Substance Over Form Principle | Definition and Examples

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Substance Over Form

While accounting for business transactions and
other events, we measure and report the
economic impact of an event instead of its legal
form. This is called substance over form
principle. Substance over form is critical for
reliable financial reporting. It is particularly
relevant in case of revenue recognition, sale
and purchase agreements, etc.

Examples
1.

A lease might not transfer ownership to

the leasee but the leasee has to record
the leased items as an asset if it intends
to use it for major portion of its useful life
or where the present value of lease
payment is fairly equal to the fair value of the asset, etc. Although legally the leasee is not the owner,
so the leased item is not his asset, but from the perspective of the underlying economics the leasee is
entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset.

2.

A company is short of cash, so it sells its machinery to the bank and obtains it back on a lease. It is
called sale and leaseback. Although the legal ownership has transferred but the underlying economics
remain the same and hence under the substance over form principle the sale and subsequent
leaseback are considered one transaction.

3.

If two companies swap their inventories they will not be allowed to record sales because not sales has
occurred even if they have entered into valid enforceable contracts.

Written by Obaidullah Jan, ACA, CFA

Financial Accounting
Financial Accounting Intro
Accounting Principles
Qualitative Characteristics of FS
Accrual Concept
Going Concern Concept
Business Entity Concept
Monetary Unit Assumption

1/18/2016 11:36 AM