Blind Freddy – Common errors when accounting for exploration and evaluation assets

The ‘Blind Freddy’ proposition is a term used by Justice Middleton in the case of ASIC v Healey & Ors [2011] (Centro case) to describe glaringly obvious mistakes.

AASB 6 Exploration for and Evaluation of Mineral Resources is in many ways a unique standard - it is industry specific, it actually has aspects of it that are outside of the conceptual framework, and contains special rules on when to test capitalised exploration and evaluation (E&E) assets for impairment.

Although AASB 6 is a short standard, there are a surprising number of ‘Blind Freddy’ errors that an entity can make if its accounting policy is to capitalise its E&E expenditure. This article focusses on a number of these ‘Blind Freddy’ errors.

Blind Freddy error 1 - Incorrectly believing expenditure is within the scope of AASB 6

AASB 6 is a unique standard and application is very much restricted to expenditure that is for the exploration and evaluation of mineral resources. Errors arise when preparers try to apply the standard to:

  • Prospecting activities
  • Development activities
  • Research activities to design equipment to extract and process mineral resources, and
  • Mining assets.

Blind Freddy error 2 - Belief that AASB 6 is exactly the same as IFRS 6

Although AASB 6 contains all of the text and guidance contained within IFRS 6, it differs in a number of respects from its international counterpart because of the insertion of specific ‘Aus’ paragraphs, which contain Australian-specific requirements. These paragraphs discussed in Blind Freddy errors 3 and 4, effectively mean that the ability of an entity to capitalise E&E expenditure is stricter under AASB 6 than under IFRS 6.

Blind Freddy error 3 - Using a unit of account that is larger than an area of interest

AASB 6 restricts the unit of account for an E&E asset to being no larger than an area of interest.

An entity’s accounting policy for the treatment of its exploration and evaluation expenditures shall be in accordance with the following requirements. For each area of interest, expenditures  incurred in the exploration for and evaluation of mineral resources shall be:

  1. expensed as incurred; or
  2. partially or fully capitalised, and recognised as an exploration and evaluation asset if the requirements of paragraph Aus7.2 are satisfied.

An entity shall make this decision separately for each area of interest.

AASB 6, paragraph Aus 7.1

An area of interest refers to an individual geological area whereby the presence of a mineral deposit or an oil or natural gas field is considered favourable or has been proved to exist. It is common for an area of interest to contract in size progressively, as exploration and evaluation lead towards the identification of a mineral deposit or an oil or natural gas field, which may prove to contain economically recoverable reserves. When this happens during the exploration for and evaluation of mineral resources, exploration and evaluation expenditures are still included in the cost of the exploration and evaluation asset notwithstanding that the size of the area of interest may contract as the exploration and evaluation operations progress. In most cases, an area of interest will comprise a single mine or deposit or a separate oil or gas field.

AASB 6, paragraph Aus 7.3

An area of interest is an individual geological area whereby the presence of a mineral deposit or an oil or natural gas field is considered favourable or has been proved to exist. This therefore prevents the grouping of separate areas of interest held in a particular country as being the appropriate unit of account. Practically this means that as smaller areas are abandoned or it is proved that they do not contain economically feasible reserves, AASB 6 will result in earlier impairment or derecognition of the E&E asset than under IFRS 6.

Blind Freddy error 4 - Capitalising E&E where the rights to tenure of the area of interest are not current

An exploration and evaluation asset shall only be recognised in relation to an area of interest if the following conditions are satisfied:

  1. the rights to tenure of the area of interest are current…

Extract of AASB 6, paragraph Aus 7.2

There may be circumstances where an entity is undertaking E&E activities where it does not have current right of tenure, for example, where E&E activity is being performed in anticipation of the granting of an exploration permit, or where a valid exploration permit has expired and work is being performed in anticipation that the exploration permit is going to be renewed/extended.

AASB 6, paragraph Aus 7.2 (a) is very clear that if legal tenure does not exist, E&E expenditure cannot be capitalised. However it will be a matter of law as to the entity’s rights of tenure where it has lodged a valid renewal application and the granting of the renewal is delayed.

Blind Freddy error 5 – Other capitalisation errors

Even if rights to tenure of the area of interest are current, other Blind Freddy errors that typically occur relate to the second limb of AASB 6, paragraph Aus 7.2(b) where entities capitalise E&E expenditure:

  • That is not expected to be recouped through successful development of the area of interest or sale of the area of interest, or
  • Where the E&E activities have reached a stage which permits a reasonable assessment of the existence or otherwise of economically recoverable reserves.

