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Unformatted text preview: ACCT3003 Issues in Accounting Theory 2009 Topic 5: Extractive industries Solutions to topic review questions 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. Issues in Accounting Theory 2009 Solutions: Topic 5 1 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. 21.6 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 Issues in Accounting Theory 2009 Solutions: Topic 5 2 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. 21.8 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. Issues in Accounting Theory 2009 Solutions: Topic 5 3 The full‐cost method will generate profits which show less variability, or volatility, than the profits generated by applying the area‐of‐interest method. 21.12 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 reports 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 2007 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. 2008 Dr Cr Dr Dr Cr Dr Dr Cr Impairment loss – exploration and evaluation assets Exploration and evaluation assets – Bad site Assets under construction – PP&E (Good Site) Assets under construction –intangible mineral assets (Good Site) Exploration and evaluation assets – Good 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 16 18.4 4.6 20 7 16 23 Assets under construction – PP&E (Good Site) Assets under construction – intangible mineral assets (Good Site) Cash/Payables/provisions for deprec. etc 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 27 Dr Dr Cr PP&E (Good Site) Intangible mineral assets (Good Site) Assets under construction – PP&E(Good Site) 38.4 11.6 38.4 4 Issues in Accounting Theory 2009 Solutions: Topic 5 C r Assets under construction – Intangible mineral assets (Good Site) To reclassify the assets as a result of the movement from the preproduction phase to the production phase 11.6 Dr Cr Cr Inventory of crude oil Accumulated depreciation – PP&E (Good Site) Accumulated depreciation – intangible mineral assets (Good Site) (3m × $3.3333 where $50m/15m = $3.3333 per tonne) 10 7.68 2.32 Dr Cr Dr Cr Inventory of crude oil Cash, payables, accumulated depreciation, etc. Cash/receivables Sales revenue (1.9m × $30) 4 57 4 57 Dr Cr Cost of goods sold Inventory of crude oil [(10 + 4)/3] × 1.9 = 8.87 8.87 8.87 (b) Full‐cost method 2007 Dr Cr Exploration and evaluation assets Cash, payables, accumulated depreciation, etc. 2008 64 64 Dr Dr Cr Dr Dr Cr Dr Dr Cr Cr Dr Cr Cr Assets under construction – PP&E Assets under construction – intangible mineral assets Exploration and evaluation assets Assets under construction – PP&E Assets under construction – intangible mineral assets Cash/payables PP&E Intangible mineral assets Assets under construction – PP&E Assets under construction – intangible mineral assets Inventory of crude oil Accumulated depreciation – PP&E Accumulated depreciation – intangible mineral assets 51.2 12.8 64 20 7 71.2 19.8 18.2 27 71.2 19.8 14.24 3.96 5 Issues in Accounting Theory 2009 Solutions: Topic 5 (91 × 3/15) 21.15 Dr Cr Dr Cr Dr Cr Inventory of crude oil Cash, payables, accumulated depreciation, etc. Cash/receivables Sales revenue Cost of goods sold Inventory of crude oil (22.2 × 1.9/3) Dr Dr Dr Cr Exploration and evaluation assets —Green site Exploration and evaluation assets —Tree site Exploration and evaluation assets —Frog site Cash/payables/accumulated depreciation, etc. $ mill 9 10 10 $ mill 4 57 14.06 4 57 14.06 29 (To account for the initial exploration and evaluation costs incurred in each site.) Dr Cr Dr Cr Assets under construction – PP&E (Green Site) Assets under construction – intangible mineral assets (Green Site) Exploration and evaluation assets (Green site) Impairment loss – exploration and evaluation assets Exploration and evaluation assets (Tree site) 3 6 10 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 PP&E (Green Site) Cash/payables/provision for depreciation, etc. 12 12 Issues in Accounting Theory 2009 Solutions: Topic 5 6 Dr Dr Cr Cr Dr Cr Cr PP&E (Green Site) Intangible mineral assets (Green Site) Assets under construction – PP&E (Green Site) Assets under construction – intangible minerals assets (Green site) Inventory of crude oil Accumulated depreciation – PP&E (Green site) Accumulated depreciation – intangible minerals assets (Green site) amount is 3 6 3 6 2.1 1.5 0.6 (Amortisation of costs carried forward. The 5000 × $420 where $21m/50 000 = $420 per tonne.) Dr Cr Inventory of crude oil Cash/payables/provision for depreciation, etc. 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 Cost of goods sold Inventory of crude oil 3.28 3.28 (To acknowledge the cost of goods sold, which is calculated as: ($2.1 million + $2 million)/ 5000 × 4000 = $3.7 million.) Issues in Accounting Theory 2009 Solutions: Topic 5 7 ...
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