Chapter 10, Problem 10.2BYP

Research Case 10–2

FASB codification; locate and extract relevant information and cite authoritative support for a financial reporting issue; restoration costs; asset retirement obligation

• LO10–1

Your client, Hazelton Mining, recently entered into an agreement to obtain the rights to operate a coal mine in West Virginia for $15 million. Hazelton incurred development costs of $6 million in preparing the mine for extraction, which began on July 1, 2018. The contract requires Hazelton to restore the land and surrounding area to its original condition after extraction is complete in three years.

The company controller, Alice Cushing, is not sure how to account for the restoration costs and has asked your advice. Alice is aware of an accounting standard addressing this issue, but is not sure of its provisions. She has narrowed down the possible cash outflows for the restoration costs to four possibilities.

Cash Outflow	Probability
$3 million	20%
4 million	30%
5 million	25%
6 million	25%

Alice also informs you that the company’s credit-adjusted risk-free interest rate is 9%. Before responding to Alice, you need to research the issue.

Required:

1. 1. Obtain the relevant authoritative literature on accounting for asset retirement obligations using the FASB Accounting Standards Codification. You might gain access at the FASB website (www.fasb.org). Explain the basic treatment of asset retirement obligations. What are the specific citations that you would rely on to determine (a) the accounting treatment for an asset retirement obligation and (b) how to measure the obligation?
2. 2. Determine the capitalized cost of the coal mine.
3. 3. Prepare a summary journal entry to record the acquisition costs of the mine.
4. 4. How much accretion expense will the company record in its income statement for the 2018 fiscal year, related to this transaction? What are the specific citations from the FASB Accounting Standards Codification that address (a) the calculation of accretion expense and (b) the classification of accretion expense in the income statement?
5. 5. Explain to Alice how Hazelton would account for the restoration if the restoration costs differed from the recorded liability in three years. By way of explanation, prepare the journal entry to record the payment of the retirement obligation in three years assuming that the actual restoration costs were $4.7 million.
6. 6. Describe to Alice the necessary disclosure requirements for the obligation. What is the specific citation from the FASB Accounting Standards Codification that contains these disclosure requirements?

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.”
2. (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.

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)

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

To determine

The accretion expense that would be recorded by the company in its income statement for the fiscal year 2018.

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 2018 is $158,104.

To determine

To identify: The specific citation that describes (a) the calculation of accretion expense and (b) the classification of accretion expense in its income statement.

Explanation of Solution

The specific citation from FASB’s Accounting Standards Codification for calculation of accretion expense is described in FASB ASC 410-20-35-5.

The classification of accretion expense in income statement is described in FASB ASC 410-20-45-1.

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.

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.