Question

Western purchased land and a building for the lump sum of $3,000,000. To maximize their tax deduction, Western allocated 90% of the purchase price to the building and only 10% to the land. A more realistic allocation based on assessed value would have been 70% to the building and 30% to the land.

1. What impact(s) will these actions have on the company’s financial statements? Be sure to discuss the balance sheet and the income statement separately, and be specific about the impacts on each statement (i.e. overstatement/understatement of account balances and net income). What are the advantages of these impacts (i.e. why is Western doing this)?

2. Discuss the role that accounting should play in this situation. Which GAAP principle(s) are being violated?

3. Discuss the ethical issues in this case (be sure to identify each party involved and whether or not they are acting in an ethical manner).

4. Identify who could be harmed and how they could be harmed (be specific). Do not include the individuals at Western who made the allocation.

5. As a personal friend, what advice would you give to the accountant who works for Western?

Answer 1

Ans 1. If Western allocate 90% of purchase amount to building and 10% to Land than it can affect the financial statement of company in following ways:-

• Depreciation is caculated on building and not on land, thus compnay can claim more depreciation by allocating larger amount to building, as land is indestructible asset no depreciation is calculated on land.
• This will help the company to reduce the tax liability and increase the amount profit after tax. Profit & Loss statement will show more profit in scnarion adopted by the company. If Company adopt realisitc approach the amount of profit will reduce to the reduced amount of depreciation claimed by the company.
• Balance sheet of the company will show building at higher book value than paid which seems to be assets of company are over valued and will gradually decrease in term of depreciation. If adopted realistic approach then Land will remain as it is in fixed asset over the life of company and building will be depreciated over the time.
• The main advantage that company can get tax benefit till the life span of company and can take more cash profit to its owners.

Ans 2. As per the genera accounting principles asset are to be valued at Historical cost or the cost of Purchase i.e Fair value of an asset.

The GAAP principle are being violated are:

1. Historical Cost
2. Fair Value

Ans 3. Ethically western should follow the realistic approach of acouting by valuing the building and land at 70% and 30% respectively of lumsum amount. Here westers is not acting in good faith and not accounting in ethical manner.

Ans 4. This method of accouting will harm the companies stakeholders by overvaluing the Balancesheet and profit & Loss statment. They can also be charged for misrepresenation of facts by tax department inorder to claim higher expense than actual. This will impact the reputation of company and may decrease its value.

Ans 5. It is adviced to the western that it should adopt realistic approach for valuation of Land and Building rather than current approach.