Decommissioning Liabilities

In document International Financial Reporting Standards (Page 13-59)

• Provisions for decommissioning and restoration liabilities should be recognized when an entity has identified a present obligation (legal or constructive) arising from a past event, it is probable that an outflow of resources will be required to settle the obligation, and a reliable estimate of the obligation can be made.

• Both legal and constructive obligations must be considered when recognizing decommissioning and restoration liabilities.

• The discounted cost of dismantling and removing an asset associated with the construction of the asset should be recognized in the original cost of that asset and as a liability (however, under the IASB’s Exposure Draft to amend IFRS 1, any measurement difference at transition between an entity’s current GAAP and IAS 37 “Provisions, Contingent Liabilities and Contingent Assets” must be determined and charged to retained earnings).

• Provisions are required in respect of PP&E and intangible and tangible oil and gas assets including, if practicable, indefinite life assets.

• An appropriate discount rate to be used in measuring the obligation is one that includes current market assessments of the time value of money and those risks specific to the liability that have not been reflected in the best estimate of the expenditure.

• Changes in the estimated timing of cash flows of resources necessary to discharge the obligation and changes in the discount rate are added to or deducted from the cost of the related asset and the adjusted amounts are amortized prospectively over the estimated useful life of the asset.

• The unwinding of the discount arising from the passage of time is recognized as a financing cost and cannot be capitalized.

• Expenditures for dismantling or removing equipment or restoring a site should be expensed when they result from operating activities and capitalized when they are associated with drilling or construction activities.

• Detailed disclosures continue to be required.

Sections 7 and 8 — Issues Specific to In-situ Heavy Oil, Oil Sands and Oil Sands Mining Operations

• There is currently no guidance from the IASB in respect of reserves quantities and pricing determinations for in-situ heavy oil and oil sands producers.

• Differences in various accounting policies currently followed by these producers are expected to continue, subject only to overall IFRS compliance, until the IASB Extractive Industries Research Project is completed.

• Increased and detailed disclosures are required.

Section 9 — Oil and Gas Assets — Transitional Issues

• The proposed IFRS 1 amendment, if approved by the IASB, will permit companies currently following full cost accounting to elect to measure oil and gas assets at transition at historical cost without retroactive application.

• At transition, companies must identify and segregate oil and gas assets into E&E assets and development or production assets.

• Identified E&E assets may be carried forward at the amount determined under the entity’s previous GAAP.

• Impairment tests of E&E assets and development or production assets will be required at transition regardless of whether impairment indicators have been identified with any impairment amounts being charged directly to retained earnings.

• In the event the proposed amendment to IFRS 1 is passed and the election is used, at transition an entity will have to:

– Carry forward development or production assets at the amount determined under the entity’s previous GAAP and allocate the amount pro rata to the underlying assets (intangible and tangible) using reserves volumes or reserves values

– Recognize the difference, if any, between decommissioning liabilities measured in accordance with IAS 37 and decommissioning liabilities measured under the entity’s current GAAP and charge the difference (plus or minus) directly to retained earnings, and

– Disclose that the entity has elected its deemed cost for oil and gas assets as the carrying amounts determined under the entity’s previous GAAP, including the basis of allocation.

• Asset impairment amounts and measurement changes in decommissioning liabilities at transition must be disclosed.

• Detailed disclosures with respect to IFRS 1 exemptions, measurement of oil and gas assets, impairments and other adjustments and reconciliations from previous GAAP are required in sufficient detail to allow readers to understand material changes in the entity’s financial statements.

• Section 9 includes an oil and gas asset transitional example which may require modification if the proposed IASB exposure draft is amended following the comment period.

The Future

Changes in accounting for oil and gas assets are only one of the changes facing the industry as the IFRS world continues to evolve. In addition to the Extractive Industries Research Project, which could be finalized by 2014, more than a dozen projects are currently under review by the IASB. By 2011, new or modified standards are expected to be promulgated on such matters as consolidation, revenue recognition, leases, earnings per share, related party disclosures, liabilities, emissions, income taxes, joint arrangements and fair value measurement guidance, to name but a few. In addition, the Securities and Exchange Commission (SEC) has publicly announced a Road Map, having several milestones, that would allow the United States to stage-in the adoption of IFRS for SEC registrants in the period from 2014 to 2016. This may result in further changes to standards and interpretations as the IASB, SEC and Financial Accounting Standards Board (FASB) negotiate and harmonize current differences and progress continues toward convergence of world-wide financial reporting standards. These changes may have further significant effect on the Canadian oil and gas industry and managements are encouraged to keep informed of developments.

