Substance Over Form Principle Definition and Examples

In other words, accountants should look beyond the surface of a transaction to its underlying economic substance. Other examples include one company essentially acting as an agent for another, so it should only record a sale on behalf of the second cost of goods sold for cleaning industry company in the amount of their commission. But they want their sales to appear larger, so record the entire amount of a sale as revenue. Company A’s financial statements do not include the balance lend to company B and liability from a loan shark.

• Likewise, a firm withdrawing inventory for internal use accounts this event in a separate account, classified as such, and not on the sale account.
• Substance over form is an accounting principle which recognizes that business transactions should be accounted in accordance with their (economic) substance instead of their (legal) form.
• For example, if a company leases a piece of equipment from another business, the transaction should be recorded as an asset and liability on the balance sheet, rather than simply as revenue and expense on the income statement.
• The principle thus maintains the sales account as reflecting only actual sales in substance (that is, items delivered to outside parties for payment), and not events that merely fit the form of sales documentation for convenience or expedience.

FAR CPA Practice Questions: Journal Entries for Treasury Stock Transactions

Legal form refers to interpretation of a business transaction in accordance with the applicable business laws. Despite accountants knowing they should not mislead readers of a company’s financial statements, substance over form in accounting is in widespread use. Substance Over Form concept in accounting means recording financial transactions to truly represent the essence in statements, focusing on economic reality rather than just legal appearances.

Substance Over Form Concept

A hypothetical example would be one firm acting as an agent for another and only recording sales on behalf of the second company in their commission amount. This way, businesses hide their debt liabilities as their debt does not appear on the balance sheet. Still, when it comes to International Financial Reporting Standards (IFRS), which is a principle-based accounting technique, it is more challenging to justify or hide the intent of a transaction, as the IFRS framework does not allow that. Ultimately, it not only acknowledges the potential intent to conceal but also underscores the complexity of specific transactions, posing challenges for honest accountants in fully validating substance.

AccountingTools

The Internal Revenue Code improves matters in one sense, as it is accessible to everyone with the time and patience to pore over its provisions. After taking ownership of the Monitor stock, she sold them for over $133,000, claiming a cost of over $57,000 and a capital net gain of $76,000. On her 1928 income tax return, she reported the transaction as a tax-free corporate reorganization. And yes the goods really move from seller’s warehouse to buyer’s warehous and vice versa. The significance of financial information that could influence the decision-making process of users, ensuring that all relevant data is included in financial reports.

International Accounting

Although the legal ownership has been transferred to the bank, the underlying economic reality for the company remain the same. Under the substance-over-form principle, the sale and subsequent leaseback are considered one transaction. Revenue recognition is a critical area in accounting where the Substance Over Form principle is rigorously applied. This standard requires companies to evaluate the terms of their contracts and the nature of their transactions to determine when control is transferred, rather than simply relying on the legal form of the agreement.

What Is the Substance Over Form Doctrine?

The country has made massive progress in the practical application of this principle and shifted from a rigid rule-of-law environment to a more reality-based one. It is mainly regarded as the implementation of PRODECON and this principal trial before the Federal Court of Administrative Justice (FCAJ). To enhance its financial appearance, TechBrite decides to sell some of its assets, specifically a section of its main office building, to another company called PropHold. Immediately after the sale, TechBrite agrees to lease the same office space back from PropHold for a period of 10 years. The IRS uses the substance over form doctrine to stop taxpayers from changing the form of a transaction to derive a financial benefit. Courts have typically allowed the IRS to make a claim of substance over form while requiring the taxpayer to justify their chosen transaction form, making the doctrine an effective tool for tax authorities.

In 1932, the Board of Tax Appeals (which preceded the U.S. Tax Court) ruled in favor of Ms. Gregory, but its decision was reversed by the U.S. The U.S. Supreme Court also ruled in favor of Commissioner Helvering, stating that the Revenue Act did not support reorganizations simply for the purpose of avoiding taxes. For example, if an entity reports on its statement of financial position an amount of CU 1 million of accounts receivable as at year-end, then that amount should be present on that specific date.

While legal form considers transactions based on their formal documentation, Substance over Form looks beyond this, focusing on the economic impact and the true nature of the transaction. It prevents entities from exploiting legal technicalities to misrepresent their financial position. 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.

The country’s court believes that inflexible approaches end up in the creation of artificial tax bases that do not reflect reality. If two companies swap inventories of identical nature, legally the ownership of goods has changed, but there is no commercial purpose of the transaction because it does not generate any profit or loss. Substance over form principle disallows recognition of revenue by any of the companies even if they have entered into valid enforceable contracts.