Chapter Overview Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment Learning Objectives Learning Objectives Chapter Overview

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1 Chapter 10 Chapter Overview Acquisition and Disposition of Property, Plant, And Equipment Chapter 10 Valuation at date of acquisition Disposition of assets Annual reports: Dr. Pepper, Winnebago, Intel, UPS, Whole Foods 1 Capitalization of interest Chapter 11 (American Airlines) APL 7 Allocation of cost over time (depreciation) Impairment of operational assets Chapter 12 Intangible assets (patents, goodwill) 2 Acquisition and Disposition of Property, Plant, and Equipment Learning Objectives Acquisition " Acquisition costs: land, buildings, equipment " Self-constructed assets " Interest costs " Observations Valuation " Cash discounts " Deferred contracts " Lump-sum purchases " Stock issuance " Nonmonetary exchanges " Contributions Cost Subsequent to Acquisition " Additions " Improvements and replacements " Rearrangement and reinstallation " Repairs " Summary " Sale Dispositions " Involuntary conversion " Miscellaneous problems Describe property, plant, and equipment Identify costs to include in initial valuation Explain accounting for self-constructed assets Explain accounting for interest capitalization Describe issues of acquiring and valuing plant assets Describe accounting for costs after acquisition Describe disposal of property, plant, and equipment " Other valuation methods 4 Learning Objectives Describe property, plant, and equipment Identify costs to include in initial valuation Chapter Overview Operational assets Used in production of goods, services Needed to generate revenue Long-term assets: Life more than 1 year Cost allocated over time (depreciation) 5 6 1

2 Operational Assets Assets Acquired By Property, plant, equipment Land, buildings, machinery, autos, trucks Natural resources (wasting assets) Oil, gas, timber, copper, minerals Intangibles (Ch 12) Legal right, no physical substance Patents, copyrights, trademarks, goodwill Timing of future benefits highly uncertain Purchase (pay cash) Exchange (trade one asset for another) Self-construction (build it ourselves) Donation (we receive asset, no cost) Lease (Intermediate II) Business combination (Advanced Actg) 7 8 Property, Plant, and Equipment Value at Historical Cost Land, buildings, equipment, machinery, furniture, tools Used in daily operations Not for resale Long-term in nature Possess physical substance Historical cost is reliable Do not anticipate gains or losses Recognize gains or losses when sold APB Opinion 6: Property, plant, and equipment should not be written up to reflect appraisal, market, or current values which are above cost IFRS: Historical cost preferred, but FMV may be used 9 10 Include in Cost of PPE Why Include in Cost of PPE All costs Prior to first use To move asset to proper location To make asset in proper condition Location: Move, insure in transit, install Condition: Ready to use (generate rev) Cleaning, calibrating, testing Support systems (plumbing, electrical) 11 Expense only benefits current period PPE expenditure benefits future periods Depreciation (matching principal) Allocate expenditure over periods it will generate revenue, not period of payment Increasing cost of asset reduces gain (or increases loss) when asset sold Debiting asset account will reduce net income over lifetime of asset as higher depreciation expense and lower gain on sale (or higher loss on sale) 12 2

3 Costs Capitalized: Land Land is a platform. Land lasts forever, not depreciated Description Amount Purchase cost $2,000,000 Legal fees, real estate commissions 150,000 Survey fees 38,000 Demolition and removal of old building 87,000 Cash received from salvage of materials (20,000) Total $2,255,000 Land 2,255,000 Cash 2,255, Description Costs Capitalized: Land Improvements Improvements to land, do not last forever, depreciated Amount Parking lot $150,000 Lighting 100,000 Landscaping 50,000 Signage 20,000 Total $320,000 Land improvements 320,000 Cash 320, Costs Capitalized: Building Costs Capitalized: Equipment Description Amount Purchase cost $6,000,000 Brokerage fees 200,000 Taxes 300,000 Repairs 800,000 Modifications prior to occupancy 1,200,000 Total $8,500,000 Building 8,500,000 Cash 8,500, Description Amount Purchase cost $100,000 Less discount (2/10 n/30) [always net] (2,000) Transportation and insurance 6,000 Construction of platform (labor, materials) 14,000 Plumbing, electrical (labor, materials) 16,000 Testing (labor, materials) 20,000 Total $154,000 Equipment 154,000 Cash 154, Cap: Leasehold Improvement Improvements to rented building Depreciate over shorter of life or lease Description Leasehold improvement 600,000 Amount Labor to remodel store $300,000 Materials to remodel store 200,000 Permanent fixtures installed in store 100,000 Total $600,000 Cash 600, Learning Objectives Explain accounting for self-constructed assets Explain accounting for interest capitalization 18 3

