The Effect of Substance Over Forms Principle towards Islamic
Financial Reporting Quality
Noven Suprayogi
Department of Islamic Economics, Faculty of Economics and Business,
Universitas Airlangga, Jl. Airlangga 4 Surabaya, Indonesia
Keywords: The substance over forms principle, financial reporting quality, musharakah mutanaqisah.
Abstract: One of the principles that must be implemented to ensure the reliability of financial reporting is substance
over forms principle. The substance over forms principle require that in preparing financial reporting should
prioritize the substance and economic reality of a transaction or event rather than its legal form. A contract
or akad in an Islamic financial transaction is the basis for determining the rights and obligations of each
party conducting the transaction so that in Islamic accounting perspective the financial reporting must
present transactions in accordance with their economic substance and legal form. This study used a
qualitative approach with case study method to analyze the implications of using the substance over forms
principle toward the quality of Islamic financial statements. The case study used is the financing of
homeownership with musyarakah mutanaqisah contract in Islamic bank. The result of the research shows
that the use substance over forms principle in Islamic financial reporting can decrease the quality of Islamic
financial reporting on relevance and reliability aspect. The substance over forms principle will lead to
Islamic financial reports in providing confusing information to users of financial reporting and causes the
transactions to be incompatible with Islamic principles because economic substance is not in accordance
with its legal forms.
1 INTRODUCTION
Reliability is one of the qualitative characteristics of
financial statements that must be fulfilled to ensure
the information presented in the financial statements
can meet the needs of users of financial reports in a
decision making. Financial statements that meet the
reliable character will be able to provide information
an entity truthfully. The character of the financial
statements that meet the elements of the reliability of
financial reporting is to provide information that is
not misleading due to material faults or the
presentation financial information that is not
conducted honestly. One of the principles which
should be implemented to ensure the reliability of
the financial statements is the principle of substance
over forms. The principle of substance over forms
requires that in drawing up the financial statements
should be more emphasis on substance and
economic realities of a transaction or event rather
than a form of law.
One of the users of Islamic financial reporting
information is the sharia supervisor. Sharia
supervisors are concerned with information relating
to the compliance of Islamic entity managers to
Islamic principles (PSAK Syariah 101, paragraph
09). At the point of view of sharia supervision,
compliance information on Islamic principles will be
fulfilled if the substance and economic reality are in
accordance with its legal form. If the substance and
economic reality are not in accordance with the legal
form it will provide information that there is an
incompatibility with the Islamic principles.
Therefore, if an Islamic financial transaction tied up
in a certain contract, and the reality or economic
substance of the implementation of the contract is
not in accordance with the contents of the agreed
contract, it will cause the Islamic financial
transaction to deviate from the Islamic principles in
the contract.
The objective of substance over form principle is
in order to the financial statements to present the
financial statements sincerely or faithfully (faith-full
presentation) so that an event is presented and
recorded in accordance with the substance and
economic reality and not just its legal form (PSAK
Suprayogi, N.
The Effect of Substance Over Forms Principle towards Islamic Financial Reporting Quality.
In Proceedings of the 1st International Conference on Islamic Economics, Business, and Philanthropy (ICIEBP 2017) - Transforming Islamic Economy and Societies, pages 353-358
ISBN: 978-989-758-315-5
Copyright © 2018 by SCITEPRESS – Science and Technology Publications, Lda. All rights reserved
353

Syariah 101, paragraph 56). Accounting and
Auditing Organization for Islamic Financial
Institutions (AAOIFI) in the framework of the
preparation and presentation of financial statements
have a viewpoint on the presentation and preparation
of financial statements sincerely or faithfully.
Presentation and preparation of financial statements
faithfully according to AAOIFI are "If the
information is to represent faithfully the transaction
and other events that it purports, it is necessary that
they are accounted for and presented in accordance
with its substance and economic reality as well as
the legal form ". The financial statements that
provide information faithfully according to AAOIFI
are financial statements that present transactions in
accordance with their economic substance and legal
form (AAOIFI, 2015). So, the quality of Islamic
financial statements will be realized if the
transactions are prepared and presented in the
financial statements in accordance with economic
substance and legal form. The principle of substance
over form in the Islamic accounting perspective is
less in line with the Islamic principles because
contracts or Akad in Islamic financial transactions
are the basis for determining the rights and
obligations for each party conducting transactions
(Sultan, 2006).
