Financial Reporting Challenges: The Case for Extractive Industries

in East Africa

byYona Killagane

Financial Reporting Challenges: The Case for Extractive Industries

in East Africa

byYona Killagane

THE 1ST EAST AFRICA CONGRESS OF ACCOUNTANTS

AICC - Arusha 2nd – 4th March 2016

OutlineOutlinen Background

Ø DefinitionØ Importance of EI to state

n Resources Availability - Recent oil and gas discoveries

n Accounting profession reaction to EIn Shortfall of accounting practices

Ø IFRS 6Ø Auditing

n International Initiatives towards EIn Conclude – Role of EAC Accounting Profession

Definition – Extractive IndustryDefinition – Extractive Industry

n “Any processes that involve the extraction of raw materials from the earth to be used by consumers. The extractive industry consists of any operations that remove metals, minerals and aggregates from the earth.Ø Examples of extractive processes include oil and gas

extraction, mining, dredging and quarrying.ӯ It includes Forestry

n Endowment from God/Nature = Natural resources thus belongs to all Citizens

http://www.businessdictionary.com/

Why EI?Why EI?n Can bring significant impact to well being of

Citizens – economic development of countries.

n Good governance and transparent management of EI essential to bring transformational impact on reducing poverty and boosting shared prosperity.

n Respect for the environment.n Most countries endured with EI are faced

with economic hardship, poverty and wars. – resource curse

Share of Government Revenue from EI Share of Government Revenue from EI

Source: IMF

Extractive Industries Value ChainExtractive Industries Value Chain

Award of contract & Licenses

Regulation & monitoring of operations

Implementation Sustainable Development

Revenue Management

Collection of Taxes & Royalties

Transparency & beneficial to citizens

Effective Reinvestment of revenue for future

Proper, transparent and Accountable for revenuesAll Dues to

State are collected

Codified, complied with, costs, revenue and EIA monitored

Policies and Systems have to be established at each stage to enhance effective EI

Enhancement of Transparency and Accountability

Enhancement of Transparency and Accountability

ResourceSteward

Fina

ncia

l In

form

atio

n Pr

oces

sing PublicReportingAccount

According to IAS 1:§Those who cannot call for specific information§financial position, financial performance and cash flows§ Economic decision§Steward discharge

Citizens

Characteristics of Extractive IndustriesCharacteristics of Extractive Industriesn Substantial Revenues n High uncertainty

Ø prices, geology, input costs, political risks, climate and environmental policies.

n Balance of information Ø IOC better informed than Host countries

n High sunk costs and takes time to realize revenue (if any),

n Long production periodsn Extensive involvement of multinationals in some

countries…and of State-Owned Enterprises in othersn Exhaustibility – revenue be invested to support future

generations – productive economic developmentn Prone to corruption for the privileged

East Africa oil and Gas FactsEast Africa oil and Gas Factsn Uganda:

Ø Oil 6.5 billion barrels oilØ 500 bcf of gas Ø Term 2/2/2 years = 6 yearsØ FID $3 billion end 2015Ø Several Minerals – Copper, Cobalt, Gold, Iron & Ore, etc

n TanzaniaØ Gas 57.3 tcf = 11 billion bblØ Term 4/3/2 = 9 yearsØ FID $5 billionØ Vast Mineral resources – Gold, uranium, Iron & Ore;

Diamonds, Gemstones, etc

East Africa oil and Gas FactsEast Africa oil and Gas Factsn Kenya

Ø Oil 500 mm bbl – 1.4 bill bblØ Gas 1.2tcfØ Minerals include soda ash, fluorite,

diatomite, gold, iron ore, lead, gemstones, etc.

n RwandaØ Lake Kivu – Methane gas project Ø capable to generate 700 MW for 50 years.Ø Minerals include – Ores processing to extract tin,

tantalum and tungsten and few gold and gemstones –1.2% to 5.27% of GDP

Reaction of IASB - issuance of IFRS 6Reaction of IASB - issuance of IFRS 6

n No IFRS that addresses accounting for activities in EI.

n There were different views and practices on how exploration and evaluation expenditures was accounted.

n Exploration and evaluation expenditures are significant to entities engaged in extractive activities and risky.

n Mineral resources activities takes a long time to commercialization.

n An increasing number of entities incurring exploration and evaluation expenditures present their financial statements in accordance with IFRSs.

n Standards excluded -

Ø IAS 16 – accounting policies (prudence)

Ø IAS 38 - Impairment – Factors not appropriate – new factors

Stages in Mineral Resource ExploitationStages in Mineral Resource Exploitation

Pre License DevelopmentAppraisalExploration

Production

IFRS 6 IFRS 6

Framework, IAS 16, IAS 38

Generally expenseIAS 8 applies.

