Plant Asset Disposals, Natural Resources, and Intangible Assets
Sale of plant assets
Companies frequently dispose of plant assets by selling them. By comparing an asset's book value (cost less accumulated depreciation) with its selling price (or net amount realized if there are selling expenses), the company may show either a gain or loss. If the sales price is greater than the asset's book value, the company shows a gain. If the sales price is less than the asset's book value, the company shows a loss. Of course, when the sales price equals the asset's book value, no gain or loss occurs.
To illustrate accounting for the sale of a plant asset, assume that a company sells equipment costing USD 45,000 with accumulated depreciation of USD 14,000 for USD 35,000. The firm realizes a gain of USD 4,000:
Equipment cost |
$ 45,000 |
Accumulated depreciation |
14,000 |
Book value |
$ 31,000 |
Sales price |
35,000 |
Gain realized |
$ 4,000 |
The journal entry to record the sale is:
Cash (+A) |
35,000 |
|
Accumulated Depreciation - Equipment (+A) |
14,000 |
|
Equipment (-A) |
45,000 |
|
Gain on Disposal of Plant Assets (+SE) |
4,000 |
|
To record sale of equipment at a price greater than book value. |
If on the other hand, the company sells the equipment for USD 28,000, it realizes a loss of USD 3,000 (USD 31,000 book value - USD 28,000 sales price). The journal entry to record the sale is:
Cash (+A) |
28,000 |
|
Accumulated Depreciation - Equipment (+A) |
14,000 |
|
Loss from Disposal of Plant Asset (-SE) |
3,000 |
|
Equipment (-A) |
45,000 |
|
To record the sale of equipment at a price less than book value. |
If a firm sells the equipment for USD 31,000, no gain or loss occurs. The journal entry to record the sale is:
Cash (+A) |
31,000 |
|
Accumulated Depreciation - Equipment (+A) |
14,000 |
|
Equipment (-A) |
45000 |
|
To record sale of equipment at a price equal to book value. |
Accounting for depreciation to date of disposal When selling or otherwise disposing of a plant asset, a firm must record the depreciation up to the date of sale or disposal. For example, if it sold an asset on April 1 and last recorded depreciation on December 31, the company should record depreciation for three months (January 1-April 1). When depreciation is not recorded for the three months, operating expenses for that period are understated, and the gain on the sale of the asset is understated or the loss overstated.
To illustrate, assume that on 2011 August 1, Ray Company sold a machine for USD 1,500. When purchased on 2003 January 2, the machine cost USD 12,000; Ray was depreciating it at the straight-line rate of 10 percent per year. As of 2010 December 31, after closing entries were made, the machine's accumulated depreciation account had a balance of USD 9,600. Before determining a gain or loss and before making an entry to record the sale, the firm must make the following entry to record depreciation for the seven months ended 2011 July 31:
+July |
31 |
Depreciation Expense - Machinery (-SE) |
700 |
|
Accumulated Depreciation - Machinery (-A) |
700 |
|||
To record depreciation for seven months |
||||
[$12,000 X 0.10 X (7/12)] |
An accountant would compute the USD 200 loss on the sale as follows:
Machine cost |
$ |
12,000 |
Accumulated depreciation ($9,600 + $700) |
10,300 |
|
Book value |
$ |
1,700 |
Sales price |
1,500 |
|
Loss realized |
$ |
200 |
The journal entry to record the sale is:
Cash (+A) |
1,500 |
|
Accumulated Depreciation - Machinery (+A) |
10,300 |
|
Loss from Disposal of Plant Assets (-SE) |
200 |
|
Machinery(-A) |
12,000 |
|
To record the sale of machinery at a price less than book value. |
When retiring a plant asset from service, a company removes the asset's cost and accumulated depreciation from its plant asset accounts. For example, Hayes Company would make the following journal entry when it retired a fully depreciated machine that cost USD 15,000 and had no salvage value:
Accumulated Depreciation - Machinery (+A) |
15,000 |
|
Machinery (-A) |
15,000 |
|
To record the retirement of a fully depreciated machine. |
Occasionally, a company continues to use a plant asset after it has been fully depreciated. In such a case, the firm should not remove the asset's cost and accumulated depreciation from the accounts until the asset is sold, traded, or retired from service. Of course, the company cannot record more depreciation on a fully depreciated asset because total depreciation expense taken on an asset may not exceed its cost.
