Substance Over Form Concept of Accounting


Definition of Substance Over Form Concept (Convention, Principle) of Accounting:

Under Substance over form concept (convention, principle) of accounting, “transactions should be dealt with reference to their economic reality rather than their legal form”. This means that while maintaining accounting records, substance of the transaction should take precedence over its legal form.

Explanation, Use and Application:

Usually the legal form of a transaction is frequently descriptive of its economic substance, so no problem arises. In some cases when the two differ and both give different results. Examples include assets held on finance lease and hire purchase which are treated as non-current assets, although they are not in the legal ownership of the business.

Example 1:

A sells a machine to B for $20000 and at the same time agrees to buy it back in 1 year’s time for $21800. The machine remains on A’s premises and A continues to use and to insure the machine. These related transactions are likely to arouse some suspicion. What is actually going on here? In legal terms, following the first transaction, B is clearly the owner of the machine. However, the substance of the transaction is that A retains the risks and rewards of ownership, and effectively, has taken out a loan for a year at an interest rate of 9%.

Solution:

Applying the substance over form concept of accounting, A should continue to carry the asset in its statement of financial position, with a corresponding liability to B. B would record the loan as a receivable in its own statement of financial position. Why might this distinction between substance and form matter? What is the motivation for A to keep the loan off the statement of financial position? Let us extend the example a little further.  A is financed partly by long-term borrowing of $30000. One of the conditions under which the loan was made (the ‘covenant’) was that A’s total liabilities, both long- and short-term should not exceed $80000. Extracts from two versions of A’s statement of financial position, one drawn up to show substance over form and the other to show legal form after the transaction are as follows:

substance over form concept example

The statement of financial position prepared adopting the principle of substance over form shown total liabilities of $30000 + $65000 = $95000. This clearly breached the terms of the covenant. The statement of financial position prepared according to strict legal form, on the other hand, shown total liabilities of $30000 + $45000 = $75000. The terms of the covenant, technically, have not been breached.

Example 2:

The business has purchased a machine on hire purchase business as this does not legally belong to the business so is not shown as a non-current asset in the balance sheet.

Solution:

The substance over form concept allows that transactions and other events are accounted for and presented in accordance with their economic and commercial reality rather than their legal form so machinery should be recorded as non-current asset.