Crude
Oil Limited purchases an oil tanker depot on July 2, 2011, at a cost of $600,000
and expects to operate the depot for 10 years. After the 10 years, the company
is legally required to dismantle the depot and remove the underground storage
tanks. It is estimated that it will cost $75,000 to do this at the end of the
depot's useful life. Crude Oil follows private enterprise GAAP.
Instructions
(a)
Prepare the journal entries to record the acquisition of the depot and the
asset retirement obligation for the depot on July 2, 2011. Based on an
effective interest rate of 6%, the present value of the asset retirement
obligation (i.e., its fair value) on the date of acquisition is $41,879.
(b)
Prepare any journal entries required for the depot and the asset retirement
obligation at December 31, 2011. Crude Oil uses straight-line depreciation. The
estimated residual value of the depot is zero.
(c)
On June 30, 2021, Crude Oil pays a demolition firm to dismantle the depot and
remove the tanks at a cost of $80,000.
Prepare
the journal entry for the settlement of the asset retirement obligation.
(d)
Prepare the schedule to calculate the balance in the asset retirement
obligation account for all years from 2011 to 2021, assuming there is no change
in the estimated cost of dismantling the depot.
(e)
Show how all relevant amounts will be reported on Crude Oil Limited's financial
statements at December 31, 2011.
(f)
How would the accretion expense be reported on the statement of cash flows?
(g)
Discuss how Crude Oil would account for the asset retirement costs and
obligations if the company reports under IFRS. Be specific.
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(a) July
2, 2011
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Oil Tanker Depot
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600,000
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Cash
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600,000
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Oil Tanker Depot
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41,879
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Asset
Retirement Obligation
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41,879
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(b) December
31, 2011
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Depreciation Expense
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32,094
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Accumulated
Depreciation –
Oil
Tanker Depot
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32,094
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($600,000 + $41,879) ÷ 10 X
6/12
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Accretion Expense
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1,256
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Asset
Retirement Obligation
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1,256
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($41,879 X 6% X 6/12)
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(c) June
30, 2021
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Asset Retirement Obligation
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75,000
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Loss on Settlement of Asset
Retirement
Obligation
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5,000
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Cash
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80,000
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(d)
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Beg. Carrying Amount
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Accretion Expense (6%)
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Ending Carrying Amount
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2012
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41,879.00
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2,512.74
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44,391.74
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2013
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44,391.74
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2,663.50
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47,055.24
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2014
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47,055.24
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2,823.31
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49,878.55
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2015
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49,878.55
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2,992.71
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52,871.26
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2016
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52,871.26
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3,172.28
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56,043.55
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2017
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56,043.54
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3,362.61
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59,406.15
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2018
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59,406.15
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3,564.37
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62,970.52
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2019
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62,970.52
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3,778.23
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66,748.75
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2020
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66,748.75
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4,004.93
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70,753.68
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2021
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70,753.68
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4,245.22
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74,998.90
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(e) Balance Sheet:
Property,
Plant, and Equipment:
Oil
Tanker Depot $641,879
Less:
Accumulated Depreciation 32,094 609,785
Long-term
Liabilities:
Asset
Retirement Obligation 43,135
($41,879
+ $1,256)
Income
Statement:
Operating
Expenses
Depreciation
Expense 32,094
Accretion
Expense 1,256
(f) The
accretion expense is a non-cash expense. It would be omitted from cash from
operations in the statement of cash flows prepared using the direct method. It
would be added back to net income in the statement prepared using the indirect
method.
In
this particular situation, there would be no difference between an “ASPE
solution” and an “IFRS solution” except that IFRS might include a broader range
of future costs. However, to illustrate the difference between IFRS and ASPE,
the solution below sets out an assumption that illustrates a significant
difference between how the two GAAPs are applied.
(g) The
IFRS considers that only half of
the ultimate costs are caused by the acquisition of the property, and if no
production were carried out, only $37,500 would need to be spent to remediate
the site at the end of the 10-year period. However, as production proceeds,
further damage is done and the costs of clean-up associated with the additional
damage caused by production have to be recognized in the liability account. The
associated costs are recognized as production costs, similar to other
production costs.
Because
production does not even begin until July 1, 2011, there is no liability
associated with the production activities until December 31, 2011, the
company’s year end. Therefore, there is no accretion recorded for the July 1 to
December 31, 2011 period. However, on
December 31, the costs of remediation caused by the July to December production
are recognized as production costs and the first of the entries to the ARO for
the production activities is made.
Under
IFRS assuming the ARO related 50% to acquisition and 50% to the subsequent
production:
·
The
July 1/11 entry to acquire the oil tanker depot would be the same as under PE
GAAP.
·
Instead
of capitalizing the full $41,879 in the oil tank depot account, only ½ X
$41,879 or $20,940 would be capitalized at July 1/11.
·
The
depreciation expense for the six months ended December 31/11 would be ($600,000
+ $20,940) ÷ 10 X 6/12 = $31,047
·
Accretion
expense for the 6 months ended December 31/11 would be lower than under the
private enterprise standard. It would be $20,940 X 6% X 6/12 = $628.
·
In
addition, an entry would have to be made to recognize the increased ARO due to
the production activities for the 6 months with the costs charged to Inventory.
This is measured at the present value of the incremental costs caused by this
production. If $37,500 of the remediation obligation (ARO) was caused by the
acquisition of the asset, then the other $37,500 of the ARO, or $1,875 every
six months, is caused by production. At the end of December 2011, $1,078 is the
present value of the incremental cost caused by production (PV $1,875 using
i=6% and n=9.5 periods which gives a PV factor of .57490). On June 30, 2012, an
additional $1,110 costs will be recognized as production costs and an increase
in the ARO (PV $1,875 using i=6% and n=9 periods which gives a PV factor of
.59190). At June 30, 2012, accretion will have to be recognized as well because
$1,078 has been included in the liability since December 31, 2011. However,
only $1,078 is charged to Inventory and credited to the Asset Retirement
Obligation at December 31, 2011.
·
At
June 30, 2021, the asset retirement obligation will have accumulated to
$75,000, the same as under the private enterprise approach. Therefore the same
entry is made to recognize the $80,000 expenditure for remediation and the
$5,000 loss.
Note
to instructors: This may be more detail than you’d like to get into with your
students, but is provided here as one way to calculate reasonable numbers for
the entries. The following table sets out a “proof” that the asset retirement
obligation related to production activity and accretion for the first year’s
production will accumulate to 1/10 of the estimated retirement costs at the end
of 10 years or $3,750.
For
each period, the ARO relating to the current production is recorded at its
present value at the end of the period of production, added to the same
liability account for the ARO recognized for the asset acquisition, and then
accreted until the obligation is eventually retired.
There
is no amount in the ARO account related to inventory production until December
31/11, so no accretion is needed in that first period.
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Present
value of additional costs resulting from production in first year
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Accretion
at 6% per year
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Balance
of ARO related to production activity for first year
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Jul.1/11
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0
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0
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0
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Dec.31/11
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1,078
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0
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1,078
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Jul.1/12
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1,110
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32
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2,220
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Jul.1/13
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0
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133
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2,353
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Jul.1/14
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0
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141
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2,494
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Jul.1/15
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0
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150
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2,644
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Jul.1/16
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0
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159
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2,803
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Jul.1/17
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0
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168
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2,971
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Jul.1/18
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0
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178
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3,149
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Jul.1/19
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0
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189
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3,338
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Jul.1/20
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0
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200
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3,538
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Jul.1/21
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0
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212
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3,750
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