Substance over form is an

accounting Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "language ...

principle used "to ensure that financial statements give a complete, relevant, and accurate picture of transactions and events". If an entity practices the 'substance over form' concept, then the financial statements will convey the overall financial reality of the entity (

economic substance Economic substance is a doctrine in the tax law of the United States under which a transaction must have both a substantial purpose aside from reduction of tax liability and an economic effect aside from the tax effect in order to qualify for any t ...

), rather than simply reporting the legal record of transactions (form). In accounting for business transactions and other events, the measurement and reporting is for the economic impact of an event, instead of its legal form. Substance over form is critical for reliable financial reporting. It is particularly relevant in cases of

revenue recognition The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle. They both determine the accounting period in which revenues and expenses are recognized. According to the principle, revenues are reco ...

, sale and purchase agreements, etc. The key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent of the transaction, which would mislead the readers of a company's financial statements.

Examples

There is widespread use of substance over form concept in accounting. Financial Statement prepared 'substance over form' are comparatively more reliable.

Leasing

Following are examples of the application of the concept in the International Financial Reporting Standards (IFRS). {{quote, he rule found in''IAS 17 Leases'' requires the preparers of financial statements to consider the substance of lease arrangements when determining the type of lease for accounting purposes. For example, an asset may be leased to a lessee without the transfer of legal title at the end of the lease term. Such a lease may, in substance, be considered as a finance lease if for instance the lease term is substantially for entire useful life of the asset or the lease agreement entitles the lessee to purchase the asset at the end of the lease term at a very nominal price and it is very likely that such option will be exercised by the lessee in the given circumstances.{{Cite web, url=https://accounting-simplified.com/financial/concepts-and-principles/substance-over-form/, title=Substance Over Form | Concept | Meaning | Examples | Importance, website=accounting-simplified.com A lease might not transfer ownership of the leased property to the lessee. In some circumstances, the lessee might nevertheless be required to record the leased item as an asset if the lessee intends to use the asset for a major portion of its useful life, or where the

present value In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has int ...

of the future lease payments is nearly equal to the fair value of the asset. Although the lessee is not the owner, the lessee may be required to record the asset as being owned by the lessee, based on the underlying economics of the transaction. Another example is the situation where a company short of cash sells its machinery to the bank and then leases the same property from the bank. This arrangement is called "

sale and leaseback Leaseback, short for "sale-and-leaseback", is a financial transaction in which one sells an asset and leases it back for the long term; therefore, one continues to be able to use the asset but no longer owns it. The transaction is generally done fo ...

". Although the legal ownership has been transferred to the bank, the underlying economic reality for the company remain the same. Under the substance-over-form principle, the sale and subsequent leaseback are considered one transaction.

Inventory

Similarly, if two companies swap their inventories, this event is not accounted as a sale because the ''substance'' is a mere in-kind exchange, despite the possible ''form'' of valid enforceable contracts for two sales and deliveries. Likewise, a firm withdrawing inventory for internal use accounts this event in a separate account, classified as such, and not on the sale account. The principle thus maintains the sales account as reflecting only actual sales in ''substance'' (that is, items delivered to outside parties for payment), and not events that merely fit the ''form'' of sales documentation for convenience or expedience.

Independent contractors and employees

The principle strictly governs and resolves disputes of whether workers are

independent contractor Employment is a relationship between two parties regulating the provision of paid labour services. Usually based on a contract, one party, the employer, which might be a corporation, a not-for-profit organization, a co-operative, or any ot ...

s or employees: Tax law forbids accounting for persons who are ''substantially'' employees in the ''form'' of independent contractors. The question of which ''form'' may be applied to any given case submits to objective tests of the ''substance'' of the work. Hence substance, over form, is the rule.

References

Accounting systems Legal doctrines and principles

Examples

Leasing

Inventory

Independent contractors and employees

See also

References