International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 666
fewer units being produced while many production costs remain fixed and, in part, a
result of many variable costs per unit increasing over time because reserves may be
harder to extract, there may be greater equipment repairs, and similar other factors.’131
Nevertheless, even under the units of production method, profitability often drops
significantly towards the end of the productive life of a field or mine. When this happens
an entity will need to carry out an impairment test and may need to recognise an
impairment charge (see 11 above).
In general, the units of production method is considered to be preferable for:
• assets used in fields or mines whose annual production may vary considerably over
their useful economic life;
• assets whose loss in value is more closely linked to the quantities of minerals
produced than to the passage of time (e.g. draglines used in the extraction of
mineral ore);
• assets that are used in production or that are inseparable from the field or mine
(e.g. wells and well heads);
• assets with a useful life that is the same as that of the field or mine in which they
are used; and
• assets that are used in only one field or mine (e.g. overland conveyor belts).
Extract 39.36 above and Extract 39.37 below indicate the classes of asset to which BHP
and Lonmin, respectively, apply the units of production method.
Extract 39.37: Lonmin Plc (2017)
NOTES TO THE ACCOUNTS [extract]
1 Statement on accounting policies [extract]
Intangible assets
Intangible assets, other than goodwill, acquired by the Group have finite useful lives and are measured at cost less
accumulated amortisation and accumulated impairment losses. Where amortisation is charged on these assets, the
expense is taken to the income statement through operating costs.
Amortisation of mineral rights is provided on a ‘units of production’ basis over the remaining life of mine to residual
value (20 to 40 years).
All other intangible assets are amortised over their useful economic lives subject to a maximum of 20 years and are
tested for impairment at each reporting date when there is an indication of a possible impairment.
Property, plant and equipment [extract]
Depreciation
Depreciation is provided on a straight-line or units of production basis as appropriate over their expected useful lives
or the remaining life of the mine, if shorter, to residual value. The life of mine is based on proven and probable
reserves. The expected useful lives of the major categories of property, plant and equipment are as follows:
Extractive
industries
3365
Method
Rate
Shafts and underground
Units of production
2.5%-5.0% per annum
20-40 years
Metallurgical
Straight line
2.5%-7.1% per annum
14-40 years
Infrastructure
Straight line
2.5%-2.9% per annum
35-40 years
Other plant and equipment
Straight line
2.5%-50.0% per annum
2-40 years
No depreciation is provided on surface mining land which has a continuing value and capital work in progress.
Residual values and useful lives are re-assessed annually and if necessary changes are accounted for prospectively.
The practical application of the units of production method gives rise to the following
issues that require entities to exercise a considerable degree of judgement in
determining the:
(a) units of production formula (see 16.1.3.A below);
(b) reserves base (see 16.1.3.B below);
(c) unit of measure (see 16.1.3.C below); and
(d) joint and by-products (see 16.1.3.D below).
As discussed at 16.1.3.B below, the asset base that is subject to depreciation should be
consistent with the reserves base that is used, which may require an entity to exclude
certain costs from (or include future investments in) the depreciation pool.
16.1.3.A
Units of production formula
There are a number of different ways in which an entity could calculate a depreciation
charge under the units of production method. The most obvious of these is probably
the following formula:
Cost of the asset at the
Cumulative depreciation and impairment
Depreciation
Current
–
beginning of the period
at the beginning of the period
charge for = period’s ×
the period
production
Opening reserves estimated
at the beginning of the period
The reserves estimate used in the above formula is the best estimate of the reserves
at the beginning of the period, but by the end of the period a revised and more
accurate estimate is often available. Therefore, it may be considered that in order to
take into account the most recent information, the opening reserves should be
calculated by adding the ‘closing reserves estimated at the end of the period’ to the
‘current period’s production’. However, reserves estimates might change for a
number of reasons:
(a) more detailed knowledge about existing reserves (e.g. detailed engineering studies or
drilling of additional wells which occurred after the commencement of the period);
(b) new events that affect the physical quantity of reserves (e.g. major fire in a mine); and
(c) changes in economic assumptions (e.g. higher commodity prices).
It is generally not appropriate to take account of these events retrospectively. For
example, changes in reserves estimates that result from events that took place after the
end of the reporting period (such as those under (b) and (c)) are non-adjusting events
that should be accounted for prospectively in accordance with IFRS. [IAS 8.32-38, IAS 10.3].