Canadian entities should become aware of and consider potential changes in IFRS standards, both before and after 2011, and factor those considerations into accounting policy choice decisions on adoption of IFRS in order to lessen further changes.

Changes in accounting for oil and gas assets are

only one of the changes facing the industry as the IFRS world continues to evolve.

Background

Until the IASB issued IFRS 6 “Exploration for and Evaluation of Mineral Resources”, there was no standard that addressed accounting practices for the extractive industries, in particular for costs incurred in the exploration and evaluation (E&E) of mineral resources. The release of IFRS 6 effectively removed the recognition and measurement of E&E costs from the scope of IAS 38

“Intangible Assets” and IAS 16 “Property, Plant and Equipment”.

The purpose of IFRS 6 was to address, on a short term basis only, certain accounting issues in relation to E&E costs until the IASB could undertake a more comprehensive review of accounting practices within the extractive industries. This review is not expected to be completed until 2014, i.e., after IFRS has been adopted by Canadian public oil and gas companies in 2011.

IFRS 6 allows an entity to determine an accounting policy for E&E expenditures based on its current national generally accepted accounting principles (GAAP). As such, IFRS 6 does not refer specifically to the successful efforts method or the full cost method of accounting, either of which is acceptable under current Canadian GAAP. A review of financial statements prepared under IFRS indicates limited disclosure with respect to the practice of capitalizing or expensing E&E expenditures, only which policy has been selected and the related recognition and measurement criteria.

Principles

The following guidance should be considered in conjunction with recognition and measurement of E&E expenditures under IFRS:

• Costs incurred prior to obtaining a right or licence to explore (the pre-exploration phase) are not included in E&E costs and may be either:

– Expensed, or

– Capitalized, in those rare and limited circumstances where the costs meet the definition of an intangible asset under IAS 381

• Costs incurred in the E&E phase must be accounted for under IFRS 6 and not under any other standard

• E&E costs must be segregated from both post-exploration costs, i.e., those costs incurred in the development or production phase, and pre-exploration costs

• E&E costs may be capitalized according to category or class of expenditure, or expensed, depending on the entity’s selected accounting policy

SECTION 1 — EXPLORATION AND EVALUATION EXPENDITURES

E&E costs must be segregated from both post-exploration costs, i.e., those costs incurred in the development or production phase, and pre-exploration costs.

Offshore oil rig

• Capitalized E&E expenditures must initially be measured at cost. After recognition as assets an entity may apply either the cost model or revaluation model to those costs in accordance with the entity’s selected accounting policy2

• Capitalized E&E costs should normally be segregated between intangible and tangible asset classes

• When tangible E&E assets are consumed in the development of intangible E&E assets the amount reflecting the consumption may form part of the cost of the intangible asset.

• Capitalized E&E costs should be reviewed for indicators of impairment at each reporting period;

if such indicators are determined to exist (by reference to IFRS 6) an impairment test is required by reference to IAS 36 “Impairment of Assets” — see Section 5

• Upon completion of the E&E phase, an IFRS 6 impairment test must be completed by reference to IAS 36 and successful capitalized E&E costs that have been tracked at a lower level, net of any impairment charge, must be reclassified to development or production assets, and

• Costs incurred subsequent to completion of the E&E phase are accounted for under IAS 16 and/or other applicable standards, not IFRS 6.

In conjunction with the selection of an accounting policy for E&E expenditures that must be consis-tently followed, entities are encouraged to consider the requirements of IAS 8 “Accounting Policies, Changes in Accounting Estimates and Errors”, IAS 16, IAS 23 “Borrowing Costs”, IAS 36, IAS 37

“Provisions, Contingent Liabilities and Contingent Assets”, and IAS 38.

