Accounting for Extractive Industries

• Extractive industries are diverse, and each

industry has its own structure and operational
characteristics
• Common feature of extractive industries
– They are engaged in the exploration for and
extraction of natural resources having commercial
value, such as minerals, tin deposits, oil and
natural gas
– The natural resources they exploit are non-
generative (or wasting assets) which means that
the resource extracted cannot be replaced
 Extractive Industries in Malaysia

The main extractive industries in Malaysia

• Tin mining industry

• Oil and gas industry
 Nature of the Industry
• High risk involved due to low probability of
discovering commercial reserves (‘all-or-
nothing’ business)
• Gestation period between discovery and
commencement of production is long
• Substantial capital expenditure before the
deposits can be extracted
 The process from searching of mineral
deposits or oil and gas reserves to the
commencement of commercial production
involves 3 distinct phases

• The exploration and evaluation phase

• The pre-production and set-up phase
• The production phase
 Exploration and Evaluation Phase
• Involves searching and testing for a mineral
deposit or an oil or gas field which appears
capable of commercial exploitation

2 stages
• First stage (Exploration)
– Initial stage involves carrying out of various
studies such as topographical, geological,
geochemical and geophysical studies and
exploratory drilling to determine the potential
prospect of the area or location
– If the results of the studies indicate no
potential prospect, the exploration is
normally abandoned

– However, if the results of such studies

indicate that commercial exploitation of
the mineral deposit or oil and gas
reserves appears possible, then the
second stage is undertaken
• Second stage (Evaluation)
– The second and final stage of the phase is to
determine the technical and commercial
viability of the particular prospect discovered

– Various tests of technical feasibility and

commercial prospects, such as on volume and
grade of mineral or reserves, extraction
methods, treatment processes, transportation
and infrastructure requirements, markets and
finance, would be evaluated before a decision is
made to either proceed with the exploitation or
to abandon the prospect
 Pre-Production Phase
• Will only commence if the enterprise decides
to proceed with the exploitation of the
particular prospect discovered

• Substantial development and construction

activities are involved to set up the area or
location for commencement of production
• Development and construction activities are
activities necessary to establish access to
the deposit or reserves, such as
– preparation of shafts, underground drives,
excavation activities, construction of
roads, tunnels, oil or gas wells, plants,
buildings and other infrastructures and
the purchase of machinery and
equipment
 Production Phase
• Commences with the first commercial
extraction of the minerals, oil or gas.
• Thereafter, the extraction becomes the day-
to-day activities of the operation
• Some further processing may be involved
prior to sale
• Production will normally cease when the
deposits or reserves are exhausted or in the
case of a fixed-period tenure, when the
lease period expires
 Exploration and Pre-Production Costs
• Substantial costs are incurred in the
exploration and pre-production phase
• Exploration and Evaluation Costs
– Acquisition costs of rights, premiums and
royalty payments for exploration
– Costs of the various exploratory studies
(topographical, geological, geochemical
and geophysical studies)
– Exploratory drilling
– Trenching
– Sampling
– Costs of evaluation studies (activities in
relation to evaluating the technical
feasibility and commercial viability of
extracting a mineral resource)
• Pre-Production Costs
– Includes development costs incurred in
developing the area or location and the
construction of infrastructures and
facilities prior to commercial production
 Accounting for Extractive Industries
in Malaysia
• Accounting practices in Malaysia are
influenced to a large extent by the
development overseas and some conventional
practices in the tin mining industry
• Over the years, oil and gas companies in
Malaysia have basically followed the
accounting procedures adopted by their
foreign parent companies
 Accounting for Exploration and
Evaluation Costs
The methods practiced by enterprises engaged in
extractive operations in the more developed
economies are diverse, and they include:
• The expense method
• The expense and subsequent reinstatement
method
• The successful effort method
• The full cost method and
• The area of interest method
 Expense Method
• Expense all exploration and evaluation costs as they
are incurred
• Argument for
– Prudent because of the low probability of discovering
commercially recoverable deposits or reserves
• Arguments against
– is excessively prudent
– Precludes a fair costing of products
– Does not result in a proper matching of costs with revenues
– Unrealistic to assume that all exploration and evaluation will
be unsuccessful and of no value
 Expense and Subsequent Reinstatement