Capitalize licenses (IAS 38) and

apply impairment (IAS 36)

Decommission

Commercial & Technical viability

IFRS 6 Generalq IAS 16 (PPE), 36 (Impairment) and 38 (Intangible assets)

exclude Exploration & Evaluation activities from their scopeq IFRS 6 covers accounting treatment for Exploration and

Evaluation q Originally intended as temporary standard.q Companies allowed to carry over their previous GAAPq Not mandatory otherwise usual standards – more expensing

Ø This would generally allow for LESS capitalisation (and therefore requires MORE expensing) than under IFRS 6

q IFRS 6 is industry specific standards. q No clear industry consensus. A lot of political lobbying behind

the standard – major oil companies vs small oil companies.q Purpose of IFRS 6 – not to prescriptive, but rather to allow

participants to say they comply with IFRS (if they do follow it)1313

RecognitionRecognition

n Recognition:Ø Companies can use a variety of methods to

account for exploration and evaluation activities, from expensing all related costs to fully capitalizing them

Ø Therefore exploration and evaluation assets are defined in terms of the policy each company chooses

MeasurementMeasurementq Initial:

q Exploration and evaluation assets are recognized at costq Expenditures related to the development not part.q Recognise any decommissioning costs at E & E stages.

qGeneral Administrative and overhead costs:- exclude unless specific.

q Borrowing costs - Entity may choose to capitalise, depends of accounting policy and degree associated with finding mineral resources.

qAfter Initial:ØCost model or valuation model

ØAcquisition - Fair value per IFRs 3 Business combination.

nChange is change in accounting policy – apply retrospectively

nAfter E & E – reclassify as tangible or intangible after impairment.

ImpairmentImpairment

n Impaired?Ø When facts and circumstances suggest that carrying

amount > recoverable amount.

n Consider (Factors):Ø the right to explore expires and is not expected to be renewedØ no other substantial expenditures are planned for exploration or

evaluation in the areaØ the entity decides to stop exploration and evaluation activities

because viable quantities have not been found in the areaØ although development is likely, the costs capitalized as

exploration and evaluation assets exceed the amounts that are likely to be recovered

n Impairment losses are taken to profit or loss – may be reversed

Disclosures - MinimumDisclosures - Minimumn Accounting policies :

Ø Expensing & capitalizationØ Administrative costsØ Borrowing costsØ Cost centreØ Impairment

n The amount of assets, liabilities, income, expense, and operating and investing cash flows from exploration and evaluation activities

n Treat exploration and evaluation assets as a separate class of assets and make the disclosures required by either IAS 16 or IAS 38 consistent with how the assets are classified.

Accounting Practices in Upstream Oil & GasAccounting Practices in Upstream Oil & Gasn Not codified in the standard only in the USn Full Cost Method (FCM)

Ø All property acquisition, exploration and development costs, even dry hole costs, are capitalized as oil and gas properties.

Ø These costs are amortized using a unit-of-production method based on volumes produced and remaining proved reserves.

n Successful Effort Method (SEM)Ø Only the cost of successful efforts is capitalized.

Ø Cost of exploratory dry holes, geological and geophysical (G&G) costs in general, delay rentals, and other property carrying costs are expensed.

Ø The net unamortized capitalized costs are amortized on unit-of-production method.

Weaknesses of current standardsWeaknesses of current standardsn IFRS 6

Ø Not a standard – issued for convenience Ø No specific mention of FC or SEØ Comparisons impracticableØ No cost centre choice basisØ Ring fencing does not address

n E & E costs are critical for EACØ Basis of cost gold platingØ Related party services & costsØ Not disclosed

n Physical work undertaken not disclosedn Reserves disclosures – only listed through stock exchange - outsiden Shareholding – by individuals not trustsn PWYP/®/EITIn Production and prices charged/obtainedn Revenue Fund collection/investments and utilisation

Mozambique issue with Anadarko:Within one year E & rose from $700Mil to $3 billion – why ?

Summary of IOCs IFRS 16 PolciesSummary of IOCs IFRS 16 PolciesSwala M&P Ophir Tullow Africa

OilHeritage BG Statoil Shell CNOOC

IFRS 6 YES YES YES YES YES YES YES YES YES

SEM V V V V v v

•Determination Annually End of explorat

ion

Annually Annually

FCM V V V

Centre Well Licence Varied Varied Licence Varied Licence or field

Well Well

Admin. ? ? YES Yes ? ? ? ?

Borrowing costs

? ? No Yes No ? ? ? ?

ImpairmentBasis W/OViability ? Appraisal

wells? Commercial

reservesCommercial

reserves

Proved+Probale

Proved+Probale

Findings based PSCs AuditsFindings based PSCs Audits“According to the IMF, “EI revenues are vulnerable to failure to audit during exploration and development phases […] Neglect in auditing exploration and development expenses can cost the tax base dearly as a project starts to generate income.”

n Cost gold-plating is commonØ Limited tendering is commonØ Donations – political/non-community relatedØ Suppliers of services/materials are biased towards the operators’ host

country– Chinese Vs EuropeanØ Rig rates are much high on this part of the world – related to volume of

work – low activity.Ø Non operational costs included in cost recoveryØ Withholding taxes not recovered from subcontractorsØ Unwarranted delays to the operations – poor planning should not be

chargeable e.g. lack of materials.Ø Excessive stockpiling of services and materials as risk mitigation measure.Ø Preference for foreign based suppliers for services which could even be

supplied from within the country.Ø Head office/Other operating centres cost allocation to operating countries.

