Question

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’s 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

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

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.

(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.

(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.

(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.