Question

Durler Company purchased equipment on January 2, 2013, for $112,000.Theequipmenthadanestimatedusefullifeof5yearswithanestimatedsalvagevalueof$12,000. Durler uses straight-line depreciation on all assets. On January 2, 2017, Durler exchanged this equipment plus $12,000incashfornewerequipment.Theoldequipmenthasafairvalueof$50,000.

Accounting

Prepare the journal entry to record the exchange on the books of Durler Company. Assume that the exchange has commercial substance.

Analysis

How will this exchange affect comparisons of the return on asset ratio for Durler in the year of the exchange compared to prior years?

Principles

How does the concept of commercial substance affect the accounting and analysis of this exchange?

Short answer

1. Gain on disposal equipment is $18,000
2. Durler’s ROA will appear higher than in prior years.
3. No gain is reported, and the nonrecurring time gain will not affect analysts’ comparisons of a company’s ROA.

Step-by-step solution

Meaning of Straight-line depreciation.

Straight-line depreciation is the simplest way to calculate depreciation expense. There is uniform depreciation from year to year and it recognizes less depreciationat the beginning compared to other depreciation methods.

(a) Explaining the Accounting

Date	Particulars	Debit ($)	Credit ($)
	Equipment	$62,000
	Accumulated Depreciation-Equipment	80,000
	Equipment		112,000
	Cash		12,000
	Gain on Disposal of Equipment		$18,000

Working notes:

Calculation of gain on disposal of equipment

The fair value of the old asset	$50,000
Less: Cost of old asset $112,000
Less: Accumulated depreciation 80,000	(32,000)
Gain on disposal of equipment	$18,000

Calculation of cost of new equipment

Cash paid	$ 12,000
The fair value of old equipment	50,000
Cost of new equipment	$ 62,000

(b) Explaining the Analysis

The profit on the sale boosts revenue, resulting in a one-time boost in return on assets in the exchange year. The gain represents how much previous years' depreciation was exaggerated by the sold item’s fair value drop. As a result, Durler's ROA in the exchange year will be greater than previous years. Some analysts may subtract these nonrecurring gains from income when doing ROA analysis.

(c) Explaining the Principles

In accounting for trades, the idea of commercial content is essential. The gain on the exchange would be delayed if the previous transaction lacked commercial substance. Durler is in the same economic position after the sale concerning traded assets if the predicted cash flows flowing from the assets exchanged are not materially different. As a result, no gain is recorded, and analysts' comparisons of a company's ROA between years with and without exchanges will be unaffected by the nonrecurring time gain.