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Substance over form is a financial statement standard from basic accounting principles. The purpose of the statement forces accountants to present transactions based on economic substance rather than on legal form. Three requirements make up this accounting principle: completeness, relevance, and accuracy. Every transaction must meet these requirements in the substance over form principle. Financial statements prepared using this principle often present information in the truest manner possible.
Completeness demands all financial transactions represent the final picture of each business activity. Companies must record each transaction in its full form. If a transaction has multiple parts that will occur over time, accountants must only record the portion that affects the current accounting period. Disclosures are often necessary to inform stakeholders about long transactions. Any schedules or other calculations necessary to record transactions may also need disclosure to stakeholders.
Relevance means that a financial transaction has an impact on the company. For example, the cost paid several years ago for assets should not factor into replacement decisions. The price paid originally is not likely to occur again. Therefore, accountants should not include the information in any reports for making new a purchase. Another example of relevance in substance over form is where cost differs under different alternatives; only the alternative considered has a relevant cost.
Accuracy in substance over form dictates all transactions recorded are free from error. Calculations should be clear and concise, showing the effect of financial information. In many cases, an accounting manager or supervisor may need to sign off on accounting reports and statements. This signature indicates a second person reviewed the documents, calculations, and transactions for accuracy. Reconciliations may also be necessary to test for accuracy.
In some cases, accountants can sacrifice accuracy when completing financial statements. Completeness and relevance are more meaningful under substance over form. Though accountants should strive for accuracy at all times, spending too many hours working on one project can result in delayed financial statements. Other activities may also suffer when accountants fall behind because of time-related issues. For example, tax reports or public filing deadlines may not be met by a company.
While companies must report all information legally, this is not necessarily the most important aspect of financial information. A company usually has a legal department that reviews this information. Accountants prefer the bottom line, that is whether the business made a profit. Attempting to satisfy both legal and financial aspects under substance over form is too cumbersome for accountants.
@David09 - I’m startled to read that the some accountants may, as the article says, “sacrifice accuracy” in their financial statements using substance over form accounting.
I thought that accuracy was the holy grail in all accounting methodologies, especially considering how easy it is to wind up with fraud and corruption.
I would think that in cases where accuracy is sacrificed in order to meet deadlines, that future accounting statements would address prior omissions in reporting. At least that’s how I would cover myself.
@NathanG - I took an economics course in college. I can’t say that I remembered many things from the class, but I did remember the concept of a fixed cost. Once you buy something for your business - equipment or something like that - you consider it a fixed cost.
In other words, you don’t keep including it in your accounting tabulations. So I suppose that the fixed cost concept would fit in with the concept of relevancy. The item should not be brought up again.
I don’t know if that’s an accurate comparison but it seems to make sense, in my opinion.
It sounds like the substance over form concept should be the only accounting practice in my opinion. The article compares this against the merely legal form of accounting.
While the legal form is not explained, I would assume this is a situation where you just put numbers down whether they are no longer relevant, or complete. In other words, you’re just filling in boxes without providing any sense of context.
I can see how a purely legal form would be misleading and possibly skew an investor’s interpretation of how well a company is doing.
However, the problem I can see with the substance over form methodology is that determining things like relevance might be open to subjectivity, in my opinion.
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