BACHELOR OF ACCOUNTING

ACC614 – INTERMEDIATE FINANCIAL ACCOUNTING 2

TOPIC: ACCOUNTING FOR EXTRACTIVE INDUSTRIES

INTRODUCTION
Accounting for extractive industries aimed at providing practical guidance in some of
the more difficult areas in accounting for extractive industries
Firms in the extractive industries engage in a search for natural resources of
commercial value and in extracting these substances from the ground. Natural
resource includes, coal, oil and natural gas. Searching for these deposits generally
involves considerable expenditure on geological and other studies or exploratory
drilling to determine whether certain area are viable for commercial development.
Although, in many cases, the exploration is unsuccessful, when an area is considered
a commercially viable proposition, further expenditures are usually required before
production is possible.

The period between the initial exploration of an area and production might be lengthy
and a change in demand for the product during this period might result in the
operation becoming uneconomical or less profitable than originally expected.
Determining whether an asset has been acquired through the expenditures associated
with exploration, evaluation and development can be very difficult. However, in order
to determine income for accounting purpose, decisions must be made about whether
these expenditures result in an asset or expense.

OPERATIONAL PHASES IN THE PROCESS OF SEARCHING FOR AND EXTRACTING NATURAL

RESOURCES

1. Acquisition of rights – acquisition of property rights by way of lease or purchase

of freehold or other right of tenure (including options to purchase)

2. Exploration – the search for natural resources that appear capable of commercial
exploitation by an extractive operation (including prospecting and topographical,
geological, geochemical and geophysical studies, as well as exploratory drilling);

3. Evaluation – the determination of the technical feasibility and commercial

viability of a particular area containing natural resources, including:
 Determining the volume and grade of the natural resources;

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  Examining and resting extraction method and metallurgical or treatment
processes;
 Surveys of transportation and infrastructure requirements.

4. Development – the establishment of access to the natural resource and other

preparation for its commercial production, including
 Shafts;
 Underground drives and permanent excavation;
 Roads and tunnels;
 Advance removal of overburden and waste rock
 Drilling of oil or natural gas wells

5. Production – the day to day activities directed at obtaining saleable product from
an area containing natural resources on a commercial scale, including extraction
and any processing prior to sale.
In practice, the distinction between these phases is not always clear and they might
overlap. Furthermore, it could be argued that where an entity is committed to
restoring a site once the extraction phase has been completed, the restoration of a
site should be recognised as the sixth phase.

COST METHODS TO ACCOUNT FOR EXTRACTIVE INDUSTRIES

Costs written off method
With this cost method, all preproduction costs are written off in the period they are
incurred. As there is a low probability of success from exploration and evaluation
activities, these costs should not be carried forward as an asset. This is consistent with
asset recognition criteria provided in the ‘Statement of Concepts for General Purpose
Financial Reporting’ (Statement of Concepts). No reinstatement is permitted, even if
economically recoverable reserves are found. This is inconsistent with the Statement
of Concepts. The related asset is the recoverable reserves, not the costs incurred in
discovering them. Critics argue that this method is excessively conservative and fails
to march costs with the benefits that flows from them.
Costs-written-off-and-reinstated method
This method is basically the same as the costs-written-off method except that
preproduction costs that are relevant to the confirmation of these reserves and that
were originally written off may be reinstated, carried forward as an asset and matched
against future revenues. It has the effect of reversing the expenses recognised in
previous periods. Although this method is not recommended in some countries (e.g.

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New Zealand), its use seems consistent with the Statement of Concepts. That is, once
the economic benefits are assessed as ‘probable’ and ‘measurable’, the Statement of
Concepts suggests that an asset can be recognised, even if the related expenditure has
previously been written off. Because the Statement of Concepts suggests that only
the expenditure deemed likely to generate economic benefits should be carried as an
asset, its application would greatly reduce the asset balances of many organisations
involved in the exploration and evaluation of economically recoverable reserves.
Full-cost Method
With the full-cost method, all preproduction costs, wherever incurred, are carried
forward to be matched against the revenue produced from the total economically
recoverable reserves discovered by the entity. In effect, all exploration and evaluation
costs may be carried forward in one pool as an asset and amortised against production
revenue. The cost carry forward should not exceed the net realisable value of all
economically recoverable reserve. In the early stages of a project, however there
might be no assurance that economically recoverable reserves exist or will be found.
Further, this method might result in matching past costs against future revenues and
current period costs against revenue from previously discovered reserves in an
entirely different area. Some argue that this is an incorrect matching of costs and
revenue. This method not permitted in New Zealand but permitted in USA.

