IASB Issues Paper on "Extractive Industries"

29 June 1999

Sir David Tweedie
Chairman
International Accounting Standards Board
167 Fleet Street
LONDON EC4A
U.K.

Dear Sir David

Extractive Industries

The Group of 100 (G100) is pleased to provide comments on the Issues Paper (IP) on "Extractive Industries". The G100 has numerous members who actively participate in the extractive industries on a domestic and international basis.

The G100 believes that the development of an international accounting standard for the extractive industries has the potential to benefit both users and preparers of the financial reports of enterprises involved in the extractive industries if the standard results in improved financial reporting. In order to achieve improved financial reporting, the standard resulting from the project must:

result in the reporting of more relevant, reliable and comparable information. It is particularly important for both users and preparers of financial reports that adoption of any standard resulting from this project would lead to the disclosure of genuinely comparable financial information; and
be recognised as being of such quality that it is adopted by national standard-setters in the major capital markets and operating environments of enterprises engaged in the extractive industries.

Rather than addressing each of the issues identified in the IP, this response identifies and addresses the major issues that the G100 considers require resolution to establish the general direction of the project. This approach has been taken because the priority the new IASB places on this project is uncertain and a number of the issues are only relevant when a broad approach to accounting for the extractive industries has been decided. Likewise, the G100 believes that the due process of this project would be more transparent and efficient if the IASB focuses on canvassing the views of interested parties on the major issues before proceeding with other aspects of the project.

The G100 believes that the major issue requiring resolution is whether to adopt a cost based or market value based approach to accounting for the extractive industries. For reasons outlined in this submission, principally being the:

unreliability of - and lack of comparability that would arise from - market value based information;
symmetry required between accounting for reserves/resources and accounting for hedges of future sales; and
current lack of a financial reporting model that distinguishes between realised and unrealised gains and losses;
the G100 believes that a cost based approach to accounting for the extractive industries should be retained at the present time.

While the G100 believes that cost based accounting for the extractive industries should be retained, we also acknowledge that there is considerable scope to improve the comparability of information based on cost based methods of accounting. We believe that this should be the primary focus of the project.

A detailed response to the major issues identified by the G100 follows.

A. Scope of the Project (Basic Issues 1.2 and 1.3)

In principle, the G100 agrees with the Steering Committee's tentative view that there should be a single standard dealing with both financial reporting of mining and petroleum-related activities with separate requirements or guidance as necessary to address industry-specific issues. At a broad level, the processes and activities of mining and petroleum-related enterprises are similar and, therefore, the accounting standards applying to both should be similar.

G100 generally agrees that, as proposed by the Steering Committee, the standard should concentrate on "upstream activities" (exploring for, finding, acquiring, and developing reserves) and not the "downstream activities" (refining, processing, and marketing the output) of enterprises in the extractive industries.

However, there may need to be some refinement of the distinction between upstream and downstream activities, particularly as they relate to 'hard rock' mining. While in the petroleum-related industries the downstream refining activities are usually distinctly separable from the extraction of the resource, this is often not the case in hard rock mining. For example, iron ore processing facilities are usually an integral part of the production process required to produce a saleable product and are nearly always site specific. This is often also the case with non-ferrous metal mining operations. Further, with such facilities, while the output of a mine may technically be able to be sold prior to final processing, the processing of ore through an integrated site plant usually indicates that it is not practicable or economic to sell the ore prior to final processing. Accordingly, where there is a close link between the processing and extraction of ore, the entire operation should be regarded as falling within the scope of the standard.

B. Basis of Primary Financial Statements (Basic Issues 5.1 and 5.2)

The G100 believes that the issues relating to the basis of measurement that should be adopted for pre-production activities and reserves/resources are the most important issues addressed in the IP.

The G100's policy across industries on this issue is that its support for market value based accounting is conditional upon the factors listed below.

i. The ability to reliably estimate market values and to provide sufficient guidance in an accounting standard that will result in real improvement (rather than merely perceived improvement) in the quality, reliability and comparability of financial reporting.

