Using a folk story to generate discussion about substance over form

Abstract

It is a well-established principle of financial accounting that the economic substance of transactions rather than their legal form should be reflected in published accounts. Recent revelations about fraudulent and misleading accounting practices at Enron Corp. and other major US companies have prompted a debate within the American accounting profession about principles versus rules-based accounting standards. In this debate, the concept of substance over form has become increasingly relevant. It is the authors' experience that it is sometimes difficult for accounting students to determine the proper presentation of substance over form when there are complex facts involved. This instructional case presents a folk story adapted from Zen Buddhism in order to illustrate the way in which the substance of a transaction may be interpreted differently by different parties to the transaction, thereby leading to conflict and disagreement. Students are also presented with descriptions of several accounting issues focusing on special purpose entities (SPEs) and the accounting treatment of share-based compensation. Questions are raised at the end of each part of the case to help students obtain a better understanding of the concept of substance over form.

Keywords:

• teaching case
• improving class discussion
• folk story
• pedagogy

Notes

The relationship and distinction between the concept of ‘substance over form’ and a ‘principles-based’ approach to accounting standards setting is discussed further below on pp. 263–264.

Each of the three parts of the case may be used separately. Some of the questions posed at the end of each part are similar, thus facilitating separate utilization of the parts.

FASB Statement No. 13 requires a lease to be capitalized in the accounts if any of the following four conditions are met: (1) the lease transfers ownership of the property to the lessee; (2) the lease contains a bargain purchase option; (3) the lease term is equal to 75% or more of the estimated economic life of the lease property; (4) the present value of the minimum lease payments equal or exceeds 90% of the fair value of the leased property (FASB, 1980b).

In late 2002, the FASB issued an Interpretation which requires SPEs to be consolidated if they fail to meet any of the following five criteria in addition to those specified in the EITF consensus document (FASB, 2002a):

1.	the legal owner of the SPE has rights that convey the ability to make decisions and manage the SPE's activities;
2.	the amount of the legal owner's equity investment is sufficient to allow the SPE to finance its activities without relying on financial support from variable interest holders (i.e. entities that provide significant financial support, such as loan guarantees);
3.	the equity owner's investment is subordinate to all other equity investments and other interests for the entire life of the SPE;
4.	the assets exchanged for the equity ownership in the SPE are not subordinated beneficial interests in another SPE;
5.	the equity investment is not provided directly or indirectly by the SPE or other variable interest holders.

In October 2002, the FASB issued an exposure draft of an amendment to FASB Statement No. 123 (FASB, 2002b) which provides for two alternative methods of transitioning to the fair value method of accounting for share-based employee compensation. The proposed amendment changes the disclosure requirements of FASB Statement No. 123 to require more prominent disclosure about the effects of the fair value method on reported results in both annual and interim financial statements. The amendment also prescribes a specific format for disclosure of the pro forma effects of applying the fair value method.