Area-of-Interest Method.
The method represents an approach part way between the full-cost method and the
costs-written-off method. It differs from the full-cost method in that it is based on a
more restricted cost/profit centre and from the costs-written-off method in that the
carrying forward of the preproduction costs relating to an area of interest, so as to
match revenues and related costs, is permitted. An area of interest is defined as an
individual geographical area that is considered to constitute a favourable environment
for the presence of a natural resource, or has been proved to contain such a resource.
With the area-of –interest method, in any one area of interest all preproduction costs
relating to both successful and unsuccessful efforts within that area are carried
forward as an asset to be matched against future revenues to the extent that those
costs do not exceed future revenue from the area. Where there is not reasonable
probability of discovering economically recoverable reserves, all preproduction costs
accumulated for an area of interest are written off in the period in which such
improbability is established.

Successful-effort method.
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This is applicable in New Zealand and only reproduction costs associated directly with
economically recoverable reserves are carried forward as an asset to be matched
against future revenues. Costs that do not results in discovery of such reserves are
written off in the period in which the effort is determined to be unsuccessful. This
method is based on a more restricted cost/profit centre for the carrying forward of
preproduction costs than the area-of-interest method.
Under this method, preproduction costs for each individual effort should be written
off in the period in which they are incurred, except that they may be carried forward
as an asset, provided that the rights to tenure of the area exist and provided that one
of the following conditions exist:
 Such costs are expected to be recouped from future revenue arising from the
effort;
 Exploration and/or valuation activities relating to the effort have not yet reached
a stage that permits a reasonable assessment of the existence or otherwise of
economically recoverable reserves, and active and significant investigations are
continuing.

DISCLOSURE REQUIREMENTS
The risks and uncertainties associated with the extractive industries mean that the
financial statements of entities involved in operations of this kind should maintain a
high standard of disclosure. The following disclosures are required in the financial
reports of companies engaged in extractive industry activities, either in the body of
the accounting reports or by way of note:
a. The amount of preproduction costs incurred in the period relating to each venture,
showing separately the cost relating to ventures which have proven reserves and
those relating to ventures which do not yet have proven reserves:
b. The amount charged in the period of amortisation of preproduction costs relating
to each venture;
c. Royalties incurred in the period on sales or production relating to each venture;
d. Total preproduction costs relating to each venture, with accumulated amortisation
charges being shown separately as a deduction and distinguishing between
ventures with proven reserves and those which do not have proven reserves;
e. The estimated quantity of economically recoverable reserves relating to each
venture remaining at the end of each year;
f. A statement of the movements in the economically recoverable reserves for each
venture (and for each product from the venture) showing separately and re-

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 estimation of reserves at the start of the year and the amount extracted during the
year;
g. Details of the periods for which property

ILLUSTRATION 1
Comparison of the full-cost method and the successful-effort method.
Fraser Island Ltd commences operations on 1 January 2014. During 2014 Fraser Island
explored two areas and incurred the following costs.
Site Acquisition Exploration Total
$m costs $m
$m
A 5 12 17
B 2 6 8
7 18 25

In 2015, oil is discovered in Site B. Site A is abandoned. Development costs of $20

million are incurred in Site B (to be written off on a production basis). Site B is
estimated to have eight million barrels. Current sale price is $30 per barrel. In 2015,
Fraser Island Limited extracts 1.2 million barrels at a production cost of $3.6 million
and sells 1.1 million barrels.

Required.
Provide the journal entries using:
a. the successful-effort method,
b. the full-cost method.

Solution to Illustration 1
a. Successful-effort method.

2014 $ $
Dec 31 Deffered acquisition and exploration costs – Site A 17
Deffered acquisition and exploration costs – Site B 8
Cash/Payable a/c 25
(Accounting for the initial exploration and
evaluation costs incurred in each site)

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The deferred acquisition and exploration costs are classified as assets of the entity.

2015 $ $
Dec 31 Depletable natural resources 8
Deffered acquisition and exploration costs – 8
Site B 17
Acquisition and exploration expenses 17
Deffered acquisition and exploration costs –
Site A
(Transfer the balance of the deferred expenditure
account to the depletable natural resources a/c).

This signifies that a judgement has been made that economically recoverable
resources exist. Also, it has been decided to write off the carried forward costs in
relation to Site A. the depletable natural resources account is an asset.
2015 $ $
Dec 31 Depletable natural resources 20
Cash/payables/provision for depreciation etc. 20
(Recognise the development costs that are
recorded in the depletable natural resources
account).

This account will subsequently be amortised to inventory via the use of a contra
account entitled accumulated depletion at is offset against depletable natural
resources.
2015 $ $
Dec 31 Inventory of crude oil 4.2
Accumulated depletion 4.2
(Amortisation of costs carried forward).

