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Intermediate Financial Reporting 1
Project 2
Intermediate Financial
Reporting 1
Project 2
Intermediate Financial Reporting 1
Project 2
Chartered Professional Accountants of Canada, CPA Canada, CPA
are trademarks and/or certification marks of the Chartered Professional Accountants of Canada.
© 2018, Chartered Professional Accountants of Canada. All Rights Reserved.
Intermediate Financial Reporting 1
Question 2 (12 marks)
CanAm Drilling Inc. (CDI) is a publicly traded, Canadian-based oil and gas company with
drilling sites located throughout the world, including in Canada. There is significant capital cost
associated with drilling activities. Investors benchmark earnings compared to market
expectations and to other similar companies.
CDI’s loan facility with a consortium of banks stipulates that CDI’s long-term debt cannot
exceed 1.5 times the book value of its equity. CDI is not currently in danger of breaching this
covenant, but is planning some acquisitions that will increase its debt significantly and bring its
debt-to-equity ratio much closer to the stipulated maximum. Wherever feasible, CDI prefers to
adopt accounting policies that increase short-term profitability, to keep the equity base strong.
As part of its compensation package, CDI awards bonuses to its executives on an annual
basis. The primary criterion considered by the board of directors when determining the size of
the bonuses to be awarded to the executives overseeing the production side of the business is
the firm’s actual earnings before interest and taxes (EBIT) compared to the budgeted EBIT for
the year.
Projected financial results for the Romanov Project are shown below. However, projections are
highly unreliable, because the price of a barrel of oil fluctuates significantly from year to year.
When prices are high, CDI increases production volume, and when prices are low, production
volume is reduced. The results below are based on expected high price/high volume in Year 2
and low price/low volume in Year 3, but the opposite situation might unfold, or prices might be
constant. Extraction costs are stable per barrel processed, and are projected to increase by
inflation only.
Projected financial results — Romanov Project (in ’000s)
Volume (in barrels)
Intermediate Financial Reporting 1
Project 2
Sales price
Earnings before interest, taxes, depreciation
and amortization (EBITDA)
EBIT Year 2: $88 sales price per barrel ×
6,000,000 barrels extracted = $528 million
Year 1
Year 2
Year 3
6,000,000 4,000,000
Year 3: $56 sales price per barrel × 4,000,000 barrels extracted = $224 million
$30 per barrel recovered, adjusted annually for inflation of 3%
Year 1: 5,000,000 barrels × $30 = $150 million
Year 2: 6,000,000 barrels × ($30 × 1.03) = $185.4 million
Year 3: $4,000,000 barrels × ($35 × 1.03 × 1.03 ) = $127.3 million
Inflation factor of 3% per year. Will not be materially affected by changes in throughput.
Depreciation expense excluding the new Turbine 3X
Vanessa Moore, the company’s chief financial officer, has asked you, the financial controller
and a CPA, to make recommendations with respect to an appropriate depreciation method for
a new class of drilling equipment, recently purchased by CDI for the Romanov Project.
Details of the equipment

The Turbine 3X is to be used in the Romanov Project and costs $21 million.

The manufacturer advises that the maximum load is 8 million barrels per year. Your
engineering staff has indicated that this is probably on the high side and could only be
achieved in ideal circumstances.

Your counterparts in other companies that use similar machinery advise that the maximum
capacity of this machine, when allowing for shutdowns for maintenance and emergency
repairs, is closer to 7 million barrels per year. They also advise that, as the machine ages,
the capacity declines by about 6% per year, because the time lost for maintenance and
repair shutdowns increases as the machine ages.
Price × Barrels extracted:
Year 1: $73 sales price per barrel × 5,000,000 barrels extracted = $365 million
Intermediate Financial Reporting 1

The manufacturer advises that the estimated useful life of the Turbine 3X model varies
depending on its usage, as shown in the following table:
Yearly production
(% of maximum)
75% to 100%
50% to 75%
25% to 50%

Project 2
Estimated maximum useful
10 years
80 million barrels
15 years
90 million barrels
25 years 100 million barrels
Your research has determined that it is difficult to resell turbines that are more than five
years old because of the ongoing advances of technology for this type of equipment, as
well as the high dismantling and shipping costs.
Other information

CDI uses the cost model to subsequently measure the value of all its property, plant and
equipment (PPE).
CDI currently uses the straight-line method to depreciate all its depreciable non-drilling
PPE. The depreciation method used by CDI to depreciate PPE directly involved in drilling
operations is governed by the nature of the PPE. Straight-line, double-declining-balance
and units-of-production methods are all used in various circumstances at other sites. When
CDI uses the double-declining-balance method of depreciation, the rate used is two times
the percentage used in the straight-line method.

Based on geological surveys, management estimates that the oil reserve of the Romanov
Project is approximately 65 million barrels. CDI expects that it will extract an average of 5
million barrels annually, thus taking about 13 years to exhaust the oil reserve. Actual
volume will change yearly based on the price of oil. It is not uncommon for the total
estimated oil reserve to be significantly different from that originally projected.

The senior vice-president of drilling has suggested that CDI should adopt the straight-line
method to depreciate the Turbine 3X because he would like to extract the same volume of
oil each year.
Write a memo to Vanessa Moore analyzing each of the three most widely used depreciation
methods. Your memo should include a summary of pertinent information and do the following:

Identify and explain what each of the methods entails, and then evaluate the advantages
and disadvantages of each method.

Determine whether each of the three depreciation methods would be suitable and explain
why or why not.

Recommend the estimated equipment life to be used (however, use management’s
assumptions of a 13-year useful life when calculating depreciation expense).
Intermediate Financial Reporting 1

Project 2
Determine the estimated residual value to be used when calculating depreciation expense.
Recommend a depreciation method. Quantify the impact on CDI’s projected EBIT for
each option under consideration.
Your response should be supported by a quantitative and qualitative analysis that considers
the precepts of the IFRS Conceptual Framework and the requirements of IFRS; CDI’s financial
reporting environment and financial reporting goals; and the potential biases of stakeholders. It
is recommended that you use point form in your memo and use language appropriate for a
financially sophisticated user, as Vanessa is the CFO of a public company.

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