• All exploration and evaluation costs are

initially expensed off as they are incurred
• Subsequently, when a prospect proved to be
successful and that commercial production is
imminent, all costs of exploration and
evaluation pertaining to that prospect which
had been previously written off are
reinstated
• Argument for
– Justified to expense the exploration and
evaluation costs initially because of the low
probability of success

• Arguments against
– Similar to arguments against expense method
– Subject to abuses because of the differing ways of
effecting reinstatement of the previously written
off costs
 Successful Effort Method
• Costs of exploration and evaluation are initially
capitalised (as deferred exploration costs, or
deferred prospecting costs, or deferred
expenditure)
• When an exploration proved to be abortive and is
abandoned, the initially capitalised costs are written
off
• Only costs that relate to discovery of commercially
recoverable deposits or reserves are carried forward
as part of the depletion base to be amortised when
commercial production commences
• Argument for
– Amount capitalised and carried forward in the
balance sheet is consistent with the definition that
an asset must possess probable future benefits to
the enterprise

• Argument against
– It fails to achieve a proper matching of costs with
revenues
 Full Cost Method

• Capitalise all exploration and evaluation costs

irrespective of whether an exploration
eventually proved to be successful or
unsuccessful
• The maximum amount capitalise is subject to a
ceiling test in that the aggregate of the costs
carried forward should not exceed the net
recoverable value of the reserves
• Arguments for
– As a going concern in an extractive industry, the enterprise
needs to continually search for viable oil/gas fields, costs of
unsuccessful exploration are thus part and parcel of the
costs of those that are successful
– The exploration and evaluation costs are all incurred and
directed towards increasing the enterprise’s pool of
commercially recoverable reserves

• Arguments against
– It is not feasible to newly established extractive enterprises
without a proven pool of reserves
– In contrast with the definition of an asset because it
capitalises the costs incurred in abandoned explorations
– Unsuccessful enterprises may end up captalising many
costs that will make them show no less favourable results
than the successful ones
 The Area of Interest Method
• Compromise between the successful effort
and the full cost methods
• An area of interest is normally defined in
terms of the geological area which is
considered to constitute a favourable
environment for the presence of a mineral
deposit or oil or gas field, or has been proved
to contain such a deposit or field
• A restricted cost centre approach is applied to an
area of interest and within that area of interest, all
exploration and evaluation costs incurred are
capitalised, so long as that area proved to contain
commercial deposits or reserves

• If the search is unsuccessful or evaluation produces

negative results, and the exploration is abandoned,
the capitalised costs or exploration and evaluation
attributable to that area is written off

• Lacks precision in defining what constitutes an area

of interest
 Accounting for Pre-Production Costs

• Development and construction costs in the

pre-production phase will be capitalised
 Depletion Accounting
• These costs, together with any related acquisition,
exploratory and evaluation costs carried forward
will be amortised or depreciated when production
commences

• Necessary to separate out the pre-production costs

into those that relate to
– Intangible development costs and
– Tangible plant machinery and equipment
• Tangible plant, machinery and equipment are
facilities used for example, to extract the
deposits or reserves, or for transportation
– They are in the nature of depreciable assets and
should b accounted for in accordance with FRS 116
Property, Plant and Equipment
– However, tangible assets which cannot be moved
from the area of operations should be depreciated
over the shorter of their useful lives or the life of
the deposits or reserves
• Intangible development costs, which include
carried forward related acquisition, exploratory
and evaluation costs, and all subsequent costs
incurred to establish access to the deposits and
reserves, form the depletion base for amortisation
• Depletion expense is normally computed by unit of
production method
• However, where production is limited by time,
such as a fixed-period tenure of an area of interest
or a limited leasehold land rights acquired, the
depletion expense should be computed based on
time
 Restoration Costs

• Terms of lease permit frequently require the

operator to restore the area covered by the
lease after the cessation of operations
• Where such restoration clause exists, the
cost of restoration necessary to return the
land to its usable condition should be
estimated initially at the commencement of
production
• The estimated cost should be allocated to
the production periods by a provision and
be treated as a cost of production
• The amount provided and the balance to
be provided should be reassessed from
time to time in the light of expected
further costs
• The extent not provided for at the end of
each accounting period, if material, should
be disclosed as a commitment under the
terms of the lease tenure
 Provision for Retrenchment Benefits
• Peculiar to tin mining
• Provision is made by a charge to operating expenses
each year and the yearly provisions are carried
forward as a liability in the balance sheet
• When the employees are retrenched, the amount
paid on retrenchment is setoff against the provision
account
• The amount provided in each period is normally
based on management’s agreement with the
employees’ union
MFRS 6 – Exploration for and Evaluation
of Mineral Resources