4 Self-Constructed Assets Self-Constructed Assets All costs necessary to make asset ready for use, including Direct labor Direct materials Fees and permits Interest during construction period Overhead (applied on rational basis) 19 Description Amount Architectural fee 700,000 Building permits 150,000 Direct labor, materials (contractor cost) 3,250,000 Application of overhead 900,000 Interest 600,000 Total 5,600,000 Construction-in-progress 5,600,000 Cash 5,600, Self-Constructed Assets Two accounting issues Overhead allocation Interest incurred during construction Overhead Costs than cannot be directly matched to asset (inventory, constructed asset) May be period costs or applied to asset 21 Indirect labor Support staff, janitorial services Indirect materials Office and construction supplies Indirect services Insurance, utilities, legal Fully discussed in ACTG 131, Three Options Overhead Application No overhead application Incremental overheard application Full-cost overhead application No Overhead Application Indirect costs fixed Project does not increase indirect costs No overhead applied to project Too tempting to shift costs from current period to asset

5 Incremental Application Indirect costs are variable Project will increase indirect costs Include only additional costs incurred because of construction of asset Full-Cost Application Overhead costs are allocated based on relative amount of chosen cost driver Labor hours Direct materials Generally accepted approach (most commonly used) Interest Capitalization Interest is debited to asset account (construction-in-progress) Interest increases the cost of asset Depreciate expense higher Lower gain on sale (higher loss on sale) Interest Capitalization Disclosure Required each period of capitalization Total interest costs Total capitalized Interest is considered cost of constructing asset just as direct material, direct labor and overhead Disclosure of Capitalized Interest Interest Not Capitalized Inventories routinely manufactured in large quantities on a repetitive basis Assets in use or ready for intended use

6 Interest revenue and expense If money borrowed to finance construction of asset is invested and earns interest revenue should interest revenue be netted against interest exp? No List interest revenue on income stmt Capitalize interest exp if criteria met 31 Interest Capitalization Vocabulary Qualifying asset Specific and general borrowing Actual interest costs Avoidable interest Interest capitalized Qualifying expenses Average Accumulated Expenditures Weighted average cost of debt 32 Qualifying Asset Assets built for a company s own use Intel builds manufacturing equipment Disney builds Hong Kong Disneyland Assets constructed as projects for sale Goetz Boats IBM builds supercomputer for UC Berkeley Borrowing: Specific, General Specific borrowing Exclusively for self-constructed asset General borrowing Unrelated to self-constructed asset Occurred in current or previous year Actual Interest Costs Total interest expense of all borrowing Specific debt $200,000, 12%, 3-year note payable General debt $500,000, 14%, 10-year bonds payable $300,000, 10%, 5-year note payable Avoidable Interest Concept Interest expense that would not have occurred if asset were not constructed and the money used to retire debt Amount Actual Total Interest Expense for Year Specific debt $200,000 12% 1 = $24,000 General debt $500,000 14% 1 = $70,000 General debt $300,000 10% 1 = $30,000 Total $124, Calculated using complex formula Avoidable interest based on AAE, Average Accumulated Expenditures 36 6

7 Interest Capitalized Capitalize the lesser of: 1. Actual interest costs 2. Avoidable interest Qualifying Expenses Construction has begun Labor, material, overhead incurred in current period on self-constructed asset Either actual interest or avoidable interest can be smaller amount; always perform test Conditions for Capitalization Capitalize interest when all true 1. Qualifying expenses incurred Construction has begun Labor, material, overhead incurred 2. Construction in progress during period 3. Interest is incurred Specific borrowings for construction General purpose borrowings Capitalization Ends Capitalize ends when 1. Asset substantially complete and ready for use OR 2. Interest costs no longer incurred If any one of these conditions not true do not capitalize Avg Accumulated Expenditure Expenditures weighted for the number of months outstanding during the current accounting period Avoidable interest based on AAE Avg Accumulated Expenditure If given expenditure for year Assume expenditures occur evenly throughout year AAE = Total Expenditures / 2 If given expenditures for month, quarter Use weighted average for year For each period calculate Expenditure time

