Substance over form. Definition | Example | Uses

Substance over form

The question of substance over form is one that has been asked by accountants for many years.

Accountants are often faced with the question of what is more critical, substance or form. This question can be applied to many aspects of life. Still, in the accounting world, it typically refers to financial statement items. 

The philosophical basis is that accountants need to focus on the natural, underlying substance of a transaction rather than on its legal form. This concept is one of the underlying accounting principles of the IASB's conceptual framework.

To learn more about the Concept and its importance, scroll our blog or watch a video explanation below!

History of substance over form

The concept of substance over form was initially identified in the early 1980s. It emerged due to how entities were financing their operations. It became apparent that financing transactions were becoming more complex.

This complexity often led to separating the legal aspect to an asset from access to its economic benefits and risk. Specific financing arrangements were being entered into, which, in some instances, were deliberately engineered to achieve the desired outcome (to keep financing arrangements off the balance sheet).

This practice was coined 'off-balance-sheet finance', and the concept is still as much a problem today as it was back in the early 1980s.  

To address these and many more such issues, the accounting bodies introduced the concept of substance over form accounting.

What is substance over form in accounting?

Substance over form concept is a notion that underlies the concept of reliability, one of the qualitative characteristics detailed in the IASB's Framework.

We have published our video explanation over the concept. do watch the same in case you dont wish to read the entire article below.

In essence, substance over form refers to the accounting concept that transactions recorded in a company's financial statements and its disclosures must reflect their economic reality rather than their legal form. 

Let's take an example of this principle with the definition of an asset & a liability as it should be recognized in the balance sheet.

 An asset is a resource controlled by the reporting entity that derives economic benefit for the entity itself. The point to emphasize where assets are concerned is the concept of 'control'. To meet the definition of an asset, an entity must have control over that asset.

As opposed to assets, liabilities are obligations that generate an expectation that the entity will experience an outflow of funds (or depletion of other assets) to settle them.

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.

Benefits of Substance Over Form in Accounting

The principle of "substance over form" in accounting plays a pivotal role in ensuring the accuracy and reliability of financial statements. This principle emphasizes the economic reality of transactions over their legal form, thereby providing several key benefits:

Accurate and Fair View of Financial Position

By focusing on the economic substance of transactions, financial statements present a more accurate picture of a company's financial position and performance. This leads to:

• Enhanced Transparency: Stakeholders better understand the company’s financial health and operational results.
• Better Decision-Making: Based on the true financial status of the entity, investors, creditors, and management can make more informed decisions.

Improved Comparability

Applying the substance over form principle allows for consistent treatment of similar transactions, irrespective of their legal forms. This enhances the comparability of financial statements:

• Across Entities: Investors can compare the financial statements of different companies more effectively.
• Over Time: Consistency in accounting treatment ensures comparability of financial performance over different periods.

Enhanced Reliability

Financial statements that reflect the economic reality of transactions are more reliable. This reliability stems from:

• Accurate Reflection of Transactions: Recognition and measurement based on substance ensure that all relevant economic activities are captured accurately.
• Consistency and Integrity: Ensuring that the financial data aligns with the actual economic impact of transactions supports the integrity of financial reporting.

Alignment with Economic Reality

The substance-over-form principle ensures financial reporting aligns with the actual economic events and conditions affecting the entity. This alignment leads to:

• True Representation of Financial Risk and Rewards: Transactions are recorded based on their actual economic impact, representing the entity's financial risks and benefits.
• Better Reflection of Operational Activities: The financial statements depict operational performance and financial conditions, aiding stakeholders in understanding the company's business operations.

Regulatory and Compliance Benefits

Adhering to the substance over form principle helps comply with accounting standards such as IFRS and GAAP, which require this approach. This compliance brings:

• Reduced Risk of Regulatory Issues: Companies that adhere to this principle are less likely to face issues with regulatory bodies over misleading financial statements.
• Enhanced Credibility: Compliance with established standards enhances the credibility and reputation of the company among investors and regulators.

Increased Stakeholder Confidence

Stakeholders, including investors, creditors, and analysts, gain greater confidence in financial statements that follow the substance over form principle. This confidence is due to:

• Greater Assurance of Transparency: Stakeholders trust that the financial statements provide an accurate and fair view of the company’s financial status.
• Improved Trust in Management: Consistent and transparent reporting builds trust in the management's ability and integrity.

Facilitation of Accurate Financial Analysis

Financial analysts and other stakeholders can perform more accurate and meaningful analyses when financial statements reflect the economic substance of transactions. This facilitation leads to the following:

• Better Risk Assessment: Accurate financial reporting allows for a more precise assessment of financial risks.
• Enhanced Valuation Accuracy: Investors can make more accurate valuations and investment decisions based on true financial data.

