What is meant by Substance over form?

“Substance over form” if said in a complete phrase, from this term is extracted, then it will be something like this: Economic substance of the transaction will be preferred over the legal form of transaction for accounting purposes.

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.