Question

(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

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

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.

(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

(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

(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.

(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

(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.

(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.