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Extracting Some Value
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Story Max Williamson FCA

 
Australia’s extractive industries are subject to a range of new standards that are likely to lead to an extraction of value from the sector. 
 
Australia’s oil and gas, mining and quarrying industries have had the luxury of operating under one accounting standard in one form or another since 1973. However, this simplistic position has changed dramatically with Australia’s adoption of Australian Equivalents to International Financial Reporting Standards (AIFRS) from 1 January 2005. 
 
The final promulgation of AASB 6 just before Christmas 2004 has completed a package of new mandatory general standards that must impact on the value of the sector on the Australian Stock Exchange (ASX) and elsewhere. 
 
Fortunately, the sector is presently riding high on the back of a commodity cycle boom that will alleviate the issue in the short term. However, once commodity prices start to weaken, the new standards will generate a lot of red ink in the published accounts of the industry participants. 
 
THE NEW STANDARDS 
 
Out goes AASB 1022 and this is replaced by:
  • AASB 6 Exploration and Evaluation 
  • AASB 102 Inventories 
  • AASB 116 Property, Plant and Equipment 
  • AASB 118 Revenue 
  • AASB 136 Impairment of Assets 
  • AASB 137 Provisions, Contingent Liabilities and Contingent Assets.
 
EXPLORATION AND EVALUATION 
 
This standard deals with only expenditures incurred during the exploration and evaluation phase. It is a temporary standard that continues to follow the ‘area of interest’ approach adopted by Australia since the early 1970s. Exploration and evaluation expenditures will be able to be carried forward on the balance sheet as assets representing the value to the company of exploration licences and production leases owned (i.e. the areas of interest). These expenditures will be able to be carried forward until it is possible to reliably carry out impairment testing on the values of the individual licences and leases. At this stage, it is believed that greenfield and brownfield exploration projects will not be subject to impairment testing as they will not have reached the stage sufficient to determine a discounted cash flow (DCF) value based on proven and probable reserves. 
 
The standard has not yet examined the proper measurement of resources and leaves the issuing of booking of reserves to the previous policy under the Joint Ore Reserves Committee of the Australian Institute of Mining and Metallurgy, at least until a later date when the International Accounting Standards Board (IASB) and the Australian boards look at the issue with conviction. 
 
PLANT AND EQUIPMENT 
 
AASB 116 adopts a range of approaches, but the extractive industries will almost certainly focus on the ‘effective life’ approach with which we are familiar for both book and tax depreciation purposes. The cost of the plant and equipment will be written off over the effective life of the item of equipment. 
 
DEVELOPMENT EXPENDITURES 
 
Also covered by AASB 116, expenditures incurred in developing an extraction site from its natural state up to the commencement of production, will be capitalised. These costs will be written off on a units of production basis compared to historic reserves. 
 
The standard will put pressure on the proper treatment of commissioning costs and when those costs should be charged against profits. 
 
The current interpretation of the standard will mean that increasing levels of expenditure in the construction/development phase will be treated as operating costs and immediately subject to write-off. This concept will cover not only expenditures associated with development and construction of the bare site, but also the installation and commissioning of plant items (e.g. treatment circuit costs and process plant costs). 
 
RESTORATION EXPENDITURES 
 
AASB 137 causes the creation of provisions to rehabilitate extraction sites from day one, rather than progressively as is currently adopted. This will produce the result that the expected costs to rehabilitate a site will be calculated, discounted into current value dollars and then added to the cost of the individual plant item or asset (e.g. mine lease) and be capitalised. 
 
These provisions will be re-assessed regularly based on expected future costs, current rehabilitation projects, projected site disturbance, law and regulation changes and other matters such as the use of new rehabilitation technologies. 
 
The normal recurring rehabilitation expenditures subsequent to production commencement will be charged against profit. In certain circumstances, the projects to which these current new expenditures relate may cause a downwards re-assessment of the future liability to rehabilitate a site, but this is unlikely in the early years on production at a site.  
 
Environmental damage due to spills and contaminate leakage, for example, will normally be booked as a current year expense. 
 
NON-CURRENT ASSETS 
 
In the context of the extractive industries, the new impairment testing rules go far beyond the old AASB 1010 and particularly the application of that superceded standard to the extraction asset carried values. 
 
The carried values of various assets including exploration licences, mine leases, production leases, retention leases, project development and plant and equipment will be subject to the more robust impairment testing rules under new AASB 136. 
 
