Question

ABC Company purchased $700,000 of vacant land one block from the College World Series Stadium which it intends to use for parking. The Company spent $300,000 this year to prepare the land for paving and $250,000 to actually pave the land. The Company is quite profitable so Management has decided to record the entire cost of the land, all of the costs to prepare the land for paving, and all of the paving costs in the Repairs and Maintenance Expense account. What is the effect of this decision on the Company's net income? What is the effect on the Balance Sheet. What is the effect on the tax return? Is this the appropriate treatment of the cost of the land and paving costs? Are the actions of Management ethical? Justify your response.

Answer 1

The effect of company's decision to record the entire cost of the land, all of the costs to prepare the land for paving, and all of the paving costs in the Repairs and Maintenance Expense account will be as follows

1. The net income will be understated by $ 1,250,000 as the entire cost of Land and paving is charged as repairs and Maintenance Expense.

2. In the Balance Sheet, both the Asset Value and the retained earnings will be understated by $ 1,250,000. Thus entire balance sheet will be understated.

3. Taxable Income will also be reduced by $ 1,250,000, as the Cost of land is charged as expense.

4. This is not the appropriate treatment to expense the cost of land and paving. The Land should be recorded as an Asset in the books of Accounts. All the costs incurred to convert the land suitable for its intended use should be added to the cost of Land. So the expenses related to pavings also should be treated as cost of land.

5. The actions of management are not ethical as these actions hide the actual income of the company and unethically evades the tax liability. Also the Balance sheet and Income statement will not show the fair picture of Financial position of the company.