Findings based PSCs AuditsFindings based PSCs Audits

n PSA Audits were not carried or not multidisciplinaryØ Objective being - “was the expenditure to be

incurred in the first place rather than authenticity of expenditure”. The three Es – efficiency, effective and economy.

Ø Affiliate services have to be matched with third party services cost and quality wise.

Ø Sharp and experienced personneln External Audits have failed to be of assistance

to EAC countries. n E & E costs not published and neither are

Reserves

International Disclosure Initiatives Reserves Accounting

Resource Classification Frameworks

International Disclosure Initiatives Reserves Accounting

Resource Classification Frameworksn Listed EI Entities in developed economies

Ø Must publish volumes/values of resources to Protect investorsØ Frameworks:

v Committee for Mineral Resources International Reporting Standard (CRIRSCO) – for minerals

v Society for Petroleum Engineers – Petroleum Resources Management System (SPE-PRMS) – for hydrocarbons

n United Nations Efforts to require systems of national accounting of countries to include resources.Ø United Nations Framework Classification for Fossil Energy and

Minerals Reserves and Resources, 2009, UNFC-2009).Ø System of Environmental – Economic Accounting, 2012 (SEEA-

2012)

International Disclosure Initiatives Publish What You Pay to Governments

International Disclosure Initiatives Publish What You Pay to Governments

n Legislated: EU (Under Accounting and Transparency Directives 2013); UK(The Reports on Payments to Governments Regulations 2014); Canada (The Extractive Sector Transparency Measures Act 2014); USA(Section 1504 of the Dodd-Frank Act); Norway (2014)

n Payment information to be disclosed:Ø Payment to each government and each Government agency by project including payments in kind in

volumes and values.n Types of payments Disclosures:

1. Production entitlements2. Taxes3. Royalties. 4. Dividends5. Signature, discovery and production bonuses. 6. Fees including licence fees, rental fees and entry fees, and other payments for licences and/or

concessions. 7. Payments for infrastructure improvements

n Activities related to minerals, oil, natural gas deposits or other materials involving: 1. Exploration 2. Prospection 3. Discovery 4. Development 5. Extraction

n Disclosure: Annually through annual reports to be authenticated by external auditorn Who – EI Listed companies or size of entity

International Disclosure Initiatives Governance Institutions

International Disclosure Initiatives Governance Institutions

n Multi Stakeholders Group on Governance – Multilateral, bilateral agencies, Governments, civil societies and institutional investors.Ø Promotion of good governance and Accountability in EI

n Natural Resources Governance InstituteØ Formulated “The Natural Resource Charter” Ø Sets principles to guide governments' and societies' use of natural resources to

attain maximum and sustained economic returns for a country's citizens. Ø It outlines tools and policy options designed to avoid the mismanagement of

diminishing natural riches, and ensure their ongoing benefits.Ø The charter is organized around 12 core precepts to provide maximum good

returns for citizens.Ø First launched in 2010 at the annual meetings of the International Monetary

Fund and the World Bank.

n The Extractive Industries Transparency Initiative (EITI) Ø EITI is an international organisation which maintains a standard, assessing the

levels of transparency regarding countries’ oil, gas and mineral resources. This standard is developed and overseen by a multi-stakeholder Board, consisting of representatives from governments, extractives companies, civil society organisations, institutional investors and international organisations.

Ø Launched 2002; 48 countries complying including Tanzania other EAC members not yet.

Role of Accounting Profession in EIRole of Accounting Profession in EI

n Government and Investors get fair shares from EIn The public enjoys the benefit of EI since these belong to the

country.n Resources are exhaustible returns from the EI must be invested for

the future generations.n Avoidance of resource curse.n Governments and Investors share the same information for planning

purposes.n Costs of investments incurred are realistic.n Statutory Audit for EI should be credible. At the moment

it is not trusted. Ø Less reliable to provide for public interests needs.

n More disclosures are required –costs/revenue/resources/prices/ownership.

Issues – EAC Accountants to considerIssues – EAC Accountants to consider

q Economic viability – technical and economic viability – IFRS 6Ø Who determines?Ø For what use?Ø Export/Local utilization?Ø Host country Vs entity objectives

q Capitalise/expense basis:Ø Type of expenditure?Ø Country?Ø License areas?Ø Block area – I block about 84 sq.km?Ø Field based/resevour basis?Ø Discovery area - legal – 9 contingent blocks

q Impairment basisØ Country?Ø License areas?Ø Block area – I block about 84 sq.km?Ø Discovery area - legal – 9 contingent blocksØ After Drilling?

q Basis of armotisationØ Unit of productionØ Tangible and intangible vs tax provisions?

Study be Commissioned

Disclosures confirming with Transparency practices

Revenue Funds

Production, reserves, & Prices

STRICTLY  PRIVATE  &  CONFIDENTIAL  −  Ministry  of  Energy  and  Minerals    8th July 2013

Meeting with the Minister of Energy and Minerals Tanzania: Block 7 & East Pande 8th July 2013

LSE Ticker: OPHR Website: www.ophir-energy.com

©killagane@raha.com & y.killagane@yahoo.com

Thank you for your attention