When purchasing a group of fixed assets together, such as land and a building, it's essential to allocate the total cost appropriately to each asset. This process is known as a lump sum purchase or basket purchase. Accurately assigning costs is crucial because land is not depreciated, while buildings are subject to depreciation. If the initial costs are misallocated, it can lead to incorrect depreciation calculations.
Typically, when assets are bought together, a discount is applied compared to their individual fair market values. To allocate the total purchase price among the assets, the relative sales value method is employed, which involves three key steps:
- Determine the total fair market value (FMV): Calculate the combined fair market value of all assets. For example, if the land is valued at \$300,000 and the building at \$2,700,000, the total FMV is \$3,000,000.
- Calculate the percentage of total FMV for each asset: Divide the fair market value of each asset by the total FMV. In this case, the land represents 10% of the total value (\(300,000 / \)3,000,000), while the building accounts for 90% (\(2,700,000 / \)3,000,000).
- Allocate the purchase price: Multiply the total amount paid by the percentage calculated for each asset. If the total payment is \$2,800,000, then the land would be recorded at \$280,000 (10% of \$2,800,000), and the building would be recorded at \$2,520,000 (90% of \$2,800,000).
After determining the allocated costs, the journal entry to record the purchase would involve debiting the land and building accounts for their respective amounts and crediting the cash account for the total payment made. In this example, the journal entry would be:
Debit Land: $280,000 Debit Building: $2,520,000 Credit Cash: $2,800,000
This method ensures that the costs are accurately reflected in the financial records, allowing for proper depreciation calculations in the future.
