Substance over form concept

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 alters the financial status of a business entity. You can read more about financial transactions here.
• Asset: An asset is anything owned and controlled by the entity that will generate future economic benefit for the entity.
• Liability: A liability is a legal obligation that arises due to a past event or transaction and is likely to derive economic outflows from an entity.
• Economic Substance: The 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 that is admitted according to law.

Explanation of substance over form concept:

The substance-over-form concept is simple to grasp but may seem odd to some stakeholders as it challenges the legal form of a transaction and substitutes it with its economic form. However, it is applied to increase the fairness of the affairs of a company, which ultimately reflects in its financial statements. The concept emphasizes that transactions and events must be seen according to their economic or financial reality instead of their legal form to foster a more objective picture of the transactions and events.

Although the legal form of a transaction is important in many cases, it may not provide the true image of the transaction or event in certain situations. Therefore, the legal form may be disregarded to provide more relevant knowledge to the users of financial statements.

This area of accounting is somehow judgmental or subjective and entails the perspective of the preparer of accounting records. The concept may be critical in relation to some deeds and agreements, but it simply compels entities to present the true intention behind a transaction.

Examples

1. A company gets a delivery van on lease from a bank. Under the lease agreement, the company will make an initial payment when taking possession of the van and the balance in 4-year equal installments. Although after initial payment, the bank will give the company possession of the van, and the company will own those vans from an economic point of view, it will not be considered the legal owner of those vans until it pays the final installment.
2. A company leases a building for 50 years, with an estimated useful economic life of 55 years. In this case, the company itself will be called the lessee, and the other party from whom it has leased the asset will be called the lessor. Now, if the lease agreement states that the ownership title will transfer to the lessee at the end of the lease period or the lease term covers a substantial span of useful life of the building, the lessee will own the building according to the economic reality, despite the fact that the lessor is the legal owner of the building. The reason is that the lessee will control the building and derive the maximum economic benefit from it. According to the substance-over-form concept, the company will report the building as an asset in its balance sheet and depreciate it like any other fixed asset. The payments to the lessors will be recorded as a decrease in liability rather than lease rental.