Sometimes a business retires or discards a plant asset before fully depreciating it. When selling the asset as scrap (even if not immediately), the firm removes its cost and accumulated depreciation from the asset and accumulated depreciation accounts. In addition, the accountant records its estimated salvage value in a Salvaged Materials account and recognizes a gain or loss on disposal. To illustrate, assume that a firm retires a machine with a USD 10,000 original cost and USD 7,500 of accumulated depreciation. If the machine's estimated salvage value is USD 500, the following entry is required:
Salvaged materials (+A) |
500 |
Accumulated Depreciation - Machinery (+A) |
7,500 |
Loss from Disposal of Plant Assets (-SE) |
2,000 |
Machinery (-A) |
10,000 |
To record the retirement of machinery, which will be sold for scrap at a later time. |
An accounting perspective:
Uses of technology
The main advantages that companies give for having a home page on the Internet are (1) increased efficiency in the work environment, (2) increased revenue, and (3) faster customer access. A home page can be developed for a small company for a few hundred dollars and can be maintained for a fairly low monthly fee. The Small Business Administration has a website at http://www.sba.gov that provides helpful information to small businesses. One concern that companies have regarding Internet use by their employees is that they might visit interesting nonbusiness related sites on company time.
Sometimes accidents, fires, floods, and storms wreck or destroy plant assets, causing companies to incur losses. For example, assume that fire completely destroyed an uninsured building costing USD 40,000 with up-to-date accumulated depreciation of USD 12,000. The journal entry is:
Fire Loss (-SE) |
28,000 |
|
Accumulated Depreciation - Buildings (+A) |
12,000 |
|
Buildings (-A) |
40,000 |
|
To record fire loss. |
If the building was insured, the company would debit only the amount of the fire loss exceeding the amount to be recovered from the insurance company to the Fire Loss account. To illustrate, assume the company partially insured the building and will recover USD 22,000 from the insurance company. The journal entry is:
Receivable from Insurance Company (+A) |
22,000 |
|
Fire Loss (-SE) |
6,000 |
|
Accumulated Depreciation - Buildings (+A) |
12,000 |
|
Buildings (-A) |
40,000 |
|
To record fire loss and amount recoverable from insurance company. |
Exchanges of nonmonetary assets Until late 2004, the rules according to 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 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. In late 2004, the FASB issued a new standard, Statement of Financial Accounting Standards No. 153, "Exchanges of Nonoperating Assets: an amendment of APB Opinion No. 29". This new standard was issued to bring about greater agreement between US Generally Accepted
Accounting Principles and International Financial Reporting Standards and is effective for exchanges occurring during fiscal periods beginning after 2005 June 15.
This change allows the financial statements of US companies to be more comparable to the financial statements of companies utilizing International Financial Reporting Standards.
The new FASB standard no longer distinguishes between dissimilar and similar asset exchanges. Instead it differentiates between exchanges that have commercial substance and those that do not have 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 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.
Exchanges of nonmonetary assets having commercial substance For exchanges of nonmonetary assets that have commercial substance, accountants record the new asset at the fair market value of the asset received or the asset(s) given up, whichever is more clearly evident. When the cash price of the new asset is stated, they use the cash price to record the new asset. If the cash price is not stated, they assume that the fair market value of the old asset plus any cash paid would equate to the cash price of the new asset and use that value to record the new asset. Thus, accountants would normally record the asset received at either (1) the stated cash price of the new asset or (2) a known fair market value of the asset given up plus any cash paid.