8 Qualifying Expenditures Avg Accumulated Expenditure Multiply qualifying expenditure by time Constructing a building for our own use Construction activities Began May 1 Ended December 31 Count months carefully Average Accumulated Expenditures Date Amount Time AAE May 1 $125,000 8/12 = $83,333 Qualifying Expenditures May 1 $125,000 July 31 $160,000 October 1 $200,000 July 31 $160,000 5/12 = $66,667 October 1 $200,000 3/12 = $50,000 December 1 $300,000 1/12 = $25,000 Total $785,000 $225,000 December 1 $300, AAE 44 Specific Borrowing Calculate Avoidable Interest Borrowed $1,000,000 on May 1 For 2 years At 10% To finance construction Actual Total Interest Expense, May 1 Dec 31 If specific borrowing > AAE use specific borrowing rate only $1,000,000 specific borrowing sufficient to cover $225,000 of AAE Use specific borrowing rate of 10% to determine avoidable interest Specific debt $1,000,000 10% 8/12 = $66,667 Avoidable Interest = AAE Specific Borrowing Rate Avoidable Interest = $225,000 10% = $22, Interest Capitalized Interest Capitalized Pick lower of two amounts Avoidable interest Actual total interest expense Pick lower of two amounts Avoidable Interest = AAE Specific Borrowing Rate Interest = $225,000 10% = $22,500 Actual Total Interest Expense, May 1 Dec 31 Specific debt $1,000,000 10% 8/12 = $66,667 Capitalize $22,

9 Adjusting Journal Entry Borrowing: Specific, General Construction-in-progress 22,500 Interest expense 22,500 Reverse interest expense to capitalize Assume previous entry debited interest expense and credited cash 49 Specific borrowing not required If specific borrowing Use specific rate first Up to amount of specific borrowing principal or AAE, whichever is smaller If no specific borrowing or if specific borrowing principal is less than AAE Use weighted average cost of debt for AAE not covered by specific borrowing principal 50 Weighted Average All Debt If no specific borrowing calculate avoidable interest using weightedaverage interest on all debt Calculate Avoidable Interest Weighted-average rate on all debt, 12% Avoidable Interest = AAE Average Borrowing Rate Avoidable Interest = $225,000 12% = $27, Using Specific, General Debt Using Specific, General Debt If AAE > specific borrowing, to calculate avoidable interest First use specific borrowing rate, up to amount of specific borrowing Then use weighted-average rate on other debt up to amount of other debt or AAE, whichever comes first Capitalize using weighted-average cost of debt Capitalize using specific borrowing rate Calculate avoidable interest when specific borrowing < AAE AAE Other debt Specific borrowing

10 January 1, 2011 Borrowed $200,000 at 12% for specific purpose of constructing equipment Other general debt on January 1, 2011 $500,000, 14%, 10-year bonds payable $300,000, 10%, 5-year note payable Actual Total Interest Expense for Year Specific debt $200,000 12% 1 = $24,000 General debt $500,000 14% 1 = $70,000 General debt $300,000 10% 1 = $30,000 Total $124,000 Actual Total Interest Expense for Year Specific debt $200,000 12% 1 = $24,000 General debt $500,000 14% 1 = $70,000 General debt $300,000 10% 1 = $30,000 Total $124, General debt 70, , , ,000 Weighted rate = 12.5% 56 Actual Expenditures Date Amount January 1, 2011 $100,000 April 30, ,000 November 1, ,000 December 31, ,000 Total expenditures $650,000 Compute Avg Accum Expend (AAE) Date Amount Time AAE January 1, 2011 $100,000 12/12 = $100,000 April 30, ,000 8/12 = 100,000 November 1, ,000 2/12 = 50,000 December 31, ,000 0/12 = 0 Total expenditures $650,000 $250,000 AAE Avoidable Interest Interest to Capitalize Borrowing Accumulated expenditures Rate Avoidable interest Specific $200, % = $24,000 General 50, % = 6,250 $250,000 $30,250 First charge interest to specific borrowing, then charge remainder to weighted-average of general borrowing 59 Capitalize lesser of Avoidable interest Actual interest Avoidable interest $ 30,250 Actual interest 124,000 Construction-in-progress 30,250 Interest expense 30,

