Definition & Explanation
When an asset of one kind is exchanged for an asset of another kind, the preferred measurement of the new asset’s cost is the fair value of the asset given up. The simplest example of this type of exchange is a purchase for cash. The journal entry is straightforward as seen for this $100,000 acquisition:
Noncash transactions are more difficult to account for. The practice was sufficiently unsettled to deal with nonmonetary transactions. The basic principle is:
“accounting for nonmonetary transactions should be based on the fair values of the assets (or services) involved. Thus, the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it.”
An important exception to this principle was drawn for exchanges of similar productive assets, which were defined as assets “of the same general type, that perform the same function or that are employed in the same line of business”.
Thus, GAAP call for exchanges of dissimilar operating assets to be recorded as if (1) the old asset is sold for its fair value and (2) the new asset is purchased with the proceeds of the sale.
Exchanges without cash
In the circumstance in which no cash is given up, the new asset would be recorded at the estimated value of the old one and a gain or loss recorded for the difference between that value and the old asset’s book value. Assume these facts:
The journal entry would be recorded:
If fair value were to be lower than book value, a loss would be recorded. If the estimate of the fair value of the new asset differs significantly from the estimated fair value of the old asset, the accountant should use the valuation that is more reliable. If, for example, the fair value of the new asset acquired is known more reliably than the value of the old one, and that value is only $1,700, this journal entry would be recorded:
If both values are viewed as equally reliable, conservatism would encourage the selection of the smaller figure. Although it seems unlikely that an exchange would be negotiated where the parties would not be reasonably certain of the values of the assets given up and received, it is stated that the book value “of the nonmonetary asset transferred from the enterprise may be the only available measure of the transaction”.
Exchanges with cash given
In most cases, the buyer of a new asset that exchanges an old asset also gives up cash. The cost of the new asset is considered to be the sum of the cash paid and the fair value of the old asset. Assume the same facts as in the above example and that $5,000 cash is also given up. This entry would be made:
Again, a loss would be recorded if the old asset’s book value exceeded its fair value.
Exchanges with cash received
When the firm gives up an old asset and receives cash, the cost of the new asset is measured as the difference between the fair value of the old asset and the cash received. For example, assume these
The cost of the new asset would be $8,600, or $13,000 less $4,400, and this entry would be recorded:
The loss is equal to the difference between the book and the fair value of the old asset.