Diamante Mining Corp. (DMC) is a publicly traded. Spanish-based mining operation with mines located around the world,
Question:
Diamante Mining Corp. (DMC) is a publicly traded. Spanish-based mining operation with mines located around the world, including in Canada. Investors benchmark earnings compared to market expectations and to other similar companies. In Canada. DMC operates an open-pit diamond mine in Northern Manitoba.
Wherever feasible. DMC prefers to adopt accounting policies that increase short-term profitability, to keep the equity base strong.
As part of its compensation package. DMC 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 Manitoba diamond mine are shown below. However. projections are highly unreliable, because the selling price of a carat 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 carat recovered, and are projected to increase by inflation only.
Projected financial results ? Manitoba mine (In '000s)
1. Carats are recovered at a rate of 87 carats per hundred tonnes processed.
Year 1: $118 sales price per carat; 2,000,000 tonnes mined/100 x 87 = 1,740,000; 1.740,000 x $118
Year 1: $168 sales price per carat; 2,400,000 tonnes mined/100 x 87 = 2,088,000; 2,088,000 x $168
Year 3: $94 sales price per carat 1 200,000 tonnes mined/100 x 87 = 1,044,000; 1,044,000 x $94
2. $65 per carat recovered with an inflation factor of 2% per year.
Year 1: 1.740,000 x $65
Year 2: 2.088,000 x ($65 x 1.02)
Year 3: 1.044,000 x ($65 x 1.02 x 1.02)
3. Inflation factor of 2% per year. Will not be materially affected by changes in throughput.
4. Depreciation expense excluding the new Crossbelt Analyzer (CA)
Janice West, 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 brand-new class of equipment recently purchased by DMC for the Manitoba mine.
Details of the equipment:
- The Crossbelt Analyzer costs $12.5 million.
- The manufacturer advises that the maximum capacity is 3 million tonnes of earth 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 2.5 million tonnes per year. They also advise that as the machine ages, the capacity declines by about 3% 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 Crossbelt Analyzer varies depending on its usage, as shown in the following table:
Your research has determined that it is difficult to resell Crossbelt Analyzers that are more then five years old because of the ongoing advances of technology for this type of equipment.
Other information
- DMC uses the cost model to subsequently measure the value of all its property. plant and equipment (PPE).
- DMC currently uses the straight-line method to depreciate all its depreciable non-mining PPE. The depreciation method used by DMC 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 DMC 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 size of the Manitoba mine is approximately 28 million tonnes. DMC expects that it will extract an average of 1.9 million tonnes of earth from the diamond mine annually. thus taking about 15 years to exhaust the mine. Actual volume will change yearly based on the price of a carat. 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 DMC should adopt the straigh-line method to depreciate the Crossbelt Analyzer because he would like to extract the same volume of earth (and therefore carats) each year.
Required:
Write a memo to Janice West 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 DMC'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 [FRS, DMC'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 Janice is the CFO of a public company.
Advanced Accounting
ISBN: 978-0538480284
11th edition
Authors: Paul M. Fischer, William J. Tayler, Rita H. Cheng