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  • 1. Transitioning to International Financial Reporting Standards Key issues for Australian mining companies Australian mining companies will shortly be faced with the most significant financial reporting changes in many years. The Financial Reporting Council (“FRC”) has announced that Australia will adopt International Financial Reporting Standards (“IFRS”) from 1 January 2005. This report, produced by KPMG’s Energy and Natural Resources Group, provides a brief analysis of the key impact to the mining industry of the IFRS, due to be adopted by 1 January 2005, together with the key actions we recommend to address those changes. This report summarises the key differences between IFRS and Australian GAAP specifically impacting mining companies. Key issues for the mining sector 1. Impairment testing expected to increase earnings volatility 2. IAS 39 will require companies to assess existing and proposed derivative transactions upfront 3. Tougher stance on the capitalisation of exploration and evaluation activities 4. Tougher stance on capitalisation of pre-production and commissioning costs 5. The gross up of rehabilitation provisions 6. Determination of the currency applied to prepare and present financial statements ACT NOW – Questions you should be asking now Energy and Natural Resources
  • 2. Transitioning to International Financial Reporting Standards Australia is one of the few countries that have had the benefit One thing is certain, the adoption of IFRS will have a significant of an official accounting standard to suit the peculiar needs of impact on balance sheets and income statements of mining the mining industry: AASB 1022 “Accounting for the Extractive companies around Australia, potentially affecting investment Industries”. IFRS do not have a corresponding standard. In 1999, decisions in the industry. the (then) IASC issued a comment paper on the extractive industries with the intention of issuing a specific accounting The effects of IFRS will need to be reflected in each company’s standard in the future. The IASB have asked a team of national opening IFRS balance sheet, which for many entities will be standard-setters led by Australia to carry the project forward. 1 July 2004 (and earlier for December year ends and SEC At this stage it is unclear whether the IASB will issue any registrants). The timeline below highlights the implementation material specific to the extractive industries prior to 2005. timetable for IFRS is tight and that all Australian mining However, it is unlikely that Australia’s transition to IFRS will companies must consider the issues raised in this report now. retain the existing AASB 1022. In the absence of a specific standard, accounting treatments will be open to interpretation and may vary between companies. Opening balances Full year comparative Full reporting required for 01/01/04 figures for 31//12/04 under IFRS 31 December 31/12/03 31/12/04 31/12/05 reporting 30 June reporting 30/06/03 30/06/04 30/06/05 30/06/06 Today Opening balances Full year comparative Full reporting required for 01/07/04 figures for 30/06/05 under IFRS 1 ➔ ➔
  • 3. Transitioning to International Financial Reporting Standards 1. Impairment testing Impairment tests performed under IFRS are expected to increase earnings volatility of Australian mining companies. Proposed revised international standard IAS 36 “Impairment of Assets” has been encompassed in Exposure Draft 109 recently released by the AASB. Under IFRS, an asset is assessed for impairment if an “impairment trigger” arises. If an asset is impaired, it is written-down to recoverable amount, defined as the higher of net selling price in an active market and its “value in use”. Value in use is the net present value (NPV) of expected future cash flows, discounted at a “current market risk-free” rate. Either the cash flows or the discount rate are adjusted for expected risks. For the first time in Australia, companies will be forced to discount their cash flows in assessing recoverable amount. As many mining companies currently assess their investment decisions for the acquisition or development of mines based on discounted cash flows, the assessment of asset values under IFRS will now be in line. Under IFRS the NPV cannot include capital expenditure that will enhance the asset in excess of its current standard of performance. Accordingly, capital expenditure and the resulting benefits of expanding the reserve base of a mine cannot be factored into impairment tests. These stringent rules will prevent companies from including the potential net upside of converting resources to reserves. This may result in write downs, especially where an asset is reliant on converting resources to reserves for an appropriate return on capital, simply because sufficient drilling has not yet occurred. Earnings volatility is further increased from the requirement to reverse previous write downs if key assumptions have improved since affecting the write down. IFRS are also more stringent in regards to aggregation of assets than under current Australian Accounting Standards when assessing recoverable amount. Assets will need to be aggregated to the smallest identifiable group of assets that generates cash flows (cash-generating unit). A cash-generating unit may not be the same as an “area of interest”. In the past Australian Accounting Standards may have been interpreted 2 ➔ ➔
