In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition (effective for fiscal years starting after December 15, 2017 for public companies) affects almost every sector of the economy, and the mining industry is no exception. The complex arrangements between mining companies, governments, and land owners pose some of the most difficult issues for the new standard. Due to customized long-term contracts and fluctuating commodity prices, application of the five-step revenue-recognition model can be particularly complicated.
The AICPA and the major accounting firms have assembled industry task forces to research the industry-specific accounting issues within ASC 606, and we will draw from the guides they have published as we provide a brief explanation of the key issues the mining industry faces when applying ASC 606. For more information on any of these issues, see:
- EY: Technical Line: The new revenue recognition standard – mining and metals
- PwC: In depth: Mining industry supplement
We will also provide references to other RevenueHub articles for more detailed explanations of related ASC 606 topics. For general information on the basics of revenue recognition, see our RevenueHub article, The Five-Step Method.
The following are the issues that companies in the mining industry commonly face:
1. Determining Whether Counterparties Are Customers: Production Sharing Arrangements (PSAs)
Production sharing arrangements (PSAs) are becoming increasingly common in the mining industry. PSAs are agreements in which governments give mining entities the right to explore for natural resources in exchange for a portion of the production profits. The mining company assumes the financial risk of the operation by paying the exploration costs and some or all the development and production costs. Through this arrangement, governments can leverage the mining company’s operational expertise and avoid the inherent risks of mineral exploration. Mining companies also benefit by gaining access to natural resources that would otherwise be inaccessible.
If the mine is successful, the company will be refunded for its costs via the proceeds of the mine. Once the company’s costs have been fully refunded, the government and mining company share any additional profits according to an agreed upon profit margin.
When accounting for PSAs, each agreement should be analyzed separately to determine whether the government is considered a customer under ASC 606. Governments often create new PSAs with different terms for each geographic region. For more information about identifying a customer, please refer to our Definition of a Customer article.
If the government is not considered a customer, then the contract is outside the scope of ASC 606 and other accounting guidance should be followed. The ASC sections related to intangible assets (ASC 350), property plant and equipment (ASC 360), and extractive industries (ASC 932) are particularly helpful for mining companies to determine how to properly recognize assets created in connection with the PSA contract. When the government is not considered a customer, the mining company’s portion of the proceeds should be recognized as revenue only when its share of production is delivered to the end customer. The costs associated with producing the government’s share of output should be classified as an operating expense to the mining company, rather than cost of goods sold.
If the government is considered a customer, the contract falls within the purview of ASC 606. The mining company would recognize revenue in the form of future production in exchange for its exploration and construction services. The future production would be considered variable non-cash consideration. For more information about these issues see our Non-Cash Consideration and Variable Consideration and the Constraint articles.
2. Determining Whether Counterparties are Customers: Product Exchange
Many mining companies enter into arrangements to exchange mineral products with other companies. These “Buy-sell” agreements aim to reduce transportation costs by exchanging the same product, like coal, in two different locations. Per ASC 606-10-15-2, some transactions are excluded from the scope of the revenue recognition standard including “non-monetary exchanges between entities in the same line of business.” Using this guidance as direction, even contracts involving different products may not be within the scope of ASC 606 if the agreement does not directly involve the end customer.
In addition to the scope exception listed previously, the revenue standard requires that a contract with a customer be present before any of the associated revenue can be recognized. To satisfy the definition of a contract with a customer under ASC 606, commercial substance must be present. Commercial substance is defined in ASC 606-10-25-1(c) as expected changes in the “risk, timing, or amount of the entity’s future cash flows” because of the agreement. Mining companies must carefully analyze each product exchange arrangement to determine whether commercial substance is present. If so, the framework of ASC 606 applies. If not, the arrangement does not qualify as a contract, which means it lies outside of the scope of ASC 606 and most likely will not be treated as revenue. For more information about identifying a customer, please refer to the Definition of a Customer article.
