10.5 Recording Asset Exchanges and Expenditures That Affect Older Assets
At the end of this section, students should be able to meet the following objectives:
- Record the exchange of one asset for another and explain the rationale for this method of accounting.
- Explain when the fair value of an asset received must be used for recording an exchange rather than the fair value of the property surrendered.
- Compute the allocation of cost between assets when more than one is acquired in a single transaction.
- Determine which costs are capitalized when incurred in connection with an asset that has already been in use for some time and explain the impact on future depreciation expense calculations.
Exchanging One Asset for Another
Question: Some items are acquired by a company through an asset exchangeA trade of one asset for another in which the net book value of the old asset is removed from the records while the new asset is recorded at the fair value surrendered (if known); the difference between the recorded fair value and the previous net book value creates a gain or loss to be shown on the income statement. instead of as the result of a purchase. For example, the limousine discussed earlier might well be traded away after two years for a newer model. Such transactions are common, especially with vehicles. How is the historical cost of a new asset measured if obtained through an exchange rather than an acquisition?
To illustrate, assume that this limousine is traded to an automobile manufacturer for a new model on December 31, Year Two. By that time, as shown in Figure 10.9 "Depreciation—Units-of-Production Method", the net book value had fallen to $30,000 (cost of $90,000 less accumulated depreciation of $60,000). However, because company employees have taken excellent care of the vehicle during its two years of use, its fair value is $45,000. As has been discussed, net book value rarely equals fair value during the life of property and equipment. Assume that the vehicle being acquired is worth $100,000 so the company also pays $55,000 in cash ($100,000 value received less $45,000 value surrendered) to complete the trade. How is such an exchange recorded?
Answer: In virtually all cases, fair value is the accounting basis used to record items received in an exchange. The net book value of the old asset is removed from the accounts and the new model is reported at fair value. Fair value is added; net book value is removed. A gain or loss is recognized for the difference.
In this example, the company surrenders two assets with a total fair value of $100,000 ($45,000 value for the old limousine plus $55,000 in cash) to obtain the new vehicle. However, the assets given up have a total net book value of only $85,000 ($30,000 and $55,000). A $15,000 gain is recognized on the exchange ($100,000 fair value less $85,000 net book value). The gain results because the old limousine had not lost as much value as the depreciation process had expensed. The net book value was reduced to $30,000 but the vehicle was worth $45,000.Accounting rules are created through a slow and meticulous process to avoid unintended consequences. For example, assume that Company A and Company B buy identical antique limousines for $30,000 that then appreciate in value to $100,000 because of their scarcity. Based solely on the accounting rule described in this section, if the two companies exchange these assets, each reports a gain of $70,000 while still retaining possession of an identical vehicle. This reporting is not appropriate because nothing has changed for either party. In reality, there was no gain since the companies retain the same financial position as before the trade. Thus, in creating the official guidance described previously, FASB held that an exchange must have commercial substance to justify using fair value. In simple terms, the asset acquired has to be different from the asset surrendered as demonstrated by the amount and timing of future cash flows. Without a difference, no rationale exists for making the exchange. If a trade does not have commercial substance, net book value is retained for the newly received asset and no gain is recognized. Based on the actual decline in value, too much expense had been recognized.
The journal entry to record this exchange of assets is presented in Figure 10.12 "Recording Exchange of Assets".
Figure 10.12 Recording Exchange of Assets
Determining the Fair Value to Record in an Exchange
Question: In the previous example, the value of the assets surrendered ($45,000 plus $55,000 or $100,000) equals the value of the new limousine received ($100,000). The trade was exactly even. Because one party might have better negotiating skills or a serious need for a quick trade, the two values can differ, at least slightly. For example, the limousine company could give up its old vehicle (worth $45,000) and cash ($55,000) and manage to convince the automobile manufacturer to hand over a new asset worth $110,000. If the values are not equal in an exchange, which fair value is used for reporting the newly acquired asset? Should the new limousine be recorded at the $100,000 value given up or the $110,000 value received?
Answer: To stay consistent with the historical cost principle, the new asset received in a trade is recorded at the fair value of the item or items surrendered. Giving up the previously owned property is the sacrifice made to obtain the new asset. That is the cost to the new buyer.
