In order to present true and fair view of the financial statements, accountants need to reflect transactions over the basis of economic substance rather than over the legal form. Substance over Form is a major accounting principle and its applicability is very wide in the industry.
Although the legal form of the transactions has key role to play and has its own importance but in order to present the information in the right sense, we have to make judgments being an accountant. In doing so, accountant has to disregard certain legal form because this is necessary and relevant under the circumstances.
Example 1
BBB Plc is providing domestic employees to its one of it director. BBB Plc pays $2,000 directly to the employee.
As per legal sense, the staffs are the workers/ staff of BBB Plc but they are actually employed for the sole purposes of the director’s personal work.
The wages paid to the staff should be treated as payments to the directors and not as company expenses.
| Substance accounted for | |
| $ | |
| Sales | 50,000 |
| Cost of goods sold | (30,000) |
| Gross profit | 20,000 |
| Expenses | (10,000) |
| Directors’ fees (including wages paid to domestic staff) | (7,000) |
| Profit | 3,000 |
| Legal form accounted for | |
| $ | |
| Sales | 50,000 |
| Cost of goods sold | (30,000) |
| Gross profit | 20,000 |
| Expenses (including wages paid to domestic staff)
Directors’ fees |
(12,000)
(5,000) |
| Profit | 3,000 |
Example # 2
The accounting for finance lease considers the substance over form principle in to consideration. In finance lease, asset is owned by the bank (legal owner) but the asset is used and remains under the control of the lesse for majority of the useful life of the asset. Not just that, the present value of the lease payment is nearly equal to the fair value of the asset. In this case, though asset is the property of bank, the lesse records this as assets under finance lease in its financial statements. This is clearly the best example of substance over form principle.
Likewise, if the companies swap various similar types of inventories, then it will not be allowed to record the same as sales because over the substance principle, there is no sale happened. Regardless, whether there is a legal contract between them exist or not for the same transaction.
Example # 2
Being the senior management accountant of Grill Plc, you are required to suggest how to treat the following transactions:
- Grill is the owner of a car. He has given this car to Mr. Y to use the car as Taxi and earn the revenue from it. All the repair & maintenance including vehicle taxes are borne by Mr. Y. In this case, there is an issue as the vehicle is the property of Grill but Y is enjoying the associated benefits from it. So, it will be regarded as the asset in the books of Y over the basis of substance over form.
- Grill is the owner of a house which he rented out Mr. D at a monthly rent of $ 1,000. Though, Mr. D has the possession of the property, this house will be regarded as the asset of Grill because legal form and economic benefits are in the favor of Grill. It means risk and rewards are still associated with Grill.
- The factory machine which Grill uses to produce spare parts for sale in the local market has been sold out to a local bank. Later, it was acquired again on easy lease terms from the same bank. This transaction should record the factory machine assets of the company as machine was not removed from the Grill premises and still in use for the production of spare parts for sale in the local market. Actually, it is a sale and lease back transaction and according to the substance over form principle, machine should still be recorded as asset of the Grill.
The substance over form is one of the main principles in accounting which helps accountant greatly in deciding which the real owner of the asset is. In fact, it is the deciding principle in various complex transactions where a lot of confusion may create significant problems for the management and accountant.