Mining companies with “Buy-sell” agreements should reference “Topic 845 – Nonmonetary Exchanges” for additional guidance about accounting for these transactions.
3. Contracts with Repurchase Provisions
A repurchase agreement, in a general sense, is a form of collateralized loan, except that the title is transferred to the lender at the end of the arrangement. One party agrees to “sell” an asset or group of assets to the other party and then buy back the asset(s) at a future date at a specified price. The counterparty can retain the title of the asset(s) for use as collateral in case the seller cannot afford to make the payment to repurchase the asset.
Although repurchase transactions take the form of a sale, many of these contracts may not qualify as contracts with a customer. ASC 606 may require the transaction to be accounted for as a financing or lease agreement rather than a sales agreement. Mining companies must carefully analyze the contract and the difference between the initial selling price and the repurchase price to determine whether the counterparty qualifies as a customer. Additional guidance on the topic can be found in ASC 606-10-55 paragraphs 66-78. If the counterparty to the transaction does not qualify as a customer, mining companies will not recognize revenue on the original sale of the asset. For more information about this topic, see our Repurchase Agreements article.
4. Derecognition of Nonfinancial Mining Assets (ASC 610)
If a mining company sells nonfinancial mining assets that are considered an integral part of the business, the contract is not within the scope of ASC 606 and the proceeds should not be considered revenue. The contract should be accounted for according to ASC 610-20, Other Income – Gains and Losses from Derecognition of Nonfinancial Assets. Some contracts may not apply under ASC 606 nor ASC 610-20. For example, the sale of a subsidiary or collection of assets may be accounted for using the ASC 810 guidance on consolidation.
5. Accounting for Pricing Considerations Tied to Commodity Prices
Many sales contracts relating to commodities include provisional pricing. Due to lengthy transportation routes, customers may prefer a price that is closer to the market price on delivery rather than on shipment. Another common scenario that gives rise to provisional pricing occurs when commodities are transferred in concentrate form and the final volume or quality is not known until further processing. Often the final price associated with these types of transactions is an average market price over an agreed-upon period.
Management must carefully consider whether the contract includes an embedded derivative that should be accounted for separately under ASC 815 – Derivatives and Hedging. The rest of the contract should then be analyzed to determine the overall transaction price, with management re-assessing the transaction price each reporting period. The transaction price may include a significant variable consideration element. Variable consideration is especially applicable in contracts where the delivered products will be subject to further processing.
When accounting for variable consideration, ASC 606 includes a constraint that management should only recognize variable consideration that is “not probable” to undergo a significant revenue reversal in the future. For example, a large decrease in the estimated cumulative amount of revenue from a contract may result in a significant revenue reversal. Management should take special care when determining whether a future significant reversal is probable, and ASC 606-10-32-12 lists several factors to consider when making this evaluation. For more information about variable consideration, see our Variable Consideration and the Constraint article.
6. Delivery Terms: Cost, Insurance, Freight (CIR) v. Free on Board (FOB)
Mining companies often extract natural resources from remote locations and transport them over long distances to the customer. Within the industry, the two main forms of shipping contracts are 1) cost, insurance, freight (CIF) and 2) free on board (FOB). Under CIF contracts, the seller assumes the risk of loss during transport by paying for the cost, insurance, and freight related to the shipment. Under FOB contracts, the buyer assumes these risks as soon as the product is in transit.
The timing of revenue recognition under ASC 606 depends on the transfer of control for the purchased product. According to ASC 606-10-25-7, revenue can only be recognized when the seller “has transferred control of the goods or services to which the consideration that has been received relates…and has no obligation under the contract to transfer additional goods or services.” The concept of control is further explained in ASC 606-10-15-15 to be “the ability to direct the use of, and obtain substantially all benefits from the asset.” Under the old revenue recognition standard, delivery played an important role in determining when to recognize revenue. ASC 606 does not rely as heavily on a single event to identify correct revenue recognition timing. Although the accounting guidance does not specify exactly how to tell when control has been transferred, ASC 606 establishes several key indicators of control transfer including the seller’s right to payment, the transfer of legal title, the physical transfer of the goods, and the customer’s acceptance of the risks and rewards of ownership.