1 Practice in the UK indicates that reporting companies surveyed by KPMG in its 2007 publication “Assessing the Impact — Adoption of IFRS 6: Exploration for and Evaluation of Mineral Resources by Oil & Gas Companies” — all wrote off pre-licensing costs. However, it may be appropriate to capitalize these costs if the conditions set out in IAS 38 can be met. The criteria for treatment as an intangible asset include identification, control and existence of future economic benefits. Examples might include field seismic programs, purchased seismic data, geological and geophysical studies or internally-developed innovative technology, but there could be others that would qualify. For instance, a technical team defining an exploration area could have developed “knowledge” or “proprietary information” to either use this information itself or sell it to another company, the proceeds from which would be used to purchase a right to explore. This situation could result from a technical team starting a new company or a large company technical team starting a new project. The challenge will be, absent precedent to date, to determine, in what are expected to be rare and limited circumstances, whether the knowledge satisfies the guidance for recognition as an internally generated intangible asset under IAS 38, is identifiable, has economic value and can be sold.

2 The revaluation model is an "on going" alternative under IAS 16, which is different from the “deemed cost” exemption at transition under IFRS 1. At transition, an entity may choose the “cost” or “deemed cost” option while after transition the entity may choose to follow the cost model under IFRS 6 or the cost and revaluation models under IAS 16 and IAS 38.

Matters for Consideration

The following matters will require consideration in conjunction with an entity’s adoption of accounting policies in respect of E&E expenditures:

• At the date of transition to IFRS, entities currently have three choices available for measuring assets: (1) the cost model under which retrospective restatement is required to determine cost in accordance with IFRS 6, IAS 16 and IAS 38; (2) the deemed cost election for individual assets, which requires fair value measurement with no retrospective treatment; or (3) the revaluation model under which fair value less accumulated amortization is determined for each class of assets — see footnote 2 above

• Identification of cost elements to be included in, and excluded from, E&E costs will be required — see “Elements of E&E Costs” below

• If a capitalization policy for E&E expenditures is chosen, additional policy choices include:

– The method of accounting for directly attributable administrative and overhead costs – The method and period, if any, for amortizing E&E costs

– The identification of so called E&E cash-generating units, if any, in which to aggregate E&E assets, and

– The method for assessing and measuring periodic impairment, i.e., expensing, amortizing and derecognizing considerations.

Exploration and Evaluation Expenditures

• Consistency of application of accounting policies for E&E costs per category

• Timing of transfer of successful E&E costs including recognition of associated decommissioning liabilities, if any, to development or production assets, and

• Detailed disclosure requirements.

Section 9 contains a discussion, analysis and illustrative example of the proposed amendment to IFRS 1, which, if approved by the IASB, would allow entities currently following full cost accounting an alternative choice for measuring oil and gas assets at transition — it is expected that the majority of public Canadian full cost entities would choose this option, if available.

IFRS 6 Discussion

The objective of IFRS 6 is limited to specifying the financial reporting for exploration and evaluation of mineral resources (the E&E phase) and does not deal with activities that precede the legal right to explore (prospecting, etc.) and with activities incurred after the technical feasibility and commercial viability of extraction have been ascertained (development, construction, production, closure and decommissioning, etc. — the development or production phase), the latter being generally recognized as an entity having demonstrated proved and probable reserves and the assets having achieved commercial viability.

Appendix A of IFRS 6 specifically states that E&E expenditures are “expenditures incurred by an entity in connection with the exploration and evaluation of mineral resources before the technical feasibility and commercial viability of extracting a mineral resources are demonstrable”, while E&E assets are “exploration and evaluation expenditures recognized as assets in accordance with the entity’s accounting policy”.

The acquisition of a “legal right to explore” is generally considered as the point at which an entity obtains control of the economic benefits expected to flow from the area.

Some examples include:

• Acquisition of exploration licences or lease rights

• Farm-in agreements

• Joint Venture Agreements (if non-operated), and

• Production Sharing Contracts, Technical Assistance Contracts and similar host government contractual arrangements.

Elements of E&E Costs

IFRS 6 requires an entity to determine its accounting policy specifying which expenditures, if any, are recognized as E&E assets and to apply that policy consistently. It is probable that different entities will identify and recognize different cost elements.

