An entity endeavor to ensure that the company’s financial statements reflect the financial reality of the entity (Substance) rather than the legal form of the transactions and events(Form) which underlie them.

It really that simple in the sense that if it is a cow but  was disguised in a legal form to look like a dog, Substance Over Form would prevail to reinstate that it is a cow and not a dog!  

Wow- sound simple.

But, to really substantiate or differentiate Substance Over Form, one need to be vigilant, have very good inner knowledge of the company’s operation and takes a more investigative in-depth approach so as to seek further evidence or proof. This is because normally these types of events or transactions are often quite complex. These events or transactions happen just around the accounting year ended. (balance sheet date)

We have seen many cases whereby many accounting fraud occur as a result of this lack of Substance Over Form.Cases like Enron and Computer Associate are describe below:

(b) In the Enron’s case we have:

Enron group’s use of over 3000 Special Purpose Entities (SPEs) structured in such a way as to enable the company to avoid including extensive debt in the consolidated financial statements of the group

© Company itself fund its own revenue

Let say in a Group of companies, Company A has recorded one transaction as a sale to a customer. Another transaction records a loan to the same customer for a similar amount. In this case, when the transactions are considered together, the sale may be without substance as it has actually been funded by the same group of company.

(d) Transaction should be lease instead of outright purchase  

An outright purchase of capital equipment, whereas in fact the substance of the transactions is a lease of (or perhaps an option to purchase) the equipment.

Example No.1

Accounting Treatment of:

Contra account/entries between a debtor Mr owing to the Company and at the same time, the company is owing Mr A

Assuming Mr A is our debtor and he owed the company for $4,000 being goods supplied by the company to him.

However, the company also purchase goods from Mr A where the company now owed him for $5,000

How do we effect the contra entries/account:

We transfer $4,000 by debiting Mr. A’s account in the Purchase ledger and crediting Mr. A in the Sales Ledger.

The transfer will then appear on the debit side of the Purchase ledger Control Account and on the credit side of the Sales Ledger Control Account.

Accounting entries:

Debit: Mr. A ( Purchase Ledger a/c) $4,000

Credit: Mr. A ( Sales Ledger a/c ) $4,000

( The above is also being transferred to the respective control account)

Being offset of account

AUTHORISED SHARE CAPITAL

Authorised share capital is also called Nominal share capital

This the total amount of share capital stated in the Memorandum of Association of a limited company. It also states how the share capital is divided into individual shares of a set amount, such as $1 a share.

The authorized share capital represents the maximum amount of capital the company is allowed to raise from the public, through the issue of shares.

There are no upper or lower limits on authorised share capital for private limited companies, but a public limited company must have a certain minimum authorised share capital. ( varies in different countries )

A company can increase its authorised share capital by passing an ordinary resolution at a general meeting. Equally, a company can decrease its authorised share capital by passing an ordinary resolution to cancel some shares - this is called ˜diminution of capital” or share capital reduction.

WHAT IS ISSUED CAPITAL, SUBSCRIBED, CALLED-UP, UNCALLED-UP & PAID-UP CAPITAL?

Called-up capital comprises that part of issued capital where the company has called up for the subscribers to pay up the money and

Uncalled-up capital comprise that part of issued capital which has not yet been called up.

Paid-up Capital is the amount of called-up capital that has been paid up by the shareholders. When a shareholder fails to pay the sum due when a call is made, the amount outstanding is called Calls in Arrear

DIFFERENCE BETWEEN AUTHORISED AND ISSUED SHARE CAPITAL?

ILLUSTRATION

Uncalled-up capital:

1,500,000 shares at 10 cents per share 150,000

THE LIMITATIONS OF FINANCIAL STATEMENTS

Some of the limitations of the financial statements are as follows:

• As the historical costs and money measurement concepts govern the preparation of the balance sheet and income statements, hence these financial statements are essentially statements reflecting historical facts. It ignore inflationary trend and does not reflect the true current worth of the enterprise,
• Certain important qualitative elements are omitted from the financial statements because they are incapable of being measured in monetary terms like the quality and reputation of the management team, employee and other,
• There are still items in the assets side of the balance sheet which has no real value and are merely deferred charges to future incomes like preliminary / pre-incorporation expenses and other.
• There are still the following issues or challenges in preparing the financial statements which may amount to overstatement of the accounting profit of an entity.

ISSUES OR CHALLENGES

• When to and how much to recognize revenue in the Income statement,

• The constant challenge of when to expense or to capitalize the expenses. It is important to determine definitely what is revenue expenditure and capital expenditure otherwise the accounting profit will be overstated or understated - for example, capitalization of borrowing costs,etc

• Method of depreciations and the rates to depreciate into the income statement are selected by management to suit their business needs. Are the rates intentionally been made lower or the depreciation rates are higher to accelerate the depreciation of the fixed assets,

• Adequacy of provisions and method of providing for doubtful debts. Are the trade debtors recoverable and to what extent the accounting method for provision for doubtful debts shows the realistic picture,

• Basis of valuation of assets- when can costs change to reflect current values? Using replacement or current costs?

• Consolidation challenges -what to eliminates to reflects the overall group performance. Some items might be omitted to show a higher accounting profits.

RESERVES

Reserves are appropriations of profit namely when profits have been ascertained after deducting all expenses which includes provision and others. Reserves are residual earnings after all expenses and taxation which belongs to the owners namely the shareholders.

There are essentially two(2) types of Reserves:

• Capital Reserves

• Revenue Reserves

WHAT ARE CAPITAL RESERVES?

