 Hello and welcome to this session in which we would look at exchange of non-monetary assets, which is part of asset valuation. Simply put, when we do an exchange, when we exchange one asset into the other, at what price? At what price do we record the new asset? This is what exchange of non-monetary asset. The same concept apply from the prior session where we looked at acquiring of property, plant and equipment via cash transaction, issuing of that lump sum purchase or issuing of stocks. The principle is the same. Property, plant and equipment are recorded at the fair value of what's given up or the fair value of the asset received and we talked about this. Exchange of non-monetary asset is little bit more involved because we might have commercial substance or lack of. We have to compute gains and losses and we have to know what do we have to do with gains and losses and sometimes cash might be involved, either received or paid. Because of these reasons, this topic is a little bit challenging for most students. This topic is covered in advanced and intermediate accounting as well as the CPA exam. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website farhatlectures.com. I don't replace your CPA review course. I'm a useful addition to your CPA review course. I explain the material slower. I give you the theory behind the concept. I go a little bit more in depth than your typical CPA review course, which will help you to prepare for your CPA review course. Your risk is one month of subscription. Give it a try. See if it works. If it works, go ahead and keep it. If it doesn't, that's your risk. Your potential gain is adding 10 to 15 points to your CPA exam score. If not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. This is a list of all my courses that I have offered lectures, multiple choice practice. Take a look at them. My CPA supplemental material are aligned with your backer, Roger, Gleam and Wiley. So it's very easy to go back and forth between my courses, my material and your CPA review course. I also give you access to 1500 plus AI CPA previously released questions with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with other connect with me on Instagram, Facebook, Twitter and Reddit. Let's start by discussing the difference between an exchange with commercial substance versus an exchange that lack commercial substance. First, we have to understand we are exchanging one asset into another asset. So one asset going out and another asset coming in. This is what non-monetary exchange means, no money involved. Could be a little bit of money, but the point is it's no money involved. An exchange is considered to have a commercial substance. If the future cash flow as a result of this exchange changes, in what sense? The amount of cash flow changes. Obviously, we want to get more cash as a result. In other words, this exchange improve our cash position. It's going to generate more cash for us in terms of revenue generating. We're going to be generating more cash. The timing we made generating this cash earlier. There is less risk having this asset in generating cash. So this exchange, this new asset is from a business perspective, it's going to give us more cash sooner and the risk is lower versus an exchange where as a result of this exchange, your cash flow does not change. What does that mean? If your cash flow does not change, it means this exchange lack commercial substance. There's no business sense. Why will you exchange one delivery truck into another delivery truck? If the effect on your cash flow timing, risk and a bound does not change. It means there's no business sense. So this is what we mean by it has commercial substance versus lacks of commercial substance. Has commercial substance means it makes business sense. You are doing it for business purposes. Exchange commercial substance. You are just doing this exchange to shuffle papers, to either book a gain or a loss. So let's start with commercial substance. If the transaction has commercial substance, it means it makes sense. It's for business purpose. You record any gain and any loss. So the first thing you do in an exchange is determine whether you have a gain or a loss because think about it. When you give up an asset, well, when you give it up, it's as if you are selling it, getting the cash and using this cash to buy something else. Well, you have to record it again or a loss. If the problem says it has commercial substance, it's easy. You don't have to think about it. You book the gain, you book the loss. This is what I mean by easy. Now how to compute the gain or the loss? You might have forgot how to compute the gain or the loss. You compare the fair value of the asset given up versus the book value. If the asset given up has a higher value than the book value you have a gain. So if you are given up an asset with $10, it has a book value of eight. Well, think about it, you have a gain of $2 because if you sell it, you would sell it for 10. The book value is two, you have a gain of two. You would sell it for 10. The book value of eight, you have a gain of two. If on the other side, you have an asset with a fair value of 10, but it has a book value of 15, well, you have a loss of $5 because if you sell it, you can only get $10 for something that's worth 15. Now how to compute the book value? Maybe you also forgot how to compute the book value because in the problem, sometimes the book value is giving. Sometimes it's not giving. Sometimes what they give you is the cost minus accumulated depreciation. Well, this is how you come up with the book value, cost minus accumulated depreciation. Usually the fair value is giving. What's the fair value is how much you will get for this asset if you sold it to someone else to a third party. So how to compute a gain or a loss? That's the first thing you do in a non-monetary exchange and these are the rules for the gains and the losses and hopefully they make sense, but you have to know them inside out how to compute the book value if not giving and how to compute the gain or a loss. So commercial substance is pretty straightforward. There's nothing to it because any gain, any losses is recorded. Well, what about lack of commercial substance? Well, if you have an exchange and it lacks commercial substance and you have a loss, also that's