Substance Over Legal Form


Explanation

Substance over form is an accounting concept which means that the economic substance of transactions and events must be recorded in the financial statements rather than just their legal form in order to present a true and fair view of the affairs of the entity.

Substance over form concept entails the use of judgment on the part of the preparers of the financial statements in order for them to derive the business sense from the transactions and events and to present them in a manner that best reflects their true essence. Whereas legal aspects of transactions and events are of great importance, they may have to be disregarded at times in order to provide more useful and relevant information to the users of financial statements.

Example

There is widespread use of substance over form concept in accounting. Following are examples of the application of the concept in the International Financial Reporting Standards (IFRS).

  • 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.
  • IAS 18 Revenue requires accountants to consider the economic substance of the sale agreements while determining whether a sale has occurred or not.
    For example, an entity may agree to sell inventory to someone and buy back the same inventory after a specified time at an inflated price that is planned to compensate the seller for the time value of money. On paper, the sale and buy back may be deemed as two different transactions which should be dealt with as such for accounting purposes i.e. recording the sale and (subsequently) purchase. However, the economic reality of the transactions is that no sale has in fact occurred. The sale and buy back, when considered in the context of both transactions, is actually a financing arrangement in which the seller has obtained a loan which is to be repaid with interest (via inflated price). Inventory acts as the security for the loan which will be returned to the 'seller' upon repayment. So instead of recognizing sale, the entity should recognize a liability for loan obtained which shall be reversed when the loan is repaid. The excess of loan received and the amount that is to be paid (i.e. inflated price) is recognized as finance cost in the income statement.

Importance

The principle of Substance over legal form is central to the faithful representation and reliability of information contained in the financial statements. By placing the responsibility on the preparers of the financial statements to actively consider the economic reality of transactions and events to be reflected in the financial statements, it will be more difficult for the preparers to justify the accounting of transactions in a manner that does fairly reflect the substance of the situation. However, the principle of substance over form has so far not been recognized by IASB or FASB as a distinct principle in their respective frameworks due to the difficulty of defining it separately from other accounting principles particularly reliability and faithful representation.