ACCOUNTING FOR MINERAL RESERVES

Michael R. Cartwright
In Partial Fulfillment of Requirements for
BA 711 Managerial Accounting
25 April 1991

SUMMARY:

The purpose of this paper is to review the current methods of accounting for ore reserves by exploration cost: Expense all, Successful Efforts and Full Cost. An alternate approach, Reserve Recognition Accounting, that was used by the SEC for a brief period of time, is reviewed and it is suggested that this method be readopted. Also addressed is the possible need for the mineral industry to adopt cumulative Income and Cash Flow Statements.

 BASIC CONCEPTS:

Mining companies have operating characteristics that differ significantly from other industries and pose special accounting questions. The principal inventory items, ores and concentrates, differ significantly from inventory in most businesses and estimating their amount and value is a complex determination. Developing new resources is a highly uncertain and expensive undertaking. mining also has some unique situations in timing of costs and income.

This paper is only going to discuss those items that appear to be relevant to determining the "value" of the solid mineral reserve asset. The SEC defines reserves as follows: "Reserves are that part of a mineral deposit (resource) which could be economically and legally extracted or produced at the time of the reserve determination." The economic element means that all cost data have been completed and an analysis of costs and returns has been made using established capital resources, and also that a market for the product(s) is viable. This economic analysis is usually called the feasibility study and it is at this point in time that the mineral resource exploration cost become mine development costs.

Under GAAP the "value" of the ore reserve asset is a function of the costs required to put the asset into service. These costs are made up of the following individually identifiable costs: acquisition, exploration and development. The Acquisition Cost of the deposit is the price paid to obtain the property right to search and find an undiscovered natural resource or the price paid for an already discovered resource. This cost does not seem to present any theoretical problems except for accounting for inflation and the possibility of transfer pricing questions. Development costs begin after the feasibility study and are the costs necessary to put the reserve into production. Again, this cost would seem to be a rather straight forward bookkeeping task with the possible exceptions of inflation and transfer pricing. Exploration costs are those that begin after acquisition and before development. All kinds of accounting chicanery can be performed in this area.

 RESERVE ACCOUNTING METHODS:

GAAP and the SEC provide three means for recording the exploration costs: (1) All exploration costs may be expensed in the period in which they are incurred ("Full Expense" approach). (2) In the Successful Efforts approach only those exploration costs that are associated with a project that results in an ore reserve are capitalized. All others are expensed in the period of incurrence. (3) In the Full Cost approach all exploration costs are capitalized until an ore reserve is eventually found. Coopers & Lybrand show five methods, not counting "not disclosed", but three of them are basically internal allocations of Successful Efforts.

Cost is used as the value for the ore reserve asset because of the Continuity assumption even though a tentative income producing value was determined at the feasibility study point. Conservatism requires that special care be taken to avoid overstating assets. The Matching principle requires that a value for the ore reserve asset be established so that the future revenues from the mine can be matched with appropriate expenses incurred in earning those revenues. Obviously, the Full Expense method is the most conservative of the three and the Full Cost method is the most liberal.

Depreciation is used to allocate costs of property, plant and equipment assets to indicate that their usefulness has declined. With natural resources the term depletion is used. A natural resource, or wasting asset, has two main characteristics: (1) the complete removal or consumption of the asset, and (2) only an act of nature can replace the asset. Normally, the depletion expense is computed on a unit of production basis, which means that depletion expense is a function of the number of units withdrawn during the period. The unit of production is usually tons. The total cost of the ore reserve is divided by the number of units estimated to be contained within it to arrive at the unit depletion cost. This cost per unit is multiplied by the number of units extracted to arrive at the depletion expense. Property, plant and equipment assets are depreciated over their useful life or the ore reserve life, whichever is shorter.

 ANALYSIS and DISCUSSION:

A number of controversies and special accounting problems occur in dealing with non-renewable natural resources. Three major accounting concerns are; (1) the establishment of the physical and economic in-situ mineral inventory itself; (2) the timing of mineral inventory development costs and revenues generated from the mine; and (3) the method of allocation of exploration expenses to their associated mineral properties.

The establishment of the physical and economic mineral inventory is a very complex undertaking and except for being the point in time that costs switch from exploration to development has little to do with accounting. Therefore no additional discussion is provided on this topic.

The timing problem is perhaps the simplest to understand and the most straight forward to deal with. The typical manufacturing company may require two or three years to acquire and prepare its property, plant and equipment for production and to begin earning revenue form them. The typical gold mine in Nevada has required almost 11 years of diligent exploration from discovery to feasibility study. Many larger or more complex mineral deposits have taken more than 20 years to arrive at the feasibility study stage. Ore deposits located in remote or environmentally sensitive areas can easily require another decade of development work before they can be put into production.