The G100 does not believe that an accounting standard could provide the required guidance to ensure the recognition or disclosure of relevant, reliable and comparable financial information about the market value of the reserves/resources of an enterprise in the extractive industries. Further, the G100 believes that a significant lack of comparability between enterprises would result from the necessarily general guidance that could be provided in such a standard.

It is assumed in this submission that if a market value based approach is adopted for accounting for pre-development activities, the approach would be based on the notion of fair value as it exists in extant IASC standards. This would require the use of a Net Market Value (NMV) approach where reliable NMVs in active and liquid markets are available or Net Present Values (NPVs), as an estimate of fair values, where NMVs are not available.

If a market value approach predicated on NMV is required to be used, reliability and comparability is likely to be significantly compromised because:

each reserve/resource has individual characteristics and it will not generally be possible to find arm's length transactions for similar assets that would enable a reliable estimate of NMV to be made; and
the quantity and quality of reserves/resources can often be influenced by undertaking further drilling programs. In this respect, it should be noted that because of the cost of drilling programs, in many cases reserves are only proved-up to the extent necessary to enable medium term production planning by the enterprise. However, if a market value approach to accounting for reserves/resources is adopted, the amount of reserves/resources recognised by an enterprise in the statement of financial position, and the changes in the value of reserves and resources recognised in the income statement, will be able to be influenced by an enterprise's drilling program. Some have observed that this will have a very detrimental impact on the comparability of information between enterprises, while others have commented on the potential for manipulation that would arise in these circumstances.

If a market value based approach predicated on NPVs is to be adopted, in addition to the problem of determining the quantity of reserve/resource as discussed above, the following factors will render resulting information unreliable and incomparable:

estimating the timing of mine output;
estimating future selling prices of the mine output;
estimating future costs to extract and process mine output;
selecting the rate used to discount cash flows; and
estimating future capital costs and rehabilitation costs.

The lack of reliability of such estimates increases with mine longevity.

Recommendation:

Taking the above into consideration, the G100 does not believe that adoption of a market value based approach would result in information that is reliable (without bias or undue error) or comparable.

ii. Symmetry of treatment of related items to ensure that periodic financial performance is not distorted by requiring some items to be measured at market values (and for changes in those market values to be recognised in the income statement) whilst not requiring related items to be similarly treated.

The G100 believes that it is important that the measurement of different but related items in the financial statements should be consistent and the reporting of financial performance should reflect the relationship between the items. For example, most of the output of mining activities is sold in $US and many non-US entities reduce the risk of currency fluctuations on the effective domestic currency price that will be achieved on future sales by purchasing future currency and/or commodity contracts. If the reserves/resources of mining enterprises are marked-to-market, then it is important that the hedge instruments are also marked-to-market. This consistency in treatment is necessary if financial statements are to correctly depict the financial impact on an enterprise of a change in the relevant currency exchange rates and/or the $US price of commodities. Recognising a change in the market value of the reserve/resource without recognising the value of a related hedging instrument would mislead users of financial statements and introduce volatility that does not reflect market exposures in a balanced way. Conversely, if hedging instruments are required to be marked-to market and changes in their value recognised in periodic income, then it would be necessary to recognise to recognise the underlying hedged item on the same basis.

iii An adequate model of reporting financial performance that can distinguish between realised and unrealised gains and losses.

The G100's strong view is that any movement to market value based accounting should be preceded by a reporting model that distinguishes between realised and unrealised gains and losses.

A distinction between changes in value (that should be recognised as changes in equity) and realised profits/losses (transferred/recycled from equity to the income statement on realisation) would be necessary in order to avoid misleading users about the impact of changes in market values on an enterprise's periodic operating performance and ability to pay dividends. This is especially important in the extractive industries where changes in the market value of reserves/resources would often dwarf the realised profit or loss resulting from operations. In this respect, the G100 is strongly of the view that the project on Performance Reporting should be a high priority of the IASB and should be completed before any further proposals to move to market value based accounting are considered.

