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Chapter 10: Q4CA (page 548)

(Nonmonetary Exchanges) You have two clients that are considering trading machinery with each other. Although the machines are different from each other, you believe that an assessment of expected cash flows on the exchanged assets will indicate the exchange lacks commercial substance. Your clients would prefer that the exchange be deemed to have commercial substance, to allow them to record gains. Here are the facts:

Client A

Client B

Original cost

\(100,000

\)150,000

Accumulated depreciation

40,000

80,000

Fair value

80,000

100,000

Cash received (paid)

(20,000)

20,000

Instructions

  1. Record the trade-in on Client A’s books assuming the exchange has commercial substance.
  2. Record the trade-in on Client A’s books assuming the exchange lacks commercial substance.
  3. Write a memo to the controller of Company A indicating and explaining the dollar impact on current and future statements of treating the exchange as having, versus lacking, commercial substance.
  4. Record the entry on Client B’s books assuming the exchange has commercial substance.
  5. Record the entry on Client B’s books assuming the exchange lacks commercial substance.
  6. Write a memo to the controller of Company B indicating and explaining the dollar impact on current and future statements of treating the exchange as having, versus lacking, commercial substance.

Short Answer

Expert verified
  1. Gain on disposal of machinery: $20,000
  2. Machinery: $80,000
  3. The income statement will reflect a before-tax gain of $20,000.
  4. Gain on disposal of machinery: $30,000
  5. Accumulated Depreciation-Machinery: $80,000
  6. The income statement will reflect a before-tax gain of $30,000 if the exchange has commercial substance.

Step by step solution

01

Meaning of Non-Interest Bearing Liabilities

Non-Interest Bearing Liabilities are the sums of money due by a corporation(a debt on the balance sheet, current or non-current)that are not subject to interest or penalties. Non-Interest Bearing Liabilities, for the avoidance of doubt, do not include liabilities linked to deferred taxes, pensions, retirement, or leases.

02

(a) Recording the trade-in on Client A’s books.

Treatment if the exchange has commercial substance

Client A would recognize a gain of $20,000 on the exchange. The basis of the asset acquired would be $100,000. The entry would be as follows:

Date

Particulars

Debit ($)

Credit ($)

Machinery

100,000

Accumulated Depreciation-Machinery

40,000

Cash

20,000

Gain on Disposal of Machinery

20,000

Machinery

100,000

Working notes:

The fair value of old machinery

$80,000

Less: Book value of old machinery

60,000

Gain on disposal of machinery

$20,000

03

(b) Recording the trade-in on Client A’s books.

Treatment if the exchange lacks commercial substance

A $20,000 gain on the trade would be disallowed for Client A. This is due to the absence of commercial substance in the deal. The new asset would have a basis of $80,000 ($100,000 less the unrecognized gain of $20,000). Following is the entry:

Date

Particulars

Debit ($)

Credit ($)

Machinery

80,000

Accumulated Depreciation-Machinery

40,000

Cash

20,000

Machinery

100,000

04

(c) Writing a memo.

Memo to the Controller:

TO: The Controller

RE: Exchanges of Assets—Commercial Substance Issues.

Financial statement effect of treating the exchange as having commercial substance versus not.

  1. The income statement will show a gain of $20,000 before taxes. This profit will be included in the financial results for this year. Future income statements will show a bigger depreciation deduction because the new asset's book value has grown. As a result, future income statements will show fewer earnings.
  2. If the exchange has commercial substance, the current balance sheet will show a $20,000 greater value for plant assets, a larger liability for taxes payable, and higher retained earnings. As the asset depreciates, the discrepancy will progressively disappear.
05

(d) Recording the entry on Client B’s books.

Client B

Treatment if the exchange has commercial substance

In this case, the entire $30,000 gain would be recorded on the income statement for this year. The new asset would be recorded at its fair market value. The following is the entry:

Date

Particulars

Debit ($)

Credit ($)

Machinery

80,000

Accumulated Depreciation-Machinery

80,000

Cash

20,000

Machinery

150,000

Gain on Disposal of Machinery

30,000

Working notes:

The fair value of old machinery

$100,000

Less: Book value of old machinery

70,000

Gain on disposal of machinery

$ 30,000

06

(e) Recording the entry on Client B’s books

Treatment if the exchange lacks commercial substance

Date

Particulars

Debit ($)

Credit ($)

Machinery ($80,000 – $24,000).

56,000

Accumulated Depreciation-Machinery

80,000

Cash

20,000

Machinery

150,000

Gain on Disposal of Machinery

6,000

Note: A partial gain will be reported in the ratio of cash received to the fair value of all assets received. A gain of $6,000 will be recorded in this situation ($20,000/$100,000 times the $30,000 gain). The $24,000 in unrecognized income will lower the new asset's base. The trade is recorded using the entry above.

07

(f) Writing a memo

Memo to the Controller:

TO: The Controller

RE: Asset Exchanges—Commercial Substance

  1. The income statement will show a $30,000 before-tax gain if the deal has commercial substance. This profit will be included in the financial results for this year. Future income statements will show a bigger depreciation deduction because the new asset's book value has grown. As a result, future income statements will show fewer earnings. If the deal lacks commercial substance, the stated gain will be a mere $6,000.
  2. If the exchange has commercial substance, the current balance statement will reflect a $24,000 higher value for plant assets, a greater liability for taxes payable, and higher retained profits. As the asset depreciates, the discrepancy will progressively disappear.

