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Proved reserves are estimated by reference to available reservoir and well information, including production and
pressure trends for producing reservoirs and, in some cases, subject to definitional limits, to similar data from
other producing reservoirs. Proved reserves estimates are attributed to future development projects only where
there is a significant commitment to project funding and execution and for which applicable governmental and
regulatory approvals have been secured or are reasonably certain to be secured. Furthermore, estimates of
proved reserves only include volumes for which access to market is assured with reasonable certainty.
1
Assume that the depletion of one of Royal Dutch Shell's proved and proved developed oil reserves is
$6,000,000 for the current year. The journal entry to record the depletion of reserves and the transaction effects
are:
Note that the amount of the natural resource that is depleted is capitalized as inventory, not expensed. When the
inventory is sold, the cost of sales is then included as an expense on the income statement.
A depletion rate is computed by dividing the total acquisition and development cost (less any estimated residual
value, which is rare) by the estimated units that can be withdrawn economically from the resource. The depletion
rate is multiplied each period by the actual number of units withdrawn during the accounting period. This
procedure is the same as the units-of-production method of calculating depreciation.
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When buildings and similar improvements are acquired for the development and exploitation of a natural
resource, they should be recorded in separate asset accounts and depreciatednot depleted. Their estimated
useful lives cannot be longer than the time needed to exploit the natural resource, unless they have a significant
use after the source is depleted.
Acquisition and Depreciation of Intangible Assets
Intangible assets are increasingly important resources for organizations. An intangible asset has value because of
certain rights and privileges conferred by law on its owner. An intangible asset has no material or physical
substance. Examples include mineral rights to explore and develop land, landing rights for timeslots at airports,
patents, trademarks, and licences. Most intangible assets usually are evidenced by a legal document. The growth
in the importance of intangible assets has resulted from the tremendous expansion in computer information
systems and Web technologies. In fact, many lawyers specialize in finding potential targets for patent infringement
lawsuits for their clients.
Intangible assets are recorded at historical cost only if they are purchased. If an intangible asset is
developed internally, the cost of development normally is recorded as an expense. Upon acquisition of intangible
assets, managers determine whether the separate intangibles have definite or indefinite lives.
Definite Life: The cost of an intangible with a definite life is allocated on a straight-line basis each period over its
useful life in a process called amortization that is similar to depreciation and depletion. However, most
companies do not estimate a residual value for their intangible assets. Let us assume a company purchases a
patent for $800,000 and intends to uses it for 20 years. The adjusting entry to record $40,000 in patent
amortization expense ($800,000 20 years) is as follows:
Amortization expense is included on the income statement each period, and the intangible assets are reported at
cost less accumulated amortization on the statement of financial position.
Indefinite Life: Intangible assets with indefinite lives are not amortized. Instead, these assets are to be tested
at least annually for possible impairment, and the asset's carrying amount is written down (decreased) to its
recoverable amount if impaired. The two-step process is similar to that used for other long-lived assets, including
intangibles with definite lives.
Let us assume a company purchases for $120,000 cash a copyright that is expected to have an indefinite life. At
the end of the current year, management determines that the fair value of the copyright is $90,000. The $30,000
loss ($120,000 carrying amount less $90,000 fair value) is recorded as follows:
Goodwill By far, the most frequently reported intangible asset is goodwill. The term goodwill, as used by most
business people, means the favourable reputation that a company has with its customers. Goodwill arises from
factors such as customer confidence, reputation for good service and quality products, and financial standing.
For example, WestJet's promise to deliver no-frills, friendly, reliable transportation combines factors that
produce customer loyalty and repeated travel. From its first day of operations, a successful business continually
builds its own goodwill through a combination of factors that cannot be sold separately. In this context, goodwill
is said to be internally generated and is not reported as an asset.
For accounting purposes, GOODWILL is the excess of the purchase price of a business over the market value
of its identifiable assets and liabilities.
