Assets Converted to Business Use

Assets Converted to Business Use Fair market value should also be recorded as the cost of assets that are converted to business use by an individual. For business purposes the cost of the van is its fair market value on the date it was converted to business use. If the fair market value of the van on the date that Joe Fass converted it to business use is $5,000, the contribution of the cash and the van to the business is recorded in the general journal as follows: Noncash Acquisitions A somewhat similar situation occurs when a corporation acquires assets by issuing corporate stock to the seller instead of paying cash. Newly formed or small businesses sometimes acquire assets in this manner. In most cases the fair market value of the asset acquired is more readily determinable than the market value of the corporate stock and should be used as the basis for valuing the transaction. In cases involving established corporations whose stock is regularly traded, the market price of the stock may be more readily determinable and could be used as the basis for valuing the asset. (Corporations and stock transactions will be discussed in more detail in Chapter 7.) Occasionally a business receives an asset as a donation or gift. Donated assets should be recorded in the accounting records at their fair market value. An asset account is debited for the fair market value and the corresponding credit is to an owners' equity account, Donated Cap-ital. Businesses also may trade in or exchange old assets for new assets. The procedures used to account for these types of transaction will be discussed later in the section on dispositions of property, plant, and equipment. Depreciation Almost all assets have a limited useful life. For accounting purposes only land is assumed to have an eternal life. All other assets will ultimately wear out, be used up, or be replaced. As was discussed in Chapter 3, depreciation is the process of allocating the cost of assets to the accounting periods that will benefit from their use. It is important to note that depreciation is strictly an allocation process not a valuation process. In accounting, no attempt is made to approximate the market value or replacement cost of assets through the depreciation process. The only purpose of depreciation is to spread the cost of an asset over the accounting periods that benefit from its use. To account for depreciation, it is necessary to make two estimates. These estimates are typically made at the time that an asset is ac-quired. The first is an estimate of the useful life of the asset. This estimate is usually made in terms of a unit of time, such as years, but may also be made in terms of a unit of use, service, or output, such as mileage. Estimating useful lives is frequently difficult and there may be disagreements over the useful lives of different types of assets as illustrated by the practical insight on page 216. When making the estimates of useful life and residual value, the actual conditions of use in the business should be kept in mind. For example, an automobile intended for use in an executive limousine transportation service might have a relatively short useful life and a relatively high residual value. That is, only new vehicles in excellent condition would be suitable for use by the business and a premium price will be received when the relatively new vehicles are sold. On the other hand, an ordinary taxi service might expect to keep its vehicles as long as they could be economically run. Therefore, the residual value of these vehicles will be relatively low. These examples illustrate that the estimation of useful life and residual value are affected by the specific circumstances. However, these estimations are only approximations that can be changed in the future if necessary. Recall from Chapter 3 that depreciation is a cost expiration adjustment that is recorded at the end of the accounting period. Several different depreciation methods may be used, but regardless of the method of depreciation used, the general journal entry to record depreciation is the same. The debit is to Depreciation Expense and the credit is to the Accumulated Depreciation account associated with the particular asset. Depreciation Expense is an expense account, as its name implies. Accumulated Depreciation is a contra asset account. Asset accounts normally have debit balances; therefore, a contra asset account such as Accumulated Depreciation normally has a credit balance. Several different depreciation methods may be used. This text illustrates the straight-line, depreciation based on use, sum-of-the-years'-digits, and declining balance methods. To illustrate the various methods of calculating depreciation, let us assume that Paul Company purchases a piece of equipment on January 1, 1993, for a total cost of $5,000. The equipment is estimated to have a useful life of five years and a residual value of $500. Assuming a cash purchase, the general journal entry to record the acquisition of the equipment is: