Substance Over Form in IFRS: Principle & Examples

Substance Over Form: The Principle That Changes How You See Financial Statements

If you have ever wondered why a company reports an asset on its balance sheet even though it does not legally own it, or why a "sale" is sometimes treated as a loan, the answer lies in one of the most important principles in accounting: substance over form.

This principle holds that financial statements should reflect what is really happening in the economy, not just what the legal documents say. It sounds simple, but applying it correctly requires judgement, experience and a deep understanding of transactions.

After 25+ years of working with IFRS in audits, implementations and ACCA Diploma in IFRS classrooms, I can tell you that substance over form is where textbook accounting meets real-world complexity. This article explains the principle in plain language, with examples that will help you in exams, interviews and practice.

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

What Is Substance Over Form?

Substance over form means that transactions and events should be accounted for and presented in accordance with their economic substance and reality, not merely their legal form.

In simpler terms:

What is actually happening matters more than what the contract says.

A Quick Example

A company sells a building to a bank for £10 million and immediately leases it back for 20 years, with an option to repurchase at the end of the lease.

• Legal form: The company sold the building and is now renting it.
• Economic substance: The company still uses the building, still bears the risks and rewards of ownership, and will likely get it back. This looks more like a loan secured against the building than a genuine sale.

Under the substance-over-form principle, this transaction would be accounted for as a financing arrangement, not a sale. The building stays on the company's balance sheet, and the £10 million is treated as a liability.

Where Does This Principle Come From?

Substance over form is embedded in the IFRS Conceptual Framework. The Framework states that financial information must provide a faithful representation of economic phenomena – and faithful representation requires reporting the substance of transactions, not just their form.

The principle is also explicitly required by many individual IFRS standards, including:

• IFRS 16 (Leases)
• IFRS 15 (Revenue from Contracts with Customers)
• IFRS 9 (Financial Instruments)
• IAS 32 (Financial Instruments: Presentation)
• IFRS 10 (Consolidated Financial Statements)

For a broader understanding of IFRS principles, see my article on objectives of IFRS.

Why Substance Over Form Matters

1. Prevents Manipulation of Financial Statements

Without this principle, companies could structure transactions to achieve a desired accounting outcome, even when the economic reality is completely different. This is exactly what happened in many corporate scandals – transactions were designed to keep liabilities off the balance sheet even though the company was economically exposed.

2. Provides Useful Information to Users

Investors, lenders, and analysts need to understand a company's real financial position and performance. If financial statements only reflect legal form, users would be misled about the company's true risks, obligations and assets.

3. Ensures Comparability

When all companies prioritize substance over form, similar transactions are treated the same way regardless of their legal structure. This makes it easier to compare companies across industries and geographies.

4. Supports Professional Judgement

Substance over form requires accountants to think critically about transactions rather than just follow a checklist. This professional judgement is what distinguishes a skilled accountant from someone who merely processes data.

Key Examples of Substance Over Form in IFRS

Example 1 – Leases (IFRS 16)

Scenario: A company leases equipment for 8 years. The equipment has a useful life of 10 years. The company bears maintenance costs and can purchase the equipment for a nominal amount at the end of the lease.

Legal form: The company does not own the equipment; it rents it.

Economic substance: The company controls the equipment, uses it for most of its useful life, bears the risks and enjoys the rewards. This is economically equivalent to purchasing with financing.

Accounting treatment: Under IFRS 16, the lessee recognises a right-of-use asset and a lease liability on the balance sheet. The transaction is treated as a financed purchase, not a rental.

This is a classic example of substance over form – the legal form says "rental" but the economic substance says "financed purchase."

For more on financial instruments and related concepts, see my IFRS 9 interview questions.

Example 2 – Sale and Leaseback

Scenario: A company sells property to a financial institution and immediately leases it back for 25 years, with an option to repurchase at fair value.

Legal form: Sale of property followed by a new lease agreement.

Economic substance: Depends on the terms. If the seller-lessee retains substantially all the risks and rewards of ownership (through the repurchase option, lease terms, etc.), this is not a true sale – it is a financing arrangement.

Accounting treatment: If the transfer does not qualify as a sale under IFRS 15, the seller-lessee continues to recognise the asset and treats the proceeds as a financial liability.

Example 3 – Revenue Recognition (IFRS 15)

Scenario: A software company signs a contract to deliver software, provide implementation services and offer 3 years of support. The contract is structured as a single payment.

Legal form: One contract, one payment.

Economic substance: Three distinct performance obligations – software licence, implementation services and ongoing support. Revenue should be recognised as each obligation is satisfied, not all at once.

Accounting treatment: Under IFRS 15, the company must identify separate performance obligations and allocate the transaction price to each. Revenue is recognised over time or at a point in time, depending on when control transfers.

For practice on revenue scenarios, see my IFRS 15 interview questions.

Example 4 – Financial Instruments (IAS 32)

Scenario: A company issues "preference shares" that pay a fixed dividend and must be redeemed by the company after 5 years.

