Question

In January 2018, the Paper Division of Dunder Mifflin Inc. purchased a piece of property in Scranton, Pennsylvania for $475,000. Other fees associated with the purchase, including closing costs and realtor commissions, totaled $25,000. The property contains land, a warehouse, and equipment. The Vice President of the Paper Division, Andy Bernard, and the Chief Financial Officer of Dunder Mifflin, Oscar Martinez, are discussing how the cost of the property should be allocated to the items purchased. The VP of the Paper Division, Andy Bernard, wants to allocate most of the cost to the land, while the CFO argues that they should allocate the bulk of the purchase cost to the equipment and warehouse because “no one wants property in Scranton.” Assume that the same depreciation methods are used for financial reporting and tax purposes, and tax rates won’t change over the next 10 years.

Andy Bernard is hoping to be promoted to the VP of the Printer Division, which is a much larger division than the Paper Division. A key determinant of whether Bernard will be promoted is the profitability of the Paper Division over the next two years.

1. What are the pros and cons of a proportionally higher allocation of the purchase cost to the land and a proportionally lower allocation to the land? (4 pts.)

2. Why do you suppose Andy Bernard wants to allocate most of the cost to the land? (6 pts.)

3. What is your recommendation for allocating the purchase costs to the assets? (6 pts.)

4. Assume the equipment has a useful life of 5 years and the warehouse has a useful life of 10 years. The company plans to sell the equipment after it has been fully depreciated and the land and warehouse will be sold after the warehouse is fully depreciated. How will this allocation decision affect ending Retained Earnings at the end of the 10^th year, after the assets have been sold? (4 pts.)

Answer 1

1. Land is never depreciated. So the company cant charge depreciation on the income statement.  Proportionally higher allocation to Land would mean that Depreciation charge is lost on that part resulting in higher income Whereas lower allocation to land means depreciation can be availed on the remaining part resulting in lower income.

2. Andy wants the Profit of paper division to be standing at a higher level. ( Because his promotion is linked to profit of Paper division) . This can be achieved by charging lesser depreciation. Lesser Depreciation is possible only if the higher portion of purchase costs is allocated to Land. ( Because land cant be depreciated as per GAAP) .

3. My recommendation will be to allocate higher amount of purchase costs to Warehouse & equipment. This is as per GAAP as warehouse & equipment results in actual use of land for which it is purchased ( Mere land without warehouse & equipment does not result in any production related activity). This will also result in availing depreciation which will result in lesser income & savings towards tax paid .

4. For first 5 years Depreciation for equipment & warehouse can be charged. From 6th till 10th year depreciation on warehouse can be charged. This will result in higher amount of retained earnings.

However retained earning will be reduced or increased by the loss or profit from sale of equipment ( 5th year) & sale of warehouse & land ( 10th year).