Substance Over Form
Substance over form is the concept that the financial statements and accompanying disclosures of a business should reflect the underlying realities of accounting transactions. Conversely, the information appearing in the financial statements should not merely comply with the legal form in which they appear. In short, the recordation of a transaction should not hide its true intent, which would mislead the readers of a company’s financial statements.
Substance over form is a particular concern under Generally Accepted Accounting Principles (GAAP), since GAAP is largely rules-based, and so creates specific hurdles that must be achieved in order to record a transaction in a certain way. Thus, someone intent on hiding the true intent of a transaction could structure it to just barely meet GAAP rules, which would allow that person to record the transaction in a manner that hides its true intent. Conversely, International Financial Reporting Standards (IFRS) are more principles-based, so it is more difficult for someone to justifiably hide the intent of a transaction if they are using the IFRS framework to construct financial statements.
Thus far, the substance over form argument assumes that someone is attempting to deliberately hide the true intent of a transaction – but it may also arise simply because a transaction is extremely complex, which makes it quite difficult to ascertain what the substance of the transaction is – even for a law-abiding accountant.
Outside auditors are continually examining the transactions of their clients to ensure that the substance over form criterion is being followed. The issue is of some importance to auditors, since they are being asked to attest to the fairness of presentation of a set of financial statements, and fairness of presentation and the substance over form concept are essentially the same thing.
Examples of Substance Over Form
Examples of substance over form issues are:
Company A is essentially an agent for Company B, and so should only record a sale on behalf of Company B in the amount of the related comission. However, Company A wants its sales to appear larger, so it records the entire amount of a sale as revenue.
Company C hides debt liabilities in related entities, so that the debt does not appear on its balance sheet.
Company D creates bill and hold paperwork to legitimize the sale of goods to customers where the goods have not yet left the premises of Company D.