Legal form: These are shares – equity instruments.

Economic substance: The company has an obligation to pay fixed amounts (dividends) and repay the principal. This is economically equivalent to debt, not equity.

Accounting treatment: Under IAS 32, these preference shares are classified as financial liabilities, not equity. The dividends are recognised as interest expense in profit or loss.

Example 5 – Consolidation (IFRS 10)

Scenario: A company creates a special purpose entity (SPE) to hold assets. The company does not own any shares in the SPE, but it designed the SPE, bears most of the risks and receives most of the benefits.

Legal form: The company has no ownership interest.

Economic substance: The company controls the SPE – it has power over it, exposure to variable returns and the ability to use that power to affect returns.

Accounting treatment: Under IFRS 10, the company must consolidate the SPE because it controls it, even if it does not have legal ownership.

How to Apply Substance Over Form in Practice

Step 1 – Understand the Transaction Fully

Do not stop at the contract. Ask questions:

• What are the real risks and rewards?
• Who controls the asset or activity?
• What are the cash flows and their timing?
• What happens in different scenarios?

Step 2 – Identify the Economic Reality

Strip away the legal labels and ask: "What is really happening here?"

• Is this a sale or a financing arrangement?
• Is this equity or debt?
• Is this a lease or a purchase?
• Is this revenue or a deposit?

Step 3 – Apply the Relevant IFRS Standard

Once you understand the substance, apply the appropriate standard:

• IFRS 16 for leases
• IFRS 15 for revenue
• IFRS 9 / IAS 32 for financial instruments
• IFRS 10 for control and consolidation

Step 4 – Document Your Judgement

Professional judgement is required. Document:

• The facts and circumstances
• The analysis performed
• The conclusion reached
• The basis for that conclusion

This documentation protects you in audits and reviews.

Substance Over Form in Exams

DipIFR and SBR exams frequently test substance over form. Common scenarios include:

• Sale and leaseback transactions
• Complex financing arrangements
• Revenue contracts with multiple elements
• Classification of financial instruments
• Control assessments for consolidation

Exam tip: When you see a transaction that seems "unusual" or where the legal form does not quite match the economic reality, that is your cue to apply substance over form.

Substance Over Form in Interviews

Interviewers love this topic because it tests whether you can think critically, not just recite rules.

Common interview questions:

• "Can you explain substance over form with an example?"
• "How would you account for a sale and leaseback?"
• "Why might a preference share be classified as a liability?"
• "How do you determine if an entity should be consolidated?"

My IFRS interview questions article includes several questions on this topic.

Connection to the Conceptual Framework

Substance over form is directly linked to the IFRS Conceptual Framework requirement for faithful representation.

The Framework states that financial information must be:

• Complete – includes all necessary information
• Neutral – free from bias
• Free from error – no errors in description or process

Reporting only the legal form of a transaction would fail the "free from error" test because it would not faithfully represent the economic reality.

For more on the Framework, see my article on the difference between a conceptual framework and accounting standards.

Criticisms and Challenges

Substance over form is not without challenges:

1. Requires Significant Judgement

Different accountants may reach different conclusions about the same transaction. This can reduce comparability if judgements are poorly documented or inconsistent.

2. Can Lead to Complex Standards

Standards like IFRS 16 and IFRS 15 are complex partly because they try to capture economic substance in all its variations. This complexity increases compliance costs.

3. Potential for Bias

Because judgement is required, there is scope for management to interpret transactions in ways that favour their preferred outcome. Strong internal controls and independent audit are essential safeguards.

For a balanced view of IFRS challenges, see my article on disadvantages of IFRS.

Benefits of Understanding Substance Over Form

1. Better exam performance – You can analyse complex scenarios, not just recall rules.
2. Stronger interview answers – You demonstrate critical thinking and commercial awareness.
3. More confident practice – You can handle unusual transactions with a principled approach.
4. Career advantage – Employers value professionals who can see beyond the legal form.

For a broader view of IFRS advantages, see my article on benefits of IFRS.

Final Thoughts

Substance over form is one of the most important principles in IFRS. It requires you to look beyond legal labels and contracts to understand what is really happening economically.

Mastering this principle will help you:

• Interpret complex transactions correctly
• Score higher in DipIFR and SBR exams
• Stand out in job interviews
• Add value in practice by advising on the true accounting treatment

Do not treat substance over form as an abstract concept. Treat it as a lens through which you analyse every significant transaction. Once you start seeing the world this way, IFRS becomes much easier to understand and apply.

About the Author

This article was written by Vicky Sarin, CA, Founder & CEO of Eduyush.com, with over 25 years of post-qualification experience in financial reporting, audit and global accounting education. Vicky has coached thousands of professionals for ACCA DipIFR and other IFRS certifications, with Eduyush students achieving world-class scores and consistently outperforming global pass rates in recent exam sessions.