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BX 3012 Tutorial 4 – Chapter 20 Deegan AFA 8th Edition

Chapter 20 Accounting for the extractive industries Review questions 20.1

Define Area of Interest. Pursuant to paragraph Aus7.3 of AASB 6: An area of interest refers to an individual geological area whereby the presence of a mineral deposit or an oil or natural gas field is considered favourable or has been proved to exist. It is common for an area of interest to contract in size progressively, as exploration and evaluation lead towards the identification of a mineral deposit or an oil or natural gas field, which may prove to contain economically recoverable reserves. When this happens during the exploration for and evaluation mineral resources, exploration and evaluation expenditures are still included in the cost of the exploration and evaluation asset notwithstanding that the size of the area of interest may contract as the exploration and evaluation operations progress. In most cases, an area of interest will comprise a single mine or deposit or a separate oil or gas field.

20.2

Would Full Cost Method, or Area of Interest Method provide for greater volatility in earnings? 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.

20.3

What method would most likely be used if the Conceptual Framework were the overriding regulation? Pursuant to the IASB/AASB Conceptual Framework, an asset shall be recognised in the financial statements when, and only when: (a)

it is probable that the future economic benefits embodied in the asset will eventuate

(b)

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 Aus7.2 of AASB 6 states: 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 end of the reporting period reached a stage which permits a reasonable assessment

BX 3012 Tutorial 4 – Chapter 20 Deegan AFA 8th Edition 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. 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 Conceptual 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 Conceptual 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 Conceptual Framework permits assets to be reinstated where the related expenditure was previously expensed. 20.7

What costs should be included in the cost of inventory of an extractive industries entity? 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:  amortisation of pre-production costs (either on a production or time basis)  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.

20.9

When would we use time as the basis for amortising preproduction costs incurred in a mining venture? 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.

20.10 For depreciable assets used in a particular area of interest, what factors would you consider in determining the depreciation period (useful life) of the asset? 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.

BX 3012 Tutorial 4 – Chapter 20 Deegan AFA 8th Edition 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). 20.11 Could an extractive industries entity write off all exploration and evaluation expenditure regardless of the success of the site? 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 entity’s 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: (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.

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. 20.12 Evaluate the statement: ‘Because exploration and mining activities are inherently risky and uncertain, all exploration and evaluation expenditure should be expensed as incurred. Such an approach would be excessively conservative and would lead to an understatement of a reporting entity’s assets. Exploration and evaluation expenditure would not be undertaken if it was considered that none of the expenditure would lead to economic

BX 3012 Tutorial 4 – Chapter 20 Deegan AFA 8th Edition 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 statements would be unable to discriminate between entities that have undertaken successful exploration and evaluation, and those that have not.

20.13 Extracto Ltd commences operations on 1 January 2017. During 2017 Extracto Ltd explores three areas and incurs the following costs: Site Exploration and evaluation expenditure ($M) Good 23 Bad 16 Indifferent 25 In 2018 oil is discovered at Good site. Bad site is abandoned. Indifferent site has not yet reached a stage that permits a reasonable assessment of the existence or otherwise of economically recoverable reserves, and active and significant operations in the area of interest are continuing. In relation to the exploration and evaluation expenditure incurred at Good site and Indifferent Site, 80% relates to property, plant and equipment, and the balance relates to intangible assets. In 2018 development costs of $27 Million are incurred at Good site (to be written off on a production basis), $20 Million of the expenditure relates to property, plant and equipment, and the balance of $7 Million relates to intangible assets. Good site is estimated to have a reserve of 15,000,000 barrels. The current sale price is $30 per barrel. 3 Million barrels are extracted at a production cost of $4 Million, and 1.9 Million barrels are sold. Provide the necessary journal entries using the area of interest method. (a)

Area-of-interest method 2017 Dr Exploration and evaluation assets—Good Site

23

Dr

Exploration and evaluation assets—Bad Site

16

Dr

Exploration and evaluation assets—Indifferent Site

25

Cr

Cash, payables, accumulated depreciation, etc.

64

(To account for the initial exploration and evaluation costs incurred in each site; the expenditure is initially measured at cost and, subject to the requirements of AASB 116 and AASB 138, can be revalued. It is assumed, however, that the entity adopts the cost model and does not perform revaluations.) 2014 Dr Impairment loss—exploration and evaluation assets

16

Cr Exploration and evaluation assets—Bad Site Dr Assets under construction—property, plant and equipment (Good Site) Dr Assets under construction—intangible mineral assets (Good Site)

16 18.4 4.6

BX 3012 Tutorial 4 – Chapter 20 Deegan AFA 8th Edition Cr Exploration and evaluation assets—Good Site

23

(To reclassify the balance of the exploration and evaluation expenditure at Good Site to ‘assets under construction’ (or similar account) consistent with paragraph 17 of AASB 6 and to recognise an impairment loss in relation to Bad Site since the site has been abandoned. Because Indifferent Site has not reached a stage where a reasonable assessment can be made of the existence of recoverable reserves, then there is no reclassification of the related expenditure.) Dr Assets under construction—property, plant and equipment (Good Site)

20

Dr Assets under construction—intangible mineral assets (Good Site)

7

Cr Cash/Payables/accumulated depreciation, etc.

