 Hello and welcome to this session. This is Professor Farhad and this session will look at an exchange of plant assets. This topic is covered in introductory financial accounting course and intermediate accounting. So if you don't find out that this recording satisfies your need for this topic, please go to my intermediate accounting where I have this topic covered a little bit more in depth. Obviously this is covered on the CPA exam. As always I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1600 plus accounting, auditing, finance and tax lectures. This is a list of all the courses that I cover, including many CPA questions. If you like my lectures, please like them, share them, put them in playlists. If they benefit you, it means they might benefit other people. Subscribe to the channel and connect with me on Instagram. On my website you will find additional resources to complement your accounting education and help you prepare for the CPA exam. If you are looking for those extra seven to ten points to pass the exam, please visit my website. Exchange of plant asset is part of the life of a plant asset. Remember when we buy a plant asset, the first thing we have to worry about is the cost to record the asset at cost. Then we depreciate the asset, allocate the cost to period benefit. Then we account for subsequent expenditure. Then we dispose of the asset. Under disposal of the asset, we can sell it, which we already talked about selling the asset. And when we sell it, either we have a gain or a loss. And now we are going to exchange the asset. And under exchange, we might have a gain or we might have a let's talk about exchanging plant asset. Many plant assets such as machinery, automobiles, office equipment are exchanged for newer assets. So what happens is when you have an old car, an old truck, what you do rather than selling it, you go to the car dealer and you give up the old asset and it'll give you a new asset. It's an exchange. Sometimes, not sometimes, you might have to pay money for the difference, but this is how it works. In exchange, a trade in allowance is received on the old balance and the old asset and the balance in cash is paid. So you give them the old asset, then you might have to pay the difference in cash. This is an important concept I want you to understand. Let's assume you went to a dealership and you are buying a truck and you find out that the truck is $50,000. So you're buying a truck for your business and the truck is $50,000. Here's what's going to happen. If the truck is $50,000, the dealer will not give you this truck unless they receive in value $50,000. So what you need to do, you need to come up with $50,000. If you gave them an old asset, an old truck, since we're talking about the truck, if you gave them an old truck worth $10,000, it means you have to come up with cash of $40,000. Why? Because if the old truck is worth $10,000 and the cash is $40,000, that's going to equalize the deal. So always remember the exchange has to equal. Remember this important economic concept. I know this is implied in any transaction, but it's very important to remember it here for accounting purposes. If you're receiving something for $50,000, you are expected to give up $50,000. So the exchange has to be equal. That's important and you will see what I mean in a moment when we work actual examples. So you have to give the old asset plus you have to pay cash. Accounting for the exchange of an asset depends on whether the transaction has commercial substance or lack commercial substance. So what is commercial substance? Commercial substance implies that the company's future cash flow will be altered. What does that mean? Well, it means if you get this new truck, remember we're exchanging an old truck with a new truck. This new truck, it's going to somehow change your cash flow, alter your cash flow, bring more cash. It's not, you're not going to be in the same position as having the old truck. The new truck will have a change to your cash flow. This is what we mean by has commercial substance. Now for educational purposes, the problem will tell you whether the exchange is commercial substance or lack of commercial substance. As far as we are concerned, we're going to be working with examples that has commercial substance. In intermediate accounting, you have to know the rules, whether it has commercial substance or no commercial substance. So commercial substance, the definition is it changes your future cash flow. So this new asset will bring you more cash flow or it's going to give you cash flow longer than the old asset. So it's going to serve you differently and in terms of differently, obviously better than the other one. So the best way to illustrate this whole concept is to work an example. So let's take a look at this example. So we're going to be working with an exchange and they're telling us right here at Salas with commercial substance. So it's going to be a commercial substance example. A company acquired a $42,000 in new equipment. So simply put, you went to the manufacturers and you purchased 42,000 worth of equipment. Do you know what you're getting? You're paying 42,000. So here's how you paid for this. Now if you have cash, you pay cash and you'll get the 42,000. That's not how it works now. In exchange, the company pays $33,000 in cash. So of this amount, you paid 33,000 and you trade an old equipment. Now immediately your old equipment must have been worth $9,000. So what we call this the fair market value of your equipment. Why? Because if you are giving them cash, if you are giving the manufacturer cash, okay, if you're giving them cash and the old asset together, they should add up to 42,000. Although they did not tell me up to this point that how much is the old equipment worth? I'm going to tell you it's worth 9,000 because the two exchange has to be equal. The old equipment has a cost of 36,000 and accumulated depreciation of 20,000. So simply put, the book value is 16 which is 36 minus 20. So you have a book value of 16. Here's what you have to do. Once you know your book value, you have to know your book value of the exchange. What is the book value? The book value, if you don't know what it is, it's the cost of the asset minus accumulated depreciation here. It's 36 minus 20. The book value is 16. Now what you have to do, you have to compare your book value. Your