What is commercial substance?

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
• Timing
• 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.

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, then you 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.

Related Topics

Basic accounting principles
Materiality principle
Revenue recognition principle
What is substance over form?