Reference no: EM134008

Question :

Raintree Company has brought 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 % of its cost. The chief financial officer (CFO) and the controller are showing the allocation of the purchase price. The CFO indicates that the largest amount possible should be assigned to the land because this action will enhance reported net income in the future. Depreciation expense may 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 every 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, could be allocated to the land, thereby saving income taxes, since the depreciation, which is tax-deductible, will be greater. Under this preparation, annual depreciation would be $648,000 [($14,400,000 - $1,440,000) / 20 years]. The annual tax savings at a 30% tax rate is $32,400 [$648,000 - $540,000) x 0.30].

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