Recommendation:

Taking the above into consideration, the G100 agrees with the Steering Committee's Tentative View that the primary financial statements of mining enterprises should be based on the historical cost concept. This is because the adoption of market value based accounting would lead to a deterioration of the reliability and comparability of financial reporting in the extractive industries.

C. Method of Historical Cost Accounting (Basic Issues 4.1, 4.2, 6.1 and 6.7)

The G100 believes that the comparability of financial reporting by enterprises in the extractive industries can be improved by specifying one allowable cost based method of accounting for pre-development costs.

The G100 believes that the accounting treatment specified for pre-development costs should comply with the definition and recognition criteria for assets (and expenses) in the IASC's Framework. Therefore, pre-development costs should be recognised as an asset (capitalised and carried forward) when it is probable that future economic benefits will flow to the enterprise from the pre-development costs and the cost or value can be measured reliably. "Subsequent to initial recognition, pre-development costs recognised as assets would, as with other assets, be subject to the requirements of Accounting Standards dealing with the impairment of assets." The G100's approach would have a similar, but not identical, outcome to that obtained by applying the method described as the successful efforts method.

On this basis, the G 100 agrees with the Steering Committee's Tentative View that a method of accounting akin to the successful efforts method is preferable, as this should result in the recognition of assets only when the definition and recognition criteria for assets are satisfied. However, if the successful efforts approach is adopted, the method for specifying the cost centre must be tightly defined in order to ensure its consistent application across enterprises.

If the definition of and recognition criteria for assets are to be strictly applied to accounting for pre-development costs, a deposit-by-deposit approach to identifying relevant cost centres will probably be required, rather than, for example, traditional area-of-interest approaches based on broad geological prospectivity or proximity. For example, under one version of successful efforts accounting, so-called 'brownfields' exploration costs (cost of exploring in the immediate area of an existing mine) can be capitalised. However, depending on the nature of the resource, a stricter application of the definition of and recognition criteria for assets may require some brownfields exploration costs to be expensed immediately, as it will often not be known whether such costs will, in probability, give rise to future economic benefits. This illustrates the need to a tightly specified approach if true comparability of financial reporting is to be achieved.

In addition to requiring some brownfields pre-development costs to be recognised immediately as an expense, applying the definition of and recognition criteria for assets would normally result in the immediate expensing of 'greenfields' exploration and evaluation costs. While the G100 believes such outcomes are consistent with proper application of the IASC Framework, the IASB should be aware that this could have a negative impact on small exploration and mining companies that are, under current accounting standards in Australia, allowed to carry forward all pre-production costs until an area-of-interest is abandoned. A change in the accounting required by such enterprises may result in them reporting of losses which, according to some commentators, will adversely affect their ability to raise funds for further exploration activity. This is a public policy issue that the IASB should consider before finalising the standard and any transitional provisions that it may contain.

However, the G100 does not agree with the Steering Committee's Tentative View that there should be some type of arbitrary time limit on the carry-forward of pre-production costs. If the carry-forward of costs is rigorously assessed as described above, an arbitrary time limit is not required and would be illogical.

The issue of whether previously expensed pre-development costs should be required to be reinstated is not adequately dealt with in the IP. It would appear to the G100 that applying the definition of and recognition criteria for an asset in the IASC's Framework would require the reinstatement of previously expensed pre-development costs where the relevant 'area-of-interest' is determined to be successful and subsequently developed.

Reinstatement would also have the advantage of ensuring consistency and comparability between the measurement and subsequent amortisation of costs relating to internally-developed and acquired resources. For example, requiring reinstatement of pre-development costs upon development would ensure that the subsequent amortisation of costs relating to an internally-developed mine would be consistent with that of an acquired exploration deposit that was subsequently developed and mined.

Recommendation:
In summary, pre-production costs should be accounted for in accordance with the definition of and recognition criteria for assets. This will require the immediate expensing of some brownfields and most greenfields pre-development costs. However, it would also require reinstatement of previously expensed costs upon successful development of an exploration project. The IASB should also carefully consider the public policy issues arising from a requirement to immediately expense most pre-development costs before finalising the standard and any transitional provisions that it may contain.

