What does the principle of substance over form require?

• A. Transactions must reflect their legal form
• B. Transactions must adhere to tax regulations
• C. Transactions must account for their economic substance
• D. Transactions must be recorded on a cash basis

Answer: (C)

The principle of substance over form emphasizes that the economic reality of transactions should be reflected in the financial statements, rather than merely their legal form. This principle is crucial in ensuring that financial reporting provides a true and fair view of a company's financial position.

By focusing on economic substance, this principle allows for a more meaningful presentation of financial information, leading to better decision-making for users of the financial statements, such as investors and creditors. It ensures that all relevant information that reflects the reality of the transactions is taken into account, which may not always align with their legal structure or classification.

For instance, a lease might legally be classified as an operating lease but may functionally resemble a financing lease. Under the principle of substance over form, the financial statements would reflect the economic implications of the lease, showing it in a way that accurately portrays the financial position of the entity.

This principle is foundational in accounting practices aligned with GAAP, allowing for transparency and integrity in financial reporting.