Debiting accumulated depreciation and crediting the old asset removes the book value of the old asset from the accounts. The firm credits the Cash account for any amount paid. If the amount at which the new asset is recorded exceeds the book value of the old asset plus any cash paid, a company records a gain to balance the journal entry. If the situation is reversed, it records a loss to balance the journal entry. To illustrate such an exchange having commercial substance, assume a company exchanges an old machine for a new delivery truck. The future cash flows from the exchange are expected to be significantly different and, therefore, the exchange has commercial substance. The machine cost USD 45,000 and had an upto-date accumulated depreciation balance of USD 38,000. The truck had a USD 55,000 cash price and was acquired by trading in the machine with a fair value of USD 3,000 and paying USD 52,000 cash. The journal entry to record the exchange is:
Trucks (+A) |
55,000 |
Accumulated Depreciation - Machinery (+A) |
38,000 |
Loss from Disposal of Plant Assets (-SE) |
4,000 |
Machinery (-A) |
45,000 |
Cash (-A) |
52,000 |
To record loss on exchange of dissimilar plant assets. |
Another way to compute the USD 4,000 loss on the exchange is to use the book value of the old asset less the fair market value of the old asset. The calculation is as follows:
Machine cost |
$ 45,000 |
|
Accumulated depreciation |
38,000 |
|
Book value |
$ 7,000 |
|
Fair market value of old asset |
||
(trade-in allowance) |
3,000 |
|
Loss realized |
$ 4,000 |
To illustrate the recognition of a gain from such an exchange having commercial substance, assume that the fair market value of the machine was USD 9,000 instead of USD 3,000, and that only USD 46,000 was paid in cash. The journal entry to record the exchange would be:
Trucks (+A) |
55,000 |
|
Accumulated Depreciation - Machinery (+A) |
38,000 |
|
Machinery (-A) |
45,000 |
|
Cash (-A) |
46,000 |
|
Gain on Disposal of Plant Assets(+SE) |
2,000 |
|
To record gain on exchange of dissimilar assets. |
Another way to compute the gain of USD 2,000 on the exchange is to use the fair market value of the old asset less the book value of the old asset. The calculation is as follows:
Machine cost |
$ 45,000 |
Accumulated depreciation |
38,000 |
Book value |
$ 7,000 |
Fair market value of old asset |
|
(trade-in allowance) |
9,000 |
Gain realized |
$ 2,000 |
Remember, when the book value and the market value of the old asset are different, companies always recognize a gain or a loss on an exchange of nonmonetary assets having commercial substance. As discussed earlier, they do not recognize a gain or loss on an exchange of nonmonetary assets not having commercial substance.
Exchanges of nonmonetary assets not having commercial substance Often firms exchange plant assets such as automobiles, trucks, and office equipment by trading the old asset for a similar new one. Once in a while, such an exchange does not result in an expected change in future cash flows and therefore lacks commercial substance. When such an exchange occurs, the company receives a trade-in allowance for the old asset, and pays the balance in cash. Usually, the cash price of the new asset is stated. If not, accountants assume the cash price of the new asset is the fair market value of the old asset plus the cash paid.
When such assets are exchanged, we must modify the general rule that new assets are recorded at the fair market value of what is given up or received, whichever is clearer. Thus, companies record the new asset at the book value of the old asset plus the cash paid. When applying this rule to exchanges of assets where no commercial substance results, firms recognize no losses or gains.
To illustrate the accounting for exchanges of nonmonetary assets that do not have commercial substance, assume that a delivery service exchanged USD 50,000 cash and truck No. 1 - which cost USD 45,000, had USD 38,000 of up-to-date accumulated depreciation, and had a USD 5,000 fair market value - for truck No. 2. The new truck has a cash price (fair market value) of USD 55,000. The delivery service realized a loss of USD 2,000 on the exchange which cannot be recorded. The loss is calculated as follows:
The journal entry to record the exchange is:
Cost of trunk No. 1 |
$ 45,000 |
Accumulated depreciation |
38,000 |
Book value |
$ 7,000 |
Fair market value of old asset |
|
(trade-in allowance) |
5,000 |
Loss indicated (but not recorded) |
$ 2,000 |
However, if a loss is indicated and is added to the recorded value of the new asset, the asset may later be written down because of rules of impairment (as required by FASB Standard No. 144), a topic left to Intermediate Accounting texts.