easy. You would always record the loss and this is true for financial accounting and reporting. Financial accounting and reporting because we are conservative. If you have a loss, you would always record the loss. Now this is going to be different when you are studying in your tax course or you are studying for reg on the CPA exam on the contrary for tax purposes. Businesses like losses because they reduce their taxes, but here we are dealing with a financial accounting course which is intermediate accounting. So losses are always recognized whether you have a commercial substance, no commercial substance. You have a loss, you record the loss. It's that easy. When it comes to gains, now we have a gain and the gain lack commercial substance. Well, what do we have to do? If no cash is involved, simply put, the problem says you did not receive any cash, you did not pay any cash, no cash is involved, no worries. We're going to defer the gain. What does that mean? It means we don't record the gain. What do we do with the gain? We defer the gain. What is deferring the gain? Don't worry, we'll talk about that in an example. We're going to defer the gain. What happened if you gave up cash? If you gave cash in the exchange, same thing. You defer the gain. No, don't record the gain. Same thing. So those two are the same. Whether no cash is involved or you are giving the cash, no gain. What happened if cash is received? Now you have an exchange and you received cash. Here's what's going to happen. Portion or all the gain is recorded. Now you compute the gain, a portion of it could be recorded or the whole gain might be recorded. Now how do we determine whether it's a portion of the gain or the whole gain is recorded? Simply put, we're going to use this formula. We're going to take the cash received because again, we received cash. We're going to take the cash received, which is called the boot. We're going to divide it by the cash received plus the fair value of the asset received, plus the fair value of the asset received. And this is going to give us some sort of a ratio. For example, if we have 10 up here and 50 here, well, we have to find out in the denominator 10 divided by 50, which is 1 fifth is 20%. Well, if it's 10 up here and 100 down here, then it's 100 in the denominator. Let me just differentiate the denominator. This is the numerator, the cash received or boot received, and the denominator is the rest. Well, we have to compute this ratio. And if this ratio is less than 25%, what we do is we will take the gain and multiply it by 25%. And this will be the gain that's recognized. If this ratio, let me put this ratio and use a different color, if this ratio here is greater than 25%, simply put, we received 25% of the transaction is cash, well, it becomes easy. It's treated like it has a commercial substance, then you would recognize the full gain. If it's less than 25%, you will compute the gain and multiply by the ratio. Well, the only way to understand this and see this is to actually work an example. So let's start with easy example, then we'll get to the most challenging starting with this example. Adam Company traded its old equipment for a newer equipment. The old equipment has a book value of 100,000. Notice the book value is giving cost of a half a million less accumulated depreciation. It has a fair value of 90,000. Adam also paid $420,000 in cash as a part of this exchange. The exchange has commercial substance. So good. So once the exchange has commercial substance, you are told the exchange has commercial substance. Sometimes they will tell you the exchange will change the timing amount or risk of your cash flow. It's the same thing. What does that mean? It means I'm going to compute the gain or the loss, and whether I have a gain or a loss, I'm going to record them. Let's start to do this. The fair value of the asset is 90,000. The fair value of the asset is 90,000. The book value is 100,000. Well, as a result, I have a loss of 10,000. Guess what? I am going to record the loss. So start by debiting the loss. Loss on the exchange, $10,000. The next thing you should do, next thing you should do, since you are getting root of the asset because you are exchanging the old asset, just remove the old asset and remove the old accumulated depreciation. So credit the asset for half a million debit. It's accumulated depreciation. Well, what would I do next? Easy. I paid $420,000 in cash. I'm going to credit my cash $420,000. At this point, all what you are left with is recording the new asset. The new asset is basically, if you don't know what you're doing, the new asset is a plugin. The new asset is a plugin. Therefore, you can plug it in or you want to go back and remember the new asset, how much you would record an asset, it's how much you gave up. What did you really give up? You gave up fair value of an asset of 90,000 and you gave up fair value of 420. So 420 plus 90 is 510,000, 510. Therefore, your new asset will be recorded at 510,000. It will be recorded at 510,000. So that's the deal, 510,000. So this transaction, we had a loss and the loss has commercial substance and the loss has commercial substance. Let's change this example and assume the transaction lacks commercial substance. Looking at the same scenario, if it lacks commercial substance, nothing will change. We would still record the loss, remove the old equipment. The amount of cash paid is the same and the asset is recorded for the same amount, 510. Simply put, whether the transaction has commercial substance or lack commercial substance, it's the same transaction. It's the same transaction. Let's take a look at another example. Adam Company traded its old equipment for a newer equipment. The old equipment has a book value of 100,000, cost minus accumulated depreciation 500,000, cost 400,000, accumulated depreciation. The fair value is 100,000. Adam paid 420 in cash as part of the exchange. The exchange has commercial substance. Well, once I know it has a commercial substance, it's easy. Why? Because any gain, any losses are recorded. Let's start to find out whether we have a gain or a loss. The fair value of the asset is 120. The book value is 100. I have a gain of 20. I will book the gain of 20,000. The next thing I do is start with the easy part. Again, remove the old asset, remove