Generally, the fair value of the items sacrificed equals the fair value of the items received. Most exchanges involve properties of relatively equal worth; a value of $100,000 is surrendered to acquire a value of $100,000. However, that is not always the case. Thus, if known, the fair value of the assets given up always serves as the basis for recording the asset received. Only if the value of the property traded away cannot be readily determined is the new asset recorded at its own fair value.
On January 1, Year One, a company spends $39,000 to buy a new piece of machinery with an expected residual value of $3,000 and a useful life of ten years. The straight-line method of depreciation is applied but not the half-year convention. On October 1, Year Three, the company wants to exchange this asset (which is now worth $31,000) for a new machine worth $40,000. To finalize the exchange, the company also pays cash of $9,000. What is the gain or loss on the trade?
- Loss of $600
- Loss of $1,100
- Gain of $1,300
- Gain of $1,900
The correct answer is choice d: Gain of $1,900.
The new asset is recorded at $40,000 ($31,000 fair value + $9,000 cash). Depreciation has been $3,600 per year—cost less residual value ($39,000 − $3,000 or $36,000) over a ten-year life. Depreciation in Year Three is $2,700 (9/12 of $3,600). Accumulated depreciation is $9,900 ($3,600 + $3,600 + $2,700); book value is $29,100 ($39,000 less $9,900). If new asset is $40,000 and book value surrendered is $38,100 ($29,100 plus $9,000), the increase in financial position creates a gain of $1,900.
Allocating a Purchase Price between Two Assets
Question: Occasionally, two or more assets are bought for a single purchase price. The most common example is the acquisition of a building along with the land on which it sits. As has been discussed, the portion of the cost assigned to the building is depreciated to expense over its useful life in some systematic and rational manner. However, land does not have a finite life. Its cost remains an asset so that this portion of the price has no impact on reported net income over time. How does an accountant separate the amount paid for land from the cost assigned to a building when the two assets are purchased together?
Assume a business pays $5.0 million for three acres of land along with a five-story building. What part of this cost is attributed to the land and what part to the building? Does management not have a bias to assign more of the $5.0 million to land and less to the building to reduce the future amounts reported as depreciation expense?
Answer: Companies commonly purchase more than one asset at a time. This is sometimes referred to as a basket purchaseThe acquisition of more than one asset at a single cost; the cost is then allocated among those assets based on their relative values.. For example, a manufacturer might buy several machines in a single transaction. The cost assigned to each should be based on their relative values.
For this illustration, assume that the land and building bought for $5.0 million have been appraised at $4.5 million and $1.5 million, respectively, for a total of $6.0 million. Perhaps the owner needed cash immediately and was willing to accept a price of only $5.0 million. For the buyer, the land makes up 75 percent of the value received ($4.5 million/$6.0 million) and the building the remaining 25 percent ($1.5 million/$6.0 million). The cost is simply assigned in those same proportions: $3.75 million to the land ($5.0 million × 75 percent) and $1.25 million to the building ($5.0 million × 25 percent). This allocation enables the buyer to make the journal entry presented in Figure 10.13 "Allocation of Cost between Land and Building with Both Values Known".
Figure 10.13 Allocation of Cost between Land and Building with Both Values Known
Occasionally, in a basket purchase, the value can be determined for one of the assets but not for all. As an example, the land might be worth $4.6 million, but no legitimate value is available for the building. Perhaps similar structures do not exist in this location for comparison purposes. In such cases, the known value is used for that asset with the remainder of the cost assigned to the other property. If the land is worth $4.6 million but no reasonable value can be ascribed to the building, the excess $400,000 ($5,000,000 cost less $4,600,000 assigned to the land) is arbitrarily assigned to the second asset.
Figure 10.14 Allocation of Cost Based on Known Value for Land Only
Does the possibility of bias exist in these allocations? Accounting is managed by human beings and they always face a variety of biases. That potential problem is one of the primary reasons that independent auditors play such an important role in the financial reporting process. These outside experts work to ensure that financial figures are presented fairly without bias. Obviously, if the buyer assigns more of the cost of a basket purchase to land, future depreciation will be less and reported net income higher. In contrast, if more of the cost is allocated to the building, depreciation expense is higher and taxable income and income tax payments are reduced. That is also a tempting choice.
Thus, the independent auditor gathers sufficient evidence to provide reasonable assurance that such allocations are based on reliable appraisal values so that both the land and the building figures are fairly presented. However, a decision maker is naïve not to realize that potential bias does exist in any reporting process.
