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Chapter 10: 16Q (page 531)

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

Expert verified

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

01

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.

02

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.

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Most popular questions from this chapter

(Analysis of Subsequent Expenditures) Plant assets often require expenditures subsequent to acquisition. It is important that they be accounted for properly. Any errors will affect both the balance sheets and income statements for a number of years.

Instructions

For each of the following items, indicate whether the expenditure should be capitalized (C) or expensed (E) in the period incurred.

  1. __________ Improvement.
  2. __________ Replacement of a minor broken part on a machine.
  3. __________ Expenditure that increases the useful life of an existing asset.
  4. __________ Expenditure that increases the efficiency and effectiveness of a productive asset but does not increase its salvage value.
  5. __________ Expenditure that increases the efficiency and effectiveness of a productive asset and increases the asset’s salvage value.
  6. __________ Expenditure that increases the quality of the output of the productive asset.
  7. __________ Improvement to a machine that increased its fair market value and its production capacity by 30% without extending the machine’s useful life.
  8. __________ Ordinary repairs.

(Acquisition Costs of Realty) The following expenditures and receipts are related to land, land improvements,

and buildings acquired for use in a business enterprise. The receipts are enclosed in parentheses.

(a) Money borrowed to pay building contractor (signed a note) \((275,000)

(b) Payment for construction from note proceeds 275,000

(c) Cost of land fill and clearing 8,000

(d) Delinquent real estate taxes on property assumed by purchaser 7,000

(e) Premium on 6-month insurance policy during construction 6,000

(f) Refund of 1-month insurance premium because construction completed early (1,000)

(g) Architect’s fee on building 22,000

(h) Cost of real estate purchased as a plant site (land \)200,000 and building $50,000) 250,000

(i) Commission fee paid to real estate agency 9,000

(j) Installation of fences around property 4,000

(k) Cost of razing and removing building 11,000

(l) Proceeds from salvage of demolished building (5,000)

(m) Interest paid during construction on money borrowed for construction 13,000

(n) Cost of parking lots and driveways 19,000

(o) Cost of trees and shrubbery planted (permanent in nature) 14,000

(p) Excavation costs for new building 3,000

Instructions

Identify each item by letter and list the items in columnar form, using the headings shown below. All receipt amounts should be

reported in parentheses. For any amounts entered in the Other Accounts column, also indicate the account title.

Item Land Land Improvements Buildings Other Accounts

The invoice price of a machine is \(50,000. Various other costs relating to the acquisition and installation of the machine, including transportation, electrical wiring, special base, and so on amount to \)7,500. The machine has an estimated life of 10 years, with no salvage value at the end of that period.

The owner of the business suggests that the incidental costs of \(7,500 be charged to theexpense immediately for the following reasons.

  1. If the machine should be sold, these costs cannot be recovered in the sales price.
  2. The inclusion of the \)7,500 in the machinery account on the books will not necessarily result in a closer approximation of the market price of this asset over the years, because of the possibility of changing demand and supply levels.
  3. Charging the $7,500 to expense immediately will reduce federal income taxes.

Instructions

Discuss each of the points raised by the owner of the business.

Question: One financial accounting issue encountered when a company constructs its own plant is whether the interest cost on funds borrowed to finance construction should be capitalized and then amortized over the life of the assets constructed. What is the justification for capitalizing such interest?

(Entries for Acquisition of Assets) Presented below is information related to Zonker Company.

1. On July 6, Zonker Company acquired the plant assets of Doonesbury Company, which had discontinued operations. The appraised value of the property is:

Land

\( 400,000

Buildings

1,200,000

Equipment

800,000

Total

\)2,400,000

Zonker Company gave 12,500 shares of its \(100 par value common stock in exchange. The stock had a market price of \)168 per share on the date of the purchase of the property.

2. Zonker Company expended the following amounts in cash between July 6 and December 15, the date when it first occupied the building.

Repairs to building

\(105,000

Construction of bases for equipment to be installed later

135,000

Driveways and parking lots

122,000

Remodeling of office space in building, including new partitions and walls

161,000

Special assessment by city on land

18,000

3. On December 20, the company paid cash for equipment, \)260,000, subject to a 2% cash discount, and freight on equipment of $10,500.

Instructions

Prepare entries on the books of Zonker Company for these transactions.
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