Last update 04/01/2020
Substance of rights and obligations is a ‘definition’ from the Conceptual Framework. The terms of a contract create rights and obligations for an entity that is a party to that contract. To represent those rights and obligations faithfully, financial statements report their substance. In some cases, the substance of the rights and obligations is clear from the legal form of the contract. In other cases, the terms of the contract or a group or series of contracts require analysis to identify the substance of the rights and obligations.
Substantive rights – For a right to be substantive, the holder must have the practical ability to exercise that right. Substance of rights and obligations
All terms in a contract—whether explicit or implicit—are considered unless they have no substance. Implicit terms could include, for example, obligations imposed by statute, such as statutory warranty obligations imposed on entities that enter into contracts to sell goods to customers. Substance of rights and obligations
Terms that have no substance are disregarded. A term has no substance if it has no discernible effect on the economics of the contract. Terms that have no substance could include, for example:
- terms that bind neither party; or Substance of rights and obligations
- rights, including options, that the holder will not have the practical ability to exercise in any circumstances. Substance of rights and obligations
A group or series of contracts may achieve or be designed to achieve an overall commercial effect. To report the substance of such contracts, it may be necessary to treat rights and obligations arising from that group or series of contracts as a single unit of account. Substance of rights and obligations
For example, if the rights or obligations in one contract merely nullify all the rights or obligations in another contract entered into at the same time with the same counterparty, the combined effect is that the two contracts create no rights or obligations.
Conversely, if a single contract creates two or more sets of rights or obligations that could have been created through two or more separate contracts, an entity may need to account for each set as if it arose from separate contracts in order to faithfully represent the rights and obligations (see conceptual framework 4.48–4.55).
Explanation
Substance over form is an accounting concept which means that the economic substance of transactions and events must be recorded in the financial statements rather than just their legal form in order to present a true and fair view of the affairs of the entity.
Substance over form concept entails the use of judgment on the part of the preparers of the financial statements in order for them to derive the business sense from the transactions and events and to present them in a manner that best reflects their true essence. Whereas legal aspects of transactions and events are of great importance, they may have to be disregarded at times in order to provide more useful and relevant information to the users of financial statements.
Importance of the concept
The principle of substance over legal form is central to the faithful representation and reliability of information contained in the financial statements. By placing the responsibility on the preparers of the financial statements to actively consider the economic reality of transactions and events to be reflected in the financial statements, it will be more difficult for the preparers to justify the accounting of transactions in a manner that does fairly reflect the substance of the situation. However, the principle of substance over form has so far not been recognized by IASB or FASB as a distinct principle in their respective frameworks due to the difficulty of defining it separately from other accounting principles particularly reliability and faithful representation.
See also: The IFRS Foundation