This creates some obvious questions concerning the costs associated with these long delayed revenues. Regardless of the exploration cost allocation method that is used there may be serious asset "value" problems due to an unstable currency. Even though long term inflation rates are relatively lower than in recent history, the generational time frame involved can cause a serious undervaluation of what may be a company's only asset.

This may be important from a theoretical accounting point of view but from a practical mine operating or financing perspective it seems relatively unimportant. The major cost associated with exploration is drilling. While drilling costs have risen significantly over time these increased costs may have been offset by improvements in drilling technology that have resulted in higher penetration rates and sampling quality.

As for the mine operator being able to obtain adequate financing to put the mine into production, the book value has little to do with this determination. Almost all mine financing decisions are made as a result of a quite detailed feasibility study that simply reduces the mine production to a series of net cash flows that are then used to evaluate the soundness of financing alternatives. Basically, if the project can repay its debt it will receive the financing regardless of its book value.

The exploration cost capitalization method, though, presents a more serious set of concerns. The most conservative approach is to expense all exploration costs as they are incurred but, because there is no cumulative income statement to track these expenses over the long time frames that are involved it can be difficult to evaluate a given company's true efficiency (return on assets?) as an operator in the minerals industry.

Assuming the company has an operating mine with a relatively long life that can supply funds for exploration and the company is an inefficient explorer, when the company finally does find another exploitable ore deposit the true cost of that asset may easily be in excess of even its feasibility study defined present value. But, that cost will not be reflected in the asset value shown in the current or subsequent financial statements as only development costs determine its carrying value. The majority of companies involved in exploration never find their first mine and of those that do, my opinion is that the majority of them do not locate another that will replace the reserves they mined. This is a very inefficient, and ineffective, use of scarce financial resources.

While this approach is considered the most conservative, it seems that it will serve better to obscure the true cost of obtaining an asset instead of serving to prevent the overvaluation of it.

The Successful Efforts exploration cost approach states that only those costs associated directly to an ore reserve should be capitalized and all others should be expensed as incurred. A major problem with this approach is that until an ore reserve is defined one does not know which costs to capitalize. In this approach one would capitalize all exploration costs except those for properties that are clearly rejected (unsuccessful) in some period.

Assuming that adequate internal accounting controls exist to record separate project expenses, the eventually successful ore reserve will have only directly related exploration costs allocated to it. But again, the true cost of the asset is obscured due to the lack of accounting for the unsuccessful projects that were required to be explored before the successful one was found.

The Full Cost method of allocating exploration costs is conceptually and theoretically more correct but, it also has serious problems associated with it. Capitalizing all exploration costs causes significant distortions in net income, both in periods of large exploration expenses and in periods of write offs of these expenses. And then one is faced with the problem of "correctly" allocating these capitalized exploration expenses if more than one commercially viable ore deposit is found in the same period or in two closely related periods.

What is evident is that the general need for accounting information and the intended use of it for determining mining company efficiencies is not adequate for the task due to the long time frames that are normally encountered. Instead, the accounting profession has bogged itself down in the formulation of voluminous rules, regulations and procedures that seem designed to obscure the necessary and sufficient information instead of highlighting it. "Presented with financial statements certified by Big Six accountants, most people presumed they bore some resemblance to reality. Really they were prepared in accordance with a set of rules, but those rules didn't measure reality."

In the same article, Breeden goes on to say, "If you are in a volatile business, then your balance sheet and income statement should reflect that volatility." This article was discussing valuing the idea that financial instruments held by financial institutions should reflect market value. While not directly related to mining companies and ore reserve asset carrying value the idea of volatility showing up in their financial statements is exactly analogous. Mining is a volatile, and quite uncertain, business. Mining companies have little control over the selling prices of the commodities they produce and these commodities have a record of swift and sharp changes in price. With the time frames involved from prospecting to production easily taking at least a generation, investors may well wonder why assets are not continually increasing in value. But, that is the nature of the business and until industry catches up with the Einsteinian idea of the convertibility of matter and energy, non-renewable natural resources will have to continue to be found the old fashioned way - chipping rocks and drilling holes.

Accounting can be expected, though, to show users of financial statements the true costs of a company's operations. Some of this necessary information is currently shown in disclosures contained in the notes to the financial statements or alluded to in management's discussion and analysis section. Short of requiring companies to publish cumulative Income and Cash Flow statements the notes may be a good place to discuss the true mineral deposit asset cost. Because of the previously mentioned difficulties with exploration cost accounting and reserve asset value a financial statement user has no idea of the mining companies prospects for survival.

