Case Study (Carnarvon Petroleum Ltd.): Carnarvon Petroleum Ltd. is an oil and ga
ID: 2575764 • Letter: C
Question
Case Study (Carnarvon Petroleum Ltd.): Carnarvon Petroleum Ltd. is an oil and gas Exploration Company that prepares financial statements using internally developed accounting rules according to GAAP. To be able to compare Carnarvon’s financial statements with those of companies in their home country, financial analysts in Country I and Country II prepared a reconciliation of Carnarvon’s current year net income and stockholders’ equity. Adjustments were based on the actual accounting policies and practices followed by biotechnology companies in Country I and Country II. The following table shows the adjustments to income and stockholders’ equity made by each country analyst: Country I Country II Income under Carnarvon GAAP. . . . . . . . . . . . . . . . .1,050 1,050 Adjustments: Goodwill amortization . . . . . . . . . . . . .300 (100) Capitalized interest. . . . . . . . . . . . . . . . . . . . . . ……..50 50 Depreciation related to capitalized interest . . . ………(20) (20) Depreciation related to revalued fixed assets………… —(8) Income under local GAAP . . . . . . . . . . . . . . . . . …… 1,380972 Stockholders’ equity under CARNARVON GAAP.. . ….15,000 15,000 Adjustments: Goodwill . . . . . . . . . . . . . . . . . . . . . . . . 900 (300) Capitalized interest. . . . . . . . . . . . . . . . . . . . . . ………3030 Revaluation of fixed assets . . . . . . . . . . . . . . . ……… —56 Stockholders’ equity under local GAAP . . . . . . . …... 15,93014,786 Description of Accounting Differences: Carnarvon capitalizes goodwill and amortizes it over a 20-year period. Goodwill is also treated as an asset in Country I and Country II. However, goodwill is not amortized in Country I, but instead is subjected to an annual impairment test. Goodwill is amortized over a 5-year period in Country II. Interest. Carnarvon expenses all interest immediately. In both Country I and Country II, interest related to self-constructed assets must be capitalized as a part of the cost of the asset. Fixed assets. Carnarvon carries assets on the balance sheet at their historical cost, less accumulated depreciation. The same treatment is required in Country I. In Country II, companies in the biotechnology industry generally carry assets on the balance sheet at revalued amounts. Depreciation is based on the revalued amount of fixed assets. Required: 1. With respect to the adjustments related to goodwill, answer the following: a) Why does the adjustment for goodwill amortization increase net income under Country I GAAP but decrease net income under Country II GAAP? b) Why does the goodwill adjustment increase stockholders’ equity in Country I but decrease stockholders’ equity in Country II? c) Why are the adjustments to stockholders’ equity larger than the adjustments to income? 2. With respect to the adjustments made by the analyst in Country I related to interest, answer the following: a) Why are there two separate adjustments to income related to interest? b) Why does the adjustment to income for capitalized interest increase income, whereas the adjustment for depreciation related to capitalized interest decreases income? c) Why is the positive adjustment to stockholders’ equity for capitalized interest smaller than the positive adjustment to income for capitalized interest? 3. With respect to the adjustments made by the analyst in Country II related to fixed assets, why does the adjustment for depreciation related to revalue fixed assets decrease income, whereas the adjustment for revaluation of fixed assets increases stockholders’ equity? .ill etisalat 12:33 AM vle.aau.ac.ae Case Study (Carnarvon Petroleum Ltd.): Carnarvon Petroleum Ltd. is an oil and gas Exploration Company that prepares financial statements using internally developed accounting rules according to GAAP. To be able to compare Carmarvon's financial statements with those of companies in their home country, financial analysts in Country I and Country II prepared a reconciliation of Carnarvon's current year net income and stockholders' equity. Adjustments were based on the actual accounting policies and practices followed by biotechnology companies in Country I and Country II. The following table shows the adjustments to income and stockholders' equity made by each country analyst: Country Country II 1,050 1,050 300 50 (20) (100) Capitalized interest... . Depreciation related to capitalized interest. . Depreciation related to revalued fixed assets.. 50 (20) Income under local GAAP 1,380 Stockholders' equity u ....15,000 nder CARNARVON GAAP 15,000 (300) 30 30 Revaluation of fixed assets ···.. , , ,-..·.. 56 Stockholders' equity under local GAAP 15,930 14.786 Description of Accounting Diferences: Carnarvon capitalizes goodwill and amortizes it over a 20-year period. Goodwill is also treated as an asset in Country I and Country II. However, goodwill is not amortized in Country I, but instead is subjected to an annual impairment test. Goodwill is amortized over a 5-year period in Country II. Interest. Carnarvon expenses all interest immediately. In both Country I and Country II, interest related to selfExplanation / Answer
1.Adjustments related to Goodwill
a) It has been provided in the given problem that Goodwill is not amortized in Country I, and hence the Goodwill Amortized by Carnarvon should be added back to Income as per the necessary GAAP Rules of Country I.
In case of Country II, Goodwill is amortized over a span of 5 Years, rather than 20 Years as done normally by Carnarvon. As a result, a bigger amount is allowed to be expensed out in Country II, resulting in reduction of income under the relevant GAAP of Country II.
b) The reason behind this is that the Goodwill Adjustment has a bearing on Retained Earnings of Stockholder’s Equity. Since, Income increases in Country I, so does the Retained Earnings and resultant, Equity under Country I.
The case is reversed in Country II, due to decrease in income under Country II.
c) Income Figures correspond to One Year only i.e. Current Year. On the other hand, Figures stated in Stockholder’s Equity respond to Amounts Accumulated Over a Period of Time.
So, Adjustments seem larger in Equity Section in comparison with Adjustments in Income.
2.Adjustments related to Interest (Country I)
a) There are Two Separate Adjustments regarding Interest with Headings – “Capitalized Interest” and “Depreciation related to Capitalized Interest”.
Capitalized Interest refers to the Portion of Interest Capitalized under the corresponding GAAPs of the Country I.
Depreciation related to Capitalized Interest denotes the Portion of Interest Expensed-Out as Depreciation in current period, which was earlier capitalized as Cost of Asset.
b) Adjustment to Capitalized Interest Increases Income because Such Interest is not being Expensed-Out in the Current Period, rather now forming part of the Value of the Asset for the purpose of Determination of Income and Valuation of Asset under GAAP of Country I.
At the same time, the other Adjustment relating to Depreciation related to Capitalized Interest Reduces Income because the Asset Value now Increased by Capitalized Interest results in Increased Depreciation Amount, hence reducing income.
c) If seen closely, Both Adjustments Result in Net Effect of Increase in Income by $30 (Increase in Income by $50 and Corresponding Decrease through Depreciation Expense of $20). This Cumulative Effect of $30 then gets Posted as Increase in Stockholder’s Equity.
3.Adjustments related to Fixed Asset (Country II)
However, the Net Effect of Asset Increase will be Higher than the Quantum of Reduction of Income due to Depreciation Expense, thus overall resulting in Increase in Stockholder’s Equity.