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SUBSTANCE OVER FORM

NATRAJH RAMAKRISHNA
Chartered Accountant

BACKGROUND: the substance and form do not differ and therefore,

The principle of substance over legal form is central to do not require any further inquiry. However, some of
the faithful representation and reliability of information these would:
contained in the financial statements. The responsibility
on the preparers of financial statements is to actively a. The party that gains the principal benefits from the
consider the economic reality of transactions and events transaction is not the legal owner of the asset;
to be reflected in the financial statements. And more
importantly, account for them in a manner that does fairly b. There are a set of transactions that we know are
reflect the substance of the transaction (and situation). all inter-linked in such manner that the commercial
This is because, preparers understand the commercial substance can be determined only by putting together all
reality best and also the reason why the legal form was these transactions, treating them as “interlinked”;
considered appropriate to a particular set of transactions.
c. An option is included on terms that make its exercise
In the same way, it is important for accountants and auditors highly likely;
whose responsibility it is to review financial statements
that they obtain the commercial reality and substance of 1.2 Let us now look at a couple of transactions:
the transactions from the preparers to serve the overall
objective of “faithful representation” which represents one a. A finance company buys a huge item of plant &
of the two ‘Fundamental Characteristics’ and components machinery that it will not use and plans to sell it to the
of the Conceptual Framework for financial reporting. previous owner? Is this a sale transaction or a financing
arrangement is what we may need to establish.
What is critical to both the preparer and the reviewer is
that ‘substance over form’ does not mean that we ignore b. An auto manufacturing company appoints dealers
‘Form’ …. in that case, the entire edifice on which Ind AS through whom it sells cars on the condition that it will
115 on Revenue Recognition where the contract with the transfer the cars at a fixed price, will bear the cost of price
customer is fundamental to revenue recognition, would fluctuations and the risk of obsolescence… in effect, the
collapse! What is meant is, we focus on the commercial auto maker bears all the significant risks and this could
substance and reality of the transaction(s) in its entirety. be a significant indicator whether the company needs to
derecognise the asset.
Accordingly, this article does not seek to judge the legality
of transactions from the narrow prism of a reviewer. 2. Substance of transactions and the
Instead, it focuses on working together as preparers and standard setters…
reviewers to reflect the substance of transactions in the
financial statements. 2.1 There has been a fair amount of understanding and
consensus among various authorities and accounting
1. Introduction: standard setters that except for certain circumstances and
reasons, "substance should follow form", although, it is
1.1 We are all aware that an entity’s financial statements not necessary that transactions should not follow form.
should report the substance of the transactions that it
has entered into. Normally, transactions are such that 2.2 Very recently, Tax Authorities introduced General

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Anti Avoidance Regulations (GAAR) to deal with certain because it was considered “redundant” to be presented
set of transactions entered into by entities, with the sole as a separate component of “Faithful Representation”.
objective of reducing or shifting the tax base, etc to the Except for FRS 5 which sets out the principles that will
detriment of the Exchequer. The net effect of the GAAR apply to all transactions where we need to inquire into
provisions (to put them simply) is to disregard the the basic principles for identifying and recognising the
legal form of these transactions and look only at the substance of transactions, none of the accounting
substance, that is the “Commercial Reality” and tax the bodies devote a separate standard to deal with the
entity accordingly. Obviously, these relate to a specific complexities arising out of “substance over form”.
set of transactions entered into with the only significant
objective of reducing tax liability. 4. Let us look at some of the account-
ing standards that specifically address the
2.3 Financial markets have been developing products issue of substance over form in greater detail:
and solutions around financial reengineering, segregating
risks between parties and selling these products. Lease a. Ind AS 115 the new Revenue Recognition Standard
financing, Securitisation, Derivative instruments, the that replaces Ind AS 11: Construction Contracts and Ind
creation of SPVs, are part of innovative products that AS 18: Revenue specifically to deal with the complexities
were developed to help finance companies. Regulators and changes that have been taking place in the structuring
and accounting bodies have been putting together their of business transactions of various types and in several
collective wisdom and market knowledge to address sectors such as Information Technology, Infrastructure
these complexities. and Real Estate, etc. by focusing on Revenue Recognition
from the customer’s point of view.
Sale and Lease back arrangements were an accepted tax
planning devise until GAAR came in and so were financial b. Ind AS 17 Leases where Operating Leases have also
leases on the basis of which an entire industry came into come within the ambit of the Standard.
being. Financial instruments became more complex with
the issue of complex derivative products, securitisation c. Ind AS 110 that deals with Consolidated and Separate
etc. The introduction of convertible securities raised issues Financial Statements. The standard deals with various
regarding the nature and classification of capital and debt. scenario which emphasises on reflecting the substance in
determination of control such as de-facto control, assessment
3. The response of the IASB of participating rights vs. protective rights, analysing the rights
and obligation assumed by the shareholders irrespective of
There is no specific international financial standard that their legal shareholding in the entity.
deals with the topic of substance over form. Unless
specifically governed by specific standards, the terms d. Ind AS 32 on Financial Instruments: Presentation
of transactions will be scrutinised to determine how the specifically deals with the classification of debt instruments
transaction should be recorded. into debt and equity in certain cases, like for example
Convertible Debentures that are broken based on a fair
It was only around 1985 that the Institute of England valuation into equity and debt. This standard also covers
and Wales issued the first authoritative document on Off a situation where in a financial instrument would classify
Balance Sheet Financing with a view to determining the as equity instruments but if the other members of the
accounting treatment of transactions and their economic group assumed any obligation or provided any guarantee
substance rather than their mere legal form. to the holder of the instrument, then such additional
terms and conditions would need to be considered for the
The IASB came up over a period of time with a fairly determination such instrument as equity or financial liability.
comprehensive Financial Reporting Framework that
formed the basis and context for standard setters across 5. Illustrative "Principles” that could apply
the world. Notwithstanding that, substance over matter to most transactions:
forms an all-pervading aspect of financial accounting;
its reference was omitted from the Framework for the i. UK GAAP deals with the concept of “substance over
Preparation and Presentation of Financial Statements form” through FRS 5 that lays down the general principles

