Accounting for Mineral Resources and Oil and Gas Exploration Companies

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By Jose T. Valencia

The International Accounting Standards Board (IASB) has come out with guidance, albeit incomplete, to address the accounting issues facing entities in the extractive industries. In particular, the standard addresses issues in relation to costs incurred in the exploration for and evaluation (E&E) of mineral resources. Prior to this standard, entities in the extractive industries followed varied accounting practices, based mainly on the accounting practices in the United States. Previous accounting practices followed either the full cost method or the successful efforts method or some variants thereof.

The timing of the issuance of this standard couldn’t be better for local companies in the extractive industries. Resurgent interest in mining and increasing investment in this sector will mean more financial reporting challenges and issues for accountants. At the very least, the new standard should promote some consistency and transparency in the financial reports of companies in the sector.

KPMG has published a report with the title First Impressions: IFRS 6 Exploration for and Evaluation of Mineral Resources. The rest of this article is based on this publication, but has been revised to make reference to PFRS (Philippine Financial Reporting Standards) instead of IFRS.

As mentioned, PFRS 6 deals with accounting for E&E expenditures. It does not address the accounting for costs incurred during the pre-exploration stage or the development phase. The diagram below illustrates the scope of PFRS 6.

For pre-exploration and development activities, entities will have to formulate accounting policies based on other existing PFRSs.

PFRS 6 seems to allow the continuation of pre-PFRS 6 accounting practices in that E&E expenditures may either be expensed or capitalized. However, there are a number of instances wherein the adoption of the standard changes previous accounting practices, and ultimately, reported financial performance and financial condition.

Here are some of the more important provisions of PFRS 6.

PFRS 6 requires entities to identify and account for pre-exploration, E&E and development expenditures separately. As mentioned, PFRS 6 deals with the recognition, measurement and disclosure of E&E expenditures. These are expenditures incurred after the acquisition of license or mineral rights and before the start of the development activities. In the extractive industries, development of a site means getting the site ready for production, and this usually begins after a site is determined to be technically feasible and commercially viable.

Examples of types of E&E expenditures that may be included in the initial measurement of the E&E asset (assuming an entity chooses to capitalize E&E costs) are as follows:

1. the acquisition of rights to explore (e.g. exploration license or mineral rights)
2. conducting topographical, geological, geochemical and geophysical studies
3. exploratory drilling
4. trenching
5. sampling
6. activities in relation to the evaluation of the technical feasibility and commercial viability of extracting a mineral resource

If an entity adopts a policy of capitalizing E&E expenditures, the following costs may also be added to the E&E asset:

1. Administrative and other general overhead costs may be capitalized provided these are directly attributable to the E&E asset. Examples include:

1. Payroll-related costs of personnel working directly on the project
2. Management costs if the roles are specific to the project
3. Legal or other costs specific to the project
• License acquisition costs, including costs incurred in acquiring the license, like professional and legal expenses.
• Borrowing costs, following the guidance in PAS 23 Borrowing Costs. Capitalized E&E expenditures are qualifying assets under PAS 23.

PFRS 6 also requires an entity to classify separately each E&E asset as either tangible or intangible asset based on the nature of the asset. The basis for classifying E&E asset into tangible and intangible should be applied consistently.

An entity may have an obligation, based on contractual commitments or past practice, to restore a site and remove structures when a site is abandoned. Liability for removal and restoration or decommissioning liability is required to be recognized in accordance with PAS 37 Provisions, Contingent Liabilities and Contingent Assets. Under PFRS, decommissioning obligations are measured and recognized based on the best estimate of the expenditure. The estimate is discounted when the effect of discounting is material.

After the recognition of E&E assets, an entity has the option to apply the cost model or revaluation model to E&E assets. However, because of the difficulties in determining the fair values of tangible and intangible E&E assets, we expect that the revaluation of these assets will be rare.

Another important issue under PFRS 6 is impairment. Unlike other assets, there is no requirement to assess whether an indication of impairment exists at each reporting date, until an entity has sufficient information to reach a conclusion about the commercial viability and feasibility of extraction. E&E assets are assessed for impairment when facts and circumstances suggest that the asset may be impaired. PFRS 6 provides examples of such facts and circumstances. One such example is that an entity’s right to explore in the specific area has expired or will expire in the near future, and is not expected to be renewed.

Once the technical feasibility and commercial viability of extracting a mineral resource are demonstrable, an entity ceases recognizing expenditures related to the development of the mineral resource as E&E assets. At this point, the entity must test the E&E assets for impairment and reclassify unimpaired E&E assets to appropriate accounts. The E&E assets may be reclassified to either tangible or intangible development assets. The policy on what types of E&E assets get classified as tangible or intangible assets is an accounting policy choice that must be applied consistently.

PFRS 6 has an interesting transition policy for existing PFRS users, which is different from first time PFRS adopters. An existing PFRS user may change its policy for E&E expenditures if, and only if, the change makes the financial statements more relevant to the economic decision-making needs of the users of the financial statements and no less reliable, or more reliable and no less relevant to those needs. For example, an existing PFRS user that already recognizes as expense E&E expenditures is precluded from changing its policy to capitalize E&E expenditures under this PFRS 6 requirement.

PFRS 6 took effect on January 1, 2006. Therefore, 2007 is the second year of the implementation of the standard. Entities in the extractive industries may refer to the following questions to assess whether or not they have properly implemented PFRS 6.

1. Does an entity have specific accounting policies for the measurement, recognition and disclosure of exploration and evaluation expenditures or assets as distinguished from pre-exploration expenditures and development expenditures?

1. If an entity has chosen to capitalize E&E expenditures, does it a have a policy for classifying E&E expenditures into tangible and intangible assets?

1. Does an entity perform impairment tests of E&E assets if facts and circumstances suggest that the carrying value of E&E assets may exceed their recoverable value?

1. Does the entity reclassify E&E assets to development assets or other appropriate accounts when the technical feasibility and commercial viability of a mineral resource or site has been established?

1. Before reclassifying E&E assets, does an entity perform impairment testing?

1. If the entity has an obligation to restore the site, has it recognized a liability based on the best estimate of the eventual costs which needs to be discounted if the effect of discounting is material?

Looking forward, the IASB has indicated that it intends to undertake a comprehensive project to develop an internationally acceptable approach to accounting issues in the extractive industries. Some believe that the IASB’s comprehensive review project will prohibit policies that allow capitalization of pre-development costs in part due to substantial uncertainty around the existence of the asset prior to the determination of proven and probable reserves. Such a change will surely have a significant impact on entities that currently capitalize E&E expenditures. However, this is not expected to be completed in the near term.


Published in the Philippine Star, September 11, 2007









(Jose T. Valencia, is a Partner in the Audit Services Group of Manabat & Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email manila@kpmg.com.ph or jvalencia@kpmg.com.)