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 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? (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 10th year, after the assets have been sold? (4 pts.)

Answer 1

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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?

Allocating higher cost to the land:

Pros: The value of the assets will remain higher throughout the life of the asset if costs are allocated to the land as there will be lower depreciation charges when the cost of the property is allocated as land.

Cons: When the cost of the property is allocated as land, then there will be no depreciation charges and the business organization would not be able to capture the tax shield benefits from such depreciation expenses.

Allocating lower cost to the land:

Pros: Lower allocation property tax to the land and higher allocation to the equipment will increase the tax shields in the business due to higher depreciation charges as equipment are usually charged with the depreciation.

Cons: Lower valued asset and lower accounting profits, as the depreciation i.e. charged on the equipment will decrease the book value of an asset throughout its life and also the profits in the books of accounts.

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

The promotion of Andy Bernard depends upon the profitability of the department, therefore, Andy Bernard will try to choose the allocation which will result in higher accounting profit. Allocating the higher proportion of property costs to the land will result in higher accounting profits as land is not charged with the depreciation.

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

Though the allocation should be done in the proportion of the fair value of assets but allocation of the property costs can be changes on the bases profitability of the division, i.e. when a division is highly profitable, then it is better to allocate higher costs to equipment as depreciation on the equipment will not much impact the profit and there will be a proper appropriation of costs, while for divisions with lower profitability, higher allocation of costs to land is better, which can result in higher accounting profit.

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?

At the end of the 10^th year, if the land is sold when the warehouse is fully depreciated, then there will be an increase in the retained earnings (assuming that the value of land will not decline in 10 years). The higher value of land over the depreciated book value of land or warehouse will result in gain from sale of asset which is recorded in the retained earnings.