Substance Over Form

Substance Over Form concept in accounting means recording financial transactions to truly represent the essence in statements, focusing on economic reality rather than just legal appearances. It involves complete disclosure and aims to reveal the genuine intent of transactions.

Ultimately, it not only acknowledges the potential intent to conceal but also underscores the complexity of specific transactions, posing challenges for honest accountants in fully validating substance. Despite these challenges, the concept emphasizes the critical role of transparency in financial reporting to ensure a comprehensive and accurate understanding of transactions within the broader financial landscape.

• The substance over form accounting principle concerns the idea that transactions shall not only be treated as records but shall disclose the underlying realities.
• It is a particular concern under the Generally Accepted Accounting Principles (GAAP) since it prevents people from recording transactions in a specific way.
• It uses two approaches: the economic reality approach and the legal form approach.
• It helps in seeking the true intent of transactions and establishing the actual economic realities.

Substance over form concept is an accounting technique that is more focused on the underlying factor and genuine intent and reality of a financial transaction rather than just recording or labeling it with a transactional name like rent, sale, purchase, lease, etc. In a nutshell, this accounting principle is more focused on the true nature of the transaction and not just the legal form that could be used to mislead the company's readers and investors. The simple concept is that the company accounts should show what it has really earned along with what it owes and owns rather than just calculations that are formally and legally correct.

The substance over form definition states that it has mainly two approaches: a legal form approach and the economic reality approach. The former stresses the legal aspects of a transaction, such as original documents, proofs, agreements, and contracts. Firms commonly use this approach to seek legal loopholes and use it as an advantage. On the contrary, the latter approach emphasizes every transaction's economic reality, such as direct and indirect risks, cash flows, nature, and intent. Companies use it to ascertain that transactions are recorded and reported accurately.

This principle is more of a concern under Generally Accepted Accounting Principles (GAAP) because of its broad scope of rules that makes it challenging to record a transaction in a certain way, so if someone is trying to mask the true intent of a transaction, they can structure it to meet the GAAP rules. Still, when it comes to International Financial Reporting Standards (IFRS), which is a principle-based accounting technique, it is more challenging to justify or hide the intent of a transaction, as the IFRS framework does not allow that.

Below are two examples to help one understand the concept better.

Example #1

A hypothetical example would be one firm acting as an agent for another and only recording sales on behalf of the second company in their commission amount. But to make their sales look big, they record the total sale amount as revenue. This way, businesses hide their debt liabilities as their debt does not appear on the balance sheet.

Again, another example would be opening small shell companies to operate for the parent company and especially locating them in different countries that have flexible tax rules, also known as tax haven countries, such as Switzerland, Mauritius, The Bahamas, etc., and then shifting the accounting records and transactions. The leading company avoids paying taxes.

Example #2

As per an article from 2022, the substance over form law has steadily grown and evolved in Mexican tax disputes. The country has made massive progress in the practical application of this principle and shifted from a rigid rule-of-law environment to a more reality-based one. It is mainly regarded as the implementation of PRODECON and this principal trial before the Federal Court of Administrative Justice (FCAJ).

The method has gone deep into the resolution of disputes and refreshed the traditional approach to Mexico's tax legal framework. The country's court believes that inflexible approaches end up in the creation of artificial tax bases that do not reflect reality. One such example is from 2016, when the FCAJ ruled that the export return was exclusive document evidence to prove that the merchandise imported under a temporary rehome had left the country on time, and without the document, the authority could conclude that the merchandise never left the country and is in the country borders illegally.

The applications of substance over form are -

• Lease agreements - As per IFRS 16, the lease agreements are accounted for their substance and financial reality and not only based on their legal form.
• Mergers and acquisitions - M&A transactions and their accounting should focus on their economic substance rather than their legal form.
• Related party transactions - When a firm participates in a transaction with a subsidiary or affiliated company, again, the accounting should be based on the economic substance rather than its labeled or legal form.
• Revenue recognition - When a manufacturer enters into a contract to offer goods or services, the contract must be structured with the transaction validation of economic substance. Likewise, the revenue should be treated based on the same and not on its legal form.
• Sale-leaseback transactions - When a firm sells an asset and then leases it back, the financing arrangement must follow the economic substance rather than just a sale.
• Off-balance sheet financing: When companies use unique purpose entities to raise capital or create financial assets, the arrangements must have economic substance. Their accounting treatment should reflect this rather than just a sale.
• Derivative instruments - When dealing with futures contracts or options, the accounting treatment of such instruments should be based on their economic substance.

The following points reflect the importance of substance over form are -

• It helps companies in their critical financial reporting.
• The accounting concept majorly helps in taxation and is worldwide appraised for it.
• It helps in complete disclosure, especially with sale and purchase agreements and revenue recognition.
• When companies report transactions parallel to their economic substance, the accounting principle helps in maintaining consistency for better decision-making.
• It reduces the risk of exploitation; companies cannot take unfair advantage or benefit from loopholes and must present their economic reality.
• It restricts firms from using complex legalities to hide their true economic nature and induces accurate financial reporting.

The criticisms of substance over form are -

• Businesses need help to involve multiple parties when using this principle.
• Many companies criticize it over the determination of the true economic substance of complex transactions.
• It is easier to keep on using it by explaining the long-term economic effects of the transactions.

This article has been a guide to Substance Over Form and its Meaning. We explain it with its examples, importance, applications, and criticisms. You may also take a look at the useful articles below –

• Commercial Substance
• Round Tripping
• Capital Lease Accounting