11 Learning Objectives Describe issues of acquiring and valuing plant assets Valuation at Purchase Value incoming asset at most objective amount, either FMV of asset received FMV of asset given Special Valuation Issues Cash Discounts (2/10 n/30) Usually reduce cost of asset, taken or not Issuance of Stock Use FMV of stock Lump-Sum Purchases Allocate total cost on relative FMV Deferred-Payment Contracts Recorded at present value Donated asset (received as donation) 63 Cash Discounts Purchase equipment, invoice $100,000 Seller offers early payment discount, 2/10 n/30 Record equipment net of discount, even if discount not taken (preferred method) Date Equipment 98,000 Accounts payable 98, Issuance of Equity Securities Asset recorded at market value of asset or market value of securities, whichever is more clearly evident If securities are actively traded, market value can be easily determined If no objective and reliable value can be determined, board of directors assigns a reasonable value 65 Lump-Sum Purchases Several assets acquired at one price Assets have different depreciable lives Must be recorded as separate assets Allocation of lump-sum price based on relative FMV of the individual assets 66 11

12 Allocation of Lump-Sum Purchase Purchase land and building, $2,800,000 Date Land?,???,??? Building?,???,??? Cash 2,800,000 Asset Allocation of Lump-Sum Purchase Purchase land and building, $2,800,000 Estimated Estimated FMV FMV of Asset of All Assets % FMV Total Cost Allocated Cost Land $2,700,000 / $3,000,000 = 90% $2,800,000 = $2,520,000 Building 300,000 / $3,000,000 = 10% $2,800,000 = 280,000 Total $3,000, % $2,800, Date Land 2,520,000 Building 280,000 Cash 2,800, Deferred Payments (Note Pay) If interest rate realistic (market rate) Asset recorded at face amount of note If interest rate unrealistic or note is noninterest bearing Asset recorded at present value Discount rate = current market rate If note is more than one year must use TMV calculation Deferred Payments January 2, 2011, purchased equipment Signed $50,000 noninterest-bearing note due on December 31, 2012 Prevailing market rate of interest, 10% Cash equivalent price unknown Use present value of future payment to calculate value of equipment Deferred Payments Face value of note $50,000 PV of $1, n=2, i=10% = PV of note $41,323 41,323 Equipment Note Payable 50,000 Date Jan 2 Equipment 41, Discount on note payable 8,677 Note payable 50,000 Interest Expense Discount on N/P 8,677 Discount is future interest expense

13 Balance Sheet: Purchase Date Balance Sheet (at date of purchase) Note payable $50,000 Less discount 8,677 Net note payable $41,323 AJE to Accrue Interest: Year 1 Date Dec 31 Interest expense 4, Discount on note payable 4,132 Accrue interest expense at end of first year $4,132 = $41,323 10% 1 Accrue interest on net note payable ,323 Equipment Interest Expense Note Payable 50,000 Discount on N/P 4,132 8,677 4,132 4,545 Balance Sheet: End of Year 1 Balance Sheet (as of 12/31/2011) Note payable $50,000 Discount 4,545 Net note payable $45, AJE to Accrue Interest: Year 2 41,323 Equipment Note Payable 50,000 50,000 Date Dec 31 Interest expense 4, Discount on note payable 4,545 0 Accrue interest expense at end of second year $4,545 = ($41,323 + $4,132) 10% 1 Interest Expense Discount on N/P Date Dec 31 Note payable 50, Cash 50,000 Pay note 77 4,132 8,677 4,132 4,545 4,545 8,

14 Donated Assets Record donated asset at fair value Non-governmental donation Record revenue Governmental donation Record paid-in capital Donated Assets From Non-Gov Owner of office park donated land for new headquarters, FVM $100,000 Date Land 100,000 Revenue: Donation of asset 100, Donated Assets From Gov City of San Jose donated land for new headquarters, FVM $100,000 Learning Objectives Describe accounting for costs after acquisition Date Land 100,000 Paid-in-capital, donated asset 100, Capitalize or Expense When expenditure made on PPE in service should we capitalize or exp? Capitalize Debit asset account Expense Debit expense account Expenditures After Acquisition Capitalize Costs incurred to increase future benefits Expense Costs incurred to maintain the planned level of services Asset or expense? 1,000 Cash 1,

15 Capitalize (Debit Asset) Expenditure benefits future periods Expenditure increases Life Salvage value Changes nature of asset Increases quality or quantity of output Not planned when life estimated Capitalize Expenditures Meet one of three conditions Useful life increased Quantity of units increased Quality of units enhanced Expense Expenditure benefits current period only Expenditure planned when life estimated Maintain asset in current condition Routine maintenance Ordinary repairs Capitalize Or Expense? Does expenditure increase life, quality, quantity, salvage value, or change asset? Yes No 87 Capital Expenditure Debit asset Expense Debit expense 88 Expenditures After Acquisition Additions Improvements and replacements Rearrangement and reinstallation Repairs Cost of Improvements Three methods to record improvements Substitution Capitalization of new cost Reduction of accumulated depreciation

