Gretna, Inc., Inc. is a medium sized petroleum company. The company has recently developed and obtained a patent for a revolutionary drill bit. The research and development leading to the patent took several years and cost $ 351,000, $ 100,000 of which were incurred in 1995. Additionally, the company spent $ 15,000 in legal fees to obtain the patent. The patent could be sold for $2,000,000. In 1995, Gretna purchased Green Co. at a total cost of $ 12,000,000. Among Green's assets was a patent, which has been recorded at its market value of $ 180,000. The net market value of Green's other assets amounted to $ 9,000,000, resulting in recorded Goodwill of $2,820,000. During 1995 Gretna, Inc. incurred oil exploration costs of $ 8,000,000. These exploration costs resulted in finding substantial quantities of oil at only one of four drill sites, three other sites were abandoned as "dry holes". These "dry holes" cost $5,200,000, compared to $2,800,000 for the productive site. The productive site is estimated to contain 500,000 barrels of oil. Gretna, Inc., uses the "Full Cost" Method of accounting for oil exploration. During 1995 20,000 bbl have been produced and sold from the new site. The controller for Gretna, Inc.. has prepared a schedule showing the following capitalized costs and expenses for patents, goodwill and partial oil reserves:

Item

BookValue

Amortization Period

Fair Market Value

Drill bit Patent

$15,000

15 years

$2,200,000

Pumper Patent

$180,000

10 years

$180,000

Exploration

$8,000,000

500,000 bbl

Goodwill

$2,820,000

40 years

Other Information

Revenue, 1995

$6,000,000

Other costs & expenses

$3,600,000

Mr. Smythe, the major shareholder and CEO of Gretna, Inc., has seen these figures and the preliminary income statement and balance sheet and he is upset. In his view the controller's figures make no sense at all. He demands to know why the patent that cost a total of $315,000, should appear on the balance sheet at a ridiculous figure of $15,000, while the much less important patent for the pumper is shown at its full cost of $180,000. "That patent is going to have major benefits for us. It will drastically reduce our costs and we will make money from it through licensing agreements with other companies."

He also wants to know why the company should have to write off the research and development costs for the patent (which after all will be very profitable) but is permitted to capitalize all of its oil exploration costs. Finally, he is upset about the required accounting treatment for Goodwill. He feels that Gretna (which he founded) has created significant amounts of goodwill, but is not allowed to recognize it. In his words:

 "Back in '75 when I founded Gretna, I was determined that this would be a class operation. We hired the best people, we treat and pay them well and it has paid off in tremendous employee loyalty and productivity. These guys and gals work like demons and have some absolutely brilliant ideas. They are the company! Not to recognize this as part of the value of the firm really understates what Gretna is worth! You accountants always talk about relevance and reliability and decision useful information and stuff like that, it seems to me you have no idea what in the world you are doing!" Unfortunately for you, Mr. Smythe has recently heard that most of software development costs can in fact be capitalized. He is demanding to know how they differ from the development costs his company incurred for the patent. "Help me out here! Do those guys at the FASB just make up these rules to drive everybody nuts or is there some method to their madness?"

Assignment Individual assignment:

1. Prepare comparative income statements using (a) the full cost method and (b) the successful effort method. Assume that the costs and expenses shown above do not include any expenses associated with the items discussed above.
2. Briefly answer Mr. Smythe's questions.

1. Refer to the presentation schedule to find out which role your group will play.
• FASB Staff - Statement evaluating IASC standards and proposals regarding Intangible Assets, Goodwill and Oil and Gas reporting
• FASB Staff - Report on current status and developments regarding the accounting for Intangible Assets, Goodwill and Oil and Gas reporting.
• Industry Lobbying (you are a small to medium size company): Submission to the FASB - Statement in Favor of Full Capitalization of all Intangible Assets. Prepare a report (including a cover letter and appropriate appendices) in which you argue in favor of capitalization of all intangible assets and continued choice between the Full Cost and the Successful Efforts method for exploration cost.
• Industry lobbying (you are a large, internationally active company, probably a multi-national) Submission to the FASB - Statement in Favor of Full Expensing all Intangible Assets. Prepare a report (including a cover letter and appropriate appendices) in which you argue in favor of expensing all intangible assets and the Successful Efforts method for exploration cost.
• Accounting Firm - Technical: Submission to the FASB - Statement in Favor of Expensing all Intangible Assets. Prepare a report (including a cover letter and appropriate appendices) in which you argue that all intangible assets (including Goodwill and Software Development costs should be expensed as incurred and that the Successful Efforts method should be required for all exploration costs.
• Accounting Firm - Technical: Submission to the FASB - Statement in Favor of Full Capitalization of all Intangible Assets. Prepare a report (including a cover letter and appropriate appendices) in which you argue in favor of capitalization of all intangible assets and continued choice between the Full Cost and the Successful Efforts method for exploration cost.

 

2. All Groups: Make sure to cite authoritative support and address the issues of relevance, reliability, decision usefulness and any other accounting principles or concepts you believe are relevant.

To help you with this assignment check the following sources:

 Check summaries of relevant Statements on the FASB's Summary page:

For the full text use FARS (CD ROM)

For information relating to Research and Development expenses and software development costs check

Statement No. 2

Statement No. 68

Statement No. 86

For information regarding accounting for oil and gas exploration see:

Statement No. 19

Statement No. 25

Statement No. 33

Statement No. 39

Statement No. 69

For information regarding the FASB's position on the IASC and international accounting principles, see the international section of the FASB homepage. Of special interest might be the FASB staff response to the IASC exposure draft on intangible assets (E60)

The FASB is re-examining the issue of Goodwill as part of its reexamination of APB 16(Business Combinations) and APB 17 (Intangible Assets) The link above is one of several files available from the FASB relating to this subject. To obtain other files do the following; go to the FASB web site. Go to the search. Type "business combinations" in the search field. Check out the files that are available. Sorry, but I can't put in any direct links to them - God bless frames. The FASB has issued a revised exposure draft on business combinations. (Goodwill!) It is accessible right on the FASB home page.

International Accounting Standards and related information: Check out the IASC webpage and IASCplus a web page that provides a lot of information regarding international accounting practices, standards, etc.

Securities and Exchange Commission (SEC)

The SEC has made a number of pronouncements on oil and gas accounting, see what you can find. 

Look up the report by the AICPA's Special Committee on Financial Reporting: Database of Materials On Users' Needs for Information.

Chapter 18 International harmonization

Chapter 7 (a) Goodwill

Chapter 7 (b) Other Intangibles

To find additional information on these and other topics, go to raw and use the search feature and use LEXIS-NEXIS and/or InfoTrac.