Substance Over Form
Substance over form is an accounting principle which recognizes that business transactions should be accounted in accordance with their (economic) substance instead of their (legal) form. Economic substance refers to the underlying economic or commercial purpose of a business transaction apart from its legal or tax considerations. Legal form refers to interpretation of a business transaction in accordance with the applicable business laws.
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.
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.
ABC, Inc. is an airline which has obtained 5 jets from DEF, Inc. on lease under following conditions:
- The jets shall be available only to ABC, Inc. for the next 10 years (useful life is 12 years)
- The jets shall be modified to meet specific requirements of ABC, Inc.
- ABC, Inc. shall make quarterly payments which when discounted appropriately equals the cost of the jet plus other related costs
- The ownership of the jets shall remain with DEF, Inc. over the life of the lease and the physical custody of the jets shall be transferred back to DEF, Inc. at the end of the lease term.
Identify the economic substance of the transaction and demonstrate how it differs from its legal form.
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. 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.
A food-processing company has cash flow problems, so it sells its fleet of delivery trucks to a bank and gets it back on a lease. The transaction is called sale and leaseback. Although the legal ownership of the assets has transferred but the underlying economics remains the same and hence under the substance over form principle the sale and subsequent leaseback are looked at as one transaction. The company cannot just remove the fleet from its balance sheet because the legal ownership has changed. It will continue to recognize the fleet as an asset and shall also record a lease liability that arise out of the associated lease-back.
If two companies swap inventories of identical nature, legally the ownership of goods has changed, but there is no commercial purpose of the transaction because it does not generate any profit or loss. Substance over form principle disallows recognition of revenue by any of the companies even if they have entered into valid enforceable contracts.