The concept substance over form means that the transactions recorded in the financial statements must reflect their economic substance rather than their legal form.
- Transaction: A transaction is an instance of an event that could alter the financial status of a business entity. A transaction usually is a contract between a buyer and a seller which gives rise to an asset for one entity and/or a liability for the other entity. Selling inventory, buying raw materials, indulging in legal agreements, getting a loan for a bank etc. are all examples of business transactions.
- Asset: An asset is anything which is owned and controlled by the entity and will generate future economic benefits for that entity.
- Liability: A liability is a legal obligation that has risen due to some past events and is likely to derive economic outflows from an entity.
- Economic Substance: Economic substance of a transaction, asset or liability is the overall economic reality of that transaction, asset or liability.
- Legal Form: The legal form refers to the legal reality of a transaction, asset or liability which is admitted according to law.
Explanation of substance over form concept:
The substance over form concept is easy to grasp but many stakeholders find it odd because this certain concept challenges the legal form of a transaction and substitutes it with the economic form. However, it is applied to increase the fairness in the affairs of a company which ultimately mirror in its financial statements. The concept signifies that transactions must be seen according to their economic or financial reality instead of their legal formation to foster a more objective picture of the transactions and events. Because at certain times the “legal form” of a transaction may not provide the true image and apart from the fact that legal form is of great importance, it may be disregarded to present more relevant knowledge to the users of financial statements. This area of accounting is somehow judgmental and subjective and entails the perspective of the preparer. The concept may be critical in relation to some deeds and agreements but simply it compels to present the true intentions behind a transaction so that users may not be misdirected.
- A company buys vans from a bank under a lease agreement for the purposes of transport. Under that agreement, the company will have to pay some advance and will pay the remaining amount for vans in 4 year installments. Now although after paying the advance bank will provide the company with the possession of the vans and company will own those vans from an “economic point of view”, but it will not be recognized as the “legal owner” of those vans until it pays the final installment.
- A company gets into a contract to lease a building for 50 years where the economic useful life of that building is estimated to be 55 years. In this case, the company itself will be called as “lessee” and the other party leasing its building will be called as “lessor”. Now if the lease agreement suggests that at the end of lease period the ownership title of the building will be transferred to the lessee (the company) or the lease term (the time period for which the building is being leased) covers a substantial span of useful life of the building (which is the case here), then although the building is legally owned by the lessor, according to the economic reality, the building will be owned by the lessee, because lessee is controlling building and is deriving maximum economic benefits from it. So according to this concept the building will be recorded as an asset in the financial statement of the company, will be depreciated as any normal asset, and remaining payments will be deemed as a decrease in liability rather than lease rental.