Substance over form
Encyclopedia
Substance over form is an accounting principle
used "to ensure that financial statement
s give a complete, relevant and accurate picture of transactions and events". If an entity practices the 'substance over form' concept, the financial statements will show the financial reality of the entity (economic substance
), rather than the legal form of transactions (form).
In accounting for business transactions and other events we measure and report 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 case of revenue recognition, sale and purchase agreements, etc.
Examples
A lease might not transfer ownership to the leasee but the leasee has to record the leased items as an asset if it intends to use it for major portion of its useful life or where the present value of lease payment is fairly equal to the fair value of the asset, etc. Although legally the leasee is not the owner, so the leased item is not his asset, but from the perspective of the underlying economics the leasee is entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset.
A company is short of cash, so it sells its machinery to the bank and obtains it back on a lease. It is called sale and leaseback. Although the legal ownership has transferred but the underlying economics remain the same and hence under the substance over form principle the sale and subsequent leaseback are considered one transaction.
If two companies swap their inventories they will not be allowed to record sales because not sales has occurred even if they have entered into valid enforceable contracts.
Generally Accepted Accounting Principles
Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
used "to ensure that financial statement
Financial statement
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
s give a complete, relevant and accurate picture of transactions and events". If an entity practices the 'substance over form' concept, the financial statements will show the financial reality of the entity (economic substance
Economic substance
Economic substance is a doctrine in the tax law of the United States under which a transaction must have an economic purpose aside from reduction of tax liability in order to be considered valid...
), rather than the legal form of transactions (form).
In accounting for business transactions and other events we measure and report 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 case of revenue recognition, sale and purchase agreements, etc.
Examples
A lease might not transfer ownership to the leasee but the leasee has to record the leased items as an asset if it intends to use it for major portion of its useful life or where the present value of lease payment is fairly equal to the fair value of the asset, etc. Although legally the leasee is not the owner, so the leased item is not his asset, but from the perspective of the underlying economics the leasee is entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset.
A company is short of cash, so it sells its machinery to the bank and obtains it back on a lease. It is called sale and leaseback. Although the legal ownership has transferred but the underlying economics remain the same and hence under the substance over form principle the sale and subsequent leaseback are considered one transaction.
If two companies swap their inventories they will not be allowed to record sales because not sales has occurred even if they have entered into valid enforceable contracts.