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Chapter 10: Q6CA (page 548)

Tones Company purchased a warehouse in a downtown district where land values are rapidly increasing. Gerald Carter, controller, and Wilma Ankara, financial vice president, are trying to allocate the cost of the purchase between the land and the building. Noting that depreciation can be taken only on the building, Carter favors placing a very high proportion of the cost on the warehouse itself, thus reducing taxable income and income taxes. Ankara, his supervisor, argues that the allocation should recognize the increasing value of the land, regardless of the depreciation potential of the warehouse. Besides, she says, net income is negatively impacted by additional depreciation and will cause the company鈥檚 stock price to go down.

Instructions

Answer the following questions.

  1. What stakeholder interests are in conflict?
  2. What ethical issues does Carter face?
  3. How should these costs be allocated?

Short Answer

Expert verified
  1. The erroneous cost values deceive stockholders and potential investors.
  2. If Ankara refuses to accept Carter's position, Carter confronts an ethical dilemma.
  3. The ratio of fair values of the land and buildings should be used to apportion costs.

Step by step solution

01

Meaning of Depreciation.

Depreciation is the accounting practice of assigning the cost of tangible assets to expenses systematically and sensibly to the periods in which the asset is expected to be used.

02

(a) Explaining the stakeholder interests are in conflict.

Management interests are served if the land is devalued, resulting in a larger depreciation charge attributed to the building. The smaller net income and lower tax obligation free up funds that can be utilized for management. On the other hand, stockholders and potential investors are deceived by erroneous cost values. They will have been unaware of the enormous influence of shifting real estate values on this asset.

03

(b) Explaining the ethical issues that Carter faced.

The ethical concern is whether the acquisition cost is allocated based on the fair market value of the land and building or based on the possible effect on net income. If Ankara refuses to accept Carter's position, Carter confronts an ethical problem. Before selecting what to do, Carter should define different courses of action and thoroughly examine the effects of each.

04

(c) Explaining the cost that should be allocated.

Costs should be apportioned based on the ratio of fair values of land and buildings for basket (lump-sum) purchases of land and buildings. The value of land and buildings are recorded separately. All expenditures directly linked to the acquisition or construction of the building are included in the building expense.

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Most popular questions from this chapter

Cheng Company traded a used truck for a new truck. The used truck cost \(30,000 and has accumulated depreciation of \)27,000. The new truck is worth \(37,000. Cheng also made a cash payment of \)36,000. Prepare Cheng鈥檚 entry to record the exchange. (The exchange lacks commercial substance.)

Hanson Company is constructing a building. Construction began on February 1 and was completed on December 31. Expenditures were \(1,800,000 on March 1, \)1,200,000 on June 1, and $3,000,000 on December 31. Compute Hanson鈥檚 weighted-average accumulated expenditures for interest capitalization purposes.

(Purchase of Equipment with Zero-Interest-Bearing Debt) Chippewas Inc. has decided to purchase equipment from Central Michigan Industries on January 2, 2017, to expand its production capacity to meet customers鈥� demand for its product. Chippewas issues an \(800,000, 5-year, zero-interest-bearing note to Central Michigan for the new equipment when the prevailing market rate of interest for obligations of this nature is 12%. The company will pay off the note in five \)160,000 installments due at the end of each year over the life of the note.

Instructions (Round to nearest dollar in all computations.)

  1. Prepare the journal entry(ies) at the date of purchase.
  2. Prepare the journal entry(ies) at the end of the first year to record the payment and interest, assuming that the company employs the effective-interest method.
  3. Prepare the journal entry(ies) at the end of the second year to record the payment and interest.
  4. Assuming that the equipment had a 10-year life and no salvage value, prepare the journal entry necessary to record depreciation in the first year. (Straight-line depreciation is employed.)

(Purchase of Computer with Zero-Interest-Bearing Debt) Cardinals Corporation purchased a computer on December 31, 2016, for \(105,000, paying \)30,000 down and agreeing to pay the balance in five equal installments of $15,000 payable each December 31 beginning in 2017. An assumed interest rate of 10% is implicit in the purchase price.

Instructions

(Round to two decimal places.)

  1. Prepare the journal entry(ies) at the date of purchase.
  2. Prepare the journal entry(ies) at December 31, 2017, to record the payment and interest (effective-interest method employed).
  3. Prepare the journal entry(ies) at December 31, 2018, to record the payment and interest (effective-interest method employed).

(Capitalization of Interest) The following three situations involve the capitalization of interest

Situation I: On January 1, 2017, Oksana Baiul, Inc. signed a fixed-price contract to have Builder Associates construct a major plant facility at a cost of \(4,000,000. It was estimated that it would take 3 years to complete the project. Also on January 1, 2017, to finance the construction cost, Oksana Baiul borrowed \)4,000,000 payable in 10 annual installments of \(400,000, plus interest at the rate of 10%. During 2017, Oksana Baiul made deposit and progress payments totaling \)1,500,000 under the contract; the weighted average amount of accumulated expenditures was \(800,000 for the year. The excess borrowed funds were invested in short-term securities, from which Oksana Baiul realized investment income of \)250,000.

Instructions

What amount should Oksana Baiul report as capitalized interest at December 31, 2017?

Situation II: During 2017, Midori Ito Corporation constructed and manufactured certain assets and incurred the following interest costs in connection with those activities.

Interest Costs Incurred

Warehouse constructed for Ito鈥檚 own use

\(30,000

Special-order machine for sale to unrelated customer, produced according to customer鈥檚 specifications

9,000

Inventories routinely manufactured, produced on a repetitive basis

8,000

All of these assets required an extended period of time for completion.

Instructions

Assuming the effect of interest capitalization is material, what is the total amount of interest costs to be capitalized?

Situation III: Peggy Fleming, Inc. has a fiscal year ending April 30. On May 1, 2017, Peggy Fleming borrowed \)10,000,000 at 11% to finance construction of its own building. Repayments of the loan are to commence the month following completion of the building. During the year ended April 30, 2018, expenditures for the partially completed structure totaled \(7,000,000. These expenditures were incurred evenly throughout the year. Interest earned on the unexpended portion of the loan amounted to \)650,000 for the year.

Instructions

How much should be shown as capitalized interest on Peggy Fleming鈥檚 financial statements on April 30, 2018?
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