its accumulated depreciation, credit the old asset, debit accumulated depreciation. Also, what's easiest to record the cash, credit the cash, 420. Now, what you have to do is book the new asset. The new asset is based on what you gave up, fair value of 120 plus 420. So I gave up a fair value of 120 plus 420. I gave up 540,000. Well, the new asset is recorded at 540,000. At this point, if you are up to this point, all what it is, it's a plug. You need the entry to balance. So a plug of 540 will make a balance, and that's the entry. Now, let's take a look at the same example, and now we're going to say it's the same example, the transaction lacks commercial substance. What does that mean? It means we have a gain of 20,000, but this gain has to be cannot be recorded. We have to defer it. Now, we're going to explain what is deferring is. Well, since we cannot record the gain, let's get rid of the old asset and get rid of its old accumulated depreciation, credit the old equipment, half a million debit accumulated depreciation. This does not change. Also easy, let's record the cash, $420,000 in cash. Now, how much do we record the new asset at? Well, remember, we record the new asset that we gave up. That's the rule. We gave up $120,000, fair value of an asset of $120,000. We paid cash $420,000. That's 540,000. However, what's going to happen is we're going to reduce the new asset by the gain minus $120,000. And here, we can explain what's going to happen with the deferred. So the new asset will be recorded at $520,000. So what is the meaning? What is the value of this minus $20,000? So what do we mean by deferring the asset? What we did is this. We lowered the basis of the asset. In other words, if we did not deferred the gain, the asset would have a basis of $540,000, which is a higher basis. Now, by reducing the basis by $20,000, what we did is we reduced the basis for the future. So when we sell this asset for the future, our basis are $20,000 lower. If our basis are $20,000 lower, it means our gain in the future will be $20,000 higher. So what we did with this $20,000, we deferred it. How did we deferred it? We hide it in the new equipment. We lower the newer equipment cost. And by lowering the newer equipment cost, what we did is we lower the basis. By lowering the basis, when we sell it in the future, we're going to have $20,000 more in gain. And this is how we deferred the gain. Again, make sure total debits equal total credits. And this is what we mean by deferring the gain. We deferred the gain by simply reducing the new asset. If we go back to the prior one, when it has commercial substance, all what we did is basically the difference is we took $20,000 out of the gain. And to make it balance, we reduced the debit by $20,000. That's all what we did. And by doing so, we deferred the gain. We pushed the gain into the future when we exchange or sell this asset down the road, this new asset. Now let's take a look at this example. Adam traded a used machinery with a book value of $80,000. It has a cost of $150,000 minus accumulated depreciation of $70,000 and a fair value of $100,000. Adam receives in exchange a machine with a fair value of $90,000 plus cash of $10,000. Now, this is where we have to be careful because now we received cash. First, the first thing you do is you always find out whether you have a gain or a loss. Well, the book value of the fair value of the machine given up as $100,000, the book value is $80,000. We have a total gain of $20,000. Well, we have a gain of $20,000. We have to be careful. We have a gain of $20,000 and we received cash. And we received cash. Well, remember, when we have a gain and we receive cash, some of the gain or the full gain might be recognized. How do we find this out? Well, we use this proportion. Boot received divided by boot received plus the fair value of the asset given up, which is the $90,000. I'm sorry, asset received, not given up in exchange for asset received. So this is the $90,000 asset received. This ratio, if we take $10,000 divided by $100,000, the ratio is 10%. 10% times the gain of $20,000 equal to $2,000. So this is the $2,000 that we are going to record. Okay, we're going to record $2,000. So we have $20,000 in total. We're going to record $2,000. And guess what's going to happen? The $18,000 remaining will be deferred. So this is recorded or recognized. So we're going to record this $2,000 and defer $18,000. That's what we're going to do. Let's start with the journal entry. Start with the easy part. Get rid of the old asset and get rid of its accumulated depreciation. Credit the old machinery 150, debit accumulated depreciation 70. Also, I know I can recognize $2,000 of gain. I'm going to recognize this $2,000 of gain. Credit the gain $2,000. What else is easy? I received cash $10,000. I'm going to debit cash $10,000. At this point, at this point, your new asset is a plug, but you don't want to treat it as a plug just in case you made a mistake. You want to confirm that it is correct. What did you give up? Well, you remember, you record the asset based on the amount that you gave up. Well, you gave up a machinery with a fair value of 100,000, right? A machinery with a fair value of 100,000. Let's see. Traded a machinery with a fair value of 100,000. They gave you 10. They gave you, for the 100,000, they gave you 10. So simply put, you gave up a net. What you gave up is 90,000 because they gave you $10,000 in cash. Now, remember, this is what you gave up. In net, you gave up 90,000, right? Because you gave up 100,000. They gave you back 10,000. So net, you gave up 90,000. Remember, we have to lower our basis now by the third gain. So I'm going to change color here to lower the basis. I'm going to lower the basis by 18,000. When I lower the basis, my new asset will be recorded at 72,000 because I need to defer the gain. So the new machinery will be recorded at 72,000. Make sure always credit 152, 70 plus 72 is 142 plus 10 is 152. 152 debits equal to 152 credits. So keep the machinery for last. Make sure it makes sense and it's a plug at the end because the others, once you fill in everything, you will be fine. Now, the best way to understand this better and get better at it is to work multiple choice and examples and view additional lectures. 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