Exchange of Fixed Assets
When a company exchanges a fixed asset with another and the transaction has commercial substance, it records the asset acquired at its fair value or the fair value of assets given up, whichever is readily available.
In most cases, fixed assets are acquired through exchange of monetary assets, such as cash. However, there are instances where two companies engage in barter transactions of fixed assets. In accounting for such exchanges of non-monetary assets, we need to find out if the transaction has commercial substance. In plain English, it means whether the exchange would change the cash flows of the business to a significant extent. If the cash flow pattern changes, the transaction is said to have commercial substance and if doesn’t, it has no commercial substance.
When commercial substance exists, the asset acquired must be recognized at fair value and if it doesn’t, the asset must be recognized at the book value of the asset given up. Materiality is an important consideration in determining whether commercial substance exists.
Where no commercial substance exists, the asset swap has effectively no accounting implications because there is no (or insignificant change) However, where an asset transfer results in a loss, the loss is recognized. If transfer of cash is involved, a gain may be recognized by the party which receives cash only to the extent of cash transfer as illustrated below.
Example 1: Exchange involving Commercial Substance
Gomal Ltd. and Tochi Ltd. are companies engaged in construction of large infrastructure. Their project life cycle is such that Gomal needs 200 dumper trucks in initial two years of its project and Tochi needs 100 concrete mixers. At the end of second year, Gomal exchanges 200 dumper trucks for 100 concrete mixers. The total fair value of dumper trucks is $20 million, and the fair value of concrete mixers is $22 million but the fair value of dumper trucks is more reliable because an active market exists for them. If the dumper truck’s fleet costed $30 million and the concrete mixers costed $35 million and useful life of each item is 10 years, find out how both companies should account for the transaction.
Because the fair value of dumper trucks is determined with greater accuracy, Gomal would record the transaction by (a) debiting Concrete Mixers account by $20 million, (b) debiting the accumulated depreciation by the amount of depreciation already charged on dumper trucks i.e. $6 million ($30 million divided by 10 multiplied by 2), (c) crediting the Dumper Trucks account at their cost i.e. $30 million and (d) recording the difference as gain or loss.
|Concrete Mixers||20 million|
|Accumulated Depreciation – Dumper Trucks||6 million|
|Loss on exchange of machinery||4 million|
|Cost – Dumper Trucks||30 million|
Sometimes exchange of cash takes place between the parties exchanging assets because there is a difference between the market value of the assets being exchanged.
Example 2: Exchange involving no Commercial Substance
Company T and Company W are two telecommunication operators. They agree that Company T will transfer one of its telecom tower installed at Palo to Company W in exchange of W’s tower installed at Alto. Company T will pay Company W an amount of $10,000. The cost, accumulated depreciation and fair value of Company T’s tower is $400,000, $180,000 and $240,000 and the corresponding values for Company W’s tower are $380,000, $160,000 and $250,000.
Company T must recognize the transaction using the following journal entry:
|Telecom tower - Alto||230,000|
|Accumulated depreciation – Palo||180,000|
|Cost – Palo||400,000|
Since the fair value of the Company W’s tower is higher than its book value by $30,000 (i.e. fair value of $250,000 minus book value of tower of $220,000 (=$380,000 - $160,000)), Company W can recognize only such gain on exchange which is realized in cash i.e. $1,2000 (=$10,000/$250,000 × $30,000).
|Telecom tower - Palo||211,200|
|Accumulated depreciation - Alto||160,000|
|Cost - Alto||380,000|
|Gain on exchange||1,200|