The only way to report goodwill as an asset is to purchase another business. Often, the purchase price of
a business exceeds the fair market value of all of the identifiable assets owned by the business minus all of the
identifiable liabilities owed to others. Why would a company pay more to acquire a business as a whole than it
would pay if it bought the assets individually? The answer is to obtain the acquired company's goodwill. It may
be easy for the acquiring company to buy a fleet of aircraft, but a new business would not generate the same
level of revenue flying the same routes as if it acquired WestJet's goodwill.
For accounting purposes, goodwill is defined as the difference between the purchase price of a company as a
whole and the fair market value of its net assets (all identifiable assets minus all identifiable liabilities).
Both parties to the sale estimate an acceptable amount for the goodwill of the company and add it to the
appraised fair value of the company's assets and liabilities. Then the sale price of the business is negotiated. The
resulting amount of goodwill is recorded as an intangible asset only when it actually is purchased at a measurable
cost, in conformity with the cost principle.
Companies that reported goodwill related to acquisitions prior to July 1, 2001, were required to amortize it over
an estimated useful life (not to exceed 40 years) by using the straight-line method. IFRS standards consider
goodwill to have an indefinite life, but any subsequent impairment in its value should be written down. This leads
to the recognition of a loss that is reported as a separate item on the income statement in the year the impairment
occurs.
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A TRADEMARK is an exclusive legal right to use a special name, image, or slogan.
Trademarks A trademark is a special name, image, or slogan identified with a product or a company. For
example, banks such as the Bank of Montreal, auto manufacturers such as Toyota and General Motors, and
fast-food restaurant chains such as Pizza Hut have familiar trademarks. Trademarks are protected by law when
they are registered at the Canadian Intellectual Property Office of Industry Canada. The protection of a
trademark provides the registered holder with exclusive rights to the trademark and can be renewed every 15
years throughout its life. Trademarks are often some of the most valuable assets that a company can own, but
they are rarely seen on statements of financial position. The reason is simple: intangible assets are not recorded
unless they are purchased. Companies often spend millions of dollars developing trademarks, but these
expenditures are recorded as expenses and not capitalized. Purchased trademarks that have definite lives are
amortized on a straight-line basis over their estimated useful life, up to a maximum period of 40 years.
Patents A patent is an exclusive right granted by the Canadian Intellectual Property Office of Industry Canada for
a period of 20 years. It is typically granted to a person who invents a new product or discovers a new process.
The patent enables the owner to use, manufacture, and sell both the subject of the patent and the patent itself.
Without the protection of a patent, inventors likely would be unwilling to develop new products. The patent
prevents a competitor from simply copying a new invention or discovery until the inventor has had a period of
time to earn an economic return on the new product.
A PATENT is granted by the federal government for an invention; it is an exclusive right given to the owner to
use, manufacture, and sell the subject of the patent.
A patent that is purchased is recorded at cost. An internally developed patent is recorded at only its
registration and legal cost because IFRS require the immediate expensing of research and development costs. In
conformity with the matching process, the cost of a patent must be amortized over the shorter of its economic life
or its remaining legal life.
A COPYRIGHT is the exclusive right to publish, use, and sell a literary, musical, or artistic work.
Copyrights Copyright protection also is granted by the Canadian Intellectual Property Office. It gives the owner
the exclusive right to publish, use, and sell a literary, musical, or artistic piece of work for a period not exceeding
50 years after the author's death. The book that you are reading has a copyright to protect the publisher and the
authors. It is illegal, for example, for an instructor to copy several chapters from this book and hand them out in
class. The same principles, guidelines, and procedures used in accounting for the cost of patents also are used for
copyrights.
A FRANCHISE is a contractual right to sell certain products or services, use certain trademarks, or perform
activties in a geographical region.