book value is 16. You have to compare your book value to your fair market value. You have a book value of 16 and they're giving you only 9,000 for that book value. Look, you're giving up something that's worth 16 and they're giving you only 9 value for it. It means you are at a loss of 7,000. You are at a loss of 7,000. There you go. We determined the loss. So this transaction has a loss. Now here's what you have to know. Because it has a loss and it has commercial substance, you are going to recognize the loss. Simply put, you are going to record the loss. So now we already have a loss and this exchange has commercial substance. The old equipment had a trade-in allowance of 9. I already know this. So here's what we do first. The first thing we do is we compute the loss. We already did it. We already did it so. You're getting something for 42,000. The fair market value of asset received. You are given up 33 in cash and 9 in fair market value. Simply put, what happened is you gave up, in a sense, you gave up 49,000 worth of things, 49,000 and you received 42. But you don't have to worry about this. All you have to worry about because the 33,000, when you give up 33,000, it's equal to 33,000. All you have to know is I give up something that's worth 16 and I received 9,000 for it. It means I am at a loss of 7. So all you have to do is look at the book value of the old asset and compare the book value of old to fair market value, to the fair market value. How much should they give you for that? They gave you for that. They gave you for that $7,000 less. If that's the case, you are at a loss. So you don't have to really compute the cash and the equipment and compare it to the total fair market value of the asset received. Just look at the old equipment and compare to it's what they gave you. They gave you less. You have a loss. So what journal entry do you make? Well, you have to get rid of the old equipment. You have to credit the old equipment and you have to debit accumulated depreciation. This is to get rid of the old equipment because you exchange the old equipment. Remember, the old equipment is an asset. So from a tea account perspective, I want you to always remember how the tea account works. So you have the equipment old. You have in there 36,000 and you have accumulated depreciation old and you have 20,000. So the first thing you have to do since you are exchanging, you have to credit the equipment and debit accumulated depreciation. Therefore, your equipment goes down to zero and your accumulated depreciation go down to zero. So you get rid of the old equipment, get rid of its accumulated depreciation. You paid $33,000 in cash, record the cash. That's easy. Now, we recorded 7,000 in a loss. Again, we computed the loss on the previous slide. The loss is a debit as we saw when we sell an asset. You record the loss of 7,000. Now, how much do you record the new asset? You record the new asset based on the fair value of what you gave up. Well, what did you give up? You gave up two things. You gave up $33,000 in cash. Let me put this in red. You gave up $33,000 in cash and an asset that's worth $9,000. That's what you gave up. So you gave up $42,000. Your new asset is recorded at $42,000. Your new asset is recorded at $42,000. So this is booking an exchange with commercial substance at a loss. Now, let's change the scenario. Let's change the scenario exactly the same thing, exactly the same company, except we paid $23,000 in cash. So forget about this here. Okay. Now, here's the same concept. We went to the store. We saw something for $42,000. Here's what we did. We paid $23,000 in cash plus old asset. Well, the old asset must have been worth $19,000 because the store, the manufacturer, those two together equal to $42,000. The dealer will not let you walk away with the asset unless you pay them $42,000. You only paid $23,000 in cash. Well, the old asset, this old asset must have now been worth $19,000. Let's stop right here. You have an asset with a book value of $16,000. They gave you $19,000 for it, fair market value $19,000. So the book value is less than the fair value. You are at a gain of $3,000. You have a gain of $3,000. You have a gain of $3,000. That's what happened. You have a gain of $3,000. Notice here you have a gain. It has a commercial substance. Now the scenario is you have a gain, not a loss. Now let's look at the journal entry. Let's look at the journal entry to see how we will book this gain. Why did we have a gain once again? Because they gave us $19,000 for an asset that's worth only $16,000 on our books. Again, we need to get rid of the old asset. We need to get rid of its accumulated depreciation. Just like in the previous thing, we have to get rid of the old asset first. We paid cash $23,000. We paid cash. Then we booked the gain. The gain has a credit of $3,000. Then we have to debit the new equipment for $42,000. Simply put, this equipment is $23,000 cash plus $19,000 of the old asset together. We paid $42,000. Now the only thing you have to know is if this transaction, which you may or may not have to know this, but if this transaction lacks commercial substance, if this transaction lacks commercial substance, it doesn't have commercial substance. What would be different? Well, for the loss, we don't have to do anything. For the loss, it does not make a difference. If this transaction lacks commercial substance, all what you have to do, you cannot book the gain. So you have to take the gain out. If you take the gain out, then you have to take $3,000 from the equipment. So the equipment will be recorded at $39,000. When you take the gain out and you reduce the equipment, we call this process deferring the gain. We call this process deferring the gain. Once again, as a financial accounting student, you don't have to worry about this process. But if you're intermediate accounting, I do have the recording. You can go to my intermediate accounting course to learn about this topic that gives students a lot of issues, because it's a little bit more involved than what we just covered. But anyhow, as always, I would like to remind you, if you like this recording, please like it, share it, put it in the playlist, subscribe, subscribe, and visit my website. If you're looking to supplement your accounting education, study hard and please stay safe during those coronavirus outbreak. Good luck.