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that could apply to transactions. It adopts a strictly significant variations occur, it may be necessary to vary
Balance Sheet strategy namely, settle the assets and the valuation of the asset or the liability. For example,
liabilities and let the profit and loss entry emerge. through a series of transactions, an entity hands over
One simple governing principle is when determining the the economic benefits from a financial asset in part
nature of transactions, one needs to decide whether, as a (one specific revenue stream is parted with), there is no
result of the transaction, the reporting entity has created complete alienation, in which case, it may be necessary
new assets or liabilities or whether it has changed any to recognise the variation in the books.
of its assets and liabilities. The Standard emphasises
the need to focus on the commercial logic of the (set of) In this context, it may help revisit some of the key
transactions of the respective parties. And, if this does not definitions to get to the substance of the transactions
make sense, probably, all aspects of the transaction or all and these are: Assets, Liabilities, Common Control,
parties to the transaction(s) have not been identified. Options, etc.

ii. Complex transactions have certain common features 6. Looking at Illustrative Case Studies to
that we need to look out for, such as: demystify some of the complexity:

a. Where the legal title to an item is separated from the A small list of illustrations to better understand this
ability to enjoy the principle benefits and exposure to the principle….
principle risks associated with it; the main issue here is the
identification of assets and liabilities and tests to ascertain A. Ind AS 115: Revenue Recognition
whether the asset or liability should be recognised in the
balance sheet Consignment Sales:

b. The tying up of all related transactions to make sense This is a case of Principal vs Agent. In this case, the Consignor
of the commercial reality or substance; sends goods to the consignee to the specifications of the
ultimate customer and is responsible for any deviations. The
c. The inclusion in the transaction of option whose terms Consignee sells the stock in the normal course and returns
make it highly likely that the option will be exercised; the unsold goods to the Consignor.

d. Situations where the relationship between the two Some of the key or significant risks for consideration that
entities is that of parent and subsidiary; the concept of would determine whose asset or obligation it is would be:
‘control’ becomes very critical here;
... does the Principal take primary responsibility for
iii. The identification and recognition of the substance fulfilling the terms of the contract on acceptability of
of transaction is to identify whether it has resulted in the product and its specifications (that is, meeting with
complete alienation of the asset or the liability or whether, customer specifications)
it has given rise to new assets or liabilities for the entity or
whether it has increased the existing assets or liabilities ... who bears the Inventory risk: this comprises of two
of the entity. The transaction may result in the entity losing components that is, whom bears the risk of slow moving
control over the future economic benefits of the asset. inventory and second, the risk of inventory after it reaches the
customer (that is, where the customer has the right of return)
iv. Transactions may result in the creation of new
obligations where the entity is unable to avoid the outflow ... is the stock transferred at a price fixed by the entity.
of benefits. If that be so, the liability is recognised!
Comments: The crucial tests are:
v. Complexities arise when there are subsequent
transactions that result in affecting these rights or i. Consignment revenues are not recognised when the
obligations. Where the transaction does not significantly goods are delivered to the consignee because control is
alter the entity's rights to benefits or its exposure to risks, not transferred. Revenue is generally recognised on sale
the entity should continue to maintain "status quo". When to the customer.

