IAS: PPE-Lack of Commercial Substance

It may happen that an entity receives an asset in exchange of another asset. This may happen on account of several reasons, such as, transactions happen between group companies.

For example, a group operating into power and automobile business (through different companies) may exchange assets through the companies in these verticals. These companies may not pay each other anything, but would exchange the assets. There may be an exchange without any monetary consideration or it may involve a partial monetary payment.

Since the ownership of assets has changed, it is important to reflect the change in the financial statements.

Example

MATA power exchanges the generators it uses for its business with MATA motors, which manufactures Nhano, a small car. Cars are supplied by MATA motors to the former for MATA power’s business use. Both MATA power and MATA motors are concerned at what value to reflect these assets transferred under exchange.

IAS 16 provides guidance with respect to the accounting of these assets:

If the fair value of assets cannot be determined or the transaction lacks commercial substance, the carrying amount of the asset given up is determined as the cost of the asset acquired under exchange.
If the fair value of assets can be determined, and also the transaction has a commercial substance, the fair value of the assets becomes the cost of the asset.

Usually, it is difficult to identify fair value of non-current assets. However, there may be certain assets whose fair value can be identified. These would be the assets which are not entity specific or production process specific assets.

For example, it may be easy to identify the fair value of an aircraft, since similar assets would be prominently used by all or majority of players in the airlines industry. However, an asset which is specifically manufactured to meet the needs of an entity, it is difficult to identify the fair value thereof.

Commercial substance

Commercial substance means that the risks and cash flows associated with one asset would differ from those of the other asset. Under exchange, the risks and rewards & cash flows are not going to be incurred had the exchange not happened. The timing, amount and risks should all substantially match.

Example

AV Ltd acquires 20 acres land in India from B Ltd in exchange of 50 stories building in the UK it owns. There is no money exchanged between A & B. AV Ltd would need land in India for its construction business. The property in the UK remained idle, and did not reap many benefits.

B Ltd, on the other hand, required a property in the UK to set-up a business there. However, fair values of the assets cannot be determined since there is no basis of calculation of the fair value in India or the UK.

The building is having a carrying amount of $500,000 in the books of AV Ltd.

Solution

Although there is a commercial substance since the risks, timing and amount of cash flows associated with the building AV Ltd are different from those of the land acquired, the fair value criterion is still not met. In the above example, land would be shown at a value of $500,000 in the books of AV Ltd as there is no fair value identified for either of the assets.

Example

AV Ltd exchanges an oil field it owns in UAE with a similar size oil field in Russia from B Ltd. The cash flows associated with the oil fields are same with regard to risks, amount and timing since the oil prices get affected by global needs.

The carrying amount of the oil field it owns in the UAE is $500 million.

In the above example, it is not known if the fair value of the assets can be identified. However, the commercial substance of the transaction does not exist. Therefore, the Russian pipeline acquired by AV Ltd in exchange with the other pipeline would be shown at the carrying amount of the asset given up.

Example

AV Ltd exchanges a building with a carrying amount of $1m with land from TV Ltd. The fair value of land is $1.5m. Fair value of the building is 1.45m. You are required to calculate the value of land in the books of AV Ltd. Show appropriate accounting impact of the transaction.

Solution

Since the above transaction would meet commercial substance, and also that fair values of assets under exchange are available, the incoming asset (land) is shown at its fair value of $1.5m. Difference between the carrying amount of asset given up (building) and asset acquired under exchange is realised gain $500,000 (1.5m – 1m). The accounting impact of above transaction is: