Question

In accounting for extractive industries, AASB 6 potentially lists the alternative methods of accounting for exploration and expenditures incurred in extractive industries.

1) Would you expect the profits of an entity to be higher or lower when the full cost method of accounting than to an entity that uses the area of interest method

2) Explain with any two reasons that might influence managers or entity decisions to use either an area of interest method or full cost method of accounting.

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Answer 1

Para 7.1 of AASB-6 states that:

"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:
(a) expensed as incurred; or
(b) 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."

It can be observed that if an entity applies full cost memthod that is charging full expenses as they are incurred ro Profit and Loss statement , its profits will be lower than the profits arrived by applyong the area of interest method and capitalising the asset under contruction for part of the expenses which have been incurred for research purposes and which may result into forming future asset.

Answer to sub -part no.(2):

2 situations that may influence management decisions in choosong between full cost emthod or area of interet method shall be -

A. The cost of extraction and the nature of resource: For instance if the cost of extraction is very low and there is a single inflow of resource to be extracted say , a particular rare chemical in certain quantity, then it will be obvious to choose full coat method, but if the resource takes a considerable period of time to develop into a valuable result then it shall be advisable to opt for area of interest method.

B. Certainty of outcome and Value of resource:

If the resultant exploration and research shall certainly provide an inflow whose value is very high in market,then its advisable to use thhe area of interest method as the partial cost charged shall be compensated by the partial revenue recognised in the books and it will not effect the financial statements much. However in the same case if full cost method is applied the entire huge cost of extraction will be cahrged to profit and loss statement once and if the resultant resource found is of not much value then profits will be highly impacted during specific certain periods.