What is Substance Over Form in Accounting?

In accordance with the terms of the lease agreement, the jets remain in ownership of DEF, Inc. throughout the lease term so the legal form of the contract/agreement dictates that ABC, Inc. should not record them as asset budgeted synonym on its balance sheet. However, when we analyze the economic effects of the lease agreement, we see that it has put ABC, Inc. in control of the economic benefits inherent in the use of jets for major portion of the lease term because it has full control on the use of the jets. Further, the present value of lease payment is fairly equal to the fair value of the jets, etc., which means that ABC, Inc. has undertaken a liability equal to the cost of the jets by entering into the agreement. The transaction is best reflected in the financial statements by showing the jets as assets and also presenting a corresponding lease liability. 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.

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Various accounting frameworks, such as the International Financial Reporting Standards (IFRS), incorporate this principle to enhance the reliability and relevance of financial statements. 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. Company A’s financial statements do not include the balance lend to company B and liability from a loan shark. The method has gone deep into the resolution of disputes and refreshed the traditional approach to Mexico’s tax legal framework.

Substance over form is an accounting principle used “to ensure that financial statements give a complete, relevant, and accurate picture of transactions and events”. It is particularly relevant in cases of revenue recognition, sale and purchase agreements, etc. The key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent of the transaction, which would mislead the readers of a company’s financial statements. While accounting for business transactions and other events, substance over form principle requires accountants to measure and present the economic impact of an event instead of its legal form. Substance over form approach is critical for preparation of true and fair financial statements. It is particularly relevant while accounting for revenues, sale and purchase agreements, leases etc.

The country’s court believes that inflexible approaches end up in the creation of artificial tax bases that do not reflect reality. 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. Based on the form, it just a movement of cash from bank to vault to support operation and so on. And it was put back into the bank at year-end, external auditor can check bank statement or send bank confirmation to ensure if the balance is correct or not.

Substance Over Form Concept

A hypothetical example would be one firm acting as an agent for another and only recording sales on behalf of the second company in their commission amount. This way, businesses hide their debt liabilities as their debt does not appear on the balance sheet. With corporate acquisitions, the doctrine has been used to question the ability of the acquiring entity to step up the purchased company’s assets to fair market value. The transaction is viewed as if the acquired company sold its assets to the purchaser and then liquidated, creating one tax level and a step up of these assets on an inside basis. Guy Helvering, the Commissioner of Internal Revenue, insisted that there had been no reorganization in economic substance. Ms. Gregory owned all three companies and simply used a legal strategy to create the impression of a reorganization so that she could sell the Monitor stock without paying more income tax.

Impact of Substance Over Form to External Auditor

The principle of Substance over legal form is central to the faithful representation and reliability of information contained in the financial statements. However, the principle of substance over form has so far not been recognized by IASB or FASB as a distinct principle in their respective frameworks due to the difficulty of defining it separately from other accounting principles particularly reliability and faithful representation. As an accounting principle, it is designed to ensure that an entity’s financial statements provide an accurate and complete overview of its events and transactions. These statements measure and report the economic impact of a transaction instead of its legal form, which could conceivably mislead people on its true intent. Substance over form is an accounting concept which means that the economic substance of transactions and events must be recorded in the financial statements rather than just their legal form in order to present a true and fair view of the affairs of the entity.

After taking ownership of the Monitor stock, she sold them for over $133,000, claiming a cost of over $57,000 and a capital net gain of $76,000. On her 1928 income tax return, she reported the transaction as a tax-free corporate reorganization. She was also the owner of the United Mortgage Company, which owned 1,000 shares of stock in Monitor Securities Corporation. Three days later, Ms. Gregory transferred these shares to Averill, which she then dissolved on September 24. If you’re interested in finding out more about fixed overhead volume variance, then get in touch with the financial experts at GoCardless.