  • 4. Transitioning to International Financial Reporting Standards 1. Impairment testing such that poorer performing assets have been aggregated with strong performing assets and therefore, in aggregate, potentially satisfying recoverable amount tests. To the extent that poorer performing units have identifiable cash flows, IFRS require these units to be tested as a separate cash-generating unit, potentially causing write downs. For example, a mining company with three mines feeding ore to one processing plant could potentially have four cash-generating units. In Australia, we have typically viewed this example as a group of assets working together to generate one source of net cash inflows. Application of IFRS will require us to review this approach. IAS 36 contains extensive disclosure requirements including descriptions of key assumptions used in impairment models. Accordingly, companies will now have the burden of disclosing sensitivity assumptions used to assess recoverable amount. 2. IAS 39 and financial instruments IFRS, specifically IAS 39 “Financial Instruments: Recognition and Measurement” and IAS 32 “Financial Instruments: Presentation and Disclosure”, will have a major impact on the accounting for financial instruments. The mining industry will be significantly affected through its widespread hedging of commodity prices and foreign exchange risks. It will be critical to assess the impact under IFRS of potential derivative transaction prior to entering into the transaction – this needs to happen now. It will also be necessary to assess the effect of IFRS on existing derivatives that will still exist as at “opening balance sheet” date. IFRS will require all financial assets and liabilities to be recorded on the face of the balance sheet, with all derivatives, including those embedded in other financial instruments, are recorded at fair value. Under IFRS, new onerous conditions must be met for fair value or cash flow hedges to be recognised. In the case of a cash flow hedge, changes in the fair value are deferred in equity (below the line) as opposed to the income statement. Companies will be required to maintain sufficient documentation to prove that a hedge is effective 3 ➔ ➔
  • 5. Transitioning to International Financial Reporting Standards 2. IAS 39 and financial instruments at inception and at each reporting date, including satisfying the 80-125% hedge effectiveness test. Further, for cash flow hedges, the forecast transaction must be highly probable, with all formal documentation of the hedge relationship being in place prior to entering into the transaction. This must be done on a transaction-by- transaction basis. This is far more onerous than the requirements of Australian GAAP. IAS 39 requires changes in fair value for non-hedge derivatives, and the ineffective portion of hedged transactions are to be recorded in the income statement. These requirements may lead to more earnings volatility under IFRS. From a practical perspective, IAS 32 and IAS 39 may impact company dividend policies, and the grossing up of balance sheets may impact debt covenant ratios. The message is clear, the implications of IAS 39 must be considered upfront so that hedge accounting under IFRS can be applied. The mining industry raises capital in a number of ways. Similar to Australian Standards, IAS 32 requires the separate debt and equity components of compound financial instruments to be recognised separately. The application of IAS 32 may require existing or new instruments classified as equity under Australian Standards to be reclassified as debt under IAS 32, with consequent impact on the balance sheet and associated ratios. In summary the key issues to consider with respect to IAS 39 include: assessing derivative instruments upfront; new onerous tests for transactions to qualify for hedge accounting; all derivative instruments recognised on balance sheet; and potential for more earnings volatility under IAS 39. 4 ➔ ➔
  • 6. Transitioning to International Financial Reporting Standards 3. Exploration expenditure In Australia, we have become accustomed to the practice of capitalising exploration and evaluation expenditure, notwithstanding the economic benefits from such activities are uncertain. AASB 1022 permits the deferral of exploration expenditure even if the activities have not established whether or not economically recoverable resources exist in the area provided certain tests are met. In Australia most junior exploration companies capitalise their exploration expenditure whilst the practice tends to be varied amongst many of the larger production companies with many choosing to write off or provide for expenditure as incurred. AASB 1022 is an old Standard and does not conform to the Australian Conceptual Framework, which requires the existence of probable future economic benefit to flow to the entity before an asset can be recognised. This anomaly may be removed with the introduction of IFRS in Australia. In the absence of a specific standard on exploration expenditure, IFRS revert to the IASB Framework to determine whether an exploration expenditure can be capitalised. Like the Australian Conceptual Framework, the IASB Framework requires probable economic benefits to flow to entities before assets can be recognised. Accordingly, the capitalisation of exploration expenditure would be difficult to justify under IFRS because of the inherent uncertainty associated with exploration activities. In fact, South African and European companies that already apply IFRS tend to commence capitalisation only when an economic resource is identified, a feasibility study is finished or commercial production begins. This change may cause earnings volatility in mining companies depending on the levels of exploration activities. Some claim that the change to IFRS may change the dynamics of investment in greenfields exploration. Funds available for the exploration market are already at an all time low, and an inability to capitalise expenditure may influence the decisions of Boards to reduce the level of exploration and limit the choice and timing of projects explored. Interestingly, junior exploration companies will appear as “cash boxes” with no significant assets recognised on their balance sheets. 5 ➔ ➔
