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Chapter 21
Accounting for the extractive industries
21.1
21.2
To the extent that carried forward costs do not exceed the net-realisable value of
economically recoverable reserves, the full-cost method allows all exploration and evaluation
expenditure to be carried forward as an asset to be amortised against future production
revenue. Adopting a larger cost base, and not requiring each area of interest to be accounted
for separately and expensed as it becomes evident that economically recoverable reserves do
not exist on a particular site, means that the full-cost method will provide a lower volatility of
earnings relative to the area-of-interest method.
21.3
Pursuant to the AASB Framework, an asset shall be recognised in the financial statements
when, and only when:
(a)
(b)
it is probable that the future economic benefits embodied in the asset will eventuate;
and
the asset possesses a cost or other value that can be measured reliably.
Apart from permitting costs to be carried forward where such costs are expected to be
recouped through successful development and exploitation of the area of interest, AASB 6
also states that where exploration and/or evaluation activities in the area of interest have not
yet reached a stage which permits a reasonable assessment of the existence or otherwise of
economically recoverable reserves, and active and significant operations in, or in relation to,
the area are continuing, then such costs may be carried forward. Specifically, paragraph Aus
7.2 of AASB 6 states:
Aus7.2 An exploration and evaluation asset shall only be recognised in relation to an
area of interest if the following conditions are satisfied:
(a) the rights to tenure of the area of interest are current; and
(b) at least one of the following conditions is also met:
(i) the exploration and evaluation expenditures are expected to be recouped
through successful development and exploitation of the area of interest, or
alternatively, by its sale; and
(ii) exploration and evaluation activities in the area of interest have not at the
reporting date reached a stage which permits a reasonable assessment of the
existence or otherwise of economically recoverable reserves, and active and
significant operations in, or in relation to, the area of interest are continuing.
Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan
211
The ability to carry forward such costs in the absence of assessing that economic benefits are
probable would not directly seem to pass the probable test of the AASB Framework.
However, it may be argued that as the work is ongoing then management must consider it
probable that future benefits will eventuate.
The costs-written-off-and-reinstated method would seem to be consistent with the
requirements of the AASB Framework. This method would require that all exploration and
evaluation costs initially be written off due to the low probability of success, but be reinstated
if economically recoverable resources are proven to exist. The AASB Framework permits
assets to be reinstated where the related expenditure was previously expensed.
21.4
Firstly, there may have been an efficiency argument in which it was argued that those firms
that used the full-cost method did so because they believed that it most reliably reflected their
performance, relative to other accounting choices. Eliminating the full-cost method from their
portfolio of accounting methods may have then necessitated them using a method which did
not efficiently reflect their performance.
The elimination of the full-cost method would have required the full-costers to reduce their
assets and their owners equity, as a result of the requirement to write off expenses associated
with expenditures carried forward in relation to unsuccessful areas. This would have adverse
effects on gearing ratios and interest coverage ratios. To the extent that such ratios were
included within contracts that were already in place, then such adverse movements may have
motivated the management of the full-cost firms to lobby against the standard. Further, the
full-cost method minimises the volatility of earnings relative to other methods. Low volatility
of earnings would typically be preferred by management.
To the extent that management bonuses were tied to reported earnings, then this may also
have motivated management to lobby for the full-cost method. This would assume, of course,
that the measure of profit used in the compensation plan does not adjust for the method
used to account for pre-production expenditures.
21.5
An entity in the extractive industry should recognise restoration costs throughout the various
phases of its operations. That is, if a particular activity generates the need for subsequent
restoration work, then restoration expenses should be recognised at that time rather than
waiting until such time as the restoration work will ultimately be undertaken. AASB 6 does
not provide guidance in relation to restoration work. Rather, reference needs to be had to
AASB 137 Provisions, Contingent Liabilities, and Contingent Assets. Paragraph 11 of
AASB 6 states:
In accordance with AASB 137 Provisions, Contingent Liabilities and Contingent
Assets an entity recognises any obligations for removal and restoration that are
incurred during a particular period as a consequence of having undertaken the
exploration for and evaluation of mineral resources.