The financial statements in Islamic accounting
perspective aim to provide information on Islamic
principle conformity of the transactions that occur so
that financial statements should be presented and
prepared based on the suitability between legal form
and its economic substance. Islamic accounting has
a principle that the economic substance and legal
form of Islamic financial transaction must be the
same because every individual who is bound in a
contract or contract must exercise his / her rights and
obligations as agreed in the contract. So, if the
economic substance is not the same as the legal form
will cause non-conformity with the Islamic
principles (Sultan, 2006). Accounting treatment for
Islamic financial transactions with the principle of
economic substance must be the same as the legal
form is often constrained by aspects of measurement
of rights and obligations. So that the Islamic entity
in Indonesia in the preparation and presentation of
its financial statements more using the principle of
substance over form as an effort to overcome the
constraints of measurement of Islamic financial
transactions in Indonesia.
Case study in this research is financing
transaction of homeownership using musyarakah
mutanaqisah contract. Musharakah mutanaqisah
contract is joint ownership of assets or capital of one
party reduced due to the gradual purchase by the
other party (MUI, 2008). Musharakah mutanaqisah
contract in Indonesia applied to financing home
ownership by an Islamic bank.
The musyarakah mutanaqisah contract
application in the financing of home ownership by
an Islamic bank is Islamic bank and the customer
share in home ownership, and the customer pays the
rent for the utilization of the asset. Rent payments by
customers will be shared between the bank and the
customer so that the bank earns profit sharing on the
lease and the customer using the profit sharing
obtained to purchase the bank's ownership of the
house, so that within the agreed time period along
with the right of home ownership will move
completely to the customer.
The accounting treatment of musyarakah
mutanaqisah transactions by Islamic banks in
Indonesia currently uses the principle of substance
over form. The submission of musyarakah capital by
Islamic bank is recognized as the surrender of cash.
capital, so the Islamic bank does not recognize the
existence of joint ownership of the house purchased
together with the customer. Meanwhile, the
musyarakah mutanaqisah contract in Islamic law is
legally home ownership between banks and
customers. The Islamic law of musyarakah
mutanaqisah contract mentions the existence of asset
ownership by the bank, but the ownership rights of
the asset by the bank are not represented in
accounting because the Islamic bank never
acknowledges the existence of musharaka
mutanasqisah assets. The phenomenon will be the
focus of the study. This study is to analyze how the
implications of the use of the principle of substance
over form in the accounting treatment of Islamic
financial transactions on the quality of Islamic
financial statements in Indonesia.
2 LITERATURE REVIEW
2.1 Qualitative Characteristics of
Financial Report
The Characteristics of financial statements should
have four main characteristics that are
understandability, relevance, reliability, and
comparability (Kartikahadi et al, 2016). The
financial statements have understandability
characteristics if the financial statements provide
convenience to users of financial statements in
understanding the information provided. The
relevant characteristic of the financial statement is
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354

financial statements capable of providing
information that can be used in decision making for
users of financial statements. Information from
financial statement can be used in decision making if
information can be used for prediction and provide
material information for decision making. The
reliability characteristic of a financial statement is
the information generated by the financial statement
should be free from misleading notions, material
mistakes and presented in faithfully. The financial
statements are comparable if the financial statement
information can be used for the identification of a
financial position and financial performance through
comparison among other entities.
2.2 Substance Over Form Principle
The substance of the transaction or any other event
is not always consistent with what appears to be the
legal form. The Substance over from is a principle
that is used if an economic substance is not in line
with the form of law then which should be preferred
is the economic substance rather than legal form.
Economic substance over the legal form is one of the
requirements for financial statements to have a
quality of reliability (Kartikahadi et al. 2016). The
principle of substance over from is used in the
preparation of financial statements in order that the
financial statements present faithfully the
transactions and other events that should be
presented so that the event will be presented and
recorded in accordance with the substance and the
economic reality and not just the legal form (PSAK
Syariah 100, paragraph 56). The principle of
substance over from in the Islamic accounting
perspective cannot be used as a basis for the
preparation and presentation of Islamic financial
statements (Sultan, 2006). So that the preparation of
financial statements in Islamic accounting
perspective should consider the phenomenon of
economic substance and its legal form must be the
same (AAOIFI, 2015).
2.3 The Objective of Islamic Financial
Reporting
The financial reporting in the Islamic perspective
serve to provide information about the ability of the
entity in carrying out God's command, Allah, not
merely providing financial information to the users
solely (Rahman, 2010). Therefore, Islamic financial
reporting should be able to provide information that
can be used to evaluate the conformity of Islamic
entities with the Islamic principles, and the ability of
Islamic entities in carrying out their social
obligations as determined by the Islamic principles
(AAOIFI, 2015). Islamic financial reporting in
addition to the purpose of providing information
concerning the financial position, performance, and
changes in financial position also aims to improve
compliance with the Islamic principles in all
transactions, provide compliance information
Islamic entities with the Islamic principles,
providing information to evaluate the fulfilment of
social responsibility the Islamic entity and provide
information on the rate of return on investment for
the owner of not restricted investment funds (PSAK
Syariah, 2017).
