• 15 Marks

CR – May 2024 – L3 – SC – Q7 – Presentation of Financial Statements (IAS 1)

Discuss allocation impacts of purchase price for land and warehouse on earnings and identify ethical issues in CFO’s approach.

Signal PLC purchased land and warehouse for N90,000,000. The warehouse is expected to last for 20 years and to have a salvage value equal to 10% of its cost. The Chief Finance Officer (CFO) and the Chief Accountant (CA) discussed the allocation of the purchase price between the land and the warehouse. The CFO believes that the largest amount possible should be assigned to the land because that will improve reported net income in the future. Depreciation expense will be lower because land is not depreciated. He suggested allocation of one third of the cost to the land. The CA argues that the smallest amount possible, about one-fifth of the purchase price, should be allocated to the land, thereby saving income taxes, since the depreciation will be greater if lesser amount is allocated to land.

Required:

(a) Evaluate how the different allocations of one-third and one-fifth to land will affect reported earnings and determine how the purchase cost should be allocated. (8 Marks)

(b) Identify and discuss inherent ethical issues in the CFO’s submission in the above scenario. (7 Marks)

Total Marks: 15

(a) Allocation of Purchase Cost and Impact on Reported Earnings

  1. Allocating One-Third of N90,000,000 to Land:
    • Allocation to Land: 1/3 of N90,000,000 = N30,000,000
    • Allocation to Warehouse: N90,000,000 – N30,000,000 = N60,000,000
    • Salvage Value of Warehouse (10%): 10% of N60,000,000 = N6,000,000
    • Depreciable Amount for Warehouse: N60,000,000 – N6,000,000 = N54,000,000
    • Annual Depreciation (Straight-Line Basis over 20 Years): N54,000,000 / 20 = N2,700,000

    Impact: With an annual depreciation of N2,700,000, reported earnings will be higher compared to a higher depreciation rate. However, the company may face a higher tax liability.

  2. Allocating One-Fifth of N90,000,000 to Land:
    • Allocation to Land: 1/5 of N90,000,000 = N18,000,000
    • Allocation to Warehouse: N90,000,000 – N18,000,000 = N72,000,000
    • Salvage Value of Warehouse (10%): 10% of N72,000,000 = N7,200,000
    • Depreciable Amount for Warehouse: N72,000,000 – N7,200,000 = N64,800,000
    • Annual Depreciation (Straight-Line Basis over 20 Years): N64,800,000 / 20 = N3,240,000

    Impact: With an annual depreciation of N3,240,000, the reported earnings will be lower, but the company will benefit from income tax savings.

  3. Income Tax Savings Calculation:
    • Difference in Depreciation: N3,240,000 – N2,700,000 = N540,000
    • Tax Savings (Assuming 30% Tax Rate): N540,000 × 30% = N162,000
  4. Optimal Allocation Decision:The economic substance of the assets should guide the allocation. Since the warehouse is a depreciable asset with a finite useful life and salvage value, a higher allocation to the warehouse accurately reflects its economic value. Thus, assigning a larger proportion of the purchase price to the warehouse is preferable for transparent and reliable financial reporting.

(b) Ethical Issues in the CFO’s Allocation Proposal

  1. Manipulation of Financial Statements:
    • The CFO’s suggestion to allocate one-third of the purchase price to land (which does not depreciate) to reduce depreciation expense is an attempt to manipulate earnings, misleading stakeholders about the company’s financial health.
  2. Lack of Transparency:
    • By advocating a disproportionate allocation to land, the CFO compromises transparency, as stakeholders depend on accurate financial reporting for decision-making.
  3. Conflict of Interest:
    • The CFO’s focus on inflating net income may reflect a conflict of interest, prioritizing short-term gains over long-term accuracy and reliability of financial information.
  4. Violation of Accounting Standards (Professional Competence and Due Care):
    • The allocation contradicts standard principles, as assets should be valued based on their economic substance. Over-allocating to non-depreciable land to manipulate depreciation is unprofessional.
  5. Risk of Misrepresentation:
    • Misallocating costs risks misrepresenting the company’s true financial position, potentially leading to regulatory issues and harming the organization’s reputation.

Conclusion: The CFO’s proposal raises significant ethical concerns, emphasizing the need for integrity and transparency in financial reporting.

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