Substance over form principle states that transaction should be recorded based on realism (substance). If there is a conflict between realism and form (legal aspects), an accountant needs to record the transaction based on realism which is substance and ignore legal form.
It’s important to note that this accounting principle aims to enhance the element of financial reality in financial reporting. It’s more relevant in sales, purchase, and revenue recognition.
The basic purpose of this accounting convention is to highlight the true intent of the transaction. So, it helps enhance the reliability of the financial statement.
Detailed explanation for substance over form
Substance = realism (true value)
Form = Value in documents (legal value/form)
This accounting convention believes that accountants should value the transaction at substance. Let’s understand the concept with the following example.
You are auditing at Mika Plc and discover that Mika Plc purchased 1,000 square yard plot from TT-CO at $2,000. It makes you conscious that how a 1,000 square yard plot can be purchased with $2,000.
You approach company management and review supporting documents. The agreed sale deed was $2,000, and you were surprised. Subsequently, it was discovered that Mika plc agreed to provide a certain production technique (internally developed) along with $2,000. However, it was not mentioned in the agreement. So, the market value of the plot was $20,000, and a sale deed was formed for $2,000.
In the above situation, there are two forms.
Substance form (real value) = $20,000
Legal form (Value in document) = $2,000
So, recording transactions at $2,000 shall lead to a violation of the accounting concept called substance over form. Hence, there is a need to correct transaction recording, and it must be done at a real value which is $20,000.
So, Mika plc needs to record the transaction as follows.
|PPE (Plot purchased)||20,000|
|Income against the sale of patent||18,000|
The debit impact of the transaction is recorded for the plot purchased. The second credit is cash paid for the purchased plot. However, the market value of the plot is $20,000. So, a balance of $18,000 ($20,000-$2,000) is a balancing figure, which will be the value of the production technique sold to TT-CO.
Substance over form is an important accounting convention. It states that the real form of the transaction should be recorded in the financial statement. This concept helps enhance the reliability of the financial statement. Further, its purpose is to increase the truth and fairness of the financial statement.