Use the Substance-over-Form Convention to Regulate the Related Transaction

Abstract

Along with the coming of knowledge economic times, many enterprises form large groups by means of capital operations, including merger and purchase, reengineering, and stockholding. As a result, the relationships between enterprises tend to be more complex. Related parties and amounts of related transactions appear. For transactions or items that have inconsistent substances and forms, we must follow the substance-over-form convention in accounting. By this way, we can guarantee the quality of accounting information, regulate the accounting, and promote the development of market economy. Entering the 21 st century, Chinese enterprises pursue for scale and knowledge operations. By means of different capital operations, such as merger and purchase, reengineering, and stockholding, many related enterprises form large groups. As a result, the relationship between enterprises becomes more complex and large amounts of related transactions appear. In order to adjust profits and make false balance sheet, related enterprises may mutually adjust and transfer incomes, expenses, and assets by manipulating the related transaction prices, which will lead to the unreasonable allocation of expenses and capitals. It will directly the fairness of financial reports and may cause decision mistakes. Here, we emphasize on the "substance-over-form" convention, aiming at "reflecting real accounting information" and rejecting "serious distortions" of related party transaction. That is a basic precondition for stopping false accounting. As for the related party transaction that does not realize the consistence of substance and form, we must deal with it by the "substance-over-form" convention in accounting. 1. The "substance-over-form" convention's requirements for related parties and its constraints on their transactions The "substance-over-form" concept firstly appeared in the Statement.4-Basic Concepts and Accounting Principles issued by the Accounting Principle Board (APB) in 1970. According to APB, financial accounting should emphasize on the transaction or item's economic substance of transaction, no matter whether the transaction or item has a legal form that differs from its economic substance. In 1997, China issued the first specific accounting convention "Related Parties' Relationship and Transaction Disclosure, which firstly mentions to use the "substance-over-form", instead of merely depending on the legal form, to judge whether there is related relationship or not. China Accounting System for Business Enterprises (2001) formally took the "substance-over-form" convention as one of requirements for enterprise accounting: "Enterprise accounting is based on the transaction or item's economic substance but not its legal form." In recent years, in judging listed companies' certain big cases, the "substance-over-form" convention has been applied frequently. After China's entry into WTO, it is urgent to realize the internationalization of accounting convention in China. In February, 2006, China amended and perfected the former accounting convention and constructed an independently applied accounting convention system that is in accordance with Chinese conditions and the convention of international accounting reports and covers all economic operations in enterprises (except small and medium-sized enterprises), in which the "substance-over-form" convention regulated by China Accounting System for Business Enterprises (2001) is included. Besides, as for the scope of integrated financial reports, the new system lays more stresses on the substance. The mother enterprise should integrate all child enterprises in control into its financial reports, without regard to the proportion of stocks. This item embodies the application of the "substance-over-form" convention. In China the enterprise accounting convention does not define the related party in special. In 2006, the new amended accounting convention extends the meanings of related party relationship, making specific requirements for the related parties' relationship and transaction disclosure. It emphasizes more on the convention of "substance-over-form". In