ACC706 Tutorial chapter 21

21.1 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.

21.3 Pursuant to the AASB 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; and
(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 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.
 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 (chapter 3 discusses the
efficiency perspective) 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.

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;
(b) it is probable that an outflow of resources embodying economic benefits
will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.

If these conditions are not met, no provision shall be recognised.

A constructive obligation is defined in AASB 137 as:

an obligation that derives from an entity’s actions where:

(a) by an established pattern of past practice, published policies or a
sufficiently specific current statement, the entity has indicated to other
parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those
other parties that it will discharge those responsibilities.

Hence, reporting entities should recognise obligations for restoration, typically as

a provision, even when there is not a specific legal requirement to do so, if there is
an expectation that such factors as custom, or ‘normal’ business practices would
require them to do so.

21.7 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);
and
 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.
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 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. 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 entity’s 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 statements would be unable to discriminate between entities that have
undertaken successful exploration and evaluation, and those that have not.
21.13 (a) Area-of-interest method

2010

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.

2011

Dr Impairment loss – exploration and

evaluation assets 16
Cr Exploration and evaluation assets – Bad site 16

Dr Assets under construction – property, plant

and equipment (Good Site) 18.4
Dr Assets under construction –intangible
mineral assets (Good Site) 4.6
Cr Exploration and evaluation assets – Good 23
site
To reclassify the balance of the exploration and evaluation
expenditure at Good Site to ‘assets under construction’ (or
similar account) consistent with par. 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 20

and equip (Good Site)
Dr Assets under construction – intangible 7
mineral assets (Good Site)
Cr Cash/Payables/provisions for deprec. 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 38.4
and equipment (Good Site)
Cr Assets under construction – Intangible
mineral assets (Good Site) 11.6
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) 7.68
Cr Accumulated depreciation – intangible
mineral assets (Good Site) 2.32

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

Dr Inventory of crude oil 4

Cr Cash, payables, accumulated depreciation,
etc. 4
Dr Cash/receivables 57
Cr Sales revenue 57

(1.9m × $30)

Dr Cost of goods sold 8.87

Cr Inventory of crude oil 8.87

[(10 + 4)/3] × 1.9 = 8.87

(b) Full-cost method

2010

Dr Exploration and evaluation assets 64

Cr Cash, payables, accumulated depreciation,
etc. 64

2011

Dr Assets under construction – property, plant 51.2

and equipment
Dr Assets under construction – intangible 12.8
mineral assets
 Cr Exploration and evaluation assets 64

Dr Assets under construction – property, plant 20

and equipment
Assets under construction – intangible 7
mineral assets
Cr Cash/payables 27

Dr Property, plant and equipment 71.2

Dr Intangible mineral assets 19.8
Cr Assets under construction – property, plant 71.2
and equipment
Cr Assets under construction – intangible 19.8
mineral assets

Dr Inventory of crude oil 18.2

Cr Accumulated depreciation – property, plant 14.24
and equipment
Cr Accumulated depreciation – intangible 3.96
mineral assets

(91 × 3/15)

Dr Inventory of crude oil 4

Cr Cash, payables, accumulated depreciation,
etc. 4

Dr Cash/receivables 57
Cr Sales revenue 57

Dr Cost of goods sold 14.06

Cr Inventory of crude oil 14.06

(22.2 × 1.9/3)