Question

Question: Stan Ott is evaluating two recent transactions involving exchanges of equipment. In one case, the exchange has commercial substance. In the second situation, the exchange lacks commercial substance. Explain to Stan the differences in accounting for these two situations.

Short answer

Answer

Normally, the fair value of the item given up or the fair value of the asset acquired should be used to account for nonmonetary asset exchanges.

Step-by-step solution

Meaning of Commercial Substance

When the cash flow of a firm is likely to alter as a result of a transaction in the future, a business transaction is said to have commercial substance. Changes in these three parameters, 1) Risk, 2) Timing, and 3) Amount, determine the change in such cash flows.

Explaining to Stan the difference between these two situations

The fair value of the asset given up or the item acquired, whichever is more clearly visible, should be used to account for the exchange of nonmonetary assets. As a result, all exchange gains and losses should be realized immediately. If the fair value of either item cannot be determined, the nonmonetary transaction is normally recorded using. Hence the value of the asset is given up. When the trade is commercially important, this strategy is always used.

When trades lack commercial substance, the basic norm is changed.In this scenario, the business is not regarded to have completed the earnings process o. Hence no profit should be reported. A loss, on the other hand, should be acknowledged quickly. When monetary consideration is paid, profits on a trade that lacks commercial substance may be recorded in certain circumstances. When money is exchanged, it is thought that a piece of the earning process has been accomplished, and hence a partial profit is recorded.