Should Exploration and Evaluation be recognised as an asset or expense?
1. define asset
Firstly, in determining whether e&e should be recognised as an asset, we need to look at what is defined as an assets under the AASB framework, that is:
“An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity” [Paragraph 49 a]
2. list recognition criteria
Additionally, the framework also provides a broad view of the recognition criteria items need to satisfy before they are considered to be assets. The framework states:
a) it is probable that future economic benefits associated with the time will flow to or from the entity ; and
b) the item has a cost or value that can be measured with reliability.
3. Mention e&e have low prob so management can use the following methods to capitalise as an asset
The implications involved with exploration and evaluation is that the industry is associated with low probability and any activities do not guarantee any future economic benefits nor can it be measured reliably.
The pre production costs of exploration and evaluation can be categorised as development and construction. Close examination of development costs suggests that they should be considered as assets under the framework. Development costs provide an establishment of access to the deposit and other activities for commercial production thus they provide future economic benefits.
However, it is difficult to determine the costs associated with construction (establishing and commissioning facilities) will lean towards being an asset as it does not have a cost or value that can be measured reliably. This creates a problem as it implies that the degree if certainty that economic benefits will flow to the entity beyond the current accounting period will be insufficient to warrant the recognition of an asset.
Despite this, the framework makes provisions for these costs to be capitalised as an asset.
1) Cost written off and reinstated method '
Under this method the costs incurred with exploration and evaluation may be reinstated and carried forward as an asset provided that there are recoverable reserves. This method is not permitted in Australia but it is consistent with the AASB standards. In particular, once an item is assessed to be probable and measured reliably it can be recognised as an asset even though prior costs involved with the item have been written off or recognised as an expense [Paragraph 87].
2) Successful efforts method-
This method allows preproduction expenditures to be carried forward if the area has not been abandoned or economically recoverable reserves has been found, as long as activities are ongoing. This allows expenditures to be capitalised as an asset even before the existence of economically recoverable reserves. Although this method is against the framework, through amortisation the costs carried forward will be matched against the revenues of the period that benefit from those costs.
Area of interest method-
This allows an organisation to carry forward preproduction costs on the basis that ‘activities in the area of interest have not at the time of preparing financial statements, reached a stage which permits a reasonable assessment of the existence or otherwise recoverable reserves’. Given this it satisfies the recognition criteria of the framework in that it provides a rough indication of probable future economic benefits
4. Theres lil reliability of measurement but framework allows assets to be recognised if they can meet criteria even though already expensed
Further, the term probable suggests that there is a “chance of the future economic benefits arising is more likely rather than less likely” , so if an item possesses a probability greater than 50% it should be recognised as an asset on the balance and income statement.
This raises the question: what if pre production costs have already been expensed but now have increased probabilities of future economic benefits? Well as mentioned earlier, paragraph 87 of the framework allows that once an item is assessed to be probable and measured reliably it can be recognised as an asset even though prior costs involved with the item have been written off or recognised as an expense.
5. Overall opinion
In summary, strict application of the recognition criteria of assets under the framework will result in a reduction of asset balances of organisations involved with exploration and evaluation. Also the framework will lead to greater write offs of exploration and evaluation expenditure. Although, the framework suggest that exploration and evaluation should be expensed but capitalising the costs may provided a truer and fair view of the company’s financial position. Thus framework will not be favourable and place restrictions for extractive industries.
Capitalising expenses as an asset provides such companies with the advantage that once future economic benefits are no longer viable it can always be written off as an expense. Therefore, using the framework we suggest that exploration and evaluation costs to be recognised as an asset in the balance and income sheets.