Franchises Franchises may be granted by either the government or other businesses for a specified period and
purpose. A city may grant one company a franchise to distribute gas to homes for heating purposes, or a
company may sell franchises, such as the right for a local outlet to operate a Mike's restaurant. Franchise
agreements are contracts that can have a variety of provisions. They usually require an investment by the
franchisee; therefore, they should be accounted for as intangible assets. The life of the franchise agreement
depends on the contract. It may be for a single year or an indefinite period. Tim Hortons, for example, had nearly
3,000 restaurants at December 31, 2008. The company's franchisees operate under several types of license
agreements. A typical franchise term for a standard restaurant is 10 years, with possible renewal periods. In
Canada, franchisees who lease land and/or buildings from the company are required to pay a royalty of 3.0
percent of the weekly gross sales of the restaurant.
TECHNOLOGY includes costs for computer software and Web development.
Technology The number of companies reporting a technology intangible asset has increased significantly in recent
years. Computer software and Web development costs are becoming increasingly significant as companies
modernize their processes and make greater use of advances in information and communication technology. In
2009, CGI Group Inc. reported a carrying amount of $124 million in Business Solutions in a note to its
statement of financial position and disclosed the following in its accounting policies:
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REAL WORLD EXCERPT
CGI Group
ANNUAL REPORT
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
2. Summary of Significant Accounting Policies
Other intangible assets
Other intangible assets consist mainly of internal-use software, business solutions, software licenses and client
relationships. Internal-use software, business solutions and software licenses are recorded at cost. Business
solutions developed internally and marketed for distribution are capitalized when they meet specific capitalization
criteria related to technical, market and financial feasibility. Business solutions and software licenses acquired
through a business combination are initially recorded at fair value based on the estimated net future income
producing capabilities of the software products.
Leaseholds A leasehold is the right granted in a contract called a lease to use a specific asset. Leasing is a
common type of business contract. For a consideration called rent, the owner (lessor) extends to another party
(lessee) certain rights to use specified property. Leases may vary from simple arrangements, such as the monthto-month (operating) lease of an office or the daily rental of an automobile, to long-lived (capital) leases having
complex contractual arrangements.
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LEASEHOLDS are rights granted to a lessee under a lease contract.
Lessees sometimes make significant improvements to a leased property when they enter into a long-term lease
agreement. A company that agrees to lease office space on a 15-year lease may install new fixtures or move
walls to make the space more useful. These improvements are called leasehold improvements and are
recorded as an asset by the lessee despite the fact that the lessor usually owns the leasehold improvements at the
end of the lease term. The cost of leasehold improvements should be amortized over the estimated useful life of
the related improvements or the remaining life of the lease, whichever is shorter.
LO7 Explain the impact on cash flows of the acquisition, use, and disposal of long-lived assets.
FOCUS ON CASH FLOWS EFFECT ON STATEMENT OF CASH FLOWS
The indirect method for preparing the operating activities section of the statement of cash flows involves
reconciling profit (reported on the income statement) to cash flows from operations. This means that, among
other adjustments, (1) revenues and expenses that do not affect cash and (2) gains and losses that relate to
investing or financing activities (not operations) should be eliminated. When depreciation is recorded, no cash
payment is made (i.e., there is no credit to Cash). Since depreciation expense (a non-cash expense) is subtracted
from revenues in calculating profit, it must be added back to profit to eliminate its effect.
Gains and losses on disposal of long-lived assets represent the difference between cash proceeds and the
carrying amount of the assets disposed of. Hence, gains and losses are non-cash amounts that do not relate to
operating activities, but they are included in the computation of profit. Therefore, gains are subtracted from profit
and losses are added to profit in the computation of cash flow from operations.
