Tones Company purchased a warehouse in a downtown district where land values are
ID: 2490229 • Letter: T
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.
What stakeholder interests are in conflict?
What ethical issues does Carter face?
How should these costs be allocated?
Explanation / Answer
(a) If the land is undervalued so that a higher cost is assigned to the building, management interests are served. The lower net income and reduced tax liability save cash to be used for management purposes. By contrast, shareholders and potential investors are misled by the inaccurate cost values. They will have been deprived of information concerning the significant impact of changing real estate values on this holding.
(b) The ethical question center on whether to allocate the cost of the purchase on the fair value of land and building or whether to determine the allocation in view of the potential effect on net income. Carter faces an ethical dilemma if Ankara will not accept Carter’s position. Carter should specify alternative courses of action and carefully assess the consequences of each before deciding what to do.
(c) For basket (lump-sum) purchases of land and buildings, costs should be allocated on the ratio of fair values of the land and buildings.