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.
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:
| 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.
| 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.
| 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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.