In accounting, “substance over form” is a principle that requires transactions to be recorded and reported in a manner that best reflects their economic content, as opposed to its legal form. This principle is particularly relevant in the context of complex transactions, and the legal structure of the transaction could not be an adequate representation of its economic substance.
The “substance over form” principle requires that the transaction be recorded and reported in a way that most accurately represents its financial content. In the example above, transaction would be recorded as a loan, rather than as a purchase contract.
For example, consider an organization that enters to an agreement to purchase piece of equipment. Agreement stipulates that the purchase price will be paid in installments over the next two years. However, the organization intends to finance the purchase by taking out a loan and using the equipment as collateral. In this case, economic content of transaction is that company is borrowing money to finance the purchase of the equipment. The legalize way of transaction, however, is that organization is entering into a purchase contract.
The “substance over form” principle is essential because it ensures that transactions are recorded and reported in a manner that is consistent with their economic reality. This principle helps to prevent accounting misrepresentation and fraud. The “substance over form” principle is codified in accounting standards, such as GAAP and IFRS.