2.4 Musharakah Mutanaqisah
Contract
Musharaka mutanaqisah contract is a form of
cooperation between two or more parties for the
ownership of a goods or an asset that contains two
elements. The elements are syirkah (cooperation)
and ijarah (lease), and this cooperation will reduce
the ownership rights of one party while the other
party increases their ownership rights (Hosen, 2008).
The legal basis for the implementation of musharaka
mutanaqisah in Islamic banking in Indonesia is the
Fatwa DSN-MUI No.73 in 2008. Musharakah
mutanaqisah contract ends when syarik (customer)
has taken over the entire portion of bank ownership.
Musyarakah mutanaqisah contract is an appropriate
contract for financing home ownership in Islamic
bank (Smolo, 2011).
3 METHOD
This research uses qualitative approach with case
study method. The case used in this research is the
process of accounting treatment for musyarakah
mutanaqisah contract on financing homeownership
in Islamic bank for individuals. The process of
accounting treatment which becomes the unit of
analysis in this study includes recognition,
measurement, and presentation. Research data
obtained through in-depth interview process and
documentation. The interview process is carried out
with the finance manager to obtain an in-depth
overview of the economic substance of financing by
using musharaka mutanaqisah contracts, and
interviews with the legal department to obtain a
description of the legal form of musyarakah
mutanaqisah contract in financing homeownership
as well as interviews with the accounting department
The Effect of Substance Over Forms Principle towards Islamic Financial Reporting Quality
355

to obtain an overview of the process accounting
treatment musyarakah mutanaqisah contract in
financing homeownership
Data Validation techniques used in this research
are the triangulation of methods and the
triangulation of data sources. Triangulation of
method is comparing data of results of interviews
with results of documentation. Triangulation of
source is to compare results of interviews with
informants in this research. The analytical technique
used in this study domain analysis is to arrange the
data structure of research results based on the same
category, taxonomy analysis that is arranging the
data structures in each category (domain) that have
been identified, and the component analysis is to
deeply analyze each structure and component of
each category (domain) and looking for patterns of
relationships between each domain that was
identified.
4 RESULTS AND DISCUSSION
The financing of home ownership by using
musyarakah mutanaqisah contract in the form of law
consists of two types of engagement, namely
musyarakah financing contract syirkatul milk and
ijara contract. Syirkatul milk financing contract is an
agreement contract between the bank and customer
for the purchase of land and buildings together, and
the customer will make payments for the acquisition
of land and buildings which become the portion of
bank ownership gradually until the maturity of the
lease term. Musyarakah mutanaqisah financing
contract also contains cooperation on a lease
between the bank and the customer by using the
profit-sharing principle of the rental income in
accordance with the agreed ratio (nisbah). The ijarah
contracts used in financing homeownership with
musyarakah mutanaqisah contracts is to bind lease
agreements between the bank and the customer i.e.
the customer leases the land and buildings that
belong together with the bank and the customer.
Musyarakah capital based on Indonesia Islamic
Financial Accounting Standards No. 106 may be
cash or non-cash assets, whereas the capital of
musyarakah mutanaqisah contract based on the
National Sharia Board, Fatwa (DSN) No.73 / DSN-
MUI / XI / 2008 is asset ownership. The contract of
musyarakah syirkatul milk agreement arranged by
the bank states that the capital is in the form of a
number of funds and or assets provided by the
parties, and in the agreement stated that the portion
of ownership is the amount of capital allocated by
the bank and the customer in order to purchase the
house. When the Islamic bank handed over cash to
the customers to purchase the land and buildings
together, the bank acknowledges it as a capital
payment in cash rather than a non-cash asset.
“The positive law and Islamic law, for now,
cannot be implemented together, in the Islamic law
we do have a certain object together but in the
positive law cannot do it, it already entered into
financing, but guaranteed him written on behalf of
the bank as well, so two people " (Legal officer
bank).
The Islamic banks face two legal issues are
positive law and Islamic law. Both types of law
cannot be harmonized so that the Islamic bank must
choose positive law as the economic substance of
musyarakah mutanaqisah contract as financing in the
form of cash money. So that the delivery of capital
in cash is recognized as musyarakah financing in the
amount of cash money handed over to the customer
to make the purchase of land and building which
became the agreement.