16 Cost of Improvements Data for the examples that follow Air conditioner on roof of building is replaced Cost of old air conditioner $200,000 Accumulated depreciation $160,000 Book value $40,000 Cash received from sale of old parts $12,000 Cost of new air conditioner $230,000 Substitution Improvement can be recorded as both Disposition of the old component Acquisition of the new component Cost and accumulated depreciation of the old component can be identified Substitution Cash 12,000 Accumulated depreciation 160,000 Loss on disposal 28,000 Equipment 200,000 Equipment 230,000 Cash 230,000 Take old asset off books, add new asset to books 93 Capitalization of New Cost Acceptable when Book value of original asset immaterial (nearly fully depreciated) New asset improves quantity, quality Debit asset account for cost of improvement, net of consideration Do not remove cost or accumulated depreciation of old asset Equipment 218,000 Cash (230,000 12,000) 218, Reduction of Accumulated Depreciation Increase book value by decreasing accumulated depreciation Increase estimated life of asset Revise future depreciation expense Accumulated depreciation 218,000 Cash (230,000 12,000) 218,000 Rearrangements Expenditures made to restructure asset without addition, replacement, or improvement Create a new capability for asset or increase efficiency, productivity Does not necessarily extend useful life

17 Rearrangements Rearrange machinery on production line to increase operational efficiency Relocate operating plant, office building Rearrangements If expenditures material and clearly increase future benefits, capitalize as separate asset and expense in future periods benefited If expenditures are not material or future benefits uncertain, expense 97 Rearrangements (assets) 100,000 Cash 100, Learning Objectives Describe disposal of property, plant, and equipment Methods of Disposal In All Cases Sell for cash or discard (1) Sell asset for cash (2) Discard or donate asset, receive no value Exchange asset for another asset (3) Commercial substance, FMV known (4) Commercial substance, FMV unknown (5) No commercial substance Three cases depending on cash received 101 Bring depreciation up-to-date Take asset off books Credit asset account Take related accumulated dep off books Debit accumulated depreciation Cash is called Boot Boot received means we received cash Boot paid means we paid cash

18 Sale of Plant Assets for Cash Sale for Cash: Calc Gain (Loss) Bring depreciation up-to-date Credit asset account Debit accumulated depreciation Debit cash for cash received (if any) Credit gain or debit loss on sale 103 Calculation of Book Value Cost Accumulated depreciation Book value Calculation of Gain (Loss) Cash received Book value Gain (loss) 104 Sale of Plant Assets for Cash Sale of Plant Assets for Cash Value received > value given = gain Value received < value given = loss Cash > book value asset sold = gain Cash < book value asset sold = loss Value received = Cash Gains increase net income Value given = NBV (Cost Acc. Dep.) Losses decrease net income Included in operating income Sell for Cash, Loss on Sale Cost of furniture $10,000 Accumulated depreciation $4,000 Book value $6,000 Cash received $5,000 Cash received from sale of asset $5,000 Book value of asset sold: Cost $10,000 Less accumulated depreciation 4,000 6, Gain (loss) on sale ($1,000)

19 Sell for Cash, Loss on Sale Sell for Cash, Gain on Sale Cost of furniture $10,000 Accumulated depreciation $4,000 Book value $6,000 Cash received $5,000 Cash 5,000 Accumulated depreciation 4,000 Loss on sale Plug 1,000 Furniture 10, Cost of furniture $10,000 Accumulated depreciation $4,000 Book value $6,000 Cash received $8,000 Cash received from sale of asset $8,000 Book value of asset sold: Cost $10,000 Less accumulated depreciation 4,000 6,000 Gain (loss) on sale $2, Sell for Cash, Gain on Sale Discard for No Value, Loss Cost of furniture $10,000 Accumulated depreciation $4,000 Book value $6,000 Cash received $8,000 Cash 8,000 Accumulated depreciation 4,000 Gain on sale Plug 2,000 Furniture 10, Cost of furniture $10,000 Accumulated depreciation $4,000 Book value $6,000 Cash received $ 0 Cash received from sale of asset $ 0 Book value of asset sold: Cost $10,000 Less accumulated depreciation 4,000 6,000 Gain (loss) on sale ($6,000) 112 Discard for No Value, Loss Cost of furniture $10,000 Accumulated depreciation $4,000 Book value $6,000 Cash received $ 0 Accumulated depreciation 4,000 Loss on sale Plug 6,000 Furniture 10, Asset Contributed (Donated) Record donation as expense at FMV Record gain (loss) on disposal Land donated for city park Fair market value of land $110,000 Cost of land $80,000 Gain (loss) on disposal of land $30,000 Contribution expense (FMV) 110,000 Land 80,000 Gain on disposal of land Plug 30,