An exploration and evaluation asset shall only be recognised in relation to an area of interest if the following conditions are satisfied:

  1. the rights to tenure of the area of interest are current; and
  2. at least one of the following conditions is also met:
    1. the exploration and evaluation expenditures are expected to be recouped through successful development and exploitation of the area of interest, or alternatively, by its sale; and
    2. exploration and evaluation activities in the area of interest have not at the end of the reporting period reached a stage which permits a reasonable assessment of the existence or otherwise of economically recoverable reserves, and active and significant operations in, or in relation to, the area of interest are continuing.

AASB 6, paragraph Aus 7.2

Blind Freddy error 6 - Capitalising expenditure before the entity has obtained the rights to explore a specific area

AASB 6, paragraph 5 only permits E&E expenditure to be capitalised if specific conditions are met. Expenditure incurred before exploration and evaluation begins cannot be capitalised, for example, costs incurred before the entity has obtained legal rights to explore an area.

An entity shall not apply the Standard to expenditures incurred:

  1. 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…

Extract of AASB 6, paragraph 5

Blind Freddy error 7 - Capitalising expenditure in the prospecting phase

Another common Blind Freddy error relates to capitalising costs incurred in the prospecting phase, which occurs prior to exploration and evaluation commencing. AASB 6, paragraph 3 specifically only permits capitalising E&E costs, which do not include costs of prospecting.

An entity shall apply the Standard to exploration and evaluation expenditures that it incurs.

AASB 6, paragraph 3

Blind Freddy error 8 - Applying AASB 6 after the technical feasibility of extracting a mineral resource is demonstrable

Other E&E costs capitalised in error include those incurred after the technical feasibility of extracting the mineral resource has been proven. Such expenditure would be capitalised as a development or production property.

An entity shall not apply the Standard to expenditures incurred:
  1. after the technical feasibility and commercial viability of extracting a mineral resource are demonstrable.

Extract of AASB 6, paragraph 5

Blind Freddy error 9 - Recording development costs as E&E assets

Again, because AASB 6 only applies to expenses incurred for exploration and evaluation of mineral resources, once exploration and evaluation is complete, development costs cannot be capitalised as E&E assets. Instead, these should be accounted for under accounting standards that apply to those specific assets, for example, property, plant and equipment under AASB 116 Property, Plant and Equipment.

Expenditures related to the development of mineral resources shall not be recognised as exploration and evaluation assets.

AASB 6, paragraph 10

Blind Freddy error 10 - Not recognising costs in respect of restoration following on from the E&E activity

Most exploration licences require restoration of areas where exploration has taken place. Another typical Blind Freddy error is failing to recognise any, or an adequate amount of provision for restoration as required by AASB 137.

In accordance with AASB 137 Provisions, Contingent Liabilities and Contingent Assets an entity recognises any obligations for removal and restoration that are incurred during a particular period as a consequence of having undertaken the exploration for and evaluation of mineral resources.

AASB 6, paragraph 11

Blind Freddy error 11 - Changing the entity’s accounting policies in respect of E&E expenditure

Once an entity has selected an accounting policy for E&E expenditure for a particular area of interest under AASB 6, paragraph Aus 7.1, it can only change the policy for that area if it 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.

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. An entity shall judge relevance and reliability using the criteria in AASB 108.

AASB 6, paragraph 13

Capitalising E&E expenditure goes against the basic requirement of AASB 138 Intangible Assets to expense costs on research activities. AASB 138’s justification for not allowing capitalisation of research costs is that it cannot be reliably determined whether economic benefits will flow to the entity from this asset.

Therefore a change in accounting policy from fully expensing E&E costs, to fully capitalising E&E costs, is unlikely to produce more reliable information.

Blind Freddy error 12 - Capitalising general overheads

Overhead costs cannot be capitalised to E&E assets unless they relate directly to operational activities in the E&E area of interest. This means that general overhead costs such as directors’ fees, secretarial, accounting fees, etc. cannot be capitalised as they relate to the business as a whole and not the particular E&E area of interest.

General and administrative costs are allocated to, and included in, the cost of an exploration and evaluation asset, but only to the extent that those costs can be related directly to operational activities in the area of interest to which the exploration and evaluation asset relates. In all other cases, these costs are expensed as incurred. For example, general and administrative costs such as directors’ fees, secretarial and share registry expenses, and salaries and other expenses of general management are recognised as expenses when incurred since they are only indirectly related to operational activities.

AASB 6, paragraph Aus 9.4

Blind Freddy error 13 - Incorrectly classifying items of plant and equipment as intangible assets

E&E activities by their nature may involve the purchase of items of plant and equipment, drill rigs, generators, etc. Although these items are used for E&E purposes, they still represent tangible assets and should be classified as such.