  • 7. Transitioning to International Financial Reporting Standards 4. Commissioning costs Commissioning of mines and processing plants is an issue that is peculiar to the mining industry. Throughout the industry there are many “war stories” where commissioning has resulted in disastrous cost blowouts and significant delays. In Australia, AASB 1022 requires companies to capitalise costs during the development and construction phase through to commercial production. Commercial production is not defined in AASB 1022. The Australian mining industry has generally addressed this subjective and difficult issue by determining that commercial production is achieved when: Recoveries are at or near the expected production level; The mine or mill has reached a pre-determined % of design capacity; or Production has become continuous. The commissioning of a complex mining and processing facility may take an extended period of time during which the technical problems are ironed out. This interpretation of AASB 1022 has allowed Australian mining companies to capitalise costs incurred during the commissioning and production “ramp up” phases, including initial operating losses. Under IFRS, start up costs and pre-production costs cannot be capitalised unless they are necessary to bring the asset to its working condition. Accordingly, costs to bring a processing facility to its normal working state can be capitalised, however, operating losses incurred prior to an asset achieving planned performance i.e. during the ramp up phase, must be recognised as an expense. 6 ➔ ➔
  • 8. Transitioning to International Financial Reporting Standards 5. Rehabilitation provisions Rehabilitation and mine closure is a necessary activity for any mining operation. Accordingly, it comes as no surprise that the rehabilitation provision can be a key part of a mining company’s balance sheet. In Australia it is industry practice that mining companies gradually build up post production rehabilitation provisions over the life of the project as the resource is depleted. Under IFRS a full provision is recorded where there is a legal or constructive obligation, or where it is more likely than not that such an obligation has arisen from a past event (i.e. the actual development). This provision is measured on a discounted basis upon initial recognition. A corresponding asset is to be recognised as part of development costs and is amortised together with the development asset. Generally amortisation will occur on commencement of production. The provision and the corresponding asset cannot be offset, increasing total assets and total liabilities within the balance sheet. This will impact any debt covenant ratios linked to total assets or total liabilities where applicable. Under IFRS the unwinding of the discounted provision (established as above) is classified as interest expense. Care should be taken when negotiating new debt agreements, or amendments to existing debt agreements, to ensure covenants are not compromised by the future grossing up of assets and liabilities, or recognition of the interest expense discount. 7 ➔ ➔
  • 9. Transitioning to International Financial Reporting Standards 6. Functional currency Under proposed IFRS the currency under which financial statements are to be prepared and presented may no longer necessarily be Australian dollars. A company will be required to measure its assets, liabilities, revenues and expenses in its functional currency and will be permitted to select the currency (or currencies) in which it presents its financial report. At present, AASB 1034 requires that Australian companies present their financial statements in Australian dollars. A company’s functional currency is defined by IFRS as “the currency of the primary economic environment” which should reflect the economic substance of the underlying events and circumstances relevant to that company. Circumstances that indicate a particular currency is an appropriate currency to be used in measuring items in the financial statements include: sales prices for goods and services are denominated and settled in that currency (or in a currency other than that currency but the price is sensitive to movements in the foreign exchange rate with that currency). For example, commodities traded on international markets or based on world market prices; purchases are financed mainly from that currency. For example, borrowings and issuance of equity instruments; receipts from operating activities are usually retained in, or converted by choice or otherwise, to that currency; and labour materials, and other costs of providing goods and services are denominated and settled in that currency. The mining industry is dominated by sales determined, or made, on international markets quoted in US dollars. Further, many larger companies may have sourced debt and/or equity from US or other markets. These factors and others would be considered in determining if the use of a currency other than Australian dollars is used to a significant extent or has a significant impact on the company. If the functional 8 ➔ ➔