20 Involuntary Conversions Use of asset terminated involuntarily Act of nature: Fire, flood, tornado Act of government: Expropriation, condemnation, eminent domain Theft If insurance settlement received, record value received (usually cash) Calculate gain or loss as if sold for cash Exchange: Calc Gain (Loss) Warning Warning Warning Gain (loss) FMV asset received BV given Gain (loss) = Fair value asset given BV given May be extraordinary if unusual and infrequent in nature Exchange: Calc Gain (Loss) (3) Commercial substance, FMV known Recognize both gains and losses (4) Commercial substance, FMV unknown Do not recognize gains or losses (5) No commercial substance Three cases depending on cash received Test: Commercial Substance Two conditions must be met 1. Change in future cash flows expected 2. Expected change significant relative to fair value of assets exchanged No Commercial Substance Fraudulently inflate earning When FMV > book value Exchange assets Both companies recognize gains No Commercial Substance Starbucks Peet s 119 Two companies have identical equipment Cost $200,000 Accumulated depreciation 150,000 Book value 50,000 Fair value 80,

21 No Commercial Substance Two companies have identical equipment Cost $200,000 Accumulated depreciation 150,000 Book value 50,000 Fair value 80,000 Exchange asset for asset (same entry both companies) New asset 80,000 Accumulated depreciation 150,000 Old asset 200,000 Gain on exchange Plug 30, No Commercial Substance If assets exchanged both companies recognize gain, but no change in operational assets, future profits or future cash flows Exchange asset for asset (same entry both companies) New asset 80,000 Accumulated depreciation 150,000 Old asset 200,000 Gain on exchange Plug 30, No Commercial Substance To discourage trades of appreciated assets solely to recognize gains, fair values only used in legitimate exchanges with commercial substance 123 Exchange: Calc Gain (Loss) Type of Exchange Commercial substance: FMV known Commercial substance: FMV unknown No commercial substance, no cash received No commercial substance, cash received less than 25% of fair value No commercial substance, cash received 25% or more of fair value Record Transaction Recognize gains and losses immediately No recognition of gains and losses Defer gains by reducing basis of incoming asset; recognize losses immediately Recognize partial gain; recognize losses immediately Recognize gains and losses immediately 124 FASB to IFRS Type of assets exchanged not relevant In past FASB had different treatment depending on whether assets exchanged were similar or dissimilar FASB rule changed to conform to IFRS Exchanges with Comm Sub Two fair market values in exchange FMV of asset given up (outgoing) FMV of asset acquired (incoming) Use more reliable, objective FVM Plug for other asset FMV value Adjusted for cash exchanged Cash exchanged equalizes FVM of assets 125 Gain (loss) calculated, not a plug figure

22 Exchanges with Comm Sub If FMV of asset given up and FMV of asset acquired both known Ignore given FMV of asset acquired Record cost of asset acquired (incoming) at fair value of asset given up (outgoing), adjusted for cash exchanged Immediately recognize gain or loss Gain (Loss) on Exchanges Calculation of Gain (Loss) on Exchange FMV of outgoing asset Book value of outgoing asset (Cost Acc Dep) Gain (Loss) on exchange Ignore cash exchanged and FMV of incoming asset Cash Exchanged Equalizes Fair Market Value of Assets Cash Exchanged Equalizes Fair Market Value of Assets = FMV asset given > FMV asset received Receive cash to equalize FMV of assets FMV asset given < FMV asset received Give cash to equalize FMV of assets = =

