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In January 2018, the Paper Division of Dunder Mifflin Inc. purchased a piece of property in...

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 5 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?

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

3. What is your recommendation for allocating the purchase costs to the assets?

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 10th year, after the assets have been sold?

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Answer #1

1. Pros and Cons of higher allocation of cost to the land.

* The higher allocation of cost to the land will lead to the higher value of assets in the financial statement as there is no depreciation for the land..

*The depreciation amount in the profit and loss account will be low.

*lower depreciation will leads to the higher profit.

*Higher profit leads to the higher tax expense..

Pros and Cons of lower allocation of cost to the land.

*The asset value in the financial statement will be lower.

*The depreciating amount will be higher.

*High depreciation leads to the lower taxable income.

*The tax expense will be less as the taxable income is low.

2. Andy Bernad expects a promotion the basis of upcoming 2 years profit of the Paper Division.So he wants to allocate most purchase cost of the property to the land.It is because land is a non-depreciable asset, the depreciation amount will be less and profit & loss account shows higher profit for the company which help him to avail the promotion.

3. Most suitable way to allocate the cost of purchase is on the proportion of fair value of equipment,land and warehouse. Once the fair value is chosen as the base to allocate the property costs, land receives lower value as there is no one requiring land in Scranton. Hence the fair value of land will be much lower as compared to warehouse and equipment.

4. Since the fair value is used as base for allocating the purchase costs to assets, larger proportion of the cost moves to equipment and warehouse than land. Equipment being depreciated over 5 years and warehouse for 10 years . Warehouse and land being sold after 10 years, the book value of warehouse will be zero as it is fully depreciated and the book value of land remains same as land is not depreciated. So the total asset value will be equal to the value of land. after 10 years. Any amount received in excess of the value of land will represent a gain while asset is sold.. After-tax portion of the gain flows to retained earnings. Since the value of land is a lesser amount, there could be a larger gain on the sale of asset. The retained earnings balance will be higher.

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