Extractive Industries

Having recently focused its attention on the needs of specialized industries, the IASC has identified certain extractive industries worthy of being addressed by it. These industries have significant financial accounting and reporting issues with broad applicability, and these industries may be disproportionately relevant in the economies of the lesser-developed nations upon which the IAS have been most influential. In particular, the IASC has directed attention to those industries which it believes most often operate on an international basis, and which exert significant economic influence worldwide. The current accounting and reporting practices by participants in these industries are seen as being quite diverse, and often will vary significantly from those of entities in other types of industries, making within-industry and across-industry comparisons difficult for users of the financial statements.

Before its demise, the IASC had undertaken a major project to develop financial reporting requirements for the "upstream" activities of mining and petroleum industries. This effort yielded a major Issues Paper (which is summarized in the balance of this section), with the expectation that definitive standards were to be promulgated in 2002. However, the IASB, as successor to IASC, has placed this project among those in which its interests are secondary, and accordingly no noticeable progress has been made since a year ago. This project does not appear on IASB's technical projects schedule, suggesting that any standard on this topic might be several years in the future. Nonetheless, the Issues Paper does provide nonauthoritative guidance and is presented here for that purpose.

The upstream activities of mining and petroleum producers consist of exploration and production. These exclude the "downstream" activities such as refining, marketing, and transportation, which would continue to be governed by other relevant international standards, such as IAS 2, addressing accounting for inventory.

The Issues Paper sets forth in vast detail the accounting practices found in the mining and petroleum industries, discussing the strengths and weaknesses of each of the alternative methods. It also expresses the Steering Committee's tentative views on the propriety and advisability of each of these accounting practices, which strongly imply what the forthcoming standard will prescribe (notwithstanding that extensive due process will precede the adoption of final requirements). IASC has taken pains to explain, furthermore, that even its tentative views do not imply unanimity among committee members and may not represent the views of the IASB, which will ultimately rule on any proposal.

Key Issues

The issues paper identifies a number of key financial reporting issues which must be resolved. These include the following items:

1. Which costs of finding, acquiring, and developing mineral reserves should be capitalized;

2. How capitalized costs should be depreciated (amortized);

3. The extent to which quantities and values of mineral reserves, rather than costs, should impact upon recognition, measurement, and disclosure; and

4. How to define, classify, and measure mineral reserves.

With regard to cost recognition, the two most popular methods, "full costing" and "successful efforts," are seen as representing the two extremes. Under full cost accounting, all costs incurred in searching for, acquiring, and developing mineral reserves in a large cost center, such as a country or continent, are capitalized as part of the cost of whatever reserves have been found, even though a specific cost was incurred in a failed effort. The underlying theory is that entities in such industries know that many "dry holes" must be drilled (to use the oil exploration industry as an example) to find one producing well, and accordingly are cognizant of the fact that all such costs are actually the necessary costs of developing successful wells. Full cost accounting is used by many midsize to small petroleum enterprises, but rarely has been employed by mining enterprises.

On the other hand, under successful efforts accounting (which is used by most large oil and gas companies and by some mining enterprises), costs that lead directly to finding mineral reserves are capitalized, while costs that do not lead directly to mineral reserves are charged to expense. The concept here is not so much that costs associated with unsuccessful efforts are rightfully charged to current expense, but rather, from a practical perspective, given that many projects are ongoing at any time (which is particularly true for the larger entities), essentially the same result will occur with less complicated accounting, if only costs associated with successful ventures are capitalized and amortized. In other words, the matching objective is met equally well, in these situations, by use of the less burdensome successful efforts method of accounting.

According to the IASC paper, many mining enterprises use an accounting method which lies between the extremes of the full costing and successful efforts methods. Other entities use various hybrid methods, adding to the difficulty of establishing a taxonomy of accounting methods. Imposing a uniform methodology is thus seen as being a pressing need.

A third major approach to cost capitalization is the "area-of-interest" method. According to the IASC paper, some view the area-of-interest concept (sometimes also referred to as the "project method") as a variation on the successful efforts method of accounting, while others see it as a version of full cost accounting applied on an area-of-interest basis. Under the area-of-interest approach, all costs that relate directly to an area of interest or that can be logically allocated to the area of interest are recorded as belonging to that area. That is, prospecting costs, mineral acquisition costs, exploration costs, appraisal costs, and development costs are associated with an individual geological area that has features that are conducive to a coordinated, unified search program and that has been identified as being a favorable environment for the presence of, or known to contain, a mineral deposit. These costs would be accumulated and deferred for each area of interest, to be depreciated as the reserves from that area of interest are produced.

The area-of-interest approach is believed to be fairly commonly employed in the mining industry, although the precise extent of its usage remains under debate. Some studies cited by IASC suggest that this method is the most commonly used way to account for costs—more so than either the successful efforts or full cost methods. Thus, while the area-of-interest approach is not one which is set forth in most textbooks (which typically only cite the successful efforts and full costing approaches), it may have great currency in actual usage.

Probably the other issue which is most important and central to this project is whether financial reporting is to be based on traditional historical costs, or on a fair value basis, driven by estimates of actual mineral reserves on hand and expected final selling prices therefor. The latter approach has been advocated for decades (in the US, the SEC's proposed "reserve recognition accounting," which was never finally adopted, was one such attempt). While many coherent arguments can be made for fair value accounting for mineral reserves, persistent questions about reliability (both of quantity estimates and of selling price projections) have ultimately prevented abandonment of historical cost-based methods. However, fair value data has been widely incorporated into supplemental disclosures (such as those required under SEC rules in the US).