As per an article from 2022, the substance over form law has steadily grown and evolved in Mexican tax disputes. The country has made massive progress in the practical application of this principle and shifted from a rigid rule-of-law environment to a more reality-based one. It is mainly regarded as the implementation of PRODECON and this principal trial before the Federal Court of Administrative Justice (FCAJ).

However, its provisions are complex and apply only to a small number of transactions, typically involving very large amounts. The principle of substance over form is explicitly set out in the revised International Accounting Standard 8. Although the lessee is not the owner, the lessee may be required to record the asset as being owned by the lessee, based on the underlying economics of the transaction. Another example is the situation where a company short of cash sells its machinery to the bank and then leases the same property from the bank. Although the legal ownership has been transferred to the bank, the underlying economic reality for the company remain the same. Under the substance-over-form principle, the sale and subsequent leaseback are considered one transaction.

1. In accordance with the terms of the lease agreement, the jets remain in ownership of DEF, Inc. throughout the lease term so the legal form of the contract/agreement dictates that ABC, Inc. should not record them as asset on its balance sheet.
2. External auditors are required to attest that companies recognize all business transactions in compliance with the substance over form concept.
3. As an accounting principle, it is designed to ensure that an entity’s financial statements provide an accurate and complete overview of its events and transactions.
4. External auditor has to be aware of this issue and make sure the company does not hide true economic substance under the required regulation.

Identify the economic substance of the transaction and demonstrate how it differs from its legal form. The IRS uses the substance over form doctrine to stop taxpayers from changing the form of a transaction to derive a financial benefit. Courts have typically allowed the IRS to make a claim of substance over form while requiring the taxpayer to justify their chosen transaction form, making the doctrine an effective tool for tax authorities.

Company X sells some inventory to Company Y, the goods are transferred and the payment has been made. After several months, the same inventories are sold back at a slightly higher price. Still, when it comes to International Financial Reporting Standards (IFRS), which is a principle-based accounting technique, it is more challenging to justify or hide the intent of a transaction, as the IFRS framework does not allow that. Ultimately, it not only acknowledges the potential intent to conceal but also underscores the complexity of specific transactions, posing challenges for honest accountants in fully validating substance.

Despite accountants knowing they should not mislead readers of a company’s financial statements, substance over form in accounting is in widespread use. To accountants, the basic legal requirement that accounts must give a ‘true and fair view’ means that they must reflect the economic substance of a transaction and not just its legal form. Substance over form principle is recognized by all major financial reporting frameworks, namely the International Financial Reporting Standards (IFRS) and US GAAP, etc. External auditors are required to attest that companies recognize all business transactions in compliance with the substance over form concept. However, these are not the sale and purchase transactions, but the loan transactions. They do not want to record these as a loan because company X has a high gearing ratio which will impact their financial statements.

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In this instance, the company itself will be called the ‘lessee’ and the other party leasing its building to them as the ‘lessor’. 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. 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. For some years, there were examples of substance over form being applied to common transactions, almost as second nature, rather than by applying a specific rule or even consciously applying the substance over form principle.

While legal form considers transactions based on their formal documentation, Substance over Form looks beyond this, focusing on the economic impact and the true nature of the transaction. It prevents entities from exploiting legal technicalities to misrepresent their financial position. 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. 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. Since this 1935 case, the doctrine of substance over form has dictated that taxpayers must abide by the economic substance of a transaction even if that substance is inconsistent with its legal form. The government started utilizing this doctrine to rectify situations where the taxpayer has willfully misrepresented a transaction in order to derive a tax benefit.

The principle is to make sure that financial information true and faithful representation so the reader will fully understand. 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 concept entails the use of judgment on the part of the the only personal finance tool that integrates with xero preparers of the financial statements in order for them to derive the business sense from the transactions and events and to present them in a manner that best reflects their true essence. Whereas legal aspects of transactions and events are of great importance, they may have to be disregarded at times in order to provide more useful and relevant information to the users of financial statements.