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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.
Whoever prepares the financial statements of a company needs to use their judgement to derive the business sense from the transactions and events in order to present them in a manner that best reflects their true essence.
At certain times the ‘legal form’' of a transaction may not provide its true image. Although the legal form can be of importance, it may be disregarded in order to present more relevant knowledge to the users of financial statements, who should not be misled.
A transaction is an instance of an event that could alter the financial status of a business entity. 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. Selling inventory, buying raw materials, indulging in legal agreements and getting a bank loan are all examples of business transactions.
Substance over form examples
Despite accountants knowing they should not mislead readers of a company’s financial statements, substance over form in accounting is in widespread use.
If a small adventure company in Cornwall buys a fleet of vans using a lease agreement from a bank, it will pay some of the advance cost and the remaining sum for the vans over, say, a five-year period. Now despite legally owning the vans from an ‘economic point of view’, the company will not be recognised as the ‘legal owner’ until it pays the final instalment at the end of the fifth year.
A large estate agency in London is looking to expand. 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 this instance, the company itself will be called the ‘lessee’ and the other party leasing its building to them as the ‘lessor’. If the lease agreement states at the end of the lease period the ownership title of the building will be transferred to the lessee (estate agent), or the lease term (time period for which the building is being leased) covers a substantial span of the useful life period expected for the building (which is the case here), then the building is owned by the lessee in economic reality. 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.
Other examples include one company essentially acting as an agent for another, so it should only record a sale on behalf of the second company in the amount of their commission. But they want their sales to appear larger, so record the entire amount of a sale as revenue.
A business could hide debt liabilities in related entities, so that its debt does not appear on the balance sheet.
Substance over form criticisms
Substance over form is a particular concern under generally accepted accounting principles (GAAP), because it is largely rules-based and creates specific hurdles that must be achieved in order to record a transaction a certain way.
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.
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