Raintree Company has purchased land and a warehouse for $18,000,000. The warehou

Question

Raintree Company has purchased land and a warehouse for $18,000,000. The warehouse is expected to last 20 years and to have a residual value equal to 10 percent of its cost. The chief financial officer (CFO) and the controller are discussing the allocation of the purchase price. The CFO believes that the largest amount possible should be assigned to the land because this action will improve reported net income in the future. Depreciation expense will be lower because land is not depreciated. He suggests allocating one-third, or $6,000,000 of the cost to the land. This results in depreciation expense each year of $540,000 [($12,000,000 - $1,200,000) / 20 years].

The controller disagrees. She argues that the smallest amount possible, say one-fifth of the purchase price, should be allocated to the land, thereby saving income taxes, since the depreciation, which is tax-deductible, will be greater. Under this plan, annual depreciation would be $648,000 [($14,400,000 - $1,440,000) / 20 years]. The annual tax savings at a 30 percent tax rate is $32,400 [$648,000 - $540,000) x 0.30].

How would each decision affect the company's cash flows? Ethically, how should the purchase cost be allocated? Who will be affected by the decision?

Explanation / Answer

Hi,

Please find the answer as follows:

Part A: How would each decision affect the company's cash flows?

Depreciation expense is a non-cash expense and it does not affect the cash flow of the company. iIt will however result in reduction in tax liability of the company. As compared to first situation where the amount of depreciation is lower, the amount of tax savings will also be lower. As a result of tax savings, cash flows will increase. The final impact would be lower cash flows in the first case and higher cash flows in the second case.

Part B: Ethically, how should the purchase cost be allocated?

The purchase cost shall be allocated on the basis of the fair market value of assets. The proportion between the fair market value of land and warehouse is required to be calculated and this proportion should be used to allocate the purchase cost.

Part C: Who will be affected by the decision?

This decision will affect shareholders and investors. Use of such practices will impact the financial statements of the company and will result in an inaccurate and unfair representation of the company's financial position.

Thanks.

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