Substance over form is a phrase used to describe the true nature of a business. In some cases, conforming to accounting rules or legal rulings won’t accurately show the reality of your client’s financial or legal standing. Instead of simply following the rules, the concept of substance over form attempts to show your client’s business as accurately as possible.
Some accounting rules may require you to record a transaction that incidentally hides the true intent of the transaction. Instead of providing additional information, these types of transactions mislead the data presented. This misleading can occur both intentionally and accidentally. Your clients may rely on Generally Accepted Accounting Principles or International Financial Reporting Standards to substantiate events. For some situations, it’s most suitable to outline all information within the note disclosures. External auditors test your client’s financial records for substance by pulling documents, contracts, and general ledger activity.
An example of substance could relate to the sale of a good. A bill of sale could be drafted the last day of the month to record the revenue in the current month. However, if your client is still in possession of the goods and ownership hasn’t technically transferred, a sale should not be recorded, even if all criteria in accounting rules are met. Another example is debt between two companies owned by the same owner. Even if the financial statements for both companies are aggregated, this debt should be recorded because there is a legitimate liability and receivable between the two companies.
Although compliance to accounting rules is always important, you may encounter situations where these rules don’t paint the correct picture. Realize the concept of substance over form helps you build the most accurate financial reports for your clients.