Definition and explanation
Because almost every type of asset can be viewed as a set of components, there are 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 material.
However, in other cases, it may be useful to recognize the separate parts in order to determine and report the cost of using each of them over their unique lives. 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.
For example, suppose that an existing factory was purchased for a single sum of $640,000. This price included title to the land, a building, and the equipment in the building. For depreciation to be computed, it will be necessary to subdivide the $640,000 among the three main items. A widely used reasonable allocation basis is the assets’ relative market values. Assume that a pre-purchase appraisal had placed the market values (if purchased separately) at $87,500 for the land, $175,000 for the building, and $437,500 for the equipment. The total cost would be allocated in accordance with this schedule:
In the event that 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.