "substance over form" means. As a teacher, I anticipate explaining to students that a real professional knows substance is, and she knows it when she sees it. As a litigation consultant, I'm already salivating over the prospects for the extra work it promises: whenever "substance over form" is invoked to justify an accounting treatment, plaintiffs and defendants alike will arm themselves with experts swearing this "substance" and that "substance."

Is this really how the AICPA envisions it will make financial reporting less burdensome for SMEs?

Second, "substance over form" can be used by standard setters to justify almost anything. Most recently we see it being proposed to help lessees smooth lease expense. The same can also be said for the revenue recognition proposals that would permit recognition of so-called "constructive liabilities" as performance obligations.

Third, now that convergence is failed, the SEC is being pressured to adopt IFRS – if not wholesale, then to allow companies to elect IFRS instead of U.S. GAAP. Yet, whenever a particular wrinkle in a contract is not specifically addressed in an authoritative document, the IFRS accountant is charged with somehow being able to parse "substance" from "legal form" with "management's intent" thrown into the mix. And, somehow, the auditor is supposed to be able to determine whether its client's divine revelation is at least "reasonable."

* * * * * * *

IFRS adoption in any form would be an unmitigated disaster, with the ridiculous notion of "substance over form" playing a leading role. It's a concept that should have no place in U.S. GAAP, and convergence is to blame for bringing it back.



  1. Reply David January 27, 2013

    I fully agree with you. Converting to IFRS is the most stupid thing to do. But you know this country is going towards Europe styple under current administration and unfortunately accounting/auditing is just part of the whole plan.

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