Changes in reserves estimates that result from new information or new developments
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which do not offer greater clarity concerning the conditions that existed at the end of
the reporting period (such as those under (a)) are not considered to be corrections of
errors; instead they are changes in accounting estimates that should be accounted for
prospectively under IFRS. [IAS 8.5, 32-38].
Determining whether actual changes in reserves estimates should be treated as adjusting
or non-adjusting events will depend upon the specific facts and circumstances and may
require significant judgement.
Usually, an entity will continue to invest during the year in assets in the depreciation
pool (see 16.1.3.B below for a discussion of ‘depreciation pools’) that are used to
extract minerals. This raises the question as to whether or not assets that were used
for only part of the production during the period should be depreciated on a different
basis. Under the straight-line method, an entity will generally calculate the
depreciation of asset additions during the period based on the assumption that they
were added (1) at the beginning of the period, (2) in the middle of the period or (3) at
the end of the period. While method (2) is often the best approximation, methods (1)
and (3) are generally not materially different when the a
ccounting period is rather
short (e.g. monthly or quarterly reporting) or when the level of asset additions is
relatively low compared to the asset base.
The above considerations explain why the units of production formula that is
commonly used in the extractive industries is slightly more complicated than the
formula given above:
Cost of the asset at the
Cumulative depreciation and impairment
Depreciation
Current
–
end of the period
at the beginning of the period
charge for = period’s ×
the period
production
Opening reserves estimated
Current period’s
+
at the end of the period
production
This units of production formula is widely used in the oil and gas sector by entities that
apply US GAAP or did apply the former OIAC SORP. In the mining sector, however,
both the first and the second units of production formulae are used in practice.
16.1.3.B Reserves
base
An important decision in applying the units of production method is selecting the
reserves base that will be used. The following reserves bases could in theory be used:
(a) proved developed reserves (see (a) below);
(b) proved developed and undeveloped reserves (see (b) below);
(c) proved and probable reserves (see (c) below);
(d) proved and probable reserves and a portion of resources expected to be converted
into reserves (see (d) below); and
(e) proved, probable and possible reserves.
The term ‘possible reserves’, which is used in the oil and gas sector, is associated with a
probability of only 10% (see 2.2.1 above). Therefore, it is generally not considered
acceptable to include possible reserves within the reserves base in applying the units of
production method.
It is important that whatever reserves base is chosen the costs applicable to that
category of reserves are included in the depreciable amount to achieve a proper
Extractive
industries
3367
matching of costs and production.132 For example, ‘if the cost centre is not fully
developed ... there may be costs that do not apply, in total or in part, to proved
developed reserves, which may create difficulties in matching costs and reserves. In
addition, some reserve categories will require future costs to bring them to the point
where production may begin’.133
IFRS does not provide any guidance on the selection of an appropriate reserves base or
cost centre (i.e. unit of account) for the application of the units of production method.
The relative merits for the use of each of the reserves bases listed under (a) to (c) above
are discussed in detail below.
(a) Proved
developed reserves
Under some national GAAPs that have accounting standards for the extractive
industries, an entity is required to use proved developed reserves as its reserves base
for the depreciation of certain types of assets. An entity would therefore calculate its
depreciation charge on the basis of actual costs that have been incurred to date.
However, the cost centre frequently includes capitalised costs that relate to
undeveloped reserves. To calculate the depreciation charge correctly, it will be
necessary to exclude a portion of the capitalised costs from the depreciation calculation.
Example 39.15 below, which is taken from the IASC’s Issues Paper, illustrates how this
might work.
Example 39.15: Exclusion of capitalised costs relating to undeveloped reserves134
In an offshore oil and gas field a platform may be constructed from which 20 development wells will be
drilled. The platform’s cost has been capitalised as a part of the total cost of the cost centre. If only 5 of the
20 wells have been drilled, it would be inappropriate to depreciate that portion of platform costs, as well as
that portion of all other capitalised costs, that are deemed to be applicable to the 15 wells not yet drilled. Only
5/20ths of the platform costs would be subject to depreciation in the current year, while 15/20ths of the
platform costs (those applicable to the 15 undrilled wells) would be withheld from the depreciable amount.
