Substance over form means financial transactions should be recorded & disclosed based on their substance/economic reality rather than legal form.

Substance/economic reality means the real purpose/intent of transactions should be identified and measured rather than a value given in the documents (form). So, presenting real economic value is the goal of this concept.

It’s important to note that there may or may not be differences in the substance/economic reality and legal form. It simply means if the transaction is executed and recorded using economic reality, both legal form and substance remain the same.

However, if there is a difference in economic reality and legal form, the transaction should be recorded/disclosed considering economic reality, which is not fabricated/artificial numbers/information but real.

Using legal form may be a manipulative strategy leading to window-dressed financial statement. Hence, accountants and auditors need to ensure transactions are recorded in a way to reflects real substance or reality.

Why is substance over form more challenging in GAAP?

GAAP is a rule-based approach. So, anything in compliance with rules/legal forms can be proven as genuine. On the other hand, IFRS is more about a principle approach where it may be difficult to justify why the legal form was used when it was not reflecting the real economic value of the transaction.

Example # 01

Company A acts under an agency contract for company B. So, Company A has the right to earn and record the commission income. However, Company-A records full revenue as their own rather than recording commission income. Hence, company A has not recorded economic reality but legal form, which is misleading in this case.

Example # 02

XYZ company purchases equipment on lease. So, the company receives and records assets in the business financial statement. However, it does not fully disclose that the asset was brought via lease. So, accountants need to carefully record/disclose the fact that the asset was purchased on the lease, which is an economic reality.

Conclusion

Substance over form means the financial transactions should be disclosed/recorded based on substance/economic reality rather than legal form.

Sometimes, the legal form may be manipulative as it does not reflect the true nature of the transaction. In this situation, the auditors and accountants are required to ensure they record/disclose information considering economic value.