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ii. Revenue recognition upon transfer of ‘control’ is Real Estate Transactions: Performance obliga-
different from the ‘risk and rewards model’ under Ind AS tion relating to the provision of common ame-
18. Per Ind AS 115, ‘control of an asset refers to the ability nities:
to direct the use of an obtaining substantially all of the
remaining benefits from the asset. One area of significant judgment is with regard to
performance obligations made by the builder. It is
Sale & Repurchase: common, builders are able to sell individual apartments
whereas common facilities forming part of the performance
A is a Developer in the Real Estate business, he also obligations, remain incomplete.
possesses significant land banks. He enters into an
agreement with ABC Bank to sell some of the land 1. Hypothetically, a builder had launched a project of five
based on: buildings, out of which, he has completed three of them in
full. Under RERA, all the five buildings were considered
i) Sale price on date of sale will be decided by the seller as one project. The builder has completed all necessary
who will appoint his own valuer; steps with regard to the individual apartments sold, viz:

ii) A gets the right to develop the land during any time - The builder has a present right for full payment from the
commencing within the next three years during ABC’s respective owners
ownership. Given A's credentials in the sector, ABC will
not unreasonably withhold any of the development plans. - Legal title has been transferred for each of the apartments
However, ABC will bear all the outgoings during this
entire period including taxes etc. ABC will also charge an - Physical possession has been completed.
addition fee of 10% of costs incurred that will cover its
administration costs; 2. Significant risks and rewards of ownership have been
transferred to the individual owners and
iii) The bank will maintain a "Memorandum" account to
which all costs incurred will be debited and should A re- - The owner has accepted the apartment.
acquire the land, all these costs will be recovered including
interest calculated at the average of the last three years; 3. Common facilities such as sports complex and social
function halls;
iv. The Bank grants A an option to buy the land anytime
within the next 5 years at the price that is determined 4.These were all part of the performance obligations of
on the date of the repurchase, except that the Bank the builder.
will deduct all expenses it incurred during the period of
its holding. The builder says that Occupancy Certificate is pending
and therefore, the builder’s contention is that they do
v. The Bank also has an option to sell the land at the not propose to recognise any revenue on the completed
same price as determined in the Memorandum to any units. The alternate view is as under:
third party, except that A will be given the first right of
refusal. In the event of the land being sold to a third party, i. Revenue should be recognised on the units actually
all proceeds net of incidental costs including brokerage sold; the amenities represent implicit obligations because
etc. will be deducted by the bank and made good to A. they are not ‘distinct’ from the project and real estate has
Comments: The substance of the transaction appears been sold without completion of these facilities;
clearly as a secured loan because, A continues to control
possession of the land, control’s its development, bearing ii. The individual units are ready and the builder has
all costs and acknowledging all the obligations relating actually been advised that they can apply for an OC
to ownership and use. The right to first refusal virtually for the completed part because it is completed in every
ensures that the return of the asset is controlled fairly which way, however, the builder has been postponing
through the entire transaction. this process.

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Comments: In the case above: This is an area arrangement with a reputed factor with the following key
of complexity and responses will differ upon conditions:
circumstances of the case:
i. The company will transfer the portfolio through an
i. There is a valid contract (whose attributes meet with the assignment to the Factor for Rs. 275 million of cash.
conditions specified in Ind AS 115) that has been entered All debts have been subject to a credit appraisal by
into with the owners; an independent agency to ensure that the portfolio
transferred is, ab ignition, not a "troubled" debt. The
ii. Individual performance level obligations have been met Factor will pay the cash of Rs. 275 million “upfront” to the
except that obligations that are implied such as sports company.
complex and function halls are yet valid expectations and
therefore, obligations that remain unfulfilled yet; however, ii. The company will open a separately nominated account
the contract states that these areas are scheduled into which it shall deposit all the collections it makes from
to be complete by the time the other two buildings its debtors. The Factor will charge a collection fee and this
are completed. will be added up to the amounts collected by the company
upon settlement and end of agreement;
iii. Given the fact that the three residential buildings are
complete in every which manner, the only question that iii. Any collections falling short of Rs.275 million will be
remains unanswered is whether the builder is in a position to the company’s account and so will any collections
to apply for the OC immediately; that would require him in excess of Rs.275 million: the company takes the
to confirm several matters including mainly, an affirmation upside too;
that all aspects of the three buildings have been completed
for survey by the Authorities. If the builder is in a position iv. Upon termination of the agreement, all outstanding are
to do so, Revenue should be recognised in respect of agreed upon and settled in cash.
every apartment sold, which meets the criteria set out in
Ind AS 115 and para I above that is, there should be a The substance of the transaction is as under:
valid contract, individual (apartment) performance level
obligations have been met, legal title has been transferred i. Under the agreement, the maximum exposure that the
for each of the apartments, physical possession has been company has is to the extent of Rs.275 million that it has
completed, significant risks and rewards of ownership received from the Factor, upfront;
have been transferred to the individual owners and the
owner has accepted the apartment. ii. It means, the company has given a guarantee to the
Factor to the extent of the entire Rs.275 million, that is,
B. Ind AS 109: Financial Instruments for all credit losses;

