What is a Commercial Substance?

How to Determine Commercial Substance?

It can be determined when there is a change in any of the following without tax effect:

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#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.read more with other organizations where it gives motor cars as an asset, and in exchange, it acquires e-vehicles (asset). With the e-vehicles, the risk of accidents got reduced because before, lots of workers were using motor cars to deliver goods. The accident rate was 5%, but the vehicle accident rate was 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 will 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 increases due to an increase in revenue, and there is a change in the timing of cash outflow, i.e., the asset is said to have commercial substance.

#3 – Change in Amount Received

There is a change in the amount received in the above example of Motor vehicles and e-vehicles 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.read more.

As the exchange transaction satisfies all the conditions of commercial substance, 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 purchase cost 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.read more was $ 750,000. And the Fair Value of old machinery was $ 400,000 (which is deemed the value of smaller advanced machinery). Determine whether the commercial substance exists and, if yes, record the transaction?

Solution:

For a commercial substance to exist, there must be three points to be verified, i.e., whether there is a change in the value of cash flow, a change in timing of cash flow, or a 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 read more 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. read more, there is an increment in the cash flow, there is a change in the risk, or more benefits occur due to the contract.For example, A Ltd entered into a contract with ABX and Co., a major supplier of raw materials required by A Ltd. for the 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. 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 and increasing revenue. In this 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 a commercial substance. If there is no change in monetary gains, the transaction does not have a commercial substance. There must be a change in risk, value, or timing of cash flows for commercial substances.Exchange transaction is essential for measuring the commercial substance. All monetary transactions are non-commercial substance transactions.If a commercial substance exists in the transaction, then the transaction is to be recorded at the asset’s fair value. If the commercial substance does not exist, then the transaction is recorded at the asset’s book value.

Conclusion

Commercial transactions exist only in those transactions where the result of such a transaction is expected to bring changes in the cash flows in the future period. The cash flow changes are considered when the transaction brings any significant change in 3 factors: 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 commercial substance is and its definition. Here we discuss how to determine it along with examples. You may learn more about financing from the following articles –

  • Arm’s Length TransactionRelated Party TransactionsTransaction RiskAccounting Transaction