“Islamic law says that the house belongs to both
of us, legally the bank authorizes or allow the house
behind the name of the customer, we are trying to
get closer to sharia, which hires the customer in fact.
The house is in positive law belongs to the customer,
but in Islamic law who bought the house was two
people" (Legal officer bank).
Ownership of houses and buildings is legally in
the positive law belongs to the customer, but the
Islamic law is a joint ownership between the bank
and the customer. The Islamic bank considers that
the joint ownership of the land and houses is realized
in a musyarakah mutanaqisah agreement which
binds a joint ownership agreement on land and
building.
Ownership of houses and buildings is legally in
the positive law belongs to the customer, but the
Islamic law is a joint ownership between the bank
and the customer. The Islamic bank considers that
the joint ownership of the land and houses is realized
in a musyarakah mutanaqisah agreement which
binds a joint ownership agreement on land and
building
The Islamic bank recognizes the transfer of cash
to customers, namely musyarakah capital as
financing. The recognition of musyarakah capital in
the form of cash causes the Islamic bank not to
recognize the ownership of assets in its statement of
financial position. So that the financing of home
ownership by using musyarakah mutanaqisah
contract in the substantive economy is the financing
not as the purchase of land and building ownership
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which will add assets in its financial statements.
Thus, the bank never recognizes the addition of
assets and depreciation expense of the assets as
stipulated in the contract of musyarakah syirkahtul
milk agreement made between the bank and the
customer, and at the time of purchasing the
ownership portion of the bank's ownership of land
and building by the customer in economic substance
is the return of musyarakah capital in the form of
cash.
Information about the existence of musyarakah
mutanaqisah contract in the Islamic bank cannot be
disclosed through the financial report. In a faithful
presentation perspective, the accounting treatment of
musyarakah mutanaqisah contract provides
information that the musyarakah mutanaqisah
contract does not work in accordance with the
Islamic law so as to provide information to users of
Islamic financial statements that the Islamic bank
does not run its operations in accordance with the
Islamic principles. These conditions will provide
different information when compared with the
agreement documents used in accordance with the
Islamic principles.
Preparation of Islamic financial reporting using
the principle of substance over form will provide
information that is different from the results of
sharia supervision by the Sharia Supervisory Board
of Islamic banks. Islamic financial reporting will
provide information that the musyarakah
mutanaqisah contracts executed by Islamic banks are
not in accordance with the Islamic principles, while
reports on the results of supervision of sharia by
Sharia Supervisory Board prepared and presented
based on the examination of existing legal
documents provide information that musharakah
mutanaqisah contract which is implemented by
Islamic banks have been in accordance with the
Islamic principles. Such conditions will result in
Islamic financial reporting will lose relevance and
reliability quality.
The quality of financial statements is largely
determined by the quality of information generated
that the resulting information is capable of being
used for decision making (Kieso et al, 2011). The
principle of substance over form will lead to
accounting not being able to realize the objectives of
Islamic financial reporting. One of the objectives of
Islamic financial reporting is to improve compliance
with Islamic principles and provide information on
compliance with Islamic principles (PSAK Syariah
100, 2007). The quality of reliability of Islamic bank
financial reporting will decrease because
information about musyarakah mutanaqisah
transaction cannot be presented fairly according to
Islamic principle. The low quality of reliability of
Islamic bank financial reporting will cause
information of Islamic financial reporting cannot be
used in decision making so that Islamic financial
reporting will lose the quality of relevance
5 CONCLUSIONS
We Based on the results of research and analysis of
the use of substance over form principle in the case
of homeownership financing using musyarakah
mutanaqisah contract in Islamic bank implies on the
deterioration of the quality of Islamic financial
statements namely the relevant and reliability quality
so that the resulting information becomes less
provide information that can be used for decision
making for users of Islamic financial Reporting.
Islamic accounting standards setter body in
Indonesia needs to reconsider the use of the
substance over form principle within the Islamic
accounting standard framework of the preparation
and presentation of Islamic financial reporting. The
review is to improve the quality of Islamic financial
reporting in Indonesia and as a harmonization
process with Islamic accounting standards prepared
by AAOIFI. A study of the implications of the
principle of substance over form in Islamic financial
reporting needs to be done on other contracts. This
research is limited to musyarakah mutanaqisah
contract and only limited to studying the
implications of the substance over form principle in
the perspective of information quality of Islamic
financial reporting.
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