Relative Fair Value Method

When long term assets such as land, land improvements and buildings are purchased it is quite common for the purchase price not to separate out the amount paid for each of the individual assets. Unfortunately the assets have to be depreciated at different rates (land for example is not depreciated), and therefore the relative fair value method is a technique used to allocate the total purchase cost to each asset.

 

The technique uses the appraised fair market value (FMV) of each asset to allocate the total purchase cost using the relative fair value method formula.

Asset allocation = Purchase cost x Asset FMV / Total FMV

Relative Fair Value Method Example

Suppose a business acquires a property comprising land, land improvements and buildings for 300,000 including fees and other relevant costs. The property appraisal shows that at the time of purchase the estimated fair market value of the individual assets totalled 340,000 as shown in the table below:

Estimated fair market value
Asset Value %
Land 68,000 20%
Land improvements 51,000 15%
Buildings 221,000 65%
Total 340,000 100%

Clearly the total fair market value of the individual assets (340,000) is greater than the purchase cost paid (300,000).

Cost Allocation Calculations

The cost of 300,000 is now allocated in proportion to the fair market value of the assets using the relative fair value method formula. For example the purchase cost allocation to the land would be calculated as follows.

Land Allocation:
Purchase cost = 300,000
Land FMV = 68,000
Total FMV = 340,000
Allocation % = Land FMV / Total FMV
Allocation % = 68,000 / 340,000 = 20%
Land allocation = Cost x Allocation %
Land allocation = 300,000 x 20% = 60,000

The calculation shows that 60,000 or 20% of the purchase price should be allocated to the land.

The relative fair value method calculations can be repeated for the land improvements and the buildings to give the following purchase cost allocations.

Land Improvements Allocation:
Purchase cost = 300,000
Land improvements FMV = 51,000
Total FMV = 340,000
Allocation % = Land improvements FMV / Total FMV
Allocation % = 51,000 / 340,000 = 15%
Land improvements allocation = Cost x Allocation %
Land improvements allocation = 300,000 x 15% = 45,000
Buildings Allocation:
Purchase cost = 300,000
Buildings FMV = 221,000
Total FMV = 340,000
Allocation % = Buildings FMV / Total FMV
Allocation % = 221,000 / 340,000 = 65%
Buildings allocation = Cost x Allocation %
Buildings allocation = 300,000 x 65% = 195,000

These calculations are summarized in the table below.

Allocation of purchase cost
Asset Value %
Land 20% 60,000
Land improvements 15% 45,000
Buildings 65% 195,000
Total 100% 300,000

Purchase Cost Allocation Journal Entry

Having allocated the cost of 300,000 to each of the individual assets the transaction can now be recorded with the following purchase cost allocation journal entry.

Relative fair value method allocation journal entry
Account Debit Credit
Land 60,000
Land improvements 45,000
Buildings 195,000
Cash 300,000
Total 300,000 300,000

It should be noted that the fair market value is only used as a method of allocation, it is the cost of the land, land improvements and buildings that is used in the bookkeeping journal entries.

Relative Fair Value Method August 9th, 2017Team

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