“Substance over form” is an accounting concept if said in a complete phrase, from which this term is extracted then it will be something like this: For Accounting purposes economic substance of the transaction will be preferred over the legal form of the transaction.
Economic substance refers to the economic benefits and economic losses or any kind of economic implications related to the transaction.
Whereas, Legal form refers to the legal status of the transaction.
Let’s understand these two different dimensions with an example. Mr. A bought a machinery. He use this machinery to bake biscuits which he sells. He has also insured the machinery against any losses.
Now, according to the legal form of the transaction tells that this machinery is in the ownership of Mr. A. And economic substance is telling that economic benefits (rewards) and the losses (risks) associated with the machinery is with the owner of the machinery i.e. Mr. A i.e. whatever income is earned by selling biscuits will be enjoyed by Mr. A and also if anything happens to the machinery, Mr. A will be bear the losses.
Most the time we don’t need to apply this concept as the economic and legal aspects of the transactions are concentrated at one place i.e. both of these aspects are not segregated among two different parties.
But in some transactions, these two aspects gets segregated and the owner might be someone else and the person who is enjoying the benefits and bearing the losses of the same asset is someone else.
For example, Mr. ABC bought a car and then gave the car to Mr. XYZ who will use the asset and will earn the income. Now Mr. ABC is the legal owner but the economics of the asset are connected with Mr. XYZ. In such examples, we get confuse that who will actually record the car as his asset. Either Mr. ABC? or Mr. XYZ?
We are confused because Mr. ABC is the owner of the car that’s why it should appear in his books. But on the other hand, Mr. XYZ is using the car and all the incomes (rewards) and losses (risks) from car are with Mr. XYZ and because of this Mr. XYZ’s financial statements should have this asset.
Thus, in order to solve this mystery, accounts have made up the rule that wherever, legal form and economic substance is not at one place or is at conflict then economic substance of the transaction will overrule the legal form of the transaction.
Lastly, “economic substance” should not be confused with “possession” or “use”. There are many examples in which the possession of the asset is with the party other than the owner and still we do not apply this concept. The reason is economic substance is not about possession and/or use, its about the risks and rewards. Through this concept we check whether the risks and rewards are with the which party and then accordingly decide what will be the accounting treatment.
Students who are still confused about the difference between economic substance and possession (or use) then they should think it this way; under this concept we check whether the risks and rewards are also with the same person who has the possession of the asset OR the risks and rewards have been transferred to another party even if the possession has not been given.
For example, in rental agreements, the possession and use is with another party but risk and rewards are still with the owner of the asset. Thus, no need to follow the economic substance instead of legal status. But under finance lease the risks and rewards are substantially transferred to the lessee and thus lessor (who is also the owner of the asset) is not responsible for risks and rewards. This is where economic substance will be preferred and the asset will be recorded in the lessee’s financial statements even if he is not the owner.
Example 1 – Sale and Leaseback
Mr. A has sold a machinery to XYZ bank on terms that the same asset will be leased back to Mr. A under finance lease agreement. The asset is sold for 10,000.
How the transaction will be recorded in the books of Mr. A?
Although the asset is sold to XYZ bank and legally bank is the new owner, however the risks and rewards are still with Mr. A exactly the way they were before sale as asset is given back to Mr. A under finance lease agreement for 10 years.
Therefore, substance over form concept will be applied and transaction is not a sale transaction rather a secured loan transaction and thus asset will remain in the books of Mr. A and any money received from XYZ bank by Mr. A will be recorded as non-current liability.
Example 2 – Sale and Leaseback
Mr. B has sold an asset to LH Plc with terms to acquire the same asset under operating lease. The lease is for 10 years. Disposal consideration received by Mr. B is 5,500.
How the transaction should be reported in Mr. B’s books.
As the risk and rewards associated with the asset has transferred from Mr. B to LH Plc and asset is possessed by Mr. B under operating lease, the transaction will be considered a sale transaction and 5,500 will be recorded as disposal of asset with gain or loss on carrying amount accounted for appropriately. Asset will be removed from the books of Mr. B.
Example 3 – Consignment
Mr. Busy and Mr. Dizzy are in a contract. Mr. Dizzy manufactures units and send them to Mr. Busy who ultimately sell the units. As per contract, any sales proceeds collected by Busy are sent to Dizzy after deducting agreed upon del credere commission. Once units reach Busy, any units lost or damaged are to be repaired by Busy.
In the contract between Busy and Dizzy, the losses are on Busy only. For both units damage or lost and if customers don’t pay (because of del credere commission in place) Busy will have to take up the loss.
In such case, inventory will be written in the books of Mr. Busy at the time of arrival.