Rather than crediting depletable natural resources directly, a contra account,

accumulated depletion is used. The amount is calculated at 1.2 million x $3.50 where
($28m ÷ 8m = $3.50 per tonne.

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 2015 $ $
Dec 31 Inventory of crude oil 3.6
Cash/Payables/Provision for depreciation 3.6
(Recognise the production costs that are treated as
a cost of the inventory rather than being written
off directly).

2015 $ $
Dec 31 Cash/Receivable 33
Sales Revenue 33
(Recognise sales made, where$33m = 1.1m barrels
x $30 per barrels).

2015 $ $
Dec 31 Cost of goods Sold 7.15
Inventory of crude oil 7.15
(Cost of goods sold).
The is calculated as [$3.6m + $4.2m] ÷ 1.2m x 1.1m = 7.15m

b. Full-cost method.

2014 $ $
Dec 31 Deferred acquisition and exploration costs 25
Cash/Payable a/c 25
(Accounting for the initial exploration and
evaluation costs incurred costs incurred in each
site)
2015
Dec 31 Depletable natural resources 25
Deferred acquisition & exploration costs 25
(Transfer the balance of the deferred expenditure
account to the depletable natural resources a/c).

The total amount is transferred as the receipts from the recoverable reserves are
expected to exceed the early forward costs plus any additional costs expected to be
incurred.
2015 $ $
Dec 31 Depletable natural resources 20
Cash/payables/provision for depreciation etc. 20

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 (Recognise the development costs that are
recorded in the depletable natural resources
account).
2015 $ $
Dec 31 Inventory of crude oil 6.76
Accumulated depletion 6.76
(Amortisation of costs carried forward).

The amount is calculated as 1.2m x $5.635, where $45m ÷8m = $5.635 per tonne.
2015 $ $
Dec 31 Inventory of crude oil 7.15
Cash/Payables/Provision for depreciation etc. 7.15
(Recognise the production costs that are treated as
a cost of the inventory, rather than being written
off directly).

2015 $ $
Dec 31 Cash/Receivable 33
Sales revenue 33
(Recognise sales made, where $33m = 1.1m barrels
x $30 per barrel).

2015 $ $
Dec 31 Cost of goods Sold 9.4967
Inventory of crude oil 9.4967
(Cost of goods sold).

This is calculated as ($3.6m + $6.76m) ÷1.2m x 1.1m = $9.4967m

Solution to Illustration 2
Application of the successful-effort method.
The AFM Mining Company Ltd is undertaking a search for oil below Hamilton.
Exploration and evaluation activity is being undertaken in three areas, these being
Newie, Club and Pink. Another site, Tattoosals, is currently producing oil on a
commercially viable basis. When Tattoosals was assessed it was considered that it
would provide seventy million barrels. This is still the case to date, 17.5 million barrels
of oil have been extracted, 500,000 barrels of which are on hand at year end.
Production commenced in Tattoosals in September 2014. Two of the other locations,
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Newie and Pink, show promising geological formations. Club, however, will be
abandoned owing to poor testing results.
The following is an analysis of the expenditure incurred by the company during the
year ended 30 June 2015 by major drilling location.
$
Tattoosals
Mine development 25 000
Production costs (including royalties of $500,000) paid on
production 18 125 000
Construction of buildings 450 000
Construction of plant 1 125 000

Club
Exploration 625 000
Evaluation 250 000

Newie
Exploration 675 000
Evaluation 480 000

Pink
Exploration 875 000
Evaluation 467 500

At 30 June 2014 the following expenditure was carried forward in the financial report.
$
Tattoosals
Exploration 1 000 000
Evaluation 800 000
Development 875 000
Fixed Assets
Buildings 3 125 000
Plant 1 567 500
Club
Exploration 50 000
Newie
Exploration -
Pink
Exploration 50,000

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The fixed assets have useful lives as follows:
Building 20 years
Machinery 15 years
The machinery could be transferred to one of the other four sites should successful
exploration commence there. It is considered impractical to move the buildings.
There is no other inventory at Tattoosals, apart from the 500 000 barrels of oil that are
ready to sale. These will sell on the open market for $9 a barrel.

Required
a. Determine the appropriate treatment for the 2014 carried-forward expenditure
and the 2015 actual expenditure in the financial report as at 30 June 2012.
b. Determine the appropriate valuation of Tattoosals’ inventory at 30 June 2015
c. Determine the result for the company for the year ended 30 June 2015. Non
production expenses (excluding any carry-forward expenditure write-offs) totalled
$5.5 million.

Solution to Illustration
a. Appropriate treatment of the preproduction costs for each area of interest at 30
June 2015.
Club $
Expenditure carried forward at 30 June 2014 50 000
Incurred during the year ended 30 June 2015 875 000
Total 925 000

The amount should be written off to the statement of financial performance since
the area of interest has been abandoned.

