Chapter 10, Problem 10.2BYP

(1)

To determine

Costs to be capitalized

The initial cost of property, plant and equipment and the intangible assets that need to be capitalized, which includes the purchase price, and all other expenditures necessary to place the assets to its desired condition and location for use.

To identify: The specific citation that would rely on to determine (a) the accounting treatment for an asset retirement obligation and (b) the way to measure the obligation.

Explanation of Solution

From the web site of FASB (Financial Accounting Standards Board), following specific citation regarding the appropriate accounting treatment for asset retirement obligations could be derived:

1. (a) FASB ASC 410-20 “Asset Retirement Obligations” deals with the citation for asset retirement obligations. Section 410-20-25 requires that “an existing legal obligation associated with the retirement of a tangible long-lived asset be recognized as a liability and measured at fair value.” Section 410-20-25-5 requires that “upon initial recognition of the liability, the entity records the related asset at the same amount.”

1. (b) Fair value is computed as the sum of all present value of future cash flows. According to Section 410-20-30-1, “Traditionally, the way uncertainty has been considered in present value calculations has been by discounting the ‘best estimate’ of future cash flows applying a discount rate that has been adjusted to reflect the uncertainty or risk of those cash flows.” But the appropriate approach should be as per FASB’s Concept Statement No. 7 that indicates to adjust the cash flows but not discount rate for the risk in the cash flows. This is known as ‘expected cash flow approach’. The discount rate would be equivalent to credit-adjusted risk free rate. As such discount rate would be higher for the for the companies with higher credit risk.

(2)

To determine

The capitalized cost of the coal.

Explanation of Solution

Compute for the capitalize cost of the coal mine as follows:

Particulars	Amount
Cost to obtain the rights to operate the mine	$15,000,000
Development costs of the mine	$6,000,000
Restoration costs of the mine	$3,513,419
Total capitalized cost of the coal	$24,513,419

Table (1)

Hence, the total capitalized cost of the coal mine is $24,513,419.

Working note:

Total cash outflows for restoration cost are:

Cash outflow	Probability	Probable cash outflow
$3,000,000	20%	$600,000
$4,000,000	30%	$1,200,000
$5,000,000	25%	$1,250,000
$6,000,000	25%	$1,500,000
Total expected cash outflow		$4,550,000
Present value table of $1, n=3, i=9%		$\times$ 0.77218
Present value of total cash flows		$3,513,419

Table (2)

(3)

To determine

To prepare: A summary journal entry to record the acquisition costs of the mine.

Explanation of Solution

Prepare a summary journal entry to record the acquisition costs of the mine.

Date	Account Title and Explanation	Debit ($)	Credit ($)
	Coal mine	$24,513,419
	Cash		$21,000,000
	Asset retirement liability		$3,513,419
	(To record acquisition cost of the mine and retirement liability)

Table (3)

1. 1. Coal mine is an asset and has increased, therefore debit it.
   1. 2. Cash $\left(\$15,000,000+\$6,000,000\right)$ is an asset and has decreased, therefore credit it.
   2. 3. Asset retirement liability (restoration costs) is a liability and had increased, therefore credit it.

(4)

To determine

The accretion expense that would be recorded by the company in its income statement for the fiscal year 2016.

Explanation of Solution

Determine the accretion expense.

$\begin{array}{c}\text{Accretion expense}=\text{Asset retirement liability}\times \text{ risk free interest rate}\times \frac{6}{12}\\ =\$3,513,419\times \frac{9}{100}\times \frac{6}{12}\\ =\$158,104\end{array}$

Hence, the accretion expense that would be recorded by the company in its income statement for the fiscal year 2016 is $158,104.

(5)

To determine

To give: An explanation to the controller that how Company H should be accounted for the restoration, if the restoration costs differed from the recorded liability in 3 years.

Explanation of Solution

When the actual restoration cost would be more than the recoded liability at the retirement date, the H Company should recognize and record a loss on the retirement of the obligation, for the difference. The result will be opposite (gain) when the actual restoration expense would be less than the recorded liability on the retirement date.

(6)

To determine

To describe: The necessary disclosures requirements for the obligations.

Explanation of Solution

Following are the necessary disclosure requirement that Person A (controller) should include in the disclosure notes to the financial statements of H Company for the asset retirement obligation:

• General description of the asset retirement obligation and other long-lived assets associated with it.
• Fair value of the assets that is restricted for settling asset retirement obligations.
• A reconciliation of the beginning and ending asset retirement obligation balances, showing liabilities incurred in the current period, liabilities settled in the current period, accretion expense and revisions in estimated cash flows for change in the components mentioned, separately.

In case the fair value of the asset retirement obligation cannot be reasonably estimated, the facts and reasons thereof should be disclosed in the notes.