Subsequent Expenditures for Property and Equipment
Question: Assume that the building discussed earlier is assigned a cost of $1,250,000 as shown in Figure 10.13 "Allocation of Cost between Land and Building with Both Values Known". Assume further that this asset has an expected life of twenty years and that straight-line depreciation is applied with no residual value. After eight years, accumulated depreciation is $500,000 ($1,250,000 × 8 years/20 years). At that point, when the building has a remaining life of 12 years, the owner spends an additional $150,000 on this asset. Should a later expenditure made in connection with a piece of property or equipment that is already in use be capitalized (added to the asset account) or expensed immediately?
Answer: The answer to this question depends on the impact that this later expenditure has on the building. In many cases, additional money is spent simply to keep the asset operating with no change in expected life or improvement in future productivity. As shown in Figure 10.15 "Recording of Cost to Maintain or Repair Asset", such costs are recorded as maintenance expense if anticipated or repair expense if unexpected. For example, changing the oil in a truck at regular intervals is a maintenance expense whereas fixing a dent from an accident is a repair expense. However, this distinction has no impact on reported net income.
Figure 10.15 Recording of Cost to Maintain or Repair Asset
Other possibilities do exist. If the $150,000 expenditure increases the future operating capacity of the asset, the cost should be capitalized as shown in Figure 10.16 "Cost Capitalized Because of Increase in Operating Capacity". The building might have been made bigger, more efficient, more productive, or less expensive to operate. If the asset has been improved as a result of this expenditure, historical cost is raised.
Figure 10.16 Cost Capitalized Because of Increase in Operating Capacity
Assuming that no change in either the useful life of the building or its residual value occurs as a result of this work, depreciation expense will be $75,000 in each of the subsequent twelve years. The newly increased net book value is simply allocated over the useful life that remains.($1,250,000 + $150,000 - $500,000)/12 remaining years = $75,000
Another possibility does exist. The $150,000 might extend the building’s life without creating any other improvement. Because the building will now generate revenue for a longer period of time than previously expected, this cost is capitalized. A clear benefit has been gained from the amount spent. The asset is not physically bigger or improved but its estimated life has been extended. Consequently, the building is not increased directly, but instead, accumulated depreciation is reduced as shown in Figure 10.17 "Cost Capitalized Because Expected Life Is Extended". In effect, this expenditure has recaptured some of the previously expensed utility.
Figure 10.17 Cost Capitalized Because Expected Life Is Extended
Assuming that the $150,000 payment extends the remaining useful life of the building from twelve to eighteen years with no accompanying change in residual value, depreciation expense will be $50,000 in each of these remaining eighteen years. Once again, net book value has increased by $150,000 but, in this situation, the life of the asset has also been lengthened.
reduced accumulated depreciation: $500,000 - $150,000 = $350,000 adjusted net book value: $1,250,000 - $350,000 = $900,000 annual depreciation: $900,000/18 years = $50,000
The Hatcher Company buys a building on January 1, Year One for $9 million. It has no anticipated residual value and should help generate revenues for thirty years. On December 31, Year Three, the company spends another $500,000 to cover the entire structure in a new type of plastic that will extend its useful life for an additional sixteen years. On December 31, Year Four, what will Hatcher report as accumulated depreciation for this building?
The correct answer is choice a: $600,000.
Annual depreciation is $300,000 ($9 million/30 years) or $900,000 after three years. The $500,000 expenditure reduces that balance to $400,000 because it extends the life (from twenty-seven years to forty-three) with no other increase in productivity. Book value is now $8.6 million ($9 million cost less $400,000 accumulated depreciation), which is allocated over forty-three years at a rate of $200,000 per year. Depreciation for Year Four raises accumulated depreciation from $400,000 to $600,000.
Assets are occasionally obtained through exchange. The reported cost for the new acquisition is based on the fair value of the property surrendered because that figure reflects the company’s sacrifice. The asset received is only recorded at its own fair value if the value of the asset given up cannot be determined. The difference between the net book value removed and the fair value recorded is recognized as a gain or loss. When more than one asset is acquired in a single transaction, the cost allocation is based on the relative fair values of the items received. Any subsequent costs incurred in connection with property and equipment are capitalized if the asset has been made bigger or better in some way or is just more efficient. If the length of the remaining useful life is extended, capitalization is established by reducing accumulated depreciation.