When it comes to the financial statements, the accountants always win … But why do they win?
The purpose of the financial statements is to faithfully represent the economic phenomena underlying transactions and events. Faithfully representing the economics of transactions and events means that the principles in the Standards of GRAP that describe relationships and their elements – revenue, expenses, assets and liabilities – are used to prepare the financial statements. Sometimes, these principles are different from the legal form described in contracts or legislation. This overarching principle is outlined in the Conceptual Framework and as is called ‘substance over form’.
While it may seem illogical that legal and accounting principles should differ, consider the following examples:
An arrangement is called an ‘operating lease’ in a contract, but the economic reality of the transaction is that the lessee is required to make payments to the lessor that equal the value of the asset over its economic life. From a legal perspective, the lessee is contractually obliged to make payments to use an asset for an agreed period.
From an economic perspective, the lessee acquires control of the benefits of an asset and must make payments to the lessor.
An entity issues equity instruments to raise funding for its capital acquisition programme. The entity agrees to buy back the equity instruments from the holder should they exercise their discretion to sell. Although legally an ‘equity instrument’ has been issued, the economics of the transactions require the entity to buy back the instruments at any point in time. This means that the entity has a liability rather than equity.
Legislation may indicate that one entity ‘controls’ another because of certain decisions that it can take regarding the other entity’s activities. As the financial statements are prepared only for those activities where an entity can direct, and benefit from, the financial and operating policies of another, control could differ from a legal and economic perspective. Similar differences could exist for other ‘relationships’ which could be described differently in law and Standards of GRAP. These include principal-agent arrangements, service concession arrangements (or public-private partnership arrangements) and related parties.
The examples above illustrate that although certain transactions or events may be given certain ‘labels’ in law, they are not always accounted for using these ‘labels’. The underlying definitions of specific transactions or relationships, the definitions of assets, liabilities, revenue and expenses, as well as the recognition, measurement and presentation principles in the Standards of GRAP, should always be applied in preparing the financial statements.
The Standards are law too …
The Accounting Standards Board (ASB) is mandated by the Public Finance Management Act to set Standards of GRAP for a variety of entities in the public sector. The Minister of Finance also prescribes the application of the Standards to specific entities by issuing a Government Gazette.
This means that the Standards of GRAP are issued in terms of the law. As a result, they are ‘secondary legislation’. This means that the Standards of GRAP, along with any other pronouncements that the board issues, are legally required to be applied by entities in preparing their financial statements. It also means that the views expressed by the board on certain matters in the pronouncements have legal standing.
Are legal views on arrangements helpful?
Contracts and legislation give rise to specific rights and obligations in arrangements. It is important to understand which rights and obligations exist in arrangements and their legal consequences. Legal experts have the necessary expertise to interpret the legal implications of arrangements. They do not necessarily possess the expertise to interpret the concepts and principles in the Standards and apply them to economic phenomena. Interpreting the Standards of GRAP and applying them to specific
transactions and events requires knowledge of the entire suite of Standards, as well as the application of professional judgement.
Opinions from legal experts on the Standards of GRAP carry no more weight than opinions provided by accounting or other experts.
For more information on the Standards of GRAP, read the ASB’s Conceptual Framework on General Purpose Financial Reporting here.
1 The article has been prepared by the secretariat of the Accounting Standards Board for information purposes only. It has not been reviewed, approved, or otherwise acted on by the board.