Many mining contracts include provisions that articulate when title to the products will be transferred, and these clauses are often used as evidence of a transfer of control. Control transfer may not align with the physical delivery of goods. For example, control of the commodities may be transferred when the product is shipped, although the physical delivery may only be complete when the product arrives at its destination.
CIF Accounting Treatment
If the transfer of control occurs after shipping, any shipping costs paid by the seller are not treated as a separate promise to the customer. The company is effectively transferring its own goods and cannot create a separate performance obligation for these activities. All revenue related to the contract will be recognized when the goods are delivered and control is transferred.
If the transfer of control occurs before shipping, any shipping costs paid by the seller may be treated as a separate performance obligation. Some factors that would indicate a separate performance obligation include the need for specialized transportation; the cost, timeliness or distance of the delivery; and the existence of opt-out clauses that allow the customer to collect the commodity themselves. If a separate performance obligation is identified, some revenue would be recognized upon shipment and additional revenue relating to the transportation services would be recognized over time.
The FASB has proposed a “practical expedient” that allows companies to treat shipping costs as a fulfillment cost rather than a separate performance obligation if the transfer of control occurs before transportation activities.
FOB Accounting Treatment
Since sellers have no obligation to pay for transportation activities in an FOB contract, revenue recognition under ASC 606 should not affect the timing of revenue recognition in these contracts. In most FOB contracts, all revenue should be recognized upon shipment because the seller has no obligations related to transportation. Control is effectively transferred upon shipment, coinciding with both title transfer and physical delivery. Although nearly all FOB contracts will follow this accounting treatment, mining companies should still analyze the terms of each contract individually to ensure that no separate transportation performance obligations exist.
7. Agency Relationships
Within the mining industry, companies often provide additional services beyond selling extracted natural resources. Some of these value-added services include transportation of goods, technical expertise, and processing. When performing these services, companies must determine whether they are acting as principals or agents.
The revenue recognition guidance outlined in ASC 606 has changed the process by which principal-agent relationships are determined, using fewer indicators than ASC 605. ASC 606 requires substantial judgement when analyzing these contracts, but we will address the principal-agent classification in general terms. If the company obtains control of another party’s goods prior to transferring these goods to the customer, the company is acting as a principal. When serving as a principal, the company recognizes revenue on the gross contract value.
If the company merely arranges for another entity to provide services, the company is acting as an agent. Some of the indicators that identify when a company is acting as an agent include little responsibility for fulfilling the contract, no inventory or customer credit risk, a lack of pricing power, and compensation via commissions. When acting as an agent, the company recognizes revenue on its commission or fee, if one exists. Alternatively, the total revenue from the contract will equal the “net” amount after paying the principal for the goods or services. For additional information on this topic, see our Principal/Agent Considerations (Gross vs Net) article.
8. Take-or-pay and Other Long-term Supply Arrangements
In the mining industry, producers and buyers often enter into long-term sales contracts over a year in duration. Mining companies use these agreements when making investment decisions and securing financing. These long-term contracts usually specify the amount of commodity to be delivered and the transaction price. Given the volatile nature of commodities prices, the sales contracts often include clauses allowing for price adjustments if the underlying commodity prices change drastically over the life of the contract. Some contracts provide the buyers with various options about the amount of commodity that the producer will deliver.
Take-or-pay arrangements between mining suppliers and customers ensure that the customer will either “take” product from the supplier or “pay” a penalty. The two parties will agree on a set price at which the customer will buy product and another price, usually lower, that serves as the penalty even if the product is not accepted by the customer. This structure of contract guarantees the supplier’s minimum level of future demand, thus reducing risk and allowing the supplier to lower its prices.
