What happens when law and accounting differ?

Over the past weeks, our social media has focused on the principle of economic substance over legal form in preparing financial statements.

In summary, the information in the financial statements should provide users with information to hold entities accountable and make various financial, economic, and other decisions. As a result, the information should, among others, provide relevant information to meet these objectives and faithfully represent the economic phenomena underlying transactions and events undertaken by the entity.

A faithful representation of economic phenomena means that information is complete, neutral, and the substance rather than the legal form of transactions and events is reflected in the financial statements. The financial statements reflect rather than those based solely on legal or similar rights.

We have received questions about what to do when legislation, contracts or similar seemingly “differ” from accounting standards. For example, a contract stipulates a principal-agent arrangement and identifies which party is the principal and which is the agent.  If GRAP 109 on Accounting by Principals and Agents is applied to determine who is the principal and the agent, a different answer emerges.

As the financial statements are prepared using Standards of GRAP and not legal prescripts, entities should apply the principles in the Standards to identify transactions and events, the roles that parties fulfil in transactions and events, and other principles relevant to their recognition and measurement.

As the Standards of GRAP acknowledge that there may be differences between accounting and the legal form of transactions and events, the following is important:

• Legislation, contracts or similar agreements do not need to be amended to reflect the accounting outcome. Anecdotally we have heard stakeholders (whether preparers or auditors) express a need for contracts to be revised to reflect the accounting outcome. This is not necessary given that contracts are designed to reflect legal principles and protect the interests of all parties. In contrast, Standards are designed to ensure credible financial reporting in the financial statements.
• Consulting legal professionals on the legal principles and legal rights and obligations in an arrangement, transaction, etc., is appropriate. Given the different objectives of legal and accounting principles, it is inappropriate to ask legal professionals to give opinions on accounting matters or interpret accounting standards.

Applying substance over form requires a high degree of judgement, which makes applying the principle complex. Just because something is difficult, does not mean it should or cannot be done. It is the role of finance and other professionals to ensure that the best economic reflection of transactions and events is reflected in the financial statements.