What is Commercial Substance?
Commercial substance exists in those business transactions where the result of such transactions is expected to bring some change in the cash flows of the business in future and is taken into account only when there is notable change in the risk of cash inflow, timing of cash inflow and amount paid due to such transactions.
How to Determine Commercial Substance?
It can be determined when there is a change in any of the following without tax effect:
#1 – Change in Risk
Let’s say a business entered a business transactionBusiness TransactionA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements. with other organizations where it gives motor cars in an asset, and in exchange, it acquired e-vehicles (asset). With the e-vehicles risk of accidents got reduced because before lots of workers were using motor cars for delivery of goods and the accident rate was 5% but with e vehicle accident rate reduced to 2%. Hence there is a change in risk, so the asset is said to have commercial substance.
#2 – Change in Timing of Cash Inflow
In the same example, if ten motor cars are exchanged for 15 e-vehicles, and due to the exchange of e vehicles, the delivery can be faster, and revenue is going to increase. The differential amount of FMV of e-vehicles less FMV of motor cars will be settled after two years. So here, the inflow of cash increase due to an increase of revenue, and there is a change in timing of cash outflow i.e., the asset is said to have commercial substance.
#3 – Change in Amount Received
In the above example of Motor vehicles and e-vehicles, there is a change in the amount received due to an increase in revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions..
As the exchange transaction satisfies all the conditions of commercial substance, hence this substance exists, and the asset is to be recognized at fair value.
Example of Commercial Substance
The company gives larger old machinery for smaller advanced machinery. The cost of purchase of old machinery was $ 1,000,000, and the accumulated depreciationAccumulated DepreciationThe accumulated depreciation of an asset is the amount of cumulative depreciation charged on the asset from its purchase date until the reporting date. It is a contra-account, the difference between the asset's purchase price and its carrying value on the balance sheet. was $ 750,000. And the Fair Value of old machinery was $ 400,000 (which is deemed to be the value of smaller advanced machinery). Determine whether the commercial substance exists and, if yes, record the transaction?
For a commercial substance to exist, there must be three points is to be verified, i.e., whether there is a change in the value of cash flow or change in timing of cash flow or change in risk due to transaction. If any of the above conditions are satisfied, then the transaction is said to have this substance.
In the above example the book value of assetBook Value Of AssetBook Value of Assets is the asset's value in the books of records of a company or an institution at any given instance. Assets Book Value Formula = Total Value of an Asset – Depreciation – Other Expenses Directly Related to it is $ 250,000 ($ 1,000,000 – $ 750,000) and the fair value of asset exchanged is $ 400,000. As there is a change in the value, this substance exists in the transaction.
Commercial Substance of Contract
- A contract is said to have the commercial substance if because of that contract there is a change in timing of cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. , there is an increment in the cash flow, there is a change in the risk, or more benefits occur due to contract.
- For example, A Ltd entered into a contract with ABX and Co. who is a major supplier of raw material required by A Ltd. for production of goods for supplying materials to A ltd.at a cost lower than the cost at which A Ltd. was buying from other suppliers, and because of it, the cost of production is decreased as a result the benefits will also be transferred to the customers by decreasing the selling price which thereby results in the increase in revenue. In this whole scenario, since there is a change in cash flow, it is said to have existed in the contract.
Commercial vs. Non-Commercial Substance
- If monetary gains exist due to exchange transactions, the transaction is said to have the commercial substance, and if there is no change in monetary gains, the transaction does not have the commercial substance. For commercial substance, there must be a change in risk, value, or timing of cash flows.
- Exchange transaction is essential for measuring the commercial substance. All monetary transactions are non-commercial substance transactions.
- If commercial substance exists in the transaction, then the transaction is to be recorded at the fair value of the asset, and if the commercial substance does not exist, then the transaction is recorded at a book value of the asset.
Commercial transaction exists only in those transactions where the result of such transaction is expected to bring the changes in the cash flows in the future time period. The cash flow changes are considered when the transaction brings any significant change in 3 factors that are; change in the risk of getting cash inflows, change in the timing of receiving cash, and change in the amount paid due to such transaction.
This has been a guide to what is Commercial Substance and its definition. Here we discuss how to determine it along with examples. You may learn more about financing from the following articles –