In 1978 the SEC required certain natural resource companies to use Reserve Recognition Accounting (RRA), which it believed would provide more useful information and better reflect the economic substance of natural resource exploration. The SEC abandoned RRA for the primary financial statements in 1982, noting that the method did not possess the required degree of reliability for use as a primary method of financial reporting.

Cited among the difficulties were practical problems in estimating (1) the amount of the reserves, (2) the future production costs, (3) the periods of expected production, (4) the discount rate, and (5) the selling price. These are indeed interesting "practical problems" because they are exactly the problems that must be solved by the company in order to change from exploration to development cost accounting!

If a commercially viable deposit has been determined by solving the "practical problems" shown above, a Full Cost company can now allocate all those capitalized exploration costs to asset value. Where yesterday there was no asset, today there is a multi-million dollar asset in place and the user has no currently documented indication of how that value was arrived at. Admittedly, mining stock analysts who save every scrap of news release or gossip about a mining company they happen to be following, may be able to make a reasonably correct verification of value.

I agree that RRA does not belong on the primary financial statements but it most certainly does belong in the notes. Oil and gas companies are required to show a "Standardized measure of Discounted Future Net Cash Flows" in the notes to the primary financial statements. Mining companies are not faced with this requirement. Mining companies say that they have additional uncertainties not faced by oil and gas companies that should exempt them from this requirement. But, even in the face of these overwhelming uncertainties, the mining companies seem to have little difficulty in convincing their Boards of Directors to approve the commitment of funds to a mining operation nor in convincing lenders to loan them hundreds of millions of dollars that are secured by these same woefully inadequately defined ore reserves.

The shareholders of a mining company have the same relationship to the company as do U S citizens and the CIA - the shareholders and the citizens are the only ones that pertinent information is withheld from.

Accounting data and information is presumed to be very precise by the accountants that assemble it and the auditors that verify it. The preciseness of the information is quite possibly less relevant than is its purported accuracy in reflecting the reality of the company's financial position.

A short history of accounting is provided by Kieso and Weygandt (pp 7) that indicates that "from 1900 to 1929 the emphasis of accounting information has changed from "solvency and liquidity" to "income producing ability" due to the growth of large corporations with their absentee ownership and the increasing investment and speculation in corporate stocks".

The balance Sheet is viewed as a statement representing a moment in time. In actuality it is the only statement that represents the cumulative effect of all past transactions. This statement provides the basic information for making liquidity decisions but fails to provide adequate information to make a reasonable determination of solvency - ability to pay debts as they mature.

Long term liabilities indicate a debt that must be repaid out of future revenue but, no presently required financial statement provides any indication of future revenue generation that is expected to be available to pay off the debt. If assets are greater than or equal to liabilities one often assumes that the entity is solvent. But, using this methodology results in abandonment of the continuity assumption. The business must be liquidated to pay its debts, in which case, assets are, by definition, misstated since they should now be reported at current market value instead of book value.

The Income and Cash Flow statements represent the results of transactions over the most recent accounting period. SEC reporting companies must show the last three years of these statements but no cumulative Income and Cash Flow statements are required to be presented. Failure to require cumulative Income and Cash Flow statements distorts the calculation of many of the financial ratios used in evaluation of overall company performance and as a result these ratios become relatively meaningless at best.

Rate of return on assets may be the only long term ratio that has any bearing on a mining company's chances of survival. This requires two values that are not available to anyone without a great deal of research: net income and total assets. We have already discussed the idea that the stated reserve asset value probably bears little relationship to reality. In a volatile industry such as mining, even an undistorted-by-accounting-chicanery net income figure for any one year is relatively meaningless because of the extreme price volatility seen in the spot metals market. Hedging activities and forward sales can serve to smooth revenue in any given year but the overall trend and results of the company's price taking abilities is the true measure of its profit making performance.

Mining can not be looked upon as a short run industry and therefore a revised method of accounting for a company's only real asset is called for. The large dollar value of the plant and equipment account is totally meaningless without an adequate mineral reserve to justify it. I am of the opinion that if the physical and economic ore reserve, expected production, future production costs and commodity prices and discounted net cash flow calculations are good enough for management, auditors and certain sophisticated lenders than these values, which more clearly reflect true asset value than does cost, are good enough for financial reporting purposes.

It is time for accounting related to mining to realize that cost is simply not an appropriate figure for the asset value of an ore reserve. A rather unique situation exists with one mining company operating in Nevada that tends to show the fallacy of current ore reserve accounting. This company has two mines of approximately the same physical size and relatively close to each other that probably required very similar true exploration costs to develop but, one of them contains about seven times as much recoverable metal content as the other. How is it then that the SEC and GAAP would have me believe that their asset values should be the same?

 REFERENCES