Acquisition of assets and creation or assumption of liabilities

A firm can acquire operating assets by giving the seller a promise to pay cash in the future and thus creating a liability. The cost of an asset acquired in this manner is equal to the present value of the future cash payments computed with an interest rate realistic for the circumstances.

For example, if the buyer gives a note with a realistic present value of $12,000, this journal entry would be recorded:

Journal entry

If a reliable fair value of the asset is known, that amount can be used for both the asset and the liability.

Assumed liabilities

The buyer may assume some of the seller’s liabilities by agreeing to pay them when they are due. Typical assumed liabilities include those associated with mortgage notes payable and unpaid property taxes. These liabilities are treated the same way as newly created liabilities if there is a material effect from discounting the future flows at a rate realistic for the circumstances existing at the date of the transaction.

For example, suppose that a buyer acquires a building by paying $100,000 cash and assuming an unpaid property tax liability of $7,500 and a mortgage note calling for five annual payments of $25,000 each. The nominal rate on the mortgage is 8 percent, such that its nominal present value at the purchase date is (PA 8% X $25,000), or $99,818. However, because the realistic rate at the purchase date is 12 percent, the realistic present value of the five payments is (PA 12%X $25,000), or $90,120. The following entry is appropriate:

Journal entry 2

Subsequent entries to record the payment of the taxes (if the effect of discounting is not material) and the first mortgage payment would be:

Journal entry 3

The amount of interest expense was found by multiplying the realistic balance ($90,120) by the realistic interest rate (12 percent).

Lease liabilities

A liability is also created when the firm enters into a lease contract that is in substance a purchase. It is sufficient for the present discussion to observe that these leases are recorded by creating an asset and a liability account. The asset account is debited for the present value of all the cash payments while the liability is credited for the difference between the asset amount and any payments made at the time of entering the lease.

Example

Suppose that a firm acquires exclusive use of an asset by agreeing to pay its owner six $40,000 annual payments. The first payment is due at once (an annuity due situation), and the appropriate interest rate is 15 percent. The cost of the asset is (PAD15% x $40,000), or $174,086. The entry to record this acquisition would be:

Journal entry 4

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