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Most popular questions from this chapter

Question: (Classification of Acquisition and Other Asset Costs) At December 31, 2016, certain accounts included in the property, plant, and equipment section of Reagan Company’s balance sheet had the following balances.

Land

\(230,000

Buildings

890,000

Leasehold improvements

660,000

Equipment

875,000

During 2017, the following transactions occurred.

  1. Land site number 621 was acquired for \)850,000. In addition, to acquire the land Reagan paid a \(51,000 commission to a real estate agent. Costs of \)35,000 were incurred to clear the land. During the course of clearing the land, timber and gravel were recovered and sold for \(13,000.
  2. A second tract of land (site number 622) with a building was acquired for \)420,000. The closing statement indicated that the land value was \(300,000 and the building value was \)120,000. Shortly after acquisition, the building was demolished at a cost of \(41,000. A new building was constructed for \)330,000 plus the following costs.

Excavation fees

\(38,000

Architectural design fees

11,000

Building permit fee

2,500

Imputed interest on funds used

during construction (stock financing)

8,500

The building was completed and occupied on September 30, 2017.

  1. A third tract of land (site number 623) was acquired for \)650,000 and was put on the market for resale.
  2. During December 2017, costs of \(89,000 were incurred to improve leased office space. The related lease will terminate on December 31, 2019, and is not expected to be renewed. (Hint: Leasehold improvements should be handled in the same manner as land improvements.)
  3. A group of new machines was purchased under a royalty agreement that provides for payment of royalties based on units of production for the machines. The invoice price of the machines was \)87,000, freight costs were \(3,300, installation costs were \)2,400, and royalty payments for 2017 were $17,500.

Instructions

a, Prepare a detailed analysis of the changes in each of the following balance sheet accounts for 2017.

Land Leasehold Improvements

Buildings Equipment

Disregard the related accumulated depreciation accounts.

b, List the items in the situation that were not used to determine the answer to (a) above, and indicate where, or if, these items should be included in Reagan’s financial statements.

(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.

(Capitalization of Interest) Laserwords Inc. is a book distributor that had been operating in its original facility since 1987. The increase in certification programs and continuing education requirements in several professions has contributed to an annual growth rate of 15% for Laserwords since 2012. Laserwords’ original facility became obsolete by early 2017 because of the increased sales volume and the fact that Laserwords now carries CDs in addition to books.

On June 1, 2017, Laserwords contracted with Black Construction to have a new building constructed for \(4,000,000 on land owned by Laserwords. The payments made by Laserwords to Black Construction are shown in the schedule below.

Date

Amount

July 30, 2017

\) 900,000

January 30, 2018

1,500,000

May 30, 2018

1,600,000

Total payments

\(4,000,000

Construction was completed and the building was ready for occupancy on May 27, 2018. Laserwords had no new borrowings directly associated with the new building but had the following debt outstanding at May 31, 2018, the end of its fiscal year

10%, 5-year note payable of \)2,000,000, dated April 1, 2014, with interest payable annually on April 1.

12%, 10-year bond issue of $3,000,000 sold at par on June 30, 2010, with interest payable annually on June 30.

The new building qualifies for interest capitalization. The effect of capitalizing the interest on the new building, compared with the effect of expensing the interest, is material.

Instructions

  1. Compute the weighted-average accumulated expenditures on Laserwords’ new building during the capitalization period.
  2. Compute the avoidable interest on Laserwords’ new building. (Round to one decimal place.)
  3. Some interest cost of Laserwords Inc. is capitalized for the year ended May 31, 2018.
    1. Identify the items relating to interest costs that must be disclosed in Laserwords’ financial statements.
    2. Compute the amount of each of the items that must be disclosed.

Mehta Company traded a used welding machine (cost \(9,000, accumulated depreciation \)3,000) for office equipment with an estimated fair value of \(5,000. Mehta also paid \)3,000 cash in the transaction. Prepare the journal entry to record the exchange. (The exchange has commercial substance.)

Question: (Nonmonetary Exchanges) During the current year, Marshall Construction trades an old crane with a book value of \(90,000 (original cost \)140,000 less accumulated depreciation of \(50,000) for a new crane from Brigham Manufacturing Co. The new crane cost Brigham \)165,000 to manufacture and is classified as inventory. The following information is also available.

Marshall Const.

Brigham Mfg. Co.

Fair value of old crane

\( 82,000

Fair value of new crane

\)200,000

Cash paid

118,000

Cash received

118,000

Instructions

  1. Assuming that this exchange is considered to have commercial substance, prepare the journal entries on the books of
    1. Marshall Construction and
    2. Brigham Manufacturing.
  2. Assuming that this exchange lacks commercial substance for Marshall, prepare the journal entries on the books of Marshall Construction.
  3. Assuming the same facts as those in (a), except that the fair value of the old crane is \(98,000 and the cash paid is \)102,000, prepare the journal entries on the books of
    1. Marshall Construction and
    2. Brigham Manufacturing.
  4. Assuming the same facts as those in (b), except that the fair value of the old crane is \(97,000 and the cash paid \)103,000, prepare the journal entries on the books of
    1. Marshall Construction and
    2. Brigham Manufacturing.
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