The first step in accounting for take-or-pay and other long-term contracts is to consider whether the contract contains any embedded derivatives or qualifies as a lease. In these situations, management should refer to the relevant accounting guidance: ASC 840 – Leases or ASC 815 – Derivatives and Hedging.
For example, options to acquire additional products should generally be treated as a separate contract when the customer exercises the option. An exception to this rule occurs when the option includes a “material right.” Per ASC 606-10-55-42, a material right is a benefit that the customer “would not receive without entering into the contract,” like a discounted price beyond the company’s regional pricing policies. Thus an option with a material right functions similarly to an advance payment for services and should be treated as a separate performance obligation within the original contract.
If no other accounting standards apply, companies should treat product deliveries (the “take” scenario) as they would any other transaction under ASC 606. Additional complications arise when accounting for situations where the customer opts to pay a penalty instead of receiving product (the “pay” scenario). The revenue associated with these penalties classifies as breakage under ASC 606.
Breakage occurs if customers do not exercise their rights to receive goods or services. ASC 605 forced companies to treat breakage revenue as contingent consideration. Under ASC 606, companies can recognize the estimated amount of breakage as revenue by using historical breakage patterns to guide their estimates. If management cannot estimate the amount of breakage, they should consider if any breakage minimum amounts are needed. (See our Variable Consideration and the Constraint article for more information about this process.) Unexpected breakage should be recognized when the customer’s probability of exercising their rights becomes remote. Management should re-evaluate their breakage estimates each reporting period.
Under ASC 606, companies may be able to recognize the future payment penalties as breakage revenue prior to the expiration of the customer’s exercisable rights if they can reliably estimate the amount of future payment penalties. However, companies may not be able to have sufficient ability to predict customer behavior to utilize this accounting treatment.
When accounting for take-or-pay contracts, managers should consider the reasons for the price changes when determining how to allocate the transaction price to the performance obligations. Depending on how mining companies view these price changes, the metric to allocate the total transaction price to the individual performance obligations may vary between standalone selling price, contractual pricing, straight line, or other methods. Future updates to the accounting standard may provide additional clarification on this topic.
9. Bill-and-hold Agreements
Some customers request that mining companies retain control of the mined goods after they are extracted. These bill-and-hold agreements often stem from the customer’s storage constraints. ASC 606 takes a more conceptual approach to the issue of bill-and-hold agreements compared to ASC 605. For example, some of the criteria qualifying an arrangement for revenue recognition have been relaxed, including the need for a fixed delivery schedule.
EY expects arrangements that qualify as bill-and-hold agreements under ASC 605 will continue to qualify as such under ASC 606. The timing of the revenue recognition may still differ. Management should analyze the contract to determine whether the production and custodial services classify as two separate performance obligations. If so, the transaction price must be allocated across these two performance obligations and each must be analyzed to determine the proper timing of revenue recognition. For additional information about these topics see our Revenue Recognition over Time and Bill and Hold Arrangements articles.
ASC 606 requires additional disclosures including a focus on management’s judgments when accounting for contracts with customers. Companies must also disclose the amount of unfulfilled performance obligations, the expected timing of revenue recognition for contracts lasting over one year in duration, and the reasoning behind these conclusions. Entities in the mining industry frequently agree to long-term contracts, which may necessitate greatly-expanded disclosures and additional investor scrutiny. For more information about this topic, see our Disclosures article.
For the mining industry, ASC 606 will generally result in similar accounting treatment as under ASC 605. However, the framework for defining a customer, determining transaction values, and treating variable consideration can lead to significant accounting changes for many mining companies. Given the complex nature of mining contracts and the many entities involved, we encourage you to carefully analyze your contracts using the resources referenced herein.
It is likely that many other issues and questions will arise within the mining industry as entities adopt ASC 606. This article serves as a base reference point for your research into some of the focal issues anticipated by industry experts. Similar industry-specific issues, discussions, and resources are available on the RevenueHub site for major industries identified by the AICPA. Click on the following link for a list of these articles: Industry-Specific Issues.