Question

Deep Down Mining Corp. (DDM) is a publicly traded, Canadian-based mining operation with various mines located throughout Canada. Investors benchmark earnings compared to market expectations and to other similar companies. DDM’s loan facility with a consortium of banks stipulates that DDM’s long-term debt cannot exceed 1.5 times the book value of its equity. DDM 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, DDM prefers to adopt accounting policies that increase short-term profitability, to keep the equity base strong. As part of its compensation package, DDM 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 mine is the firm’s actual earnings before interest and taxes (EBIT) compared to the budgeted EBIT for the year. Projected financial results for the Xavier mine, an open-pit gold mine in northern British Columbia, are shown below. However, projections are notoriously unreliable, because the selling price of gold per ounce fluctuates significantly from year to year. When prices are high, the mine 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 tonne processed, and are projected to increase by inflation only. Projected financial results — Xavier mine (in $’000s) Year 1 Year 2 Year 3 Volume 110,000 154,000 88,000 Sales price $1,500 $2,100 $1,250 Revenue1 $165,000 $323,400 $110,000 Extraction2 88,000 126,896 74,687 Administration3 20,000 20,600 21,218 Earnings before interest, taxes, depreciation and amortization (EBITDA) $ 57,000 $175,904 $ 14,095 Depreciation4 10,000 10,000 10,000 EBIT $ 47,000 $165,904 $ 4,095 Intermediate Financial Reporting 1 Project 2 6 / 8 1 1,000,000 tonnes mined; 0.11 ounces recovered per tonne processed; Year 1, C$1,500 sales price per ounce; 1,000,000 tonnes mined × 0.11 = 110,000; 110,000 × $1,500 = $165 million; Year 2, C$2,100 sales price per ounce; 1,400,000 tonnes mined × 0.11 = 154,000; 154,000 × $2,100 = $323.4 million; Year 3, C$1,250 sales price per ounce; 800,000 tonnes mined × 0.11 = 88,000; 88,000 × $1,250 = $110 million 2 C$800 per ounce recovered with an inflation factor of 3% per year. For year 1: 110,000 × $800 = $88 million; Year 2 154,000 × ($800 × 1.03) = $126.896 million; Year 3 88,000 × ($800 × 1.03 × 1.03) = $74.687 million 3 Inflation factor of 3% per year. Will not be materially affected by changes in throughput. 4 Depreciation expense excluding the new Jaw Crusher. A brand-new class of equipment has recently been purchased by DDM for the Xavier mine. Details of the equipment • Jaw Crusher model XY2 is to be used in the Xavier mine and costs $10.5 million. • The manufacturer advises that the maximum capacity is 1.6 million tonnes per year. Your engineering staff has indicated that this throughput is probably on the high side and could only be achieved in ideal circumstances. • Your counterparts in other mining 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 1.4 million tonnes per year. They also advise that, as the machine ages, the capacity declines by about 5% per year, because the time lost for maintenance and repair shutdowns increases as the machine ages. • The manufacturer advises that the estimated useful life of the Jaw Crusher model XY2 varies depending on its usage, per the following table: Yearly production (% of maximum) Estimated maximum useful life 75% to 100% 10 years 16 million tonnes 50% to 75% 15 years 18 million tonnes 25% to 50% 25 years 20 million tonnes • Your research has determined that it is difficult to resell Jaw Crushers that are more than five years old due to the ongoing advances of technology for this type of equipment, as well as the prohibitive dismantling and shipping costs. Intermediate Financial Reporting 1 Project 2 7 / 8 Other information • DDM uses the cost model to subsequently measure the value of all its property, plant, and equipment (PPE). • DDM currently uses the straight-line method to depreciate all its depreciable nonmining PPE. The depreciation method used by DDM to depreciate PPE directly involved in mining 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 mines. When DDM 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 ore body1 of the Xavier mine is approximately 15 million tonnes. DDM expects that it will extract an average of 1 million tonnes of ore from the gold mine annually, thus taking about 15 years to exhaust the ore body. Actual volume will change yearly based on the price of gold. It is not uncommon for the tonnage extracted from mines to be significantly different from that originally projected. • The senior vice president of extraction has suggested that DDM should adopt the straight-line method to depreciate the Jaw Crusher because he would like to extract the same volume of ore each year. Required: Brian, 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 the brand-new class of equipment recently purchased by DDM for the Xavier mine. Prepare a memo to Brian 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 15-year useful life when calculating depreciation expense. • Determine the estimated residual value to be used when calculating depreciation expense. • Recommend a depreciation method. Quantify the impact on DDM’s projected EBIT for each option under consideration. 1 An ore body is an area of land that contains minerals such as gold, silver, or zinc, and is commercially viable to mine (extract the minerals). Intermediate Financial Reporting 1 Project 2 8 / 8 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, DDM’s financial reporting environment, the 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 Brian is the CFO of a public company.

Answer 1