23 Exchanges with Comm Sub Exchange 1 Loss, Receive Cash Use more reliable, objective FVM Adjusted for cash exchanged Plug for other asset FMV FMV given up + cash paid = FMV acquired FMV given up cash received = FMV acquired FMV acquired cash paid FMV acquired + cash received = FMV given up = FMV given up 133 Exchange machine for computer FMV of machine (asset given) known FMV computer (asset received) unknown We received $8,000 in cash Cost of machine $65,000 Accumulated depreciation $45,000 Book value $20,000 Fair value of asset given $17,000 Gain (loss) on exchange ($3,000) 134 Exchange 1 Loss, Receive Cash Asset received, Computer FMV computer unknown (or less reliable) We received $8,000 cash in exchange FMV given up + cash paid FMV given up cash received = FMV acquired = FMV acquired FMV given up cash received = FMV acquired $17,000 $8,000 = $9, Exchange 1 Loss, Receive Cash Exchanged machine for computer Cash 8,000 Computer Plug 9,000 Accumulated depreciation 45,000 Loss on exchange 3,000 Machinery 65, Exchange 2 Gain, Receive Cash Exchange 2 Gain, Receive Cash Exchange furniture for truck FMV of furniture (asset given) known FMV truck (asset received) unknown We received $16,000 in cash Cost of furniture $130,000 Accumulated depreciation $90,000 Book value $40,000 Fair value asset given $48,000 Gain (loss) on exchange $8, Asset received, Truck FMV truck unknown (or less reliable) We received $16,000 cash in exchange FMV given up + cash paid FMV given up cash received = FMV acquired = FMV acquired FMV given up cash received = FMV acquired $48,000 $16,000 = $32,

24 Exchange 2 Gain, Receive Cash Exchanged furniture for truck Cash 16,000 Trucks Plug 32,000 Accumulated depreciation 90,000 Furniture 130,000 Gain on exchange 8, Exchange 3 Loss, Pay Cash Exchange patent for land FMV of patent (asset given) unknown FMV land (asset received) known We paid $40,000 in cash Cost of patent $90,000 Accumulated amortization $10,000 Book value $80,000 Fair value of asset given Gain (loss) on exchange Unknown Unknown 140 Exchange 3 Loss, Pay Cash Exchange 3 Loss, Pay Cash Asset received, Land Fair value $70,000 We paid $40,000 in cash FMV acquired cash paid FMV acquired + cash received = FMV given up = FMV given up FMV acquired cash paid = FMV given up $70,000 $40,000 = $30, Exchange patent for land FMV of patent (asset given) calculated FMV land (asset received) known We paid $40,000 in cash Cost of patent $90,000 Accumulated amortization $10,000 Book value $80,000 Fair value Plug $30,000 Loss on exchange ($50,000) 142 Exchange 3 Loss, Pay Cash Exchanged patent for land Land 70,000 Accumulated amortization 10,000 Loss on exchange Plug 50,000 Patent 90,000 Cash 40, Trade-In Allowance Reduces cash paid Effect of Trade-In Allowance Invoice price of incoming asset (FMV) Trade-in allowance on outgoing asset Cash paid Effect of Trade-In Allowance $10,000 Invoice price of new machine (FMV) 3,000 Allowance for old machine $ 7,000 Cash paid

25 Exceptions: Do Not Use FMV In exchange of operational assets fair value is used except in rare situations Neither fair value can be determined Exchange lacks commercial substance Even though these two cases are rare exceptions many CPA exam questions may be on these topics Exchanges: FMV Unknown Fair values cannot be determined No gain (loss) is recognized Asset acquired valued at Book value of asset given up Plus cash given (or minus cash received) Book value given + cash paid = FMV acquired Book value given cash received = FMV acquired Exchange 4: FMV Unknown Exchange building for land Cannot determine FMV of either asset Cost of building $600,000 Accumulated depreciation $400,000 Book value $200,000 We paid cash $100,000 Book value given + cash paid = FMV acquired Book value given cash received = FMV acquired Book value given + cash paid = FMV acquired $200, ,000 = 300, Exchange 4: FMV Unknown Exchanged building for land, FMV of both assets unknown Land (new) Plug 300,000 Accumulated depreciation 400,000 Building (old) 600,000 Cash 100,000 No recognition of gain or loss 148 No Commercial Substance To discourage trades of appreciated assets solely to recognize gains, fair values only used in legitimate exchanges with commercial substance No Commercial Substance Fraudulently inflate earning When FMV > book value Exchange assets Both companies recognize gains