The costs withheld would be transferred to the depreciable amount as the additional wells are drilled. In lieu
of basing the exclusion from depreciation on the number of wells, the exclusion (and subsequent transfer to
depreciable amount) could be based on the quantity of reserves developed by individual wells compared with
the estimated total quantity of reserves to be developed.
Similarly, an appropriate portion of prospecting costs, mineral acquisition costs,
exploration costs, appraisal costs, and future dismantlement, removal, and restoration
costs that have been capitalised should be withheld from the depreciation calculation if
proved developed reserves are used as the reserves base and if there are undeveloped
reserves in the cost pool.135
By withholding some of the costs from the depreciation pool, an entity is able to achieve
a better matching of the costs incurred with the benefits of production. This is particularly
important in respect of pre-development costs, which provide future economic benefits
in relation to reserves that are not yet classified as ‘proved developed’.
However, excluding costs from the depreciation pool may not be appropriate if it is not
possible to determine reliably the portion of costs to be excluded or if the reserves that
are not ‘proved developed’ are highly uncertain. It may not be necessary to exclude any
costs at all from the depreciation pool if those costs are immaterial, which is sometimes
the case in mining operations.
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As illustrated in Extract 39.38, Royal Dutch Shell, in reporting under IFRS, applies the
units of production method based on proved developed reserves.
Extract 39.38: Royal Dutch Shell plc (2017)
Notes to the Consolidated Financial Statements [extract]
2 SIGNIFICANT ACCOUNTING POLICIES, JUDGEMENTS AND ESTIMATES [extract]
PROPERTY, PLANT AND EQUIPMENT AND INTANGIBLE ASSETS [extract]
Depreciation, depletion and amortisation [extract]
Property, plant and equipment related to hydrocarbon production activities are in principle depreciated on a unit-of-
production basis over the proved developed reserves of the field concerned, other than assets whose useful lives differ
from the lifetime of the field which are depreciated applying the straight-line method. However, for certain Upstream
assets, the use for this purpose of proved developed reserves, which are determined using the SEC-mandated yearly
average oil and gas prices, would result in depreciation charges for these assets which do not reflect the pattern in
which their future economic benefits are expected to be consumed as, for example, it may result in assets with long-
term expected lives being depreciated in full within one year. Therefore, in these instances, other approaches are
applied to determine the reserves base for the purpose of calculating depreciation, such as using management’s
expectations of future oil and gas prices rather than yearly average prices, to provide a phasing of periodic
depreciation charges that m
ore appropriately reflects the expected utilisation of the assets concerned.
Rights and concessions in respect of proved properties are depleted on the unit-of-production basis over the total
proved reserves of the relevant area. Where individually insignificant, unproved properties may be grouped and
depreciated based on factors such as the average concession term and past experience of recognising proved reserves.
(b) Proved
developed
and undeveloped reserves
Another approach that is common under IFRS is to use ‘proved developed and
undeveloped reserves’ as the reserves base for the application of the units of production
method. This approach reflects the fact that it is often difficult to allocate costs that have
already been incurred between developed and undeveloped reserves and has the
advantage that it effectively straight-lines the depreciation charge per unit of production
across the different phases of a project. For example, if the depreciation cost in phase 1
of the development is $24/barrel and the depreciation cost in phase 2 of the
development could be $18/barrel, an entity that uses proved developed and
undeveloped reserves as its reserves base might recognise depreciation of, say,
$22/barrel during phase 1 and phase 2.
Application of this approach is complicated by the fact that phase 1 of the project will
start production before phase 2 is completed. To apply the units of production method
on the basis of proved developed and undeveloped reserves, the entity would need to
forecast the remaining investment related to phase 2. The approach does not appear
unreasonable at first sight, given that the proved reserves are reasonably certain to exist
and ‘the costs of developing the proved undeveloped reserves will be incurred in the
near future in most situations, the total depreciable costs can also be estimated with a
high degree of reliability’.136 Nevertheless, the entity would therefore define its cost pool
(i.e. unit of account) as including both assets that it currently owns and certain future
investments. Although there is no specific precedent within IFRS for using such a widely
defined unit of account, such an approach is not prohibited, while in practice it has
gained a broad measure of acceptance within the extractive industries.