New impairment testing rules were established for exploration and evaluation assets during December 2004. The impairment testing circumstances include:<ul.
  • The exploration tenement is about to expire and the term will not be renewed 
  • No future budget allocations for work on a particular exploration tenement 
  • Exploration activities have been discontinued in an area; and 
  • Sufficient data is available on an area to indicate that notwithstanding the continuance of exploration in an area, exploration expenditure on an area to date is unlikely to be recovered from extractive activities to be conducted later (i.e. would not apply to greenfield and brownfield licences). 
    Once an impairment testing circumstance arises for an exploration asset, then the normal process of establishing value must be gone through and, if necessary, charges made against profits to reduce carrying values of these exploration assets. This is substantially different to the old AASB 1022 that permitted exploration and evaluation costs to be assets to be carried forward as assets virtually indefinitely under the area of interest approach. 
     
    Plant and equipment and development expenditures (e.g. housing and welfare, decline development, production well, pipelines and access roads) will all be subject to impairment testing once one of the standard seven factors in AASB 136 are encountered relative to a project or cash generating unit. Examples of such circumstances would include major environmental spills, cyclonic damage to production platforms, significant drops in key commodity prices, technology failures for product treatment generating mined product below client specifications and failures of current exploration projects to expand known proven reserves. 
     
    There will be pressure on the definition of a cash-generating unit in both the mining and oil and gas sectors because of the common physical approach of central treatment plants and transport facilities. Similarly, the carrying value of adjoining permits, with or without crossover below ground reserves, will need to be considered in defining what is the ‘cash-generating unit’ in the context. 
     
    The greater reality is the increased amount of background data will need to be generated and maintained to demonstrate DCF values as compared to carrying values for the assets subject to the impairment testing. 
     
    This is seen as a recognition that the assets side of the balance sheet accounts are moving way from a depreciated costs approach to a mixture of costs and values and a calculation of profits really being the difference between two balance sheets. In periods of high commodity prices, impairment testing is considerably less relevant, but once projects approach marginal profitability, impairment testing will generate a lot of red ink. 
     
    Directors’ valuations will require considerable third-party and independent support and ‘back of the envelope’-style valuations will no longer be justifiable. The disclosure provisions for the application of the impairment rules may expose some companies to sensitive data release. 
     
    The capitalisation of future rehabilitation expenditures to plant and equipment and other assets will have the effect of boosting the carried values of those assets at day one and subsequent. If an impairment test event arises, the higher carrying values will be under pressure for impairment tested value reductions and charges against profits. 
     
    INVENTORIES AND TRADING STOCK 
     
    This superseded standard also covered issues such as take or pay contracts and substantial delivery of products flowing into the timing of revenue recognition and the reduction of trading stocks. 
     
    The new standards AASB 102 and 118 are more general in nature, leading to circumstances delaying the booking of revenue and extending the periods when trading stock is held. 
     
    For companies using standard costing approaches to cost values for trading stock, the new impairment test rules and the charges against profits will potentially impact those trading stock values at year end. 
     
    Analysts’ understandingSurveys conducted externally are identifying a major lack of understanding on the part of the ASX broker analysts of the new standards and what the entries for the transitional adjustments and the roll forward application of the package of new standards over the accounts of participants in this sector. 
     
    The above-mentioned and other standards will cause disclosure changes to accounts for the 2005 financial year and more particularly to subsequent years and many of those changes will be negative in the context of charges to profits and reductions of asset values and proprietorship equity. The surveys seem to be indicating these changes as well as the transitional adjustments and write downs will be interpreted negatively by the analysts in their assessment of corporate values, partly because of the analysts lack of understanding of what the changes mean. 
     
    INDUSTRY CHALLENGES 
     
    Recent articles in Australia’s major financial newspapers have indicated only 14 of Australia’s top 100 companies have moved to quantify and disclose in their accounts the financial impact of the new AASBs in their accounts released to the ASX for the December half year. Obviously many of Australia’s top 100 companies are involved in the extractive industries. 
     
    The biggest challenges appear to be readiness to deal with impacts on corporate values and corporate willingness to disclose how these new standards will impact upon their published accounts. An education program may be needed not only for Australia’s broker analysts. 
     
    Rumours that Australia’s immigration policies have been updated to accelerate the migration of people with AIFRS experience suggests personnel and technical understanding will be big issues in the 2005 and 2006 financial year accounts. 
     
    PREPARATION OF TAXATION DATA 
     
    The movement away from traditional historic costs and revenues and the tracking of values other than depreciated values for the extractive industries in particular will lead to an almost parallel set of records being generated that will become increasingly difficult to reconcile back to the company’s financial accounts. 
     
    This will generate challenges both for those companies and the ATO in meeting and auditing the companies taxation obligations.  
     
    The better examples will be the provisions created for rehabilitation by debiting the cost of the relevant assets and the various entries made to reflect the movements in exposures to hedging and forward transactions.  
     
    DISCLAIMER:  
     
    The views and opinions of the authors appearing in Charter are not necessarily those of the Institute of the Chartered Accountants and should be viewed as such. 
     

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