Provisions, including provisions for restoration, are to be measured at present values.
Specifically, paragraphs 36, 45 and 47 of AASB 137 require:
36. The amount recognised as a provision shall be the best estimate of the
expenditure required to settle the present obligation at the reporting date.
212
45. Where the effect of the time value of money is material, the amount of a
provision shall be the present value of the expenditures expected to be required
to settle the obligation.
47. The discount rate (or rates) shall be a pre-tax rate (or rates) that reflect(s)
current market assessments of the time value of money and the risks specific to
the liability. The discount rate(s) shall not reflect risks for which future cash
flow estimates have been adjusted.
Appendix C to AASB 137 provides an illustration of a provision that has a bearing on this
question. This Appendix is reproduced in Chapter 21. As the Appendix indicates, if the
construction of particular facilities, such as drilling platforms and so forth necessitates future
remediation or restoration works when such facilities are removed, then a provision for
restoration should be recognised at the time the facilities are constructed and the expected
cost of restoration should be included as part of the cost of the assets, with the total cost
being amortised over the useful life of the site. Other restoration costs necessitated by the
ongoing operations of the site should be provided for throughout the operations and treated
as part of the cost of the respective phases of operations. These costs will ultimately form
part of the cost of the inventory of the organisation.
The reporting entity would be required periodically to reassess the amount provided for the
restoration provision in the light of changes in expected future costs, changes in expectations
relating to the amount of disturbance being caused, changes in relevant laws and changes in
technologies utilised to perform the restoration and rehabilitation works.
Entities involved in the extractive industries might also be held responsible for environmental
damage caused by spills and leakages to land or water. Cost related to required clean-ups
would typically be treated as expenses in the periods in which the spills or leakages occur.
21.6
The recognition of liabilities is not restricted to liabilities that only arise because of legal
obligations. Provisions for restorations should be recognised where there is an expectation
that an area of interest will be restored. AASB 137 does not restrict recognition to those
situations where there is a legal obligation to restore the land.
Pursuant to the AASB Framework, liabilities would include those obligations required by law,
as well as obligations that are equitable or constructive. Paragraph 60 of the AASB
Framework states that:
An essential characteristic of a liability is that the entity has a present obligation. An
obligation is a duty or responsibility to act or perform in a certain way. Obligations
may be legally enforceable as a consequence of a binding contract or statutory
requirement. This is normally the case, for example, with amounts payable for goods
and services received. Obligations also arise, however, from normal business practice,
custom and a desire to maintain good business relations or act in an equitable manner.
If, for example, an entity decides as a matter of policy to rectify faults in its products
even when these become apparent after the warranty period has expired, the amounts
that are expected to be expended in respect of goods already sold are liabilities.
Any obligation for restoration would typically be considered to be a
provision. According to paragraph 14 of AASB 137 Provisions, Contingent
Liabilities and Contingent Assets, a provision shall be recognised when:
(a) an entity has a present obligation (legal or constructive) as a
result of a past event;
213
The cost of inventories should include all the expenses necessarily incurred to get the
inventory into the condition and position at the point of sale. This will necessarily require
amounts attributed to:
production costs.
The above costs would be allocated in respect of exploration and evaluation expenditures;
restoration costs; costs incurred in establishing access to the deposit or field; and costs
incurred in establishing necessary infrastructure.
Under the area-of-interest method, the cost of inventories would not include expenses
relating to operations in other areas of interest, some of which may have been abandoned.
21.8
If the full-cost method is used, this will mean that a greater amount of costs will be carried
forward relative to the area-of-interest method. If a particular area is abandoned and an entity
is using the full cost method, then to the extent that the entity considers the returns from its
economically recoverable reserves will equal or exceed the total costs incurred across all
sites, there will be no expenses recognised when the area is abandoned. This can be
contrasted with the area-of-interest method, which would require the costs carried forward in
respect of an area-of-interest to be expensed in the period in which the decision to abandon is
made. Hence, in the initial years in which particular sites are abandoned, the full-cost method
will generate greater profits.