Capital Reserves:

• Are appropriation from profits ( refer above) which cannot be distributed by way of cash dividends.

• These capital reserves arises mainly from
• (i) equity transactions between the enterprise and its shareholders;
• (ii) from adjustments arising in accounting for business combinations;
• (iii) from differences arising on translation of foreign currency operations;
• (iv) from surpluses arising from asset revaluation;
• (iv) any unrealized gain which has not been included in income.

• Examples of capital reserves includes: share premium, capital redemption reserves, capital reserves arising on merger and acquisition, statutory reserves, asset revaluation reserve and exchange fluctuation reserves.

WHAT ARE REVENUE RESERVES?

Revenue Reserves are:

• Are appropriation from profit ( refer above) which can be distributed by way of cash dividends although some may be set aside for other purposes.

• Examples like retained profits and general reserves.

SUMMARY: TO RECAP FOR OWNER’S EQUITY SIDE OF THE BALANCE SHEET

        Balance Sheet And Its Owners’ Equity Side consists of :

Paid In Capital + Capital Reserves + Revenue Reserves

DEFINE OWNERS’ EQUITY:

Looking at the equation:

Assets= Liabilities + Owners’ Equity

However, if we change it to :

Owners’ Equity= Assets-Liabilities

(Assets=what the entity owns & Liabilities=what the entity owes)

In this case, we can see that the owners’ equity is the residual after total assets minus the liabilities relating to the acquiring the assets. Owners’ equity is the paid-up capital plus free reserves and retained earnings or undistributed profits

Here, we can understand that Owners’ equity can also be called the NET WORTH of the business namely whatever belonging to the owners of the business.

WHAT ARE THE MAJOR COMPONENTS OF THE OWNERS’ EQUITY?

Comprises:

1. Paid Up Capital

2. Capital Reserves or Non-Distributable Reserves

3. General Reserves or Distributable Reserves

 LONG TERM LIABILITES ARE:

Long Term Liabilities:

• Is opposite of current liabilities which are more than 12 months from the date of the balance sheet.

Examples are:

• Long term debts /fixed term loan

Remember that we need to classify the total debts into two(2) parts:

• Current portion of long-term debts( amount owing within 12 months of balance sheet date and
• Non-current portion namely More than 12 months of balance sheet date
• Also, the current portion of the long term debts is to be classify as Current Liabilities whilst the non-current portion is in the Long Term Liabilities

SUMMARY: TO RECAP FOR LIABILITIES SIDE OF THE BALANCE SHEET

Balance Sheet And Its Liabilities Side (Total Liabilities) consists of :

Current Liabilities +Long Term Liabilities

CURRENT LIABILITIES ARE:-

Obligations/liabilities:

• that is expected to be settled in the normal course of the enterprise’s operating cycle ; or

• Is due to be settled within twelve months of the balance sheet date

Current Liabilities

Description

Accounts payable

Claims of suppliers arising from their providing goods or services to the entity for which they have not been paid

Accrued expenses

Amounts earned by outside parties but have not been paid by the entity

Deferred revenues

Liabilities that arise because the entity receives advanced payments for services it has agreed to render in the future

Taxes Payable

Amount owed to government agencies

Other Creditors

Amounting owing by the entity to non-Accounts payables like staff and others

Short term loan

Debts that are payable within 12 months of the balance sheet date

As explained earlier a BALANCE SHEET is:-

A snapshot of the financial position of an entity.This snapshot is at a point of time.

Say, as at 7 May 2006, you look at Company A’s balance sheet, it reflects the financial position as at that day. After that day, the financial position company A  can change to a better or worse situation.

In the Balance Sheet, we have the three (3) key components:

Assets= LIABILITIES + Owner’s Equity

( Refer to my illustration for the Dual Aspect Concept)

LET’S DEFINE WHAT ARE THE CHARACTERISTIC OF LIABILITIES?

• Future transfer or use of assets the entity has no discretion to avoid it

• Transaction already happened

WHAT ARE THE MAJOR COMPONENTS OF THE TOTAL LIABILITIES?

Comprises:

1. Current Liabilities and

2. Long Term Liabilities

WHAT ARE FIXED ASSETS

Fixed Assets are unlike current assets:

• Which are NOT expected to be realised  or held for trading or sale

• The costs of the fixed assets are allocated over the period of the useful lives to generate the income associate with it. This follows closely to the matching concept.

• Examples of Fixed Assets are:
• Property
• Plant & machinery
• Motor Vehicles
• Furniture & Fixtures
• Air-conditioners
• Office Rennovations

WHAT ARE LONG TERM INVESTMENTS?

Long Term investments are:

• investments a company intends to hold for more than one year.Consist of stocks and bonds of other companies, real estate, and cash that has been set aside for a specific purpose or project.

• also consist of the stock in a company’s affiliates and subsidiaries.

The difference between Short Term and Long Term investments lie in the company’s motive for owning them.

Short term investments consist of stocks, bonds, etc. a company has bought and will sell shortly. The investments made under long term investments may never be sold

WHAT ARE INTANGIBLE ASSETS?

Intangible assets:

• have no physical existence and a long life. They include patents, copyrights, trademarks, etc.

SUMMARY: TO RECAP FOR ASSET SIDE OF THE BALANCE SHEET

         Balance Sheet And Its Assets Side (Total Assets) consists of :

Current Assets+ Fixed Assets +Long Term Investments + Intangible Assets