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Natural Resources and Intangible Assets Acquisition and Depletion of Natural Resources

LO 6 Apply measurement and reporting concepts for natural resources and intangible assets.

NATURAL RESOURCES are assets that occur in nature, such as mineral deposits, timber, oil, and gas.

You may be familiar with some large companies that develop raw materials and products from natural resources, such as oil, diamonds, gold, or iron ore (e.g., Royal Dutch Shell, Anglo American, Barrick Gold). These resources are often called wasting assets because they are depleted (i.e., physically used up). Companies that develop natural resources are critical to the economy because they produce such essential items as lumber for construction and fuel for heating and transportation. Such companies attract considerable public attention because of the significant effect they can have on the environment.

It may surprise you to know that, in Canada, natural resource companies do not own the land from which they extract oil or minerals. They acquire mineral rights from the government to explore, develop, and extract minerals from the land, but they do not own the land itself. When the rights to explore and develop natural resources are acquired, they are recorded in conformity with the cost principle. The land remains the common property of Canadians. This is one reason why concerned citizens often read financial statements from companies involved in mineral exploration, development, and extraction to determine the amount of money spent to protect and remediate any damage done to the environment.

Through exploration, the company estimates the value of the resources extracted and sold throughout their productive lives. The quantity of resources in the reserve is carefully surveyed by using sophisticated geological engineering methods. The initial reserve value is then allocated or depleted on a reasonable basis to match the expected revenue generated from the sale of the resources.7

DEPLETION is the systematic and rational allocation of the cost of a natural resource over the period of exploitation.

Often these companies keep the reserve value separate from other property, plant, and equipment values incurred, because the companies may have to construct special roads and erect housing, buildings, and facilities in remote locations to extract the resources. When the site is put into production, these accumulated costs will be depreciated over the productive life of the site. Thus, natural resource companies amortize the acquisition costs of intangible mineral rights, deplete their reserve values, and depreciate exploration and development costs as well as self-constructed extraction facilities.

Royal Dutch Shell, for example, is a global company identified as an integrated petroleum explorer, developer, and refiner. The company depletes the acquisition cost of oil and gas reserves by using the units-of-production method. The company values the barrels of oil and cubic feet of natural gas in the reserves by using an estimate of proved, proved developed, and undeveloped reserves.


Depreciation, depletion and Amortisation

[B] Depreciation, depletion and amortisation

Property, plant and equipment related to hydrocarbon production activities are depreciated on a unit-of- production basis over the proved developed reserves of the field concerned (proven and probable minable reserves in respect of oil sands extraction facilities), except in the case of assets whose useful life is shorter than the lifetime of the field, in which case the straight-line method is applied. Rights and concessions are depleted on the unit-of-production basis over the total proved reserves of the relevant area. Where individually insignificant, unproved properties may be grouped and amortised based on factors such as average concession term and past experience of recognising proved reserves. Other property, plant and equipment are generally depreciated on a straight-line basis.

Estimation of Oil and Gas Reserves

Proved oil and gas reserves are the estimated quantities of crude oil, natural gas and natural gas liquids that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made. Proved developed reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. Estimates of oil and gas reserves are inherently imprecise, require the application of judgement and are subject to future revision.

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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.


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:

the depletion of reserves and the transaction effects are: Note that the amount of the natural

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 depreciated—not 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 ($800,000 ÷ 20 years) is as follows: Amortization expense is included on the income

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:

Examples of Intangible Assets Many Canadian companies disclose information about goodwill and other intangible assets

Examples of Intangible Assets

Many Canadian companies disclose information about goodwill and other intangible assets in their annual reports. These intangibles include broadcast rights, publishing rights, trademarks, patents, licences, customer lists, franchises, and purchased research and development. For example, WestJet provided the following details on its intangible assets in the notes to its 2009 annual report:

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Page 491 REAL WORLD EXCERPT Westjet Airlines ANNUAL REPORT Goodwill By far, the most frequently reported

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

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


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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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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.

Source: CGI Group Annual Report 2009.


LICENCES AND OPERATING RIGHTS, obtained through agreements with governmental units and agencies, permit owners to use public property in performing their services.

Licences and Operating Rights Licences and operating rights are typically obtained through agreements with governmental units or agencies and permit the holders to use public property in performing their services. For airline companies, the operating rights are authorized landing slots that are regulated by the government and are in limited supply at many airports. They are intangible assets that can be bought and sold by the airlines. Other types of licences that grant permission to companies include air waves for radio and television broadcasts, and land for cable and telephone lines.