27

(To recognise the development costs incurred in relation to Good Site. Such capitalised costs will be reclassified when the development phase concludes. Because the assets are not ready for use they will not be depreciated; however, they will be subject to impairment testing. The capitalised costs will ultimately form part of the cost of inventories as a result of applying the entity’s amortisation/depreciation policies.) Dr Property, plant and equipment (Good Site)

38.4

Dr Intangible mineral assets (Good Site)

11.6

Cr Assets under construction—property, plant and equipment (Good Site)

38.4

Cr Assets under construction—intangible mineral assets (Good 11.6 Site) (to reclassify the assets as a result of the movement from the preproduction phase to the production phase) Dr Inventory of crude oil

10

Cr Accumulated depreciation—property, plant and equipment (Good Site) Cr Accumulated depreciation—intangible mineral assets (Good Site)

7.68 2.32

(3 m × $3.3333 where $50 m/15 m = $3.3333 per tonne)

Dr

Inventory of crude oil

Cr

Cash, payables, accumulated depreciation, etc.

Dr

Cash/receivables

Cr

Sales revenue

4 4 57 57

(1.9 m × $30) Dr

Cost of goods sold

Cr

Inventory of crude oil

[(10 + 4)/3] × 1.9 = 8.87

8.87 8.87

BX 3012 Tutorial 4 – Chapter 20 Deegan AFA 8th Edition 20.14 (a) Surfcity Mining Ltd. incurs the following exploration and evaluation costs at two sites, Ian and Eddie, over the years indicated. Ian $1500 $2000 $3000

2017 2018 2019

Eddie $2000 $3000 $4000

In relation to this expenditure 20% relates to intangible assets and the balance to PP&E. At the end of 2019, economically recoverable oil reserve is found at Ian, but Eddie is abandoned. Following the discovery of oil at Ian, roads and other infrastructure of a fixed nature are constructed in 2020 at a cost of $2000. Portable buildings with a life of 10 years are put in place at a cost of $500. Production at Ian begins in 2020, with an expected reserve of 1500 barrels. Sale price is $25 per barrel. Incremental production costs associated with each barrel is $5. During 2020 400 barrels are extracted, of which 250 are sold. Assets are amortised or depreciated using the production output method, except where assets can be redeployed elsewhere, in which case useful life is used. Provide the journal entries for 2017 to 2020 using the area of interest method. Area-of-interest method 2017 Dr Exploration and evaluation assets—Ian site Dr

Exploration and evaluation assets—Eddie site

Cr

Cash, payables, accumulated depreciation, etc.

1 500 2 000 3 500

2018 Dr

Exploration and evaluation assets—Ian site

2 000

Dr

Exploration and evaluation assets—Eddie site

3 000

Cr

Cash, payables, accumulated depreciation, etc.

5 000

2019 Dr

Exploration and evaluation assets—Ian site

3 000

Dr

Exploration and evaluation assets—Eddie site

4 000

Cr

Cash/payables

Dr

Assets under construction—property, plant and equipment

5 200

Dr

Assets under construction—intangible mineral assets

1 300

Cr

Exploration and evaluation assets—Ian site

Dr

Impairment loss—exploration and evaluation assets

7 000

6 500 9 000

BX 3012 Tutorial 4 – Chapter 20 Deegan AFA 8th Edition Cr

Exploration and evaluation assets—Eddie site

9 000

2020 Dr

Property plant and equipment

Cr

Cash, payables, accumulated depreciation, etc.

Dr

Buildings

Cr

Cash/payables

Dr

Property, plant and equipment

5 200

Dr

Intangible mineral assets

1 300

Cr

Assets under construction—property, plant and equipment

5 200

Assets under construction—property, plant and equipment

1 300

Cr

2 000 2 000 500 500

Dr

Inventory of crude oil

Cr

Accumulated depreciation—property, plant and equipment

1 920

Accumulated depreciation—intangible mineral assets

348

2 268

(400 × $5.67, where ($5200 + $1300 + $2000)/1500 = $5.67 per tonne) Dr

Inventory of crude oil

Cr

Accumulated depreciation: portable buildings

50 50

(It is assumed buildings were acquired at the commencement of the year. 50 = 500/10) Dr

Inventory of crude oil

Cr

Cash, payables, accumulated depreciation, etc.

2 000 2 000

(400 × 5.00) Dr

Cash/receivables

Cr

Sales revenue

6 250 6 250

(250 × 25.00) Dr

Cost of goods sold

Cr

Inventory of crude oil

[(2268 + 50 + 2000)/400] × 250 = 2699

2 699 2 699

BX 3012 Tutorial 4 – Chapter 20 Deegan AFA 8th Edition

Challenging questions 20.15 $ million Exploration and evaluation assets—Green site

$ million

9

Exploration and evaluation assets—Tree site

10

Exploration and evaluation assets—Frog site