- Journalize entries for exchanging plant assets
When a company exchanges a fixed asset with another and the transaction has “commercial substance,” the company records the asset acquired at its fair value (or, if that is not readily available, the fair value of assets given up).
In most cases, fixed assets are acquired through exchange of monetary assets, such as cash. However, there are instances where two companies engage in barter transactions of fixed assets. To account for such exchanges of nonmonetary assets, we need to find out if the transaction has commercial substance. In plain English, we need to find out whether the exchange would change the cash flows of the business to a significant extent. If the cash flow pattern changes, the transaction is said to have commercial substance; if it doesn’t change, it has no commercial substance.
An exchange has commercial substance if, as a result of the exchange, future cash flows are expected to change significantly. For instance, if a company exchanges a building for land (a dissimilar exchange), the timing and the future cash flows are likely to be different than if the exchange had not occurred. Most property exchanges qualify as having commercial substance. However, if the exchange is not expected to create a significant change in future cash flows, the exchange does not result in commercial substance. For example, if a company exchanges one truck for another truck (a similar exchange) that will perform the same function as the old truck and for the same time period so that the future cash flows are not significantly different, then the exchange does not result in commercial substance. However, if the future cash flows are likely to be significantly different, then the exchange of similar assets has commercial substance.
For example, Log, Inc. exchanges two dump trucks that it had owned for two years for a concrete mixer. The total fair value of the dump trucks is $200,000, and the fair value of the concrete mixer is $220,000. The fair value of dump trucks is reliable because there is an active market for them. The dump trucks are recorded on Log, Inc.’s books at $300,000. Assume the useful life trucks and mixers is 10 years.
Because the fair value of dump trucks is the most reliable, Log, Inc. would record the transaction by (a) debiting equipment account by $200,000 to add the mixer to the books using the FMV of the assets given up; (b) debiting the accumulated depreciation by the amount of depreciation already charged on dump trucks, i.e., $60,000 ($300,000 divided by 10 multiplied by 2); (c) crediting the equipment account by $300,000 to remove the cost of the dump trucks; and (d) recording the difference as gain or loss.
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20– | ||||
| Dec 1 | Equipment (Concrete Mixer) | 200,000 | ||
| Accumulated Depreciation (Dump Trucks) | 60,000 | |||
| Loss on exchange of machinery | 40,000 | |||
| Equipment (Dump Trucks) | 300,000 | |||
| To record exchange of of Dump Trucks for Concrete Mixer |
It looks complicated, but the idea is simple. Remove the assets that are gone (the dump trucks in this case) along with the accumulated depreciation that goes with them, and then record the new asset on the books at fair market value.
If there is some cash involved in the transaction as well, include the cash in the journal entry. For instance, if Log, Inc. had to include a check for $10,000 along with the dump trucks, the entry would look like this:
| Date | Description | Post. Ref. | Debit | Credit |
|---|---|---|---|---|
| 20– | ||||
| Dec 1 | Equipment (Concrete Mixer) | 200,000 | ||
| Accumulated Depreciation (Dump Trucks) | 60,000 | |||
| Loss on exchange of machinery | 50,000 | |||
| Equipment (Dump Trucks) | 300,000 | |||
| Checking Account | 10,000 | |||
| To record exchange of of Dump Trucks for Concrete Mixer |
Most exchanges have commercial substance. However, if a transaction lacks commercial substance, things get even a little more complicated. The accounting treatment will depend on the circumstances. The simplest circumstance is when two assets are traded with no cash payment from either side. In this case, the new asset is recorded at the carrying amount of the old asset (original cost minus accumulated depreciation). Take a look at the following conditions:
- If cash is given along with the old asset, the new asset is similarly recorded at the carrying amount of the old asset plus the amount of money paid.
- If cash is received and the cash is less than 25% of the total consideration received, some or all the realized gain is recognized. For example, assume a machine with a fair value of $20,000 and accumulated depreciation of $5,000 is exchanged for a similar machine and $3,000 in cash. When you record the new machine at $20,000, you would also realize a $5,000 gain. However, since the cash is 15% ($3,000 / $20,000) of the fair value of the old asset, only 15% ($750 = $5,000 x 15%) of the realized gain will actually be recognized.
- If cash is more than 25% of the total assets received, the exchange is treated as a cash sale and the entire difference between the fair value and carrying amount of the old asset is booked as a gain.
- If the carrying amount of the old asset is greater than the fair value of the assets received, the entire loss is booked and the new asset is recorded at the lower fair value.
This accounting treatment may seem complicated, and it is; however, this treatment was a Financial Accounting Standards Board (FASB) update to GAAP in 2004. Before the FASB issued Statement of Financial Accounting Standards No. 153, “Exchanges of Nonoperating Assets: an amendment of APB Opinion No. 29,″ the rules according to Accounting Principles Board (APB) Opinion No. 29 for recording exchanges of nonmonetary assets depended on whether they were exchanges of dissimilar assets, such as a truck for a machine, or were similar assets, such as a truck for a truck. If the exchange was classified as an exchange of dissimilar assets, the acquired asset would be recorded at its fair value and any gain or loss would be recognized. The new standard was issued to bring about greater agreement between GAAP and International Financial Reporting Standards (IFRS) (part of the convergence project) and was effective for exchanges occurring during fiscal periods beginning after June 15, 2005.
There are three takeaways: (1) as accountants, we always have to be learning and staying up to date on the changing standards; (2) often things get more complicated, not simpler, as they develop and change according to circumstances; and (3) GAAP is still very much rule based, as you can see from this section on how to deal with exchanges.
You can view the transcript for “Property Plant And Equipment Nonmonetary Exchange (Gain On Trade In Of Equipment)” here (opens in new window).