The standard does not specify which cost elements are to be included in E&E expenditures, but rather provides a non-exhaustive list of choices which may be included:

• Acquisition of licences to explore undeveloped mineral rights

• Post acquisition of legal rights to explore in connection with topographical, geological and geophysical (G&G) and geochemical studies

• Exploratory drilling

• Trenching, sampling, logging and testing procedures, and/or

• Activities in relation to evaluating the technical feasibility and commercial viability of extracting the mineral resource.

It is probable that different entities will identify and recognize different cost elements.

The application of IFRS 6 is restricted to E&E expenditures and, until an entity has achieved commercial viability, accumulated costs remain as E&E assets and should continue to be accounted for under IFRS 6. Entities may choose to capitalize administrative and overhead costs that are directly attributable to and associated with E&E activities. In addition, provided the assets are determined to be “qualifying assets” under IAS 23, e.g., an extended multi-well exploratory drilling program, borrowing costs will require capitalization as part of E&E assets. However, the recognition hurdle required under IAS 23R that it be “probable that economic benefit will arise” would appear to rule out interest capitalization on E&E expenditures except in rare situations. Application of this hurdle ensures that capitalization generally should not commence until the project enters the post-E&E phase. In addition, interest capitalization may be limited to large infrastructure projects.

IAS 23 — Borrowing Costs

Recognition

Borrowing costs directly attributable to the acquisition, construction, development or production of a qualifying asset (a qualifying asset is one which takes a substantial period of time to get ready for use or sale) form part of the cost of that asset and should be capitalized. Other borrowing costs are recognized as an expense.

Measurement

Where funds are borrowed specifically, costs eligible for capitalization are the actual costs incurred less any income earned on the temporary investment of such borrowings. Where the borrowed funds are part of a general pool, the amount eligible for capitalization is determined by applying the weighted average of the borrowing costs applicable to the general pool to the expenditure on the qualifying asset.

Capitalization of borrowing costs should commence when expenditures are being incurred, when borrowing costs are being incurred and when activities that are necessary to prepare the asset for its intended use are in progress. This may include some activities prior to commencement of physical production, e.g., E&E activities. Capitalization should be suspended during periods in which active exploration and evaluation is interrupted. Capitalized borrowing costs should be included with E&E costs subject to periodic impairment assessment. Capitalization would continue subsequent to the transfer of E&E assets to development or production assets until substantially all of the activities necessary to prepare the asset for its intended use are complete.

Disclosure

• The amount of borrowing cost capitalized during the period, and

• The capitalization rate used.

Farm-outs

In practice, many oil and gas entities have chosen to apply an accounting policy for farm-out arrangements based on their previous national GAAP, which is allowed under IFRS 6. Under this approach, the farmee accounts for E&E expenditures in the same manner as directly incurred E&E expenditures. The farmor accounts for the farm-out arrangement as follows:

• There is no accounting for expenditures made by the farmee

• No gain or loss is recognized, and

• Any cash consideration received is credited against costs previously capitalized.

Capitalized borrowing costs should be included with E&E costs subject to periodic impairment assessment.

Exploration and Evaluation Expenditures

Asset Swaps

Accounting for E&E asset swaps falls within IFRS 6; however, the standard does not specifically address swaps. In practice, entities have continued to apply the accounting policies used under their previous national GAAP, in particular when the fair value of the E&E asset cannot be determined reliably. Because reliable fair value measurement is usually unavailable given the nature of exploratory assets, entities have generally selected an accounting policy under which the E&E assets obtained in the swap transaction are recognized at the carrying amount of the E&E assets relinquished.

Measurement after Recognition

After transition to IFRS, an entity may choose from the cost model under IFRS 6 and the cost and revaluation models under IAS 16 and IAS 38. However, IAS 38 allows for the revaluation of intangible assets (but not in the case of internally generated intangible assets) only if fair value can be

determined by reference to an active market, which is expected to be a rare situation; and, IFRS 6 requires that E&E assets be segregated into intangible and tangible components. The revaluation

determined by reference to an active market, which is expected to be a rare situation; and, IFRS 6 requires that E&E assets be segregated into intangible and tangible components. The revaluation

In document International Financial Reporting Standards (Page 13-59)