Definition and Explanation
Since almost every type of asset can be viewed as a set of components, there are very few situations in which a single asset is acquired.
In many (if not most) cases, this fact is ignored because the components are either permanently joined together, share the same useful life, or information about the separate components is not relevant.
However, in other cases, it may be useful to recognize the separate parts of an asset in order to determine and report the cost of using each part over the course of their unique service lifetimes.
To accomplish this separation, it is necessary to allocate the cost of the package of assets among the separate items in accordance with some logical allocation basis.
Suppose that an existing factory is purchased for a single sum of $640,000. This price includes the land deed, a building, and the equipment in the building.
To calculate depreciation, it is necessary to subdivide the $640,000 across the three main items. A widely used reasonable allocation basis is the assets’ relative market values.
Assume that a pre-purchase appraisal worked out the following market values for the respective assets if purchased separately:
- $87,500 for the land
- $175,000 for the building
- $437,500 for the equipment
The total cost would be allocated in accordance with the following schedule:
If the total cost exceeds the total market value of the identifiable assets when an entire company is being purchased, there is evidence that goodwill exists, and this allocation procedure should not be used.