Factoring of Debts: iii. In addition, the company is entitled to the upside too;

Factoring is a common practice to raise money's Comments:

especially in cases where a company wishes to remove
the factored debts from the balance sheet and preferably, i. This means, the company has retained both the credit
show no liability for payments made by the Factor. and late payment risks associated with the portfolio;
therefore, the entity has retained substantially all the
Factoring: a Case Study: risks and rewards of ownership of the receivables and
continues to recognise the receivables.
A company with a poor history of collections approaches
a "Factor" because a stage has arrived where the ii. Such type of transactions can be a very useful way of
bankers have threatened not to increase working capital raising cash quickly and can be tricky from accounting
limits to the extent of overdue debts. The company holds perspective. It involves analysing terms of arrangement
a portfolio of Rs.300 million. It enters into a "factoring" to establish the substance of the transaction. Key

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point here is, understanding the “ownership” of the to determine the real substance behind the structuring.
receivable in establishing the commercial substance
of the transaction. In cases cited above (that is, where voting rights are not
the dominant factor in deciding control over the investee),
iii The company will therefore need to recognise the an understanding of the purpose and design of the
consideration received from the broker as a secured investee would help to understand the reasons why the
borrowing. investor is involved with the investee, what risks was the
investee designed to be exposed and which are the key
C. Ind AS 110: Consolidation parties exposed to those risks and variable returns. Such
mapping of power with the ability to use that power to
Case Study: Control influence the variable returns will be helpful in determining
who has the control.
The assessment whether an investor has control over
an investee depends whether the entity has all the three In certain complex situations where two or more investors
elements of control over the investee, viz; power over the control several relevant activities of the investee, it is
investee, exposure, or rights to variable returns and the important to ascertain which investor controls the activities
ability to use its power to influence the investor’s returns. with the most significant returns.

It is a simple situation where control of an investee is held One may conclude that the substance of the control
through voting rights; however, it is not clear whether can be determined by examining where the decision-
control of the investee is through voting rights, a critical making powers resides i.e. seat of power. To establish
step in assessing control is identifying the relevant the decision making with complex legal structure, it is
activities of the investee, and the way decisions about necessary to look into framework for assessment of
such activities are made. Relevant activities are activities control i.e. i) Assessment of purpose and design of the
that significantly impact the investee’s returns. Power investee, ii) Its relevant activities, iii) and how decision
over an investee is fairly established when an investor about these relevant activities are made. This involves
who does not have majority voting rights has power to complete understanding of the lucidity behind the
influence decision making with regard to the relevant structure and role of each party.
activities that significantly affect the investee’s returns.
7. Conclusion:
Generally, decision making is controlled by majority voting
rights that also give rise to variable returns. But in certain Given the complexities that the financial markets are
cases, the investor may be holding less than majority of made of and also given the financial structuring options
the voting rights, in which case, it may not be as straight that businesses have, it is necessary that the Financial
forward. This is particularly so in the case of a structured Accounting and Reporting Framework specifically may
entity (SPV) that is used to control an investee company necessitate separate guidance that deals with 'Substance
and the investor does not have any dominant holding over Form'. While the specific standards such as Leasing,
in the structured entity and voting rights are not the Revenue Recognition and Consolidation have dealt with
dominant factor in deciding who controls that structured several of the complexities, the need for an independent
entity. This is where all factors listed above (power, standard that builds the logic for accountants and auditors
exposure to variable returns and ability to use power over to apply cannot be overemphasised.
investee) may all be need to be taken into consideration

Learning is not virtue but the means to bring us an acquaintance with it. Integrity
without knowledge is weak and useless, and knowledge without integrity is dangerous
and dreadful. Let these be your motives to action throughout life:
the relief of the distressed, the detection of frauds, the defeat of oppression,
and diffusion of happiness. — Nathanael Greene
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