Newie $
Expenditure carried forward at 30 June 2014 -
Incurred during the year ended 30 June 2015 1 155 000
Total 1 155 000

The amount should be carried forward since the area of interest shows promise.

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Pink $
Expenditure carried forward at 30 June 2014 50 000
Incurred during the year ended 30 June 2015 1 342 000
Total 1 392 000

The amount should be carried forward since the area of interest shows promise.

Tattoosals $
Preproduction costs
Expenditure carried forward at 30 June 2014 ($1 000 + $800 + 2 675 000
$875) 250 000
Incurred during the year ended 30 June 2015
Total 2 925 000

Fixed asset
Buildings $
Expenditure carried forward at 30 June 2014 3 125 000
Incurred during the year ended 30 June 2015 450 000
Total 3 575 000

Plant $
Expenditure carried forward at 30 June 2014 1 567 000
Incurred during the year ended 30 June 2015 1 125 000
Total 2 692 000

The amounts should be amortised, since the area of interest reached the
production phase. The preproduction costs and buildings should be amortised
using the production output method. The plant amortised using the company’s
normal depreciation method. The actual amortisations for 2015 are:

Preproduction costs ($2 925 000 ÷ 70 000 000) x (17 500 000) = $731
Buildings (3 575 000 ÷ 70 000 000) x (17 500 000) 250
Plant (2 692 500 ÷ 15) x (10 ÷ 12) = $893
750
= $149
583

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 Note that the plant is amortised using the straight-line method over 15 years and
only ten months’ depreciation is recorded in the first year since production started
in September.

b) Valuation of inventory
$
Production costs 18 125 000
Amortisation of preproduction costs 731 250
Depreciation of buildings 893 750
Depreciation of plant 149 583
Costs of goods manufactured 19 899 583

Cost per barrel (rounded) $19 899 583 ÷ 17 500 000 1.137
Inventory value (500 000 x (1.137) 568 560

c) Operating result for the year

Statement of financial performance for the year ended 30 June 2015
$
Sales (17 000 000 x $9) 153 000 000
Cost of sales (17 000 000 x $1.137) 19 329 000
Gross profit 133 671 000
Non production expense 5 500 000
Write off of club area of interest 925 000
Operating profit 127 246 000

Illustration 3

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Accounting for the extractive industries.
Meridian Mining Company (MMC) is an Australian-based coal mining company. It
currently operates in two areas of interest – Blackwell and Brownstone. The company
has adopted the cost model for all assets and uses the straight-line method of
depreciation for its assets unless the units-of-production method is appropriate. A
discount rate of 5% has been identified by the company’s accountants as best
reflecting the current market conditions and risk profile of MMC’s operations. The
financial year ends on 30 June. On 1 July 2013, the company commenced operations
to search for coal.

Part (a)

During 2014 financial year, it incurred following exploration and evaluation costs in
two areas of interest:

Blackwell area of interest: $1,060,000 As a result of above activities, the company’s

geologists assessed that 25 million tonnes of commercially exploitable coal deposits
exists in the Blackwell area.

Brownstone area of interest: $850,000 Based on recent discoveries by competitors,

the managers of MMC believed that large coal deposits are likely to be found in the
Brownstone area. However, it is too early to reach a conclusion about the likely
outcome of exploration in the area.

Solution to Illustration 3

Journal entries for financial year ended 30 June 2014:

Date Account Dr Cr
30/6/2014 Exploration and Evaluation Asset 1,060,000
(Blackwell) 1,060,000
Cash/Payables
(Recognition of E&E costs for Blackwell)
30/6/2014 Exploration and Evaluation Asset 850,000 ***
(Brownstone) 850,000
Cash/Payables
(Recognition of E&E costs for Brownstone)

Blackwell area of interest:

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It can be implied from the facts provided that the exploration and evaluation costs
incurred during 2014 financial year should be capitalised as an asset because they
meet the conditions of Aus 7.2 of AASB 6. That is:

a. There is no evidence to suggest any imprediments to the current rights to

tenure of the area of interest; and
b. The exploration and evaluation costs are expected to be recouped through
successful development and exploitation of the area.

Definition
Preproduction Costs means all exploration and development expenditures and all
other costs, expenses including cash payments, obligations, and liabilities, including
those of a capital nature, directly or indirectly incurred prior to the date in which the
Property are placed in Commercial Production.

Depletable Assets
Included are all costs incurred in making the assets usable (such as transportation and
installation) Gross value of depreciable/depletable assets includes: All buildings,
structures, machinery, and equipment (new and used) for which depreciation reserves
are maintained.

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