Substance over form

Substance over form is an accounting 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 show the overall financial reality of the entity (economic substance), rather than the legal form of transactions (form).[1] 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, 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

A lease might not transfer ownership of the leased property to the leasee. 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 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 economic reality.

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". 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.

Similarly, if two companies swap their inventories, then they will not be allowed to record sales because in substance no sales have occurred, even if they have entered into valid enforceable contracts.

See also

References

  1. ↑ Basic college accounting.com (Jun 20, 2006). "Substance over form". Retrieved Jul 17, 2008.