On 1 July 2022, WOW purchased land and a building for a lump sum payment of $400,000. An individual expert valued the land at $150,000 and the building at $300,000. The land is not depreciable. The building is estimated to have a 20-year useful life with no residual value. A reducing balance method at a 10% annual depreciation rate is used for the building depreciation.
The correct answer and explanation is:
Correct Answer:
To allocate the $400,000 purchase price between the land and building:
- Total valuation by expert = $150,000 (land) + $300,000 (building) = $450,000
- Land allocation = ($150,000 / $450,000) × $400,000 = $133,333.33
- Building allocation = ($300,000 / $450,000) × $400,000 = $266,666.67
Depreciation for Building using Reducing Balance Method:
Year 1 depreciation (2022–2023) = 10% × $266,666.67 = $26,666.67
Book value at end of Year 1 = $266,666.67 − $26,666.67 = $240,000.00
Explanation (300 words):
When a lump sum is paid to acquire both land and a building, the total cost must be allocated proportionally based on their individual appraised values. This ensures the correct accounting treatment, especially since land is not depreciable and the building is.
The total appraised value of both assets is $450,000. The valuation assigns $150,000 to the land and $300,000 to the building. To allocate the $400,000 purchase price correctly, calculate the ratio of each component to the total appraised value. The land’s ratio is 1/3 and the building’s is 2/3. Applying these ratios to the actual purchase price, the land is allocated $133,333.33, and the building is allocated $266,666.67.
Since land is not depreciated, only the building is subject to depreciation. The building has a useful life of 20 years with no residual value, and the reducing balance method is applied at a 10% annual rate. This method means each year’s depreciation is based on the book value at the start of the year, not the original cost.
For the first year, 10% of the initial building value ($266,666.67) is calculated, resulting in $26,666.67 of depreciation expense. This amount is subtracted from the book value, giving a new book value of $240,000 for the beginning of the next year.
This approach matches depreciation expense more closely with the asset’s decreasing value and provides a conservative method of recognizing expenses over the asset’s life.