Information presented in the financial statements should faithfully represent the transaction and events that occur during a period.
Faithfull representation requires that transactions and events should be accounted for in a manner that represent their true economic substance rather than the mere legal form. This concept is known as Substance Over Form.
Substance over form requires that if substance of transaction differs from its legal form than such transaction should be accounted for in accordance with its substance and economic reality.
The rationale behind this is that financial information contained in the financial statements should represent the business essence of transactions and events not merely their legal aspects in order to present a true and fair view.
A machine is leased to Company A for the entire duration of its useful life. Although Company A is not the legal owner of the machine, it may be recognized as an asset in its balance sheet since the Company has control over the economic benefits that would be derived from the use of the asset. This is an application of the accountancy concept of substance over legal form, where economic substance of a transaction takes precedence over its legal aspects.
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ABC LTD sold 3000 bread loafs to XYZ Bakers in the year 2011 costing $1 each. XYZ Bakers has the option to return unsold breads to ABC LTD within 7 days of the sale. In the first week of 2012, XYZ Bakers returned 200 of unsold bread loafs to ABC LTD. How much sale should ABC LTD recognize in the income statement for the year 2011?
Although ABC LTD had in fact sold 3000 bread loafs during the year, not all of the sales should be recognized because there was a known and obvious risk at the year end that sales made in the last week of the year may be returned subsequently. It would not be true and fair in the circumstances to recognize $3000 sales when it has been confirmed subsequently that 200 units of bread loafs were returned to ABC LTD.
As XYZ Bakers had the option to return unsold bread loafs within 7 days of purchase, there was a risk that not all of the sales made by ABC LTD to XYZ Bakers may be realized. Therefore, in order to present true and fair view of ABC LTD's activities during the year, only confirmed sales (i.e. $2800) must be taken into account when preparing financial statements.