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Chapter 9: Q1EP (page 543)

Western Bank & Trust purchased land and a building for the lump sum of $3,000,000. To get the maximum tax deduction, Western allocated 90% of the purchase price to the building and only 10% to the land. A more realistic allocation would have been 70% to the building and 30% to the land.

Requirements

1. Explain the tax advantage of allocating too much to the building and too little to the land.

2. Was Western鈥檚 allocation ethical? If so, state why. If not, why not? Identify who was harmed.

Short Answer

Expert verified

In the given case the allocation is unethical as the best accounting practice has not been adopted.

Step by step solution

01

Tax advantage of allocation

Tax is levied on net income after providing for depreciation. Depreciation is levied on property, plant, and equipment but not on land. When assets are purchased at lump sum price then the cost is allocated based on some criteria.

In the given case, more allocation to the building has been done purposely to overvalue the depreciation expense. This would lower the net income and tax expenses would be lower. So, there would be a tax advantage to the company.

02

Ethical issue

No, the Western allocation is not ethical. As per the applicable accounting principle, the estimation and allocation should be based on past experience and best judgment. In the given case, the over-allocation to the building violates the accounting rules.

Furthermore, it would also affect the other financial results too.

The parties who would be harmed by this practice would-be investors, creditors, and lenders.

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Most popular questions from this chapter

Journalizing natural resource depletion

Cannon Mountain Mining paid \(462,300 for the right to extract mineral assets from a 400,000-ton deposit. In addition to the purchase price, Cannon also paid a \)900 filing fee, a \(1,800 license fee to the state of Nevada, and \)55,000 for a geological survey of the property. Because Cannon purchased the rights to the minerals only and did not purchase the land, it expects the asset to have zero residual value. During the first year, Cannon removed and sold 50,000 tons of the minerals. Make journal entries to record (a) purchase of the minerals (debit Minerals), (b) payment of fees and other costs, and (c) depletion for the first year.

Maxim Company reported beginning and ending total assets of \(140,000 and \)160,000, respectively. Its net sales revenue for the year was $240,000. What was Maxim鈥檚 asset turnover ratio?

What is a lump-sum purchase, and how is it accounted for?

Whitney Plumb Associates surveys American eating habits. The company鈥檚 accounts include Land, Buildings, Office Equipment, and Communication Equipment, with a separate Accumulated Depreciation account for each asset. During 2018, Whitney Plumb completed the following transactions:

Jan. 1 Purchased office equipment, \(117,000. Paid \)77,000 cash and financed the remainder with a note payable.

Apr. 1 Acquired land and communication equipment in a lump-sum purchase. Total cost was \(350,000 paid in cash. An independent appraisal valued the land at \)275,625 and the communication equipment at \(91,875.

Sep. 1 Sold a building that cost \)520,000 (accumulated depreciation of \(285,000 through December 31 of the preceding year). Whitney Plumb received \)390,000 cash from the sale of the building. Depreciation is computed on a straight-line basis. The building has a 40-year useful life and a residual value of \(25,000.

Dec. 31 Recorded depreciation as follows:

Communication equipment is depreciated by the straight-line method over a five-year life with zero residual value. Office equipment is depreciated using the double-declining-balance method over five years with a \)2,000 residual value.

Record the transactions in the journal of Whitney Plumb Associates.

Jim Reed manages a fleet of utility trucks for a rural county government. He鈥檚 been in his job for 30 years, and he knows where the angles are. He makes sure that when new trucks are purchased, the residual value is set as low as possible. Then, when they become fully depreciated, they are sold off by the county at residual value. Jim makes sure his buddies in the construction business are first in line for the bargain sales, and they make sure he gets a little something back. Recently, a new county commissioner was elected with vows to cut expenses for the taxpayers. Unlike other commissioners, this man has a business degree, and he is coming to visit Jim tomorrow.

Requirements

1. When a business sells a fully depreciated asset for its residual value, is a gain or loss recognized?

2. How do businesses determine what residual values to use for their various assets? Are there 鈥渉ard and fast鈥� rules for residual values?

3. How would an organization prevent the kind of fraud depicted here?
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