26 Test: Commercial Substance Both conditions must be met: 1. Change in future cash flows expected 2. Expected change significant relative to fair value of assets exchanged Exchange: Calc Gain (Loss) Type of Exchange No commercial substance, no cash received No commercial substance, cash received less than 25% of fair value No commercial substance, cash received 25% or more of fair value Record Transaction Defer gains by reducing basis of incoming asset; recognize losses immediately Recognize partial gain; recognize losses immediately Recognize all gains and losses immediately Always recognize losses immediately Difference is in treatment of gains Recognition of Losses No Commercial Substance No Cash Received Recognize loss immediately (except commercial sub: FMV unknown) Unlikely transaction entered into solely to generate loss If the loss were deferred, assets would be overstated Companies should not value assets at more than their cash equivalent price 153 No gain recognized Loss may be recognized If gain, asset acquired valued at BV asset given plus cash given Actual FMV asset received gain Same Book value given + cash paid = FMV acquired If no cash paid Book value given = FMV acquired 154 Exchange 5: No Commercial Substance, No Cash Received Exchange truck for truck (identical) Cost of truck $50,000 Accumulated depreciation $40,000 Book value $10,000 Fair value asset given $25,000 Gain on exchange (not allowed) $15,000 Recognition of gain not allowed 155 JE Below Not Allowed Exchange identical truck for truck, both companies recognize gain Truck (new) FMV 25,000 Accumulated depreciation 40,000 Truck (old) 50,000 Gain on exchange Plug 15,000 Because FMV > book value for both trucks both companies will show gain if they exchange assets even though there is no economic benefit to the exchange

27 Exchange 5: No Commercial Substance, No Cash Received Exchange identical truck for truck, no gain recognized Truck (new) FMV gain 10,000 Accumulated depreciation 40,000 Truck (old) 50,000 Gain on exchange 15,000 Do not recognize gain Reduce basis of incoming asset by amount of gain New asset = FMV gain New asset = Book value old asset 157 Exchange 5: No Commercial Substance, No Cash Received Exchange identical truck for truck, no gain recognized Truck (new) FMV gain 10,000 Accumulated depreciation 40,000 Truck (old) 50,000 Gain on exchange 15,000 Lower value of incoming asset leads to lower depreciation expense in future periods which raises net income (allocates gain over life of asset) 158 Exchange: Calc Gain (Loss) No Commercial Substance Cash Received < 25% Type of Exchange No commercial substance, no cash received No commercial substance, cash received less than 25% of fair value No commercial substance, cash received 25% or more of fair value Record Transaction Defer gains by reducing basis of incoming asset; recognize losses immediately Recognize partial gain; recognize losses immediately Recognize all gains and losses immediately Always recognize losses immediately Difference is in treatment of gains 159 No commercial substance Cash received < 25% of fair value Loss recognized Recognize portion of gain Reason for partial recognition of gain Transaction part cash sale, part exchange Recognize gain on cash sale portion Boot received represents portion sold 160 Exchange 6: No Comm. Sub., Cash Received < 25% Exchange old truck for new machine Cost of truck given $110,000 Accumulated amortization $50,000 Book value $60,000 Fair value $100,000 Gain (loss) on exchange $40,000 Fair value of machine received $90,000 Received cash (boot) in exchange $10, Exchange 6: No Comm. Sub., Cash Received < 25% Gain (loss) on exchange $40,000 Fair value of machine received $90,000 Received cash (boot) in exchange $10,000 Formula to Recognize Gain Cash received (Boot) Cash received (Boot) + FV asset received Total gain Formula to Recognize Gain 10,000 10, ,000 = Gain recognized 40,000 = 4,000 Gain deferred = $40,000 $4,000 = $36,

28 Exchange 6: No Comm. Sub., Cash Received < 25% Record exchange, recognize part of gain Cash 10,000 Machine (incoming asset) Plug 54,000 Accumulated depreciation (truck) 50,000 Truck (outgoing asset) 110,000 Gain on sale of truck 4, Exchange 6: No Comm. Sub., Cash Received < 25% Book value of outgoing asset $60,000 Fair value of machine received $90,000 Received cash (boot) in exchange $10,000 Formula to Recognize Book Value Sold Cash received (Boot) Cash received (Boot) + FV asset received Book Value Formula to Recognize Book Value Sold 10,000 10, ,000 = Book value sold 60,000 = 6, Exchange 6: No Comm. Sub., Cash Received < 25% Calculation of basis of incoming asset Book value of asset given (truck) $60,000 Portion of book value sold $ 6,000 Basis of new machine $54,000 Calculation of basis of incoming asset Fair value of asset received (machine) $90,000 Less gain deferred $36,000 Basis of new machine $54,000 Exchange 6: No Comm. Sub., Cash Received < 25% Record exchange, recognize part of gain Cash 10,000 Machine (incoming asset) 54,000 Accumulated depreciation (truck) 50,000 Truck (outgoing asset) 110,000 Gain on sale of truck Plug 4, Summary of Exchange Entries End of Chapter