Under the full-cost method, greater costs will be carried forward (because the costs
attributed to the abandoned sites are still retained as part of the cost base). This means that,
relative to the area-of-interest method, amortisation costs will be greater. This further means
that in those periods when no sites are abandoned, the area-of-interest method will generate a
greater profit for the reporting entity, relative to the full-cost method.
The full-cost method will generate profits which show less variability, or volatility, than the
profits generated by applying the area-of-interest method.
214
21.9
Amortisation based on the expiration of time is relevant where production is limited by time,
for example where the area is under a fixed period of tenure and the expected reserves are
expected to outlast the period of the tenure. However, if activities are to be continued in the
area of interest until such time that the economically recoverable reserves have been
exhausted then amortisation of carry forward costs should be undertaken on a production
basis with the denominator being expected recoverable reserves.
21.10 AASB 6 restricts its attention to activities undertaken in the exploration and evaluation
phases. During the exploration and evaluation phase there is typically no revenue against
which capitalised costs can be amortised. Nevertheless, the carried-forward expenditure is
required to be subject to regular impairment testing. As paragraph 18 of AASB 6 states:
Exploration and evaluation assets shall be assessed for impairment when facts and
circumstances suggest that the carrying amount of an exploration and evaluation
asset may exceed its recoverable amount. When facts and circumstances suggest
that the carrying amount exceeds the recoverable amount, an entity shall measure,
present and disclose any resulting impairment loss in accordance with AASB 136.
Because the capitalised exploration and evaluation expenditure has not generated an asset
that is available for use, it would not be depreciated but, as indicated above, it would need to
be tested for impairment.
Amortisation based on time is suitable where production is limited by time, as it would be
under a fixed-period tenure of the area of interest. It may also be appropriate where reserves
are so large as to approach an infinite life; to adopt some arbitrary time limit for the purposes
of amortisation.
One important issue to consider in determining the useful life of assets associated with the
extractive industries is whether the assets can be transferred to some other area of interest or
whether they may have further use not necessarily connected with any particular area of
interest. If they are portable, or transferable to other uses, then they should be depreciated
over their own specific useful life. If they are not transferable then their useful life will not be
greater than the expected life of the particular area of interest. Such non-transferable assets
would be depreciated over the life of the area of interest, using either a time basis, or a
production basis (whichever is the more appropriate).
21.11 The Accounting Standard AASB 6 states that assets associated with exploration and
evaluation activities may be carried forward, as long as a reasonable probability of success
exists in that area of interest. Therefore, the expenditure can be expensed as incurred if an
entity chooses. Specifically, paragraphs Aus 7.1 and 7.2 of AASB 6 state:
Aus7.1 An entitys accounting policy for the treatment of its exploration and evaluation
expenditures shall be in accordance with the following requirements. For each area
of interest, expenditures incurred in the exploration for and evaluation of mineral
resources shall be:
(a) expensed as incurred; or
(b) partially or fully capitalised, and recognised as an exploration and evaluation
asset if the requirements of paragraph Aus7.2 are satisfied.
An entity shall make this decision separately for each area of interest.
Aus7.2 An exploration and evaluation asset shall only be recognised in relation to an area
of interest if the following conditions are satisfied:
(a) the rights to tenure of the area of interest are current; and
(b) at least one of the following conditions is also met:
Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan
215
(i)
(ii)
Hence, pursuant to AASB 6, a reporting entity can elect to write-off all exploration and
evaluation expenditure as incurred, regardless of their expectations regarding the likelihood
that the expenditure will lead to the discovery of economically recoverable reserves. Students
should be encouraged to consider why a reporting entity might elect to write-off all
exploration and evaluation expenditure.
21.12 Such an approach would be excessively conservative and would lead to an understatement of
a reporting entitys assets. Exploration and evaluation expenditure would not be undertaken if
it was considered that none of the expenditure would lead to economic benefits. Clearly,
some of the expenditure will lead to future economic benefits, and as such, some of the
expenditure should be carried forward to future periods. Further, if every reporting entity
were simply to write-off all its exploration and evaluation expenditure as incurred, readers of
financial reports would be unable to discriminate between entities that have undertaken
successful exploration and evaluation, and those that have not.
