What Is the Substance Over Form Doctrine?

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. The revised expression avoids the implication that form and substance or antipodes. Fischer et al. do not actually claim or document that substance has declined relative to form nor do they malign form. International financial reporting standards (IFRS) are more principles-based, so it is even more difficult for someone to justify hiding the intent of a transaction if they are using IFRS frameworks to construct their financial statements.

Further, the present value of lease payment is fairly equal to the fair value of the jets, etc., which means that ABC, Inc. has undertaken a liability equal to the cost of the jets by entering into the agreement. The transaction is best reflected in the financial statements by showing the jets as assets and also presenting a corresponding lease liability. It signs a contract to lease a building in Aldgate for 30 years, where the economic useful life of the building is estimated to be 35 years. In https://turbo-tax.org/business-infographic-template/ this instance, the company itself will be called the ‘lessee’ and the other party leasing its building to them as the ‘lessor’. This is because although the building is legally owned by the lessor, the estate agency controls the building and derives maximum benefits from it. Therefore it should be recorded as an asset in the financial statement of the company, as it will depreciate like any normal asset and remaining payments will be deemed as a decrease in liability rather than lease rental.

SUBSTANCE OVER FORM Definition

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. While accounting for business transactions and other events, substance over form principle requires accountants to measure and present the economic impact of an event instead of its legal form.

Under the substance-over-form principle, the sale and subsequent leaseback are considered one transaction. One challenge to the substance-over-form principle is that it may ignore legal formalities, leading to inconsistency in reporting. For example, a company may structure a transaction in a certain way for legal reasons, but under the substance over form principle, the economic reality of the transaction would be considered more important than its legal structure. This can lead to inconsistencies in financial reporting and make it difficult for stakeholders to compare financial statements across different companies. Substance over form refers to a fundamental accounting principle that dictates that transactions should be recorded based on their true substance rather than just their legal form. In other words, the economic reality of a transaction should take precedence over its legal structure or documentation.

Independent contractors and employees

Substance over form approach is critical for preparation of true and fair financial statements. It is particularly relevant while accounting for revenues, sale and purchase agreements, leases etc. In accordance with the terms of the lease agreement, the jets remain in ownership of DEF, Inc. throughout the lease term so the legal form of the contract/agreement dictates that ABC, Inc. should not record them as asset on its balance sheet.

Financial statements and disclosures should always represent the economic realities underlying the business transaction. One example of substance over form is the lease accounting standard implementation by companies. Under old lease accounting rules, companies were required to report leases on their balance sheets only if they met certain criteria such as being long-term or involving significant assets. However, this allowed some companies to engage in off-balance-sheet financing by structuring leasing arrangements as service contracts or other types of agreements.

Substance over form. Definition Example Uses

But under finance lease the risks and rewards are substantially transferred to the lessee and thus lessor (who is also the owner of the asset) is not responsible for risks and rewards. This is where economic substance will be preferred and the asset will be recorded in the lessee’s financial statements even if he is not the owner. Substance over form in accounting refers to a concept that transactions recorded in the financial statements and accompanying disclosures of a company must reflect their economic substance rather than their legal form. In assessing whether an asset or a liability has been created, the economic substance of the transaction should be scrutinized, not simply the legal form of transaction. The term’ risks and rewards’ are often cited when determining the substance of business transactions, and some factors that may be considered are as follows. SUBSTANCE OVER FORM is an accounting concept where the entity is accounting for items according to their substance and economic reality and not merely their legal form.

• It states that the real form of the transaction should be recorded in the financial statement.
• It is usually a contract between a buyer and seller, which gives rise to an asset for one entity and/or a liability for the other entity.
• With corporate acquisitions, the doctrine has been used to question the ability of the acquiring entity to step up the purchased company’s assets to fair market value.
• Hence, there is a need to correct transaction recording, and it must be done at a real value which is $20,000.
• This is the highly reticulated Internal Revenue Code [we are talking about], which uses language, lots of language, with nearly mathematic precision.

For example, the cost paid several years ago for assets should not factor into replacement decisions. Therefore, accountants should not include the information in any reports for making new a purchase. Another example of relevance in substance over form is where cost differs under different alternatives; only the alternative considered has a relevant cost. Although the asset is sold to XYZ bank and legally bank is the new owner, however the risks and rewards are still with Mr. A exactly the way they were before sale as asset is given back to Mr. A under finance lease agreement for 10 years. Substance over form is a particular concern under Generally Accepted Accounting Principles (GAAP), since GAAP is largely rules-based, and so creates specific hurdles that must be achieved in order to record a transaction in a certain way. Thus, someone intent on hiding the true intent of a transaction could structure it to just barely meet GAAP rules, which would allow that person to record the transaction in a manner that hides its true intent.

Basics of IFRS 9 ECL- Part 2

Our answer is that the “substance over form” concept does not imply that they are antipodes. Rather, it states that when the two generate different reporting outcomes then practitioners should have the prerogative to prioritize substance over form. Furthermore, substance should inform the nature and direction of the form in which accounting practice develops. Williams understood the meaning of “Decline of Substance over Form in Accounting” in the title of Fischer et al. to indicate that there has been a decline of substance relative to form in the practice, theory, or regulation of accounting. Substance over form implies that transactions are recorded at their economic substance rather than at their legal form. Just as “Right of use asset” is recorded as asset in the books of the Lessee.

• The concept of substance over form was initially identified in the early 1980s.
• Still, in the accounting world, it typically refers to financial statement items.
• The issue is of some importance to auditors, since they are being asked to attest to the fairness of presentation of a set of financial statements, and fairness of presentation and the substance over form concept are essentially the same thing.
• Since this 1935 case, the doctrine of substance over form has dictated that taxpayers must abide by the economic substance of a transaction even if that substance is inconsistent with its legal form.