Steering Committee's Views

The Steering Committee has developed tentative views on many of the major issues set out in the Issues Paper. In some cases, these address only the basic issues and do not extend to the subissues associated with a given basic issue. These views are tentative and will be revisited in light of comment letters received, and thus may change markedly as the research continues. Also, the Steering Committee notes that it had not discussed its tentative views with the IASC Board, which is the body that will establish the financial reporting standard.

The Steering Committee's tentative views have been summarized as follows in the Issues Paper:

1. An International Accounting Standard on financial reporting in the extractive industries is needed.

2. IASC should develop a single IAS with common standards for both the mining and petroleum industries, but with separate requirements or guidance for mining or petroleum, as necessary, to address industry-specific issues.

3. The IAS should be restricted to upstream activities (exploration for, and development and production of, minerals).

4. Information about reserve quantities and values, and changes in them, is a key indicator of the performance of an extractive industries enterprise.

5. The primary financial statements of an extractive industries enterprise should be based on historical costs, not on estimated reserve values.

6. Information about reserve quantities and values, and changes in them, should be disclosed as supplemental information.

7. The Steering Committee favors adoption of a method of accounting more consistent with the successful efforts concept than with other concepts (such as full costing or area-of-interest accounting).

8. All preacquisition prospecting and exploration costs should be charged to expense when incurred, and not deferred to future periods.

9. All direct and incidental property acquisition costs should be initially recognized as an asset.

10. All postacquisition exploration and appraisal costs should be initially recognized as an asset, pending the determination of whether commercially recoverable reserves have been found.

11. Some limit should be imposed if postacquisition exploration and appraisal costs are deferred, pending determination of whether commercially recoverable reserves have been found.

12. All development costs should be recognized as an asset.

13. Construction costs that relate to a single mineral cost center should be capitalized as part of the capitalized costs of that cost center (normally to be depreciated on a unit-of-production basis if the life of the assets is coincident with the life of the mineral reserves, or on a straight-line basis if the economic life is less than the life of the reserves). Construction costs that relate to more than one mineral cost center should be accounted for in the same way as other property, plant, and equipment under IAS 16, (normally depreciated on a time basis).

14. Postproduction exploration and development costs should be treated in the same way as any other exploration or development costs.

15. Both the benchmark (immediate expensing) and allowed alternative (capitalization and amortization) treatments of borrowing costs contained in IAS 23 should be permitted.

16. Overhead cost should be attributed to the relevant phase of operations (prospecting, acquisition, exploration, valuation, development, and construction) and further identified with a specific prospect, property, or area of interest. The overhead cost should be capitalized if, and only if, the indirect costs of that phase of operations are capitalized for that specific prospect, property, or area of interest.

17. The Steering Committee does not favor cost reinstatement (reversing a prior period expense recognition in a subsequent period in which information becomes available that commercially recoverable reserves have been discovered).

18. Costs should be accumulated by area of interest or geological units smaller than an area of interest (e.g., the field or the mine).

19. Use unit-of-production depreciation for all capitalized preproduction costs with two exceptions

    1. Use straight-line depreciation for capitalized construction costs that serve a single mineral cost center, if the economic life of the asset is less than the life of the reserves, and

    2. Follow IAS 16 for capitalized construction costs that serve two or more cost centers (sometimes called service assets).

20. Changes in reserve estimates should be reflected prospectively; that is, included in the determination of net profit or loss in the period of the change and future periods, consistent with the requirements of IAS 8.

21. IAS 37 should be applied without modification to the recognition of removal and restoration costs and obligations in the extractive industries.

22. If the amount of a provision is part of the cost of acquiring the asset, it is recognized as such and is included in the depreciable amount of the asset.

23. The cost relating to a provision necessitated by production activities after an asset is installed should be capitalized as an additional cost of acquiring the asset, if the cost provides incremental future economic benefits.

24. If the cost associated with a provision was initially capitalized, changes in the estimated amount of the provision should be recognized is subsequent periods as an adjustment to the carrying amount of the asset.

25. IAS 36 should be applied without modification to account for impairments of assets in the extractive industries.

26. Impairment of capitalized preproduction costs should be assessed based on proved and probable reserves.

27. An impairment test cannot be applied to deferred preproduction costs whose outcome is unknown. The Steering Committee favors some type of limit if preproduction costs are deferred, pending determination of whether commercially recoverable reserves are found.

28. The general provisions of IAS 18 should apply to enterprises in the extractive industries, and IAS 18 should be amended to eliminate the scope exclusion.

29. Revenue received prior to the production phase should be recognized as revenue to other income, not as a reduction of capitalizable costs.

30. Royalties paid in cash, royalties paid in kind, and severance taxes should all be included in the producer's gross revenue and deducted as an expense.

31. Inventories of minerals should be measured at historical cost, even if those minerals have quoted market prices in active markets with a short time between production and sale and insignificant costs to be incurred beyond the point of production, and the enterprise intends to sell those minerals in that market.

32. All members of the Steering Committee favor disclosure of reserve quantities. The Steering Committee is divided regarding disclosure of reserve values, however.

33. Proved and probable reserves should be disclosed separately, and within proved reserves disclosure should be made separately of proved developed and proved undeveloped reserves.