A business transaction is said to have commercial substance when it is expected that the future cash flows of a business will change as a result of the transaction. A change in cash flows is considered to be when there is a significant change in any one of the following (not including tax considerations):
- Risk. Such as experiencing an increase in the risk that inbound cash flows will not occur as the result of a transaction; for example, a business accepts junior secured status on a debt in exchange for a larger repayment amount.
- Timing. Such as a change in the timing of cash inflows received as the result of a transaction; for example, a business agrees to a delayed payment in exchange for a larger amount.
- Amount. Such as a change in the amount paid as the result of a transaction; for example, a business receives cash sooner in exchange for receiving a smaller amount.
This concept can be used to ferret out situations where a company is making accounting or legal changes that are technically correct in order to create sham transactions to generate revenue or profits where the commercial substance of the situation indicates that no real transaction has actually occurred. In these situations, the sham transaction should not be recognized in the financial statements.
Examples of situations where there is no commercial substance include:
- Sale of assets to the owner of a sole proprietorship, who immediately leases it back to the business. There is little distinction between a proprietorship and its owner, so it is likely that no real change of ownership occurred.
- The swapping of bandwidth capacity by different Internet and phone service providers. By doing so, both entities recognize revenue, when in fact no real revenue generation occurrs that would result in a change in profits.
The concept of commercial substance is also applied to exchanges of assets between businesses. When there is commercial substance (which is when there is a change in cash flow resulting from the transaction), the parties should recognize a gain or loss on the exchange. If there is no commercial substance, record the acquired asset at the book value of the asset given up in the exchange. There are additional issues related to the recognition of a gain or loss when a transaction has no commercial substance.