ABREMA: glossary: substance over form

Substance over form

In the final opinion formulation stage, the auditor considers the financial statements as a whole in order to evaluate whether they are consistent with the auditor's, by now, very detailed knowledge of the client, including knowledge of the business of the entity.

In so doing, the concept of substance over form plays a dominant role. In other words, the auditor considers whether the financial statements reflect the financial reality of the entity rather than the legal form of the transactions and events which underlie them.

In particular, auditors look for transactions where the substance of the transaction differs significantly from the form. The form is the description the auditee gives the transaction(s). For example, the auditee may describe the transaction(s) as a lease of equipment or a sale of inventory. There may be evidence that appears to support the form of the transaction, but auditors look beyond the evidence and the description given to the transaction(s), and instead focus on the substance of the transactions(s).

Auditors look for a transaction or groups of transactions that do not make economic sense or appear to 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 often are recorded around balance date and often appear unduly complex.

Examples:

The auditee has recorded one transaction in a group of transactions as a sale to a customer. Another transaction records a loan to the same customer for a similar amount. In this case, when the transactions are considered together, the sale may be without substance as it has been funded by the auditee.
The auditee has sold goods or services to a particular customer on the undisclosed understanding that the auditee will purchase a similar value of goods or services from the customer.
The group of transactions have the form of an outright purchase of capital equipment, whereas in fact the substance of the transactions is a lease of (or perhaps an option to purchase) the equipment.
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. (See the article by Time magazine "Behind the Enron Scandal".) 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 that the SPE is controlled by that entity.

The concept of substance over form is relevant to management's assertions that the financial statement items are complete, valid and accurate, and in particular that the financial statement items are accurate as to presentation and disclosure.

Activity Based Risk Evaluation Model of Auditing

Substance over form