FOCUS COMPANY ANALYSIS Exhibit 9.5 shows a condensed version of WestJet's statement of cash
flows prepared by using the indirect method. Buying and selling long-lived assets are investing activities. In 2009,
WestJet used $119 million in cash to purchase aircraft and other property and equipment. WestJet sold old
aircraft during 2009 and received $27,000 in cash. Since selling long-lived assets is not an operating activity, any
gains (losses) on sale of long-lived assets that are included in profit are deducted from (added to) profit in the
operating activities section to eliminate the effect of the sale. Unless they are large, these gain and loss
adjustments are normally not specifically highlighted on the statement of cash flows. WestJet reports a gain of
$1,504,000 in its statement of cash flows for 2009.
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Finally, in capital-intensive industries such as airlines, depreciation is a significant non-cash expense included in
profit. In WestJet's case, depreciation expense is the single largest adjustment to profit in determining cash flows
from operations. It was 39 percent of operating cash flows in 2008 and has reached 44 percent in 2009.
on the statement of cash flows, depreciation expense is added back to profit (on an accrual basis) to compute
cash flows from operations (profit on a cash basis).
Although depreciation is a non-cash expense, the depreciation method used for tax purposes can affect a
company's cash flows. Depreciation, in the form of capital cost allowance (CCA), is a deductible expense for
income tax purposes. The higher the amount of CCA reported by a company for tax purposes, the lower the
taxable profit and the taxes it must pay. Because taxes must be paid in cash, a reduction in the tax obligation of a
company reduces the company's cash outflows.
The maximum deduction for CCA for each class of assets is based on rates specified by Canada Revenue
Agency, but corporations may choose to deduct lower amounts for CCA during periods of losses or low profit
before taxes, and postpone CCA deductions to future years to minimize their tax obligations.
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ACCOUNTING STANDARDS FOR PRIVATE INTERPRISES
Accounting standards for private enterprises differ from IFRS in two main areas: valuation of long-lived assets at
market value and measurement of impairment losses.
Under IFRS, Canadian publicly accountable enterprises may report their property, plant, and equipment by using
either the cost model or the revaluation model that uses the fair value of these assets as a basis for measurement.
However, most companies choose the cost model. In contrast, the accounting standards for Canadian private
enterprises do not permit the use of fair value as a basis for valuation of property, plant, and equipment.
The second area of difference relates to the measurement of impairment of long-lived assets. As a first step, the
undiscounted future cash flows expected to be generated from an asset, not the present value of the future cash
flows, are compared with the asset's carrying amount. If the asset's carrying amount exceeds the undiscounted
future cash flows, then the asset's carrying amount is compared with its net realizable value. When the asset's net
realizable value is less than its carrying amount, then the asset is impaired and should be written down to its net
realizable value. The write down of the asset would not be reversed in the future if its net realizable value
improves. In contrast, write downs of property, plant, and equipment of Canadian publicly accountable
enterprises can be reversed if the asset's recoverable amount increases in the future.
DEMONSTRATION CASE
Diversified Industries has been operating for a number of years. It started as a residential construction company.
In recent years, it expanded into heavy construction, ready-mix concrete, sand and gravel, construction supplies,
and earth-moving services.
The following transactions were selected from those completed during year 2011. They focus on the primary
issues discussed in this chapter. Amounts have been simplified for case purposes.
2011
Jan. 1 The management decided to buy a building that was about 10-years old. The location was excellent, and
there was adequate parking space. The company bought the building and the land on which it was situated for
$305,000. It paid $100,000 in cash and signed a mortgage note payable for the rest. A reliable appraiser
provided the following market values: land, $132,300, and building, $182,700.
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2. Record the adjusting journal entries based on the information for December 31([a] and [b] only).
3. Show the December 31, 2011, statement of financial position classifications and amount for each of the
following items:
Property, plant, and equipment land, building, equipment, and gravel pit Intangible assetpatent
4. Assuming that the company had sales of $1,000,000 for the year and a carrying amount of $500,000 for
property, plant, and equipment at the beginning of the year, compute the fixed asset turnover ratio. Explain
its meaning.
We strongly recommend that you attempt to answer the requirements on your own and then check your answers
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