216
21.13 (a)
Area-of-interest method
2007
Dr
Dr
Dr
16
Cr
25
64
2008
Dr
Cr
Dr
Dr
Cr
16
16
18.4
4.6
23
Dr
Dr
Cr
Dr
Dr
Cr
Cr
20
38.4
11.6
7
27
38.4
11.6
217
Dr
Cr
Cr
10
7.68
2.32
4
4
57
57
(1.9m $30)
Dr
Cr
8.87
8.87
Full-cost method
2007
Dr
Cr
64
64
218
2008
Dr
Dr
Cr
Dr
Cr
Dr
Dr
Cr
Cr
Dr
Cr
Cr
51.2
20
71.2
19.8
18.2
12.8
64
7
27
71.2
19.8
14.24
3.96
(91 3/15)
Dr
Cr
Dr
Cr
Cash/receivables
Sales revenue
Dr
Cr
4
4
57
57
14.06
14.06
(22.2 1.9/3)
21.14 (a)
Area-of-interest method
2007
Dr
Dr
Cr
1 500
2 000
3 500
2008
Solutions Manual t/a Australian Financial Accounting 5/e by Craig Deegan
219
Dr
Dr
Cr
2 000
3 000
5 000
2110
2009
Dr
Dr
Cr
Dr
Cr
Dr
Cr
3 000
5 200
9 000
2 000
4 000
7 000
1 300
6 500
9 000
2010
Dr
Cr
2 000
Dr
Cr
Buildings
Cash/payables
Dr
Dr
Cr
5 200
1 300
2 268
Cr
Dr
Cr
500
500
5 200
1 300
1 920
348
50
50
2 000
2 000
(400 5.00)
Dr
Cash/receivables
6 250
2111
Cr
Sales revenue
6 250
(250 25.00)
Dr
Cr
2 699
2 699
2112
(b)
Full-cost method
2007
Dr
Cr
3 500
5 000
7 000
3 100
3 500
2008
Dr
Cr
5 000
2009
Dr
Cr
Dr
Dr
Cr
7 000
12,400
15 500
(It is assessed that future production will enable the recoupment of all of this
expenditure.)
2010
Dr
Cr
Dr
Cr
Dr
Cr
Dr
Cr
Dr
Cr
Cr
2 000
12 400
4 668
2 000
500
500
12 400
3 100
3 100
3 840
828
(400 $11.67, where ($12 400 + $3 100 + $2000)/1500 = $11.67 per tonne.)
Dr
50
2113
Cr
50
2 000
2 000
(400 5.00)
Dr
Cr
Cash/receivables
Sales revenue
6 250
6 250
(250 25.00)
Cost of goods sold
Inventory of crude oil
4 199
4 199
$ million
9
10
10
$ million
29
(To account for the initial exploration and evaluation costs incurred in each site.)
Dr
Cr
Dr
Cr
10
6
9
10
(To signify that a judgement has been made that economically recoverable resources exist.
Also, to write-off the carried forward costs in relation to Tree Site.)
Dr
Cr
Dr
Dr
Cr
3
6
2.1
Cr
Dr
Cr
Cr
12
12
3
6
1.5
0.6
2114
amount
is
calculated
as
2
2
(To recognise the production costs which are treated as a cost of the inventory, rather than
being written-off directly.)
Dr
Cr
Cash/receivables
Sales revenue
12
12
(To recognise sales made, where $12 million equals 4000 tonnes multiplied by $3000 per
tonne.)
Dr
Cr
3.28
3.28
The company therefore has a choice. It can write off the exploration and evaluation costs
incurred. Alternatively, on the basis that activities have not reached a stage that permits a
reasonable assessment of the existence or otherwise of economically recoverable reserves,
the company might elect to capitalise the expenses in an asset account identified as
exploration and evaluation assets (or similar). The company would need to clearly segregate
the costs associated with the particular area of interest from other areas of interest.
2115