Problem 28 - Accounting

Question

On October 1, Hot Springs Co., a water distiller, acquired new bottling equipment with a list price (fair market value) of \(462,000. Hot Springs received a trade-in allowance of \)96,000 on the old equipment of a similar type and paid cash of \(366,000. The following information about the old equipment is obtained from the account in the equipment ledger: cost, \)336,000; accumulated depreciation on December 31, the end of the preceding fiscal year, \(220,000; annual depreciation, \)20,000. Assuming the exchange has commercial substance, journalize the entries to record (a) the current depreciation of the old equipment to the date of trade-in and (b) the exchange transaction on October 1.

Step-by-Step Solution

Answer

Depreciation is \(15,000\); record a \(5,000\) loss on exchange and new equipment with a fair value of \(462,000\) against cash and old equipment.

Step 1: Determine Current Depreciation for Old Equipment

As the old equipment is traded in on October 1, we need to calculate the depreciation for the part of the year until that date. With annual depreciation of \(20,000\), the depreciation for 9 months (from January 1 to September 30) is calculated as: \( \frac{20,000}{12} \times 9 = 15,000 \).

Step 2: Calculate the Net Book Value of Old Equipment

Find the net book value by subtracting the accumulated depreciation up to October 1 (\( 220,000 + 15,000 \)) from the original cost of the equipment \( 336,000 \). This gives us a net book value of \( 336,000 - 235,000 = 101,000 \).

Step 3: Determine Gain or Loss on Trade-in

The trade-in value of the old equipment is \( 96,000 \), and the net book value is \( 101,000 \). Since the trade-in value is less than the net book value, there is a loss. The loss on trade-in is calculated as \( 101,000 - 96,000 = 5,000 \).

Step 4: Record Journal Entry for Depreciation

Journalize the depreciation of old equipment: Debit Depreciation Expense \(15,000\) and Credit Accumulated Depreciation \(15,000\).

Step 5: Record Exchange of Equipment

Journalize the full transaction on October 1: Debit Equipment (new) \(462,000\), Debit Accumulated Depreciation \(235,000\), Debit Loss on Disposal of Equipment \(5,000\), Credit Equipment (old) \(336,000\), and Credit Cash \(366,000\).

Key Concepts

Depreciation

Depreciation is an accounting method used to spread out the cost of a tangible asset over its useful life. Every year, a portion of the asset's cost is "expensed" on the company's income statement, reflecting a loss in value. This way, companies can match the cost of an asset to the revenues it generates. For example, if a piece of equipment costs $120,000 and is expected to last 10 years, the company might expense $12,000 each year as depreciation.
The purpose of depreciation is to allocate the expense of the asset over its productive life. It's a non-cash charge, meaning no money physically leaves the company. Instead, it's a method to reflect the wearing down or obsolescence of the asset over time. In calculating partial year depreciation, such as in the exercise above, we prorate the annual depreciation amount based on the period of use within the fiscal year. This step ensures the company's financial records accurately reflect asset usage.

Trade-in Allowance

A trade-in allowance is a discount offered on new equipment or assets when a company trades in an old asset. It's an incentive to encourage buyers to upgrade their old equipment with newer models.
In accounting, this trade-in allowance acts like a form of payment towards the new asset. For the example in the exercise, Hot Springs Co. received a $96,000 trade-in allowance against the purchase of their new bottling equipment. The trade-in allowance reduces the actual cash amount that the company needs to pay for the new asset. This recognized value is used to offset the cost of acquiring new equipment, reducing the cash outflow from the company. Understanding the concept of trade-in allowance helps in bookkeeping, as it affects the valuation entries made in accounting journals.

Net Book Value

The net book value (NBV) of an asset is its original cost minus accumulated depreciation. It's the asset's value on the company's books at any given point in time. To calculate it, subtract the total depreciation to date from the asset's initial cost.
For instance, if equipment was bought for $336,000 and had accumulated $235,000 in depreciation, its net book value would be $101,000. This figure represents the company's investment in the asset that hasn't yet been expensed. NBV is important in evaluating whether a company might gain or lose money when selling or trading in an asset. A higher NBV than the trade-in value indicates potential losses, as seen in the exercise example.
NBV provides insight into the actual worth of an asset compared to its purchase price, aiding stakeholders in making informed financial decisions about whether to retain, sell, or replace assets.

Commercial Substance

Commercial substance in accounting signifies that a transaction is expected to impact cash flow significantly. If a transaction results in significant changes in risk, timing, or manner of cash flows, it has commercial substance.
For the transaction in the exercise, since it impacts the asset usage significantly, it is considered to have commercial substance. This means that the journal entries reflect not only the change in assets but also any gain or loss arising from the transaction.
The presence of commercial substance mandates fully recognizing any resulting gain or loss in income statements. It distinguishes from transactions with no substantial change, where gains might not be fully recognized immediately. Understanding and recognizing when commercial substance is present in transactions help ensure accurate accounting and financial statements.