“How should stripping(in mining) be reported in the financial statements” by Eleanore A. Layug (November 28, 2011)

SUITS THE C-SUITE By Eleanore A. Layug

First Published in Business World (11/28/2011)

The mining industry in the Philippines is vibrant and investors have been keen on its vast potential. With more interest and investment projects focused on the industry, there is a parallel concern on how mining procedures, processes and systems are to be reported in accordance with the appropriate accounting standards. Take for example what is called the “stripping activity” in mining.

What is stripping?
A mining entity often needs to remove overburden (the material lying above the area of economic mining interest) to access ore reserves. This is called the stripping activity. It is a costly exercise that may continue well into the production phase.

There is no clear IFRS guidance on addressing production stripping costs, which can make the accounting treatment challenging since such costs incurred may benefit both current and future periods of production.
There is also a perceived diversity in practice. If costs are spread evenly from period to period, they are treated as production costs as incurred. Often, “excess” costs incurred in the earlier periods of a mine’s life are deferred and depreciated during later periods when less is spent on removal. To address this divergence in practice, the IFRS Interpretations Committee issued IFRIC Interpretation 20 “Stripping Costs in the Production Phase of a Surface Mine” (Interpretation), which will be effective for annual periods beginning on or after 1 January 2013.

In applying the Interpretation, a mining entity may face the following key challenges:

Accounting for production stripping costs
Costs are capitalized during production if the activity meets the definition of an asset (i.e., generates future economic benefits and is reliably measurable) and an entity can identify which “component/s” of the ore body received improved access. If benefits are realized in the current period, an entity accounts for costs under IAS 2 Inventories. If benefits create improved access to the ore to be mined in future periods, an entity accounts for costs as “stripping activity asset,” a non-current asset treated as part of an existing asset, and classified as tangible or intangible based on the existing asset to which it relates.
Hence, capitalization is now required if certain criteria are met. Mining entities that previously expensed such costs or treated the same as inventoriable will need to establish a process to calculate the capitalizable portion.

In addition, the new key feature of identifying the component of the ore body which gains improved access directs the accounting, not only in recognition, but also in depreciation and therefore the charging to profit or loss. This approach is critical because it differs from the widely used life-of-mine (LOM) average strip ratio approach. As a result, an entity needs to exercise significant judgment to identify components by reviewing mine plan/s and determining whether such provide the information required.

Initial measurement of stripping activity asset
The asset is initially recognized at cost, plus directly attributable overhead costs. Costs are either directly allocated to the asset (inventory or stripping activity asset) or where not possible, a rational and consistent allocation basis is permitted using a production-based metric (e.g., cost of inventory produced against expected cost; actual volume of waste extracted against expected volume, for a given volume of ore production; actual mineral content of ore extracted against projected content, for a given quantity of ore produced).

While allocation bases appear similar to the LOM approach, one key difference is that the expected level is initially determined at component level. In effect, the Interpretation requires an entity to make the determination based upon the mine plan. Given the complexity of some mine plans, this exercise may be particularly challenging and may require further discussions with mine engineers and management. The allocation bases may also mean a change in the allocation processes and models, as well as systems and controls.

Subsequent measurement of stripping activity asset
The asset is subsequently carried at cost, less depreciation and any impairment. Depreciation is on a systematic basis, over the expected useful life of the identified component of the ore body that becomes more accessible as a result of the activity. Unless another method is more appropriate, the unit of production method is applied.

The above requirements seem to indicate that the LOM approach is not acceptable, since the LOM approach considers the estimated life of the entire mine to be the depreciable period, while the stripping activity asset may relate only to a component of the ore body for which access has been improved. The benefit to be derived from the stripping activity asset is expected to last for a shorter period than the entire estimated mine life. Moreover, significant judgment and individual monitoring is required to determine which component/s each stripping activity asset benefits.

An entity is required to apply the Interpretation for costs incurred from the start of the earliest period presented. This means that an entity needs to monitor the impact at least from 1 January 2012, and to reclassify previous deferred balances (capitalized up to 1 January 2012) as part of an existing asset to which the activity related, if an identifiable component of the ore body associated with the stripping activity still remains. These balances are depreciated over the remaining expected useful life of the identified component of ore body to which each existing asset balance relates.

Where an entity is incapable of identifying the component of the ore body to which previous deferred balances relate, it writes off this asset via the opening retained earnings at the beginning of the earliest period presented.

Depending on the nature and stage of a mine and how deferred balances were accumulated, it is possible to identify remaining component/s of the ore body to which such assets relate. Hence, reclassification of deferred balances is possible without unnecessary cost and effort.

Tax and other considerations
In taxation, deductibility of the expenditure as business expense is generally based on the theory that such is part of cost of operating the business for the period it was paid or incurred. On the other hand, when payment creates or enhances what is essentially a separate and distinct asset, such payment may constitute a capital expenditure for tax purposes. Given these principles, determining the tax implications of the stripping activity asset is important upon adoption of the Interpretation because (1) derecognizing amounts via opening retained earnings may result in lost tax deductions and (2) the entity may have to revisit its mine feasibility studies to assess the impact of appropriate tax treatment to current and future mine cash flows.

IFRIC 20 may impact both financial position and earnings profile, as well as require changes in the processes, procedures and systems of the reporting entity, all of which are highly influenced by the physical characteristics of the mineral deposit and an entity’s mine plan.

Final thoughts
An entity needs to conduct a detailed analysis to assess if the Interpretation’s requirements impact currently-applied accounting and tax treatment of production stripping costs. This assessment is highly variable since no two mines are similar. Every mine and its related mine plan needs to be studied to identify components and consequential implications. The transitory provisions of the Interpretation require that this analysis be done from, at the very least, 1 January 2012 which is a little over a month from now.

(Eleanore A. Layug is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.