An entity shall classify exploration and evaluation assets as tangible or intangible according to the nature of the assets acquired and apply the classification consistently.

AASB 6, paragraph 15

Blind Freddy error 14 - Continuing to present capitalised expenditure as E&E when it has moved into the development phase

Once technical feasibility and commercial viability of extracting a mineral resource are demonstrable, the capitalised expenditure must be reclassified as either a development asset or a mine property.
The importance of correct classification centres on the special rules on impairment testing that apply only to capitalised E&E expenditure.

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.

AASB 6, paragraph 17

Blind Freddy error 15 - Not testing for impairment as the asset transitions from the exploration phase to the development phase

AASB 6 has unique requirements about when capitalised E&E expenditure is tested for impairment. These special rules only apply to an asset that qualifies as E&E; therefore as the asset transitions to the development phase, it must be tested for impairment.

Exploration and evaluation assets shall be assessed for impairment, and any impairment loss recognised, before reclassification.

AASB 6, paragraph 17

Blind Freddy error 16 - Believing E&E is not subject to impairment testing

Although capitalised E&E expenditure is subject to special rules as to when impairment testing is to be performed, AASB 6 nonetheless does require impairment testing when there are indicators of impairment as set out in AASB 6, paragraph 20.

Exploration and evaluation assets shall be assessed for impairment when facts and circumstances suggest that the carrying amount of an exploration and evaluation asset may exceed its recoverable amount. When facts and circumstances suggest that the carrying amount exceeds the recoverable amount, an entity shall measure, present and disclose any resulting impairment loss in accordance with AASB 136, except as provided by paragraph 21 below.

AASB 6, paragraph 18

Blind Freddy error 17 - Not testing for impairment when there is an indicator of impairment

Renewals

An E&E asset must firstly be tested for impairment if:

  • The period for which the entity has the right to explore in the specific area has expired
  • The right to explore in the specific area will expire in the near future
  • The right to explore in the specific area is not expected to be renewed.

In applying the above requirements it must be recognised that the last test involves forecasting whether the right to explore will be renewed. This consideration involves both judging the action of the relevant government in respect of granting a renewal, and the intentions of the entity itself to seek to renew its exploration right.

If an entity plans not to renew its exploration right, be it because of poor geological results, a decision to focus activities on other areas, or a simple lack of funds to renew tenure, then the asset should be tested for impairment.

Budgeted or planned substantive expenditure

An E&E asset must be also tested for impairment if substantive expenditure on further exploration and evaluation of mineral resources in the specific area is neither budgeted nor planned. Again this is very much a prospective indicator of impairment, resting on the entity’s plans and ability to incur ‘substantive expenditure’, and will be influenced by whether geological results to date justify  performing  ‘substantive expenditure’, whether the entity will focus its efforts on other prospects, or indeed whether the entity has the ability to commit funds to incur ‘substantive expenditure’.

No commercially viable quantities

If exploration in the specific area has 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, an impairment test must be performed. This is very much linked to the earlier step that because of geological data or the current commodity price, the entity has decided not to continue its E&E activity.

Unlikely recovery

Lastly, even though development in a specific area is likely to proceed, if sufficient data exists to indicate that the carrying amount of the E&E asset is unlikely to be recovered in full from successful development or by sale, an impairment test needs to be performed.

Just because an E&E asset is likely to go into production does not mean an impairment test can be avoided. From a marginal costing perspective, it may make economic sense to spend say $10 million to generate cash flows of $20 million. However, if the entity had already capitalised E&E assets of $15 million, the asset should be tested for impairment. This information could well become obvious when preparing feasibility studies or even pre-feasibility studies.

One or more of the following facts and circumstances indicate that an entity should test exploration and evaluation assets for impairment (the list is not exhaustive):

  1. the 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.
  2. substantive expenditure on further exploration for and evaluation of mineral resources in the specific area is neither budgeted nor planned.
  3. 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.
  4. 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.

AASB 6, paragraph 20

Blind Freddy error 18 - Testing E&E assets for impairment at a level larger than an area of interest

As discussed previously, AAAB 6 uses a different unit of account than IFRS 6, limiting the unit of account to an area of interest, which flows onto impairment testing. Errors do occur where an entity tests for impairment on say a national level or geographic level, rather than based on the area of interest.

Notwithstanding paragraphs 21 and 22, the level identified by the entity for the purposes of testing exploration and evaluation assets for impairment shall be no larger than the area of interest to which the exploration and evaluation asset relates.

AASB 6, paragraph Aus 22.1