A “farm out” occurs when a venturer (the “farmor”) assigns an interest in the reserves and future production of a mine to another party (the “farmee”). This is often in exchange for an agreement by the farmee to pay for both its own share of the future mine development costs and those of the farmor. There may also be a cash payment made by the farmee to the farmor. This is a “farm in”
when considered from the farmee’s perspective. This typically occurs during the exploration or development stage and is a common method entities use to share the cost and risk of developing properties. The farmee hopes that their share of future production will generate sufficient revenue to compensate them for performing the exploration or development activity.
7.10.1 Accounting by the farmor Farm out agreements are largely non-monetary transactions at the point of signature for which there is no specific guidance in IFRS. Different accounting treatments have evolved as a response. The accounting depends on the specific facts and circumstances of the arrangement, particularly the stage of development of the underlying asset.
Assets with reserves
If there are reserves associated with the property, the farm-in should be accounted for in accordance with the principles of IAS 16. The farm out will be viewed as an economic event, as the farmor has relinquished its interest in part of the asset in return for the farmee delivering a developed asset in the future. There is sufficient information for there to be a reliable estimate of fair value of both the asset surrendered and the commitment given to pay cash in the future.
The rights and obligations of the parties need to be understood while determining the accounting treatment.
The consideration received by the farmor in exchange for the disposal of their interest is the value of the work performed by the farmee plus any cash received. This is presumed to represent the fair value of the interest disposed of in an arm’s length transaction.
The farmor should de-recognise the carrying value of the asset attributable to the proportion given up, and then recognise the “new” asset to be received at the expected value of the work to be performed by the farmee. After also recording any cash received as part of the transaction, a gain or loss is recognised in the income statement. The asset to be received is normally recognised as an intangible asset or “other receivable”.
When the asset is constructed, it is transferred to property, plant and equipment.
Assessing the value of the asset to be received may be difficult, given the unique nature of each development.
Most farm out agreements will specify the expected level of expenditure to be incurred on the project (based on the overall budget approved by all participants in the mine development). The agreement may contain a cap on the level of expenditure the farmee will actually incur.
The value recognised for the asset will often be based on this budget. A consequence is that the value of the asset will be subject to change as the actual expenditure is incurred, with the resulting adjustments affecting the gain or loss previously recognised. The stage of development of the asset and the reliability of budgeting will impact the volatility of subsequent accounting.
Assets with no proved reserves
The accounting is not as clear where the mineral asset is still in the exploration or evaluation stage. The asset would still be subject to IFRS 6 ‘Exploration for and
Evaluation of Mineral Resources’ rather than IAS 16.
The reliable measurement test in IAS 16 for non-cash exchanges may not be met. Neither IFRS 6 nor IFRS 11 gives specific guidance on the appropriate accounting for farm outs.
Several approaches have developed in practice by farmors:
• recognise only any cash payments received and do not recognise any consideration in respect of the value of the work to be performed by the farmee and instead carry the remaining interest at the previous cost of the full interest reduced by the amount of any cash consideration received for entering the agreement. The effect will be that there is no gain recognised on the disposal unless the cash consideration received exceeds the carrying value of the entire asset held;
• follow an approach similar to that for assets with proved reserves, recognising both cash payments received and value of future asset to be received, but only recognise the future asset when it is completed and put into operation, deferring gain recognition until that point; or
• follow an approach similar to that for assets with proved resources, recognising both cash payments received and value of future asset to be received, and recognise future asset receivable when the agreement is signed with an accompanying gain in the income statement for the portion of reserves disposed of.
All three approaches are used today under current IFRS.
There can be volatility associated with determining the value of the asset to be received as consideration for a disposal in a farm out of assets with proved resources.
This volatility is exacerbated for assets which are still in the exploration phase. Prevalent industry practice follows the first approach outlined above.
7.10.2 Accounting by the farmee
The farmee will only recognise costs as incurred, regardless of the stage of development of the asset.
The farmee is required to disclose their contractual obligations to construct the asset and meet the farmor’s share of costs. The farmee should follow its normal accounting policies for capitalisation, and also apply them to those costs incurred to build the farmor’s share.
Accounting for a farm out Background
Company N and company P participate jointly in the exploration and development of a copper deposit located in Peru.
Company N has an 18% share in the arrangement, and Company B has an 82% share. Companies N and P have signed a joint arrangement agreement that establishes the manner in which the area should operate. N and P have a joint operation under IFRS 11. The joint operation comprises the mine area, machinery and equipment. There are no proved reserves.
The companies have entered into purchase and sale agreements to each sell 45% of their participation to a new investor—Company R. Company N receives cash of C4 million and company P receives cash of C20 million. The three companies entered into a revised ‘joint development agreement’ to establish the rights and obligations of all three parties in connection with the funding, development and operations of the asset. The composition of the interests of the three companies is presented in the table below:
Company N Company P Company R Total
Before transaction 18% 82% - 100%
After transaction 10% 45% 45% 100%
Cash received C4 million C20 million - C24 million
Each party to the joint development agreement is liable in proportion to their interest for costs subsequent to the date of the agreement. However, 75% of the exploration and development costs attributable to companies N and P must be paid by company R on their behalf. The total capital budget for the exploration and development of the asset is C200 million. Company N’s share of this based on their participant interest would be C20 million, however, Company R will be required to pay C15 million of this on behalf of Company N.
The carrying value of the asset in Company N’s financial statements prior to the transaction was C3 million.
Question: How should company N account for such transaction?
Solution
This transaction has all the characteristics of a farm out agreement. The cash payments and the subsequent obligation of company R to pay for development costs on behalf of companies N and P appear to be part of the same transaction. Companies N and P act as farmors and company R acts as the farmee. The structure described also meets the definition of a joint operation per IFRS 11. Therefore company N should account for its share of the assets and liabilities and share of the revenue and expenses.
The gain on disposal could be accounted for by company N using one of three approaches, as follows:
1. Recognise only cash payments received.
Company N will reduce the carrying value of the mining asset by the C4 million cash received. The C1 million excess over the carrying amount is credited to the income statement as a gain. The C15 million of future expenditure to be paid by Company R on behalf of Company N is not recognised as an asset. As noted above, this approach would be consistent with common industry practice.