Question

In January 2018, Dunder Mifflin Inc. bought property in downtown Scranton. The property contains land, a warehouse, and some limited equipment. Property values in the area have been increasing rapidly over the past decade. The price paid for the property needs to be allocated to the items purchased and the controller and financial vice president are having that discussion. Dunder Mifflen’s controller wants to allocate the largest proportion of the cost to the warehouse and equipment while the financial VP, David Wallace, argues that the allocation should recognize the steadily increasing value of the land by allocating the highest value to the land. Assume that the same depreciation methods are used for financial and tax return purposes.

-What are the pros and cons of a proportionally higher allocation of the purchase cost to the land and a proportionally lower allocation to building and equipment?

-Assume the equipment and warehouse have the same useful life. The company plans to sell the equipment after it has been fully depreciated and the land will be sold after the warehouse is fully depreciated. Assuming no change in tax rates over the life of the warehouse, how will this allocation decision affect Retained Earnings in the long-run, after the assets have been sold? Explain in depth.

Answer 1

HIGHER ALLOCATION OF PURCHASE COST TO THE LAND
PROS
When less amount of depreciation expense will be charged, it will lead to more profits. Thus, more amount of dividend can be distributed to the shareholders.
Also, increase in profits can lead to increase in retained earnings. Which can further be used for starting new projects.
If in future Dunder Mifflin Inc. decide to sell the land then, the amount of capital gain on the sale of land will be less. As, we have increased the amount of cost of acquisition of the land.
CONS
Higher allocation of purchase cost to the land will lead to lower allocation to warehouse and equipment. As we know, depreciation is charged on the buildings and equipment. However, depreciation is not charged on land. This will lead to less amount of depreciation expense in th year.
When less amount of depreciation expense will be charged, it will lead to more profits. Thus, increase in amount of taxes paid to government.

It will be more appropriate to apportion the amount on the basis of the fair value of land, warehouse and equipment.

If straight line method of depreciation is used and the useful life of both equipment and warehouse is same. Then, as per the instructions given in the question, both equipment and the land will be sold at the same time.
If the higher allocation of purchase cost is made to the land then, the cost of acquisition will be more. Thus, when the land will be sold it will lead to the reduced amount of capital gain.
Also, as the amount of land is significantly increasing and on the sale of land there will be profits which will lead to increase in retained earnings. However, if we would have allocated lower amount of purchase cost in the land then, the cost of land would have been less leading to more profits. Thus, more retained earnings.