Research and Development Expense—Not an Intangible Asset If an intangible asset is developed internally, the cost of development normally is recorded as research and development expense. Nokia Corporation has grown through acquisition of other companies with technology complementary to Nokia's, and it has recognized the value of its intangible assets, including goodwill. This industry can often attribute research and development expense to specific projects that are commercialized and successfully put into production. If Nokia can demonstrate that adequate resources are available or can be obtained to complete the project, and that future benefits are reasonably certain, then research and development costs can be deferred and amortized over the lifetime of the commercialized product as disclosed in the following note:



1. Accounting Principles

Research and development

Research and development costs are expensed as they are incurred, except for certain development costs, which are capitalized when it is probable that a development project will generate future economic benefits, and certain criteria, including commercial and technological feasibility, have been met.

Capitalized development costs, comprising direct labor and related overhead, are amortized on a systematic basis over their expected useful lives between two and five years. Capitalized development costs are subject to regular assessments of recoverability based on anticipated future revenues, including the impact of changes in technology. Unamortized capitalized development costs determined to be in excess of their recoverable amounts are expensed immediately.

Source: Nokia Corporation Annual Report 2009.

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 month- to-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.

LO 7 Explain the impact on cash flows of the acquisition, use, and disposal of long-lived assets.


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.

to profit in the computation of cash flow from operations. FOCUS COMPANY ANALYSIS → Exhibit 9.5

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.

gain of $1,504,000 in its statement of cash flows for 2009. Page 495 Finally, in capital-intensive

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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.

cash flows in 2008 and has reached 44 percent in 2009. REAL WORLD EXCERPT WestJet Airlines


Exhibit 9.5 WestJet Statement of Cash Flows FINANCIAL ANALYSIS A Misinterpretation

Some analysts misinterpret the meaning of a non-cash expense and often say that “cash is provided by depreciation.” Although depreciation is added in the operating section of the statement of cash flows, depreciation is not a source of cash. Cash from operations can be provided only by selling goods and services. A company with a large amount of depreciation expense does not generate more cash compared with a company that reports a small amount of depreciation expense, assuming that they are exactly the same in every other respect. Depreciation expense reduces the amount of reported profit for a company, but it does not reduce the amount of cash generated by the company, because it is a non-cash expense. Remember that the effects of recording depreciation are a reduction in shareholders' equity and in long-lived assets, not in cash. That is why,

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.


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.


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.


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.

Jan. 12 Paid renovation costs on the building of $38,100, prior to use.

June 19 Bought a third location for a gravel pit (designated No. 3) for $50,000 cash. The location had been carefully surveyed. It was estimated that 100,000 cubic metres of gravel could be removed from the deposit.

July 10 Paid $1,200 for ordinary repairs on the building.

Aug. 1 Paid $10,000 for costs of preparing the new gravel pit for exploitation.

Dec. 31 Year-end adjustments:

1. The building will be depreciated on a straight-line basis over an estimated useful life of 30 years. The estimated residual value is $35,000.

2. During 2011, 12,000 cubic metres of gravel were removed from gravel pit No. 3 and sold.

3. The company owns a patent right that is used in operations. On January 1, 2011, the patent account had a balance of $3,300. The patent has an estimated remaining useful life of six years (including 2011).

4. At the beginning of the year, the company owned equipment with a cost of $650,000 and a carrying amount of $500,000. The equipment is being depreciated by using the double-declining-balance method, with a useful life of 20 years with no residual value.

5. At year-end, the company identified a piece of old excavation equipment with a cost of $156,000 and remaining carrying amount of $120,000. Due to its smaller size and lack of safety features, the old equipment has limited use. The company reviewed the asset for possible impairment of value. The equipment has a fair value of $40,000.


1. Indicate the accounts affected and the amount and direction (+ for increase and - for decrease) of the effect for each of the preceding events on the basic accounting equation. Use the following headings:

the basic accounting equation. Use the following headings: Page 497 2. Record the adjusting journal entries

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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 asset—patent

We strongly recommend that you attempt to answer the requirements on your own and then check your answers with the suggested solution.


to answer the requirements on your own and then check your answers with the suggested solution.
7 Consistent with the procedure for recording depreciation, an accumulated depletion account may be used.

7 Consistent with the procedure for recording depreciation, an accumulated depletion account may be used. In practice, most companies credit the asset account directly for the periodic depletion. This procedure is also typically used for intangible assets, which are discussed in the next section.