In accounting, substance over form principle requires that business transactions should be recorded in accordance with their economic substance rather than their legal form, if there is a contradiction between the two. Let’s elaborate this principle to make it clearer.
What is economic substance? The underlying economic purpose of a business transaction is economic substance. To apply this principle, it is very important to understand the business rationale and essence of business transactions. There are practical circumstances where the legal form of transactions suggests something which is actually different from the actual underlying economic purpose of those transactions. In such circumstances, legal form should be disregarded and transactions should be accounted for in accordance with their economic substance.
Let’s take a look at the following examples to understand this principle.
- In Country ABC, there is a minimum salary specified by the Ministry of Human Resources. A company has employed certain individuals which are working for the company as full time employees. However, the company is paying them lesser than the stipulated minimum salary. To avoid any adverse legal consequences, they have made consultancy agreements and are showing this expense as consultancy charges in the books of account. External auditor has observed this point and has reported this issue, as regardless of the legal agreement, these individuals are hired by the company and are working there as full time employees, so this expense should be recorded as salary expense.
- Company A has purchased three used vehicles from Company B, however, their title has not yet been transferred to Company A. As the Company A has paid for the vehicles and is using them, so in the books of account, these vehicles should be recorded as Company A’s assets regardless of the fact that the legal ownership title of these vehicles is still with Company B.