Form v. substance

When business life was somewhat simpler than it is today, accounting for a transaction in accordance with its legal form generally gave an appropriate result. However, over the last twenty years or so, as business transactions have become more complex, there have been increasing numbers of transactions in which the legal form and economic substance have diverged from each other; gradually it became clear, in UK GAAP at least, that following the legal form did not properly reflect the commercial transaction.

To accountants, the basic legal requirement that accounts must give a ‘true and fair view’ means that they must reflect the economic substance of a transaction and not just its legal form.

In this chapter we will discuss the UK GAAP experience regarding substance over form before concluding with a look at the position under IFRS because the UK perspective on this topic is relevant to applying IFRS in the UK.

Early examples

For some years, there were examples of substance over form being applied to common transactions, almost as second nature, rather than by applying a specific rule or even consciously applying the substance over form principle. One example is accounting for an asset being ‘bought’ under hire purchase. The legal analysis is that the asset is being hired (or leased) for the term of the agreement. There is then an option for the lessee to purchase the asset, generally for a nominal sum such as £1. In almost all circumstances, the option to purchase is exercised, and the commercial effect of the transaction is that, from the start, the asset is being purchased on deferred payment terms.