On January 1, 2010, Herschel Locks Corporation purchased drilling equipment for $11,500. The equipment has an estimated useful life of four years and a salvage value of $200. Assuming that Herschel uses the straight-line method of depreciation, if it trades the equipment for new equipment with a list price of $15,500 on December 31, 2011, and pays $4,050 in the exchange, assuming the exchange lacks commercial substance, the new equipment should be recorded at
A) $15,500.
B) $11,450.
C) $9,850.
D) $9,900.

Question

Quizplus · Accepted Answer

Under the straight-line method of depreciation, the annual depreciation expense can be calculated as follows:

Depreciation expense per year = (Purchase price - Salvage value) / Useful life
Depreciation expense per year = ($11,500 - $200) / 4 = $2,825

Since the equipment was traded in after two years, the accumulated depreciation would be:

Accumulated depreciation = Depreciation expense per year * Number of years
Accumulated depreciation = $2,825 * 2 = $5,650

The carrying value of the equipment would be:

Carrying value = Purchase price - Accumulated depreciation - Salvage value
Carrying value = $11,500 - $5,650 - $200 = $5,650

Since the exchange lacks commercial substance, the cost of the new equipment should be recorded at the carrying value of the old equipment, which is $5,650. Since Herschel paid $4,050 in the exchange, the recorded cost of the new equipment should be:

Recorded cost of new equipment = Carrying value of old equipment + Cash paid
Recorded cost of new equipment = $5,650 + $4,050 = $9,700

However, the new equipment has a list price of $15,500, so Herschel would record a gain on the exchange of:

Gain on exchange = List price of new equipment - Recorded cost of new equipment
Gain on exchange = $15,500 - $9,700 = $5,800

Therefore, the journal entry to record the exchange would be:

Dr. New equipment $15,500
Cr. Old equipment $11,500
Cr. Gain on exchange $5,800
Cr. Cash paid $4,050

On January 1, 2010, Herschel Locks Corporation Purchased Drilling Equipment