The principle prioritizes the underlying reality and economic impact of transactions and events over their strict legal appearance. This concept means that the true essence of a situation should govern its accounting and legal treatment, rather than a superficial adherence to established procedures or documentation. For example, a lease agreement that, while legally structured as a lease, effectively transfers the risks and rewards of ownership to the lessee should be accounted for as a purchase.
Adherence to this principle ensures a more accurate and transparent representation of a business’s financial position. By focusing on the true economic nature of transactions, it prevents the manipulation of financial statements through technical loopholes or artificial structuring. This promotes better decision-making by investors, creditors, and other stakeholders who rely on financial information. Historically, it emerged as a countermeasure to situations where strict adherence to legal structures obscured the true financial picture, leading to misleading reporting.
