Question

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’s allocation ethical? If so, state why. If not, why not? Identify who was harmed.

Short answer

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

Step-by-step solution

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.

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.