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Why substance over form is important in accounting?

Under IASB  conceptual framework for financial reporting, certain qualitative characteristics of useful financial information are identified. These are subdivided into characteristics considered  fundamental and those considered to be enhancing. The two fundamental characteristics identified by framework are relevance and faithful representation. In order for financial transaction to be represented  faithfully in the financial statements the principle of substance over form should be applied.This means that wherever there is difference between the legal form of transaction and its economic substance, the financial statements should reflect economic substance.It has been one of the failure of accounting regulation over the years that creative means  of circumventing well meaning rules have been found. The result of such efforts have been the undermining of the faith in the ability of financial statement to reflect faithfully the truth and fairness of the performance and financial position of the reporting entity.It has become clear that any hard rule can be creatively circumvented by contriving transactions appropriately. This is because transaction are necessarily structured between  parties as they wish, and to suit their business needs. Regulators can not anticipate the needs of transacting parties, and rules by their nature always lags behind the transactions themselves. In other words, as regulators see a transaction that is not covered by the existing rule, they seek to plug the gap. This is not a satisfactory way to ensure that financial statements reflect truth and fairness.

 Since 1990s, regulators have sought to implement a principle based set of standards. These place the truth and fairness objective above any single rule. Indeed, they require that rules be departed from if they do not result in fair presentation of a transaction. One of this principle is substance over form. If a transaction is structured in such a way that economic reality (substance) differ from the legal form of the transaction, the accounting must reflect economic substance.

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