  • 10. Transitioning to International Financial Reporting Standards 6. Functional currency currency is determined to be the USD (or other currency), all transactions in currencies other than US dollars, would be treated as transactions in foreign currencies. Should an entity with a functional currency other than Australia dollar be required to present financial statements in Australian dollars, or should the company choose to present its financial statements in a currency other than its functional currency, all assets, liabilities and equity are translated at closing rates and revenues and expenses would be translated at rates at the date of the transactions. It is possible that non- monetary assets (and liabilities) that converted at historical rates may be under/over valued depending on foreign exchange movements. Implications of this include: decision on what the functional currency is; requirement for currency hedging must hedge the functional currency for it to be effective; and possible changes in accounting systems, or need for independent systems to maintain the functional currency. 9 ➔ ➔
  • 11. Transitioning to International Financial Reporting Standards Act now Above, we have summarised the key technical differences, which in isolation or together have wide ranging consequences. However, conversion to IFRS is much more than an accounting compliance issue for Australian mining companies. It poses a number of significant and complex questions that mining business leaders need to consider now. Questions such as: What are the significant impact areas for each business and how complex will it be to convert to IFRS? How will IFRS impact reported business performance and how will this impact be communicated effectively internally and to the market at large? What expertise and resources will be needed to ensure a successful conversion? How should conversion to IFRS be managed? and What are the potential benefits of converting to IFRS? Mining companies also need to note that there are general changes arising from the introduction of IFRS that will impact on their results. These changes are wide ranging and include requirements relating to financial instruments and impairment of assets, accounting for employee options and defined benefit plans (only some of which are discussed here). All of these proposed changes require immediate attention. KPMG is working with organisations throughout Australia and around the world to answer these questions. KPMG is a world leader in IFRS conversion projects having assisted many large European companies with their conversion. Our large team of Australian IFRS conversion professionals are part of KPMG’s extensive global IFRS network, which together serves over 2,500 companies globally, who report under IFRS. The global network is supported by KPMG’s dedicated international centre of excellence, IAS Advisory Services based in London. 10 ➔ ➔
  • 12. Transitioning to International Financial Reporting Standards Act now KPMG provide both the insight into the strategic implications of converting to IFRS as well as the practical support needed for a smooth transition. Our integrated approach uses tested methodologies and tools. “Quick Scan” is one such tool developed by KPMG. Quick Scan is a high level analysis that provides a qualitative assessment of the impact IFRS conversion will have on a company’s business activities, resources and financial statements. Quick Scan provides a powerful communication tool that can be used within the organisation to explain the impact of IFRS conversion in a clear and concise way. The timeframe to implement IFRS is tight. Being in a position to publish IFRS financial statements for 2005 means that work needs to start now. KPMG can help you to make that start and seize the opportunity and challenge that IFRS conversion provides. KPMG’s Energy and Natural Resources Group KPMG’s Energy and Natural Resources Group supports companies in the mining, oil and gas, power and utilities and forestry sectors with assurance, tax and financial advisory services. For more information contact Chairman, Alison Kitchen on +61 3 9288 5345 or National General Manager, Helen Cook on +61 8 9263 7342. 11 ➔ ➔
  • 13. Transitioning to International Financial Reporting Standards Contacts For further details please contact your KPMG Energy and Natural Resources Group assurance specialists: National Sydney Alison Kitchen Trent van Veen Chairman, Partner, Assurance and Advisory Energy and Natural Resources Group +61 2 9335 8993 Partner, Assurance and Advisory +61 3 9288 5345 Perth Denise McComish Rob Gambitta Partner, Assurance and Advisory Senior Manager, Assurance and Advisory +61 8 9263 7173 +61 8 9263 7451 Brisbane Melbourne Warren Austin Alison Kitchen Partner, Assurance and Advisory Chairman, +61 7 3233 3101 Energy and Natural Resources Group Partner, Assurance and Advisory +61 3 9288 5345 Adelaide Brent Steedman Partner, Assurance and Advisory +61 8 8236 3344 Visit the KPMG Energy and Natural Resources website at © 2003 KPMG, the Australian member firm of KPMG International, a Swiss non-operating association. All rights reserved. Printed in Australia. ➔ May 20 03 WA0036ENR