Standards
Non-Monetary Transactions
With revisions to Section 3830, commercial substance has replaced culmination of the earnings process as the test for fair value measurement.
FROM: JUL-AUG 2005 ISSUE | BY STEPHEN SPECTOR
Over the years, the recommendations of Handbook Section 3830, Non-Monetary Transactions, have been the source of much confusion. The Accounting Standards Board (AcSB) recently approved significant changes to the standard and on June 1, 2005, released Section 3831 to replace Section 3830.
The new requirements apply to non-monetary transactions initiated in periods beginning on or after January 1, 2006. Earlier adoption is permitted for a period beginning on or after July 1, 2005; retroactive application is not permitted. The optional early implementation date means some entities will be applying Section 3830 while others will have adopted Section 3831. The revised standard converges with recently changed International Accounting Standards Board standards and U.S. GAAP. As for small and medium-sized business enterprises, the AcSB's Differential Reporting Advisory Committee reviewed Section 3830's changes and concluded that differential reporting options should not be incorporated into the section.
When the AcSB added Section 3830 15 years ago, the central notion was that non-monetary exchanges should be measured at fair value when they represented the culmination of the earnings process, but at book value if they did not. What constituted "culmination of the earnings process" was often a point long debated by an enterprise and its auditor. Transactions between unrelated entities were treated differently than transactions between related entities when it came to recognizing any gain or loss on the exchange. And if that was not enough, a third complication related to cash was included with the exchange. If the cash component exceeded 10 per cent of the fair value, then the transaction would be treated differently than if the cash component was less than 10 per cent.
Commercial substance replaced the culmination of the earnings process as the test for fair value measurement. A transaction has commercial substance if it causes an identifiable and measurable change in the economic circumstances of an enterprise. Thus, there no longer is a need to determine whether the assets exchanged are similar productive assets.
Furthermore, because the commercial substance tests require assessment of all cash flows, the rule regarding the 10 per cent cash component has been eliminated. Section 3831 now stipulates that all non-monetary transactions are to be measured at fair value unless:
- the transaction lacks commercial substance;
- the transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange;
- neither the fair value of the assets or services received nor the fair value of he assets or services given up is reliably measurable; or
- the transaction is a non-monetary, non-reciprocal transfer to owners that represents a spin-off or other form of restructuring or liquidation.
Two tests determine whether commercial substance is present:
- comparing the configuration of the asset-specific or service-specific cash flows before and after the transaction;
- comparing entity-specific values.
Commercial substance occurs when either the difference in cash flow configuration or entity-specific value is significant relative to the fair value of the assets exchanged. Cash flow configuration looks at the risk, timing, and amounts of the cash flows directly associated with the assets or services exchanged. A transaction will have commercial significance if there is a significant difference in any of these elements relative to the fair values of the assets exchanged.
Entity-specific value is the sum of the present value of the after-tax cash flows expected from the continuing use of an asset, the cash flows from its disposal at the end of its useful life, or the cash flows expected to be incurred when settling a liability.
Implementation will require consequential amendments to remove references in other Handbook sections to either (or both) the culmination of the earnings process or the exchange of similar assets. Implementation will also require consequential amendments to Section 3055, Interests in Joint Ventures. When the venturers are unrelated, transfers will be measured at fair value since there is a significant change in cash flow configuration.
On the other hand, when the venturers are related, transfers are deemed related party transactions. Consequently, the scope of Section 3830/3831 has been
modified to require that related party non-monetary transactions, other than non-monetary, non-reciprocal transfers to non-controlling owners, be accounted for in accordance with Section 3840, Related Party Transactions.
Update:
Regular readers of this column may recall previous articles dealing with the Audit Risk Model (September-October 2004) and Recognition and Measurement of Financial Instruments (September-October 2003). Canadian standard-setters have concluded deliberations on these topics, and updates to the Handbook have been released. Readers should note that the amended audit risk model sections are effective for fiscal periods beginning on or after January 1, 2006, and not from the originally planned effective date of July 1, 2005. Likewise, the new sections covering financial instruments are effective for interim and annual financial statements relating to fiscal years beginning on or after October 1, 2006. This represents a change from the originally planned effective date of October 1, 2005.
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Stephen Spector, MA, FCGA, owns Spector and Associates and teaches Financial and Managerial Accounting at Simon Fraser University. He also serves on CGA-BC’s board of governors. E-mail shspector@shaw.ca.