Truck (cost of No. 2) (+A) |
57000 |
|
Accumulated Depreciation - Trucks (+A) |
38,000 |
|
Trucks (cost of No. 1) (-A) |
45,000 |
|
Cash (-A) |
50,000 |
|
To record the exchange of non-monetary assets with no commercial substance (no loss recorded). |
Accounting for any gain resulting from exchanges of nonmonetary assets having no commercial substance is similar to the case where a loss is present but unrecorded. To illustrate, assume that in the preceding example, the delivery service gave truck No. 1 (now with a fair market value of USD 9,000) and USD 46,000 cash in exchange for truck No. 2. The gain on the exchange is USD 2,000, but would be unrecorded.
Book value of old truck (No. 1) |
$ 7,000 |
1 |
Cash paid |
46,000 |
|
Cost of new truck (No. 2) |
$ 53,000 |
|
Fair market value of new truck |
$ 55,000 |
1 |
(No. 2) |
2,000 |
(equal) |
Less: Gain indicated |
||
Cost of new truck (No. 2) |
$ 53,000 |
1 |
The company would record the new asset at the book value of the old asset (USD 7,000) plus cash paid (USD 46,000). The company deducts the gain from the cost of the new asset (USD 55,000). Thus, the cost basis of the new delivery truck is equal to USD 55,000 less than the USD 2,000 gain, or USD 53,000. The delivery service uses this USD 53,000 cost basis in recording depreciation on the truck and determining any gain or loss on its disposal.
The journal entry to record the exchange is:
Cost of trunk No. 1 |
$ 45,000 |
Accumulated depreciation |
38,000 |
Book value |
$ 7,000 |
Fair market value of old asset (trade-in allowance) |
5,000 |
Loss indicated (but not recorded) |
$ 2,000 |
Firms would realize the gain on an exchange of nonmonetary assets not having commercial substance in future accounting periods as increased net income resulting from smaller depreciation charges on the newly acquired asset. In the preceding example, annual depreciation expense is less if it is based on the truck's USD 53,000 cost basis than if it is based on the truck's USD 55,000 cash price. Thus, future net income per year will be larger.
Trucks (cost of No. 2) (+A) |
53,000 |
|
Accumulated Depreciation - Trucks (+A) |
38,000 |
|
Trucks (cost of No. 1) (-A) |
45,000 |
|
Cash (-A) |
46,000 |
|
To record exchange of nonmonetary assets with no commercial substance (no gain recorded). |
In Exhibit 17, we summarize the rules for recording nonmonetary asset exchanges.
An accounting perspective:
Uses of technology
Although sophisticated computer systems automatically compute the gain or loss on the disposal of assets, such programs depend on human input. If an error was made in inputting the type of disposal or exchange, or if the life of the asset was estimated inaccurately, the calculated gain or loss would be incorrect.
Exchanges Having Commercial Substance |
Exchanges NOT Having Commercial Substance |
|
Recognize Gains? |
Yes |
No |
Recognize Losses? |
Yes |
No |
Record New Asset At: |
Fair market value of asset received (new asset) or fair market value of asset given up (old asset), whichever is more clearly evident |
Book value of old asset plus cash paid |
Exhibit 17: Summary of rules for recording exchanges of plant assets
Companies incur removal costs when dismantling and removing old plant assets. They deduct these costs from salvage proceeds to determine the asset's net salvage value. (The removal costs could be greater than the salvage proceeds). Accountants associate removal costs with the old asset, not the new asset acquired as a replacement.
The next section discusses natural resources. Note the underlying accounting principle of matching the expenses with the revenues earned in that same accounting period.