Substance over form

What it means

Substance over form is an accounting principle under which a transaction is recorded and presented according to its economic substance, not according to what the contract calls it or its legal form. The Slovak Accounting Act expressly requires it, and it is one of the conditions for the financial statements to give a true and fair view.

The classic example is a finance lease. Formally it is a rental and the leasing company is the owner, but economically the lessee uses the asset for its whole useful life and buys it at the end for a token price. The lessee therefore records it as its own asset and depreciates it.

The principle also applies elsewhere: a sale and leaseback that is really a loan secured on the asset, a “purchase” of goods that can be returned without restriction, or contracts in which the risks and rewards of an asset are allocated differently from what their title suggests.

How it works in practice

When assessing unusual contracts, we ask clients who bears the risks and enjoys the rewards of the asset, who decides how it is used and what happens at the end of the contract. The answers determine the accounting more than the contract’s heading or the wording on an invoice.

We apply the principle to revenue too. If the company receives money for a service it has not yet provided, it is not revenue of the period, even if the invoice says “sale”. Likewise, with commissions and intermediation we look at whether the company acts in its own name or merely as an agent, and present either the full sale or just the commission accordingly.

For tax purposes, however, substance and form can diverge. Tax rules sometimes have their own treatment, for example for depreciating a finance-leased asset, and the difference between the books and tax is then handled through add-backs or deductions.

What to watch out for

Substance over form does not mean the accountant can book things at their own discretion. Where the accounting procedures regulate a specific transaction, their rules apply. The principle is mainly for cases where the rules are silent or where applying them literally would give a misleading picture.

Arrangements designed mainly to “look” different from what they really are will be judged on substance in an audit or tax inspection. A company should therefore document its accounting decision in its accounting policy or an internal memo.