Question

Intermediate Accounting I Ethics Question (20 pts. for content; 10 pts. for communication): Thank you very much!

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.

1. Under generally accepted accounting principles, how should the total cost of the property be determined? (2 pts.)

2. Why is there any question about how much of the purchase cost should be allocated to each of the assets? How should the purchase cost be allocated to each of the assets? (4 pts.)

3. 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? (8 pts.)

4. 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 depreciate 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. (6 pts.)

Answer 1

General:- Property consist of Land(Being immovable property), Warehouse building(Built on that land), and limited equipment( to be used in the warehouse).

In Jan 2018, Dunder Mifflin Inc. has purchased the property and has made a consolidated payment for the said property.

Answers:-

1. As per GAAP, cost of the property consists of land and building includes all the expenses incurred to purchase and to get the title in the property transferred in the company's name. Cost of Plant and Equipment includes all the expenses incurred in its acquisition, installation, and initial trail running expenses until the companies start commercial production.

2. The acquisition cost of each component of PPE should disclose the true value of the acquisition. Globally Fair Market Value (FMV), the optimum tool to measure the true cost of PPE. FMV is the value which could be fetched to the company by selling the component of PPE on the reporting date. To achieve this motive, the organizations provide for depreciation and make provision for the impairment.

Depreciation is a charged to the asset for denunciation in the value due to the passage of time, technology up-gradation, non-usage condition to carry book value of assets something around equal to FMV at the reporting date.

Hence each component should be shown at their respective FMV. To achieve this, property purchased cost is to be allocated in the different components of PPE based upon their components FMV on the date of acquisition of PPE.

The company should evaluate the FMV of land, building, and equipment separately and allocate purchase cost proportionally.

3. Following would be pros and cons:-

• Pros:-

- Being value Non Depreciable assets high, the company will report high assets to balance sheet.

- Value of the company will be higher since generally land is not subject to depreciation. The company would have a high potential to leverage its high-value debts.

- There would be fewer amortization expenses leading the company to report comparably higher profits and higher EPS.

- Shareholder's wealth as well value got increases and company ROI would be high.

- The company can have a lower or adverse debt-equity ratio.

• Cons:-

- Showing the higher value of land is not at True and Fair Reporting.

- Since as per GAAP value of land should be shown at cost price, unless it is necessary to make revaluation. In such a case the company needs to provide higher Deferred Tax Liability provisions as at on selling date FMV of the property will be higher (except for unfavorable conditions attached to this).

- Lower allocation to depreciable assets to ultimately leads to higher reporting of profits.

- There would not be true reporting the consumption of economic benefits by the usage of assets.

- PE ratio of the company would be high but not in actual.

- Initial year company reports comparably higher profits.

4. As mentioned earlier higher value of land leads to under reporting of amortization expenses, for the long run fluctuations in the profits would be as below:-

A). From the year, the Assets is acquired till the year warehouse and equipment are sold:- Under this period the company will report comparably higher profits as it is providing a lower amount of depreciation. Actual tax Expenses would be comparatively higher.

B). In the year in which warehouse and equipment are sold:- In this year since land is to sell as to when warehouse and equipment are sold, Profits of the company increases significantly as land is to be sold at FMV. Actual tax expenses will increase occasionally.

C). From the year onwards in which land is sold:- Now onwards, the profit of the company will be much lower as compared to the earlier year. Actual tax expenses will be comparatively lower.