Commentary: Changes ahead for mining balance sheets

Starting in 2011, Canadian public companies will be migrating from using Canada’s own generally accepted accounting principles (Canadian GAAP) to using International Financial Reporting Standards (IFRS).

In broad terms, the movement means Canada gives up some of its ability to create accounting standards responding to local issues and preferences, but obtains the benefit of the international infrastructure underlying IFRS, leading to greater international comparability and easier access to overseas capital markets.

Most other major countries have either already made a similar trade-off or are preparing to, although the U.S. remains a prominent exception for now.

For some companies, IFRS will have little or no effect on their reported numbers, although they still have to work through their current practices item by item before they can determine that. For others, the differences will be extensive, significantly altering the basic picture presented in the financial statements.

For junior mining companies, many aspects of their financial statements – cash, receivables, payables – are straightforward and there’s no reason they would change under IFRS.

For many junior miners, the most significant issue will be how they treat the costs of exploring for and evaluating mineral resources (that is, before establishing technical feasibility and commercial viability).

These costs often pose something of an accounting dilemma. They’re obviously incurred with a long-term purpose in mind, rather than to generate revenue in the short term. However, it’s often impossible to know at the time whether this long-term purpose will ever be realized.

If the costs are recognized as assets on the balance sheet (until it’s clearly demonstrated nothing will ever come of them), then the balance sheet may provide a good snapshot for a reader of the company’s historical investment in its current projects, but of course might provide the illusion of value where none exists.

Canadian GAAP states that the cost of a mining property “includes exploration costs if the enterprise considers that such costs have the characteristics of property, plant and equipment,” effectively allowing mining companies to exercise a high degree of judgment on whether those costs enter its balance sheet.

IFRS doesn’t change the basic philosophy. It says: “An entity shall determine an accounting policy specifying which expenditures are recognized as exploration and evaluation assets and apply the policy consistently.” In other words, it’s largely up to them.

Still, there’s a little more clarity on this in the IFRS literature. For example, it specifies that this choice doesn’t apply to “expenditures incurred before the entity has obtained the legal rights to explore a specific area” – in most cases, IFRS doesn’t allow any rationale for treating such very early-stage costs as assets.

Given these differences, and since moving to IFRS in any event provides a convenient point for revisiting existing practices, many Canadian entities are currently taking a look at this area, and some will end up with leaner-looking balance sheets because of it. For example, discussing the issue in its management discussion and analysis (MD&A) filing, one Canadian company summed up the difference like this:

The Company’s policy under Canadian GAAP requires exploration and evaluation costs to be capitalized when a project is determined to be potentially economically viable. Under IFRS, the Corporation is considering adopting a policy of capitalization upon probable economic recovery.

Clearly, the population of what’s only potentially economically viable might be much greater than what’s probably going to be recovered, meaning the company may have capitalized these early-stage expenditures more often in the past than it will in the future. Another entity, though, sees it differently:

Upon adoption of IFRS, the Company will have a choice between retaining its existing policy of capitalizing all prefeasibility evaluation and exploration (“E&E”) expenditures and electing to change its policy retrospectively to expense some or all pre-feasibility costs as an adjustment through retained earnings. The Company does not expect that a change in policy would add value for the economic decision-making needs of the financial statement users.

What does this mean for readers?

It should certainly help reinforce the limitations of financial statements as a window into a junior miner’s activities. The statements can provide valuable information about cash raised and spent and remaining (bearing in mind that by the time the statements are released, the picture may already have moved on considerably). But it’s impossible to draw any firm conclusion about particular projects just because certain exploration and evaluation costs are on the balance sheet or not.

Some entities with excellent prospects may choose to be conservative until they’re entirely confident of technical feasibility and viability. Others with worse prospects may be more interested in having a balance sheet that helps get out the message.

These may both be perfectly acceptable strategies, but in isolation don’t ultimately provide much of a basis for deciding whether a particular company’s stock makes for a good buying opportunity at any given price.

That evaluation will continue to depend much more on the information available in other documents such as technical reports and news releases, on broader market factors, and of course on the investor’s personal risk tolerance.

— The author, a Toronto-based chartered accountant, is an IFRS and financial reporting specialist and author of IFRS Literacy: Understanding the New Financial Statements, to be published in October 2010 and available at www.cch.com. He may be reached at jhughes@mscm.ca.