D. Allocation of Acquisition Cost (Basic Issues 13.1 and 13.2)

Consistent with historical cost/acquisition accounting generally, the purchase of pre-development mining properties should be capitalised. Acquisitions are made where there is an expectation that the cost will be recovered through subsequent development or sale. Immediately expensing acquisition costs would result in an understatement of acquired assets and operating costs upon successful development. It should be noted that acquisition of exploration or evaluation stage mining properties sometimes involves acquisition of property, plant and equipment in addition to exploration/mine rights. For example, in Australia large mining tenements are often acquired in the form of sheep or cattle stations with land and building improvements. The properties continue to be run as stock stations before/while mining exploration and evaluation is being undertaken.

With respect to purchased development properties or operating mines, the G100 believes that normal acquisition accounting rules should apply. This would mean that:

All identifiable assets are recorded by reference to their fair value. Identifiable intangible assets that may be acquired include, for example, patented extraction or processing technology and exploration rights/tenements. Tangible assets that may be acquired include property, plant and equipment, and measured/indicated reserves and resources.
Where the output of an extractive industry is non-homogenous and sold directly to customers (for example, iron ore and coal) it is possible for goodwill to arise upon acquisition. This will especially be the case where products are significantly differentiated, where the product is not readily substitutable from the perspective of customers and/or where long-term sales contracts exist.
Similarly, where the output is relatively homogeneous (for example, alumina, silver, lead and zinc) and is often sold into international daily-traded commodity markets, but the output of a particular operation is sold under contract to customers with which a valuable relationship exists, it is possible for goodwill to arise upon acquisition. For example, a mine may produce refined ore that is not yet ready for trading into daily-traded commodity markets before further processing. That partly-processed ore may be on-sold to another party that completes the processing of the ore. Alternatively, the other party may, under contract, complete processing of the ore for the extracting enterprise. In either case, depending on the terms of the relationship with the other party, goodwill upon acquisition may arise.
While in all of the cases outlined above goodwill may arise upon acquisition, where there is significant potential upside in the reserve/resource base of an acquisition, it is likely that at least part of the consideration in excess of the identifiable net assets (inclusive of measured reserves/resource) will be attributable to the possible upside in resource (sometimes referred to as 'blue-sky') rather than to goodwill - that is, in some cases part of the consideration will be attributable to the possibility that the reserves/resources acquired will be greater than that which has been measured at acquisition. While the possible 'blue-sky' component of an acquisition will vary depending on the nature of each particular mining property acquired, it is important that the allocation of the purchase consideration take into account any significant 'blue-sky' potential.

Recommendation:
In summary, the acquisition accounting required for the extractive industries should require the economic substance of an acquisition transaction to be reflected in the financial statements of the acquirer. This would, in respect of each acquisition, require the net assets acquired and accounted for to reflect the unique mix of:

'blue-sky' potential (if any);
tangible assets acquired; and
customer relationships (if any).

E. Disclosure of Reserve Quantities and Grades (Issue 14.1)

The G100 is of the view that while the measurement of reserve quantities and grades is too unreliable for recognition in the primary financial statements, disclosure of such information should be required by way of notes to the financial statements. From the perspective of users, being able to make some assessment of reserve quantities and grades is important for assessing the future of an enterprise.

However, for the reasons outlined above in the discussion of Issues 5.1 and 5.2, there should be no requirement to place a value on the disclosed reserves and resources. Again, this is because of the unreliability and lack of comparability of any resulting value.

F. Other Issues

G100 believes that the project could usefully examine whether certain extractive industry Key Performance Indicators (KPIs) that are sometimes reported could be standardised. For example, gold mining enterprises often report total cash production costs and cash production costs per unit as a key measure of efficiency and an indicator of resource value. Measures of this type would be more meaningful if they were compiled according to standardised requirements.

G100 would be pleased to elaborate on any of the views included in its submission. Please contact me (+61 2 9378 3569) if we can provide any assistance in this respect.

Yours sincerely

Tom Pockett
National President