• Adoption on IFRS 6
• Applicable to exploration and evaluation
expenditures
• Not applicable to expenditures incurred
– Before the exploration for and evaluation of
mineral resources, such as expenditures
incurred before the entity has obtained the
legal rights to explore a specific area

– After the technical feasibility and commercial

viability of extracting a mineral resource are
demonstrable
 Recognition of Exploration and
Evaluation Assets

• Temporary exemption from FRS 108 para 11

and 12
– When developing its accounting policies, an
entity recognising exploration and evaluation
assets shall apply para 10 of FRS 108
Accounting Policies, Changes in Accounting
Estimates and Errors
• Para 10 FRS 108
In the absence of a Standard or an
Interpretation that specifically applies to a
transaction, other event or condition,
management shall use its judgment in
developing and applying an accounting policy
that results in information that is
– Relevant to the economic decision-making
needs or users and
– Reliable, in that the financial statements
• Represent faithfully the financial position,
financial performance and cash flows of
the entity
• Reflect the economic substance of
transactions, other events and conditions,
and not merely the legal form
• Are neutral
• Are prudent and
• Are complete in all material respects
• Para 11 and 12 of FRS 108 specify sources of
authoritative requirements and guidance
that management is required to consider in
developing an accounting policy for an item
if no FRS applies specifically to that item

• FRS 6 exempts an entity from applying those

paragraphs to its accounting policies for the
recognition and measurement of exploration
and evaluation assets
 Measurement of Exploration and
Evaluation Assets

• Measurement at recognition
Exploration and evaluation assets shall
be measured at cost
Expenditures related to the development
of mineral resources shall not be
recognised as exploration and evaluation
assets
 To recognise any obligations for removal
and restoration that are incurred during a
particular period as a consequence of
having undertaken the exploration of or
and evaluation of mineral resources

• Measurement after Recognition

After recognition, an entity shall apply the
cost model or the revaluation model to
the exploration and evaluation assets
 Changes in Accounting Policies

• An entity may change its accounting policies

for exploration and evaluation expenditures if
the change makes the financial statements
more relevant to the economic decision-
making needs of users and no less reliable, or
more reliable and no less relevant to those
needs
 Presentation

• Classification of exploration and evaluation

assets
– Tangible (eg vehicle, drilling rigs) or
– Intangible (eg drilling rights)

• To apply the classification consistently

• Reclassification of exploration and
evaluation assets
– An exploration and evaluation asset shall no
longer be classified as such when the technical
feasibility and commercial viability of
extracting a mineral resource are demonstrable

– To be assessed for impairment and any

impairment loss to be recognised, before
reclassification
 Impairment of Exploration and
Evaluation Assets
• To be assessed for impairment when facts
and circumstances suggest that the carrying
amount may exceed its recoverable amount
• Factors that indicate that an entity should
perform an impairment test
– Period for which the entity has the right to
explore in the specific area has expired during
the period or will expire in the near future, and
is not expected to be renewed
– Substantive expenditure on further exploration
for and evaluation of mineral resources in the
specific area is neither budgeted nor planned

– Exploration for and evaluation of mineral

resources in the specific area have not led to the
discovery of commercially viable quantities of
mineral resources and the entity has decided to
discontinue such activities in the specific area
 – Sufficient data exist to indicate that, although a
development in the specific area is likely to
proceed, the carrying amount of the
exploration and evaluation asset is unlikely to
be recovered in full from successful
development or by sale

• To determine an accounting policy for

allocating exploration and evaluation assets
to cash-generating units or groups of cash-
generating units for the purpose of
assessing impairment of assets
 Disclosure
• An entity shall disclose information that identifies
and explains the amounts recognised in its
financial statements arising from the exploration
for and evaluation of mineral resources

• To disclose the accounting policies for exploration

and evaluation expenditures including the
recognition of exploration and evaluation assets
• The amounts of assets, liabilities, income
and expense and operation and investing
cash flows arising from the exploration for
and evaluation of mineral resources

• To treat exploration and evaluation assets

as a separate class of assets