Implementing Substance Over Form in Accounting

Implementing the principle of substance over form in accounting requires a thorough understanding of the economic realities of transactions and a commitment to reflecting those realities accurately in financial statements. Below are steps and best practices for effectively implementing this principle within an organization:

Understand the Principle

• Training and Education: Ensure that all accounting and finance personnel are thoroughly trained on the principle of substance over form, its importance, and its applicability under IFRS and GAAP.
• Conceptual Framework: Familiarize the team with the relevant sections of the IFRS and GAAP conceptual frameworks that emphasize this principle.

Evaluate Transactions Based on Economic Substance

• Detailed Analysis: Conduct a detailed analysis of each transaction to understand its economic impact beyond its legal form. This includes examining all aspects of the transaction, such as rights, obligations, risks, and rewards.
• Use of Professional Judgment: Apply professional judgment to assess the substance of complex transactions, considering factors such as control, ownership, and the flow of economic benefits.

Documenting the Substance of Transactions

• Comprehensive Documentation: Maintain detailed documentation that explains the economic substance of transactions. This should include analyses, assumptions, and judgments in determining the substance over form.
• Supporting Evidence: Gather and preserve supporting evidence such as contracts, agreements, and other relevant documents highlighting the transactions' economic reality.

Accounting Policies and Procedures

• Develop Policies: Create accounting policies explicitly incorporating the substance over form principle. Ensure these policies provide clear guidance on how to evaluate and record transactions.
• Consistent Application: Apply these policies consistently across all transactions to ensure uniformity and comparability in financial reporting.

Regular Review and Monitoring

• Internal Controls: Establish internal controls to monitor the application of the substance over form principle. Regularly review transactions and financial statements to ensure compliance.
• Audits and Assessments: Conduct internal audits and assessments to verify the principle is correctly applied. Address any deviations promptly.

Collaboration and Communication

• Cross-Functional Teams: Encourage collaboration between accounting, finance, legal, and operational teams to understand the transactions and their economic implications fully.
• Stakeholder Communication: Communicate the importance and application of the substance over form principle to stakeholders, including investors, auditors, and regulators, to enhance transparency and trust.

Technology and Tools

• Utilize Technology: Leverage accounting software and tools that support the analysis and documentation of transactions based on their substance. These tools can help maintain accuracy and consistency.
• Continuous Improvement: Stay updated with advancements in accounting technology and integrate new tools that can enhance the implementation of the substance over form principle.

Some of the applications of substance over form accounting in IFRS. 

• An undertaking may dispose of an asset to another party so that the document purports to pass legal ownership to that party. Nevertheless, agreements may ensure that the undertaking continues enjoying the asset's benefits. This may be done to raise finance, using the asset as collateral. In such circumstances, the reporting of a sale would not represent the transaction faithfully. 

• Lease agreements as per IFRS 16 are accounted for following their substance and financial reality and not merely with the legal form. The lessee may acquire no legal title to the leased asset in a finance lease. In return for paying the asset's value and interest charges, the lessee enjoys the benefits of the leased asset for most of its economic life. IFRS 16 on leases, therefore, requires the lease to be shown as an asset on the lessee's balance sheet.

• IAS 32 requires capital instruments to be classified as debt or equity to be recorded in the financial statements, whichever represents the substance.
• Derivative instruments: Derivative instruments, such as options or futures contracts, may be structured in a way that obscures their economic substance. In these cases, the accounting treatment of the instruments should be based on their economic substance, rather than their legal form.

• Sale and leaseback transactions: A company may sell an asset and then lease it back from the purchaser in a transaction known as a sale and leaseback. If the transaction has the economic substance of a financing arrangement, rather than a sale, the accounting treatment should reflect this substance.

• Related party transactions: If a company engages in a transaction with a related party, such as a subsidiary or affiliated company, the accounting treatment of the transaction should be based on its economic substance rather than its legal form or the way it is labelled.

• Off-balance sheet financing: A company may use off-balance sheet financing arrangements, such as unique purpose entities or sale and leaseback transactions, to raise capital or finance assets. If these arrangements have the economic substance of a financing arrangement rather than a sale, the accounting treatment should reflect this substance.
• Revenue recognition: A company may enter into a contract to provide goods or services, but the contract may be structured in a way that obscures the economic substance of the transaction. In these cases, the accounting treatment of the revenue should be based on the substance of the transaction rather than its legal form.
• Business combinations: When two companies merge or one company acquires another, the accounting treatment of the transaction should be based on its economic substance rather than its legal form or the way it is labelled.

Criticism of substance over form

• Substance over form principle can lead to complex accounting standards and disclosures, making it difficult for investors and others to understand a company's financial statements.

• Application of the substance over form principle increases bias in accounting. It is primarily determined by the accountant doing professional judgment and their moral and ethical qualities.

If you would like to understand IFRS more, do read our blogs on IFRS or take a review course on IFRS with Eduyush.