Substance Over Form

Many students have the problem in understanding the meaning of this term "substance over form"--Here is my little endeavor to make them understand its meaning, hope you all will like it.

Substance over form:

Here SUBSTANCE means truth; in other words “financial reality”.

FORM means shape, you can say giving transaction a legal shape; in other words “legal status”

This principal says that while recording the transaction in the financial statement we need to consider on the financial reality of that transaction not on its legal status.

1)      Suppose, we have sold a building to the buyer for RS100000, and the risk and reward relating to that building has been transferred to the buyer; only the legal formalities are pending. Here this principle says that neither we nor buyer; can postponed recording of this transaction in our financial statements just because the legal formalities are pending. Here the substance is “building has been sold” form is “legal formalities pending”, as substance should be preferred over form so both the parties are bound to record this transaction in their books of account.

2)      We can see this case in the financial lease where we all know that the seller transfers the risk and reward of the related asset to the buyer at the time of initial payments but the legal ownership remains with seller. Here again this principle is being applied that the buyer has to record that lease asset as ASSET in its balance sheet even though the legal ownership remains with seller.

The word “risk and reward transferred” means-- buyer enjoys all the benefits and rights as if he is an owner of the asset or goods and on the same hand he is responsible for any damages or liability exists on that goods or asset”

3)      Suppose, I have sold goods for Rs 200000 to you, and after 2 months, I have purchased it back from you in an inflated price; here legally it’s a sale and purchase transaction-- it is called form of the transaction but reality is that I have used this transaction as loan and this inflated price is the interest of that loan, this is called the substance of the transaction. So according to this principle, we can’t record this transaction as sale or purchase.

The final important example is,

If two parties exchanged their goods of similar nature and with same price, it would not be called sales transaction according to this principle (because the financial reality is only the exchange of goods; no gain no loss) although both the parties entered into a legal contract to exchanged their goods.

Conclusion:

 This principle came into existence to avoid or to control the window dressing done by the enterprise. It says that financial statements should reflect true and fair view of the company so all the transaction should be considered by its substance not by its form. Here we should keep in mind that form of transaction can be changed in its favor by any enterprise but its financial reality can’t be changed and that’s why this principle is important in accounting.

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