Substance over form concept explained

The term substance over form implies that preparers of financial statements should examine the commercial or economic reality of a transaction rather than its legal form when preparing those statements. When the true intent of the transaction is not the same with what is provided in the laws of the land, then the economic substance is used in treating the transaction. This article explained this concept in detail.

1. What's substance over form concept

Substance over form is an accounting concept that states that in the recognition of transactions in the financial statements, the preparer should consider the economic reality rather than the legal forms. Financial statements are prepared based on regulation from the accounting regulatory bodies and not from the laws of the land. Although, it is the laws that give the regulatory body the power to act.

Generally, it is expected that the economic or commercial realities of transactions to be equal to their legal forms. But, this is not always the case. As a result, the preparer must look at the intent or substance of the transaction to decide how the transaction will be treated correctly. For example, a sales transaction is governed by the law of contract.

And it is believed that once the buyer makes payment or consideration, then the title (or ownership) of the goods passes to the buyer. In such a case, the intent is the fact that ownership has passed to the third party. So, it can be recognized as a sales transaction. In this case, the economic substance is the same with the legal form.

However, there are instances when they are not equal. For example, a holding company might transfer goods to a subsidiary company without cost. Based on the law of contract (legal form), it can be said that the subsidiary doesn't have title to the goods. But in reality the intent is that the subsidiary will sell the goods and record the same in their books. Therefore, the economic substance is clear that the goods are owned by the subsidiary. In this case, the economic reality of the transaction is considered rather than its form.

2. Differences between economic substance and legal reality

Economic substance means the intent of the transaction. Another name for it is commercial substance or reality. On the other hand, legal form is what the law says. In this aspect, the preparer is looking at the intent of the law. In substance over form concept the economic reality is given more weight than the legal form.

Accounting standards provide a more relevant and fair presentation of transactions, events, and conditions in the financial statements than what the law said. Since, users of financial statements are mainly investors rather than lawyers in the courtroom, complying with financial reporting standards such as the IFRS or the US GAAP is paramount.

3. Applying substance over form in financial statements

A well known transaction where substance over form concept is applied is in lease agreement. To the law, the lessee only has possession of the goods leased to him. However, because the intent of the leased item is to generate revenue for the lessee, the economic reality is considered. Therefore, it is treated as if the leased item is owned by the lessee.

Other areas are:

Inventory swaps between holding and subsidiary companies
Lease agreements
Advances and loans to subsidiary company that are not repayable
Principal/agent relationships

We have explained inventory swap and lease agreements earlier. For principal-agent relationships, if the agent is responsible for credit sales, then he is seen as an individual with right of ownership to the goods (the economic reality) rather than a person with possession (legal reality). In all cases, it is clear that accountants or preparers of financial statements must examine the economic intent and not the legal form.