Letters to the editor: PKF's 'Impairment Review'

Comment

Last week, the Mining Journal published an article disussing PKF's controversial 'Impairment review'. Ernst & Young, Grant Thornton and now Deloitte have chosen to respond with letters to our Editor.

Ersnt & Young Response

Dear Sir,

I write with reference to last week's coverage of PKF’s 'Impairment Review'. As highlighted in our October publication 'Metal Price Collapse – Implications for Impairment Testing', Ernst & Young agrees that impairment is a key accounting issue for the industry. We welcome any surveys or other publicity which seek to encourage good practice in relation to the accounting treatment and disclosure of impairment.

I would like to highlight two points from our experience of this issue. First, our experience confirms the relatively small number of impairment charges in mining companies’ most recently published financial statements, and we are not surprised and believe there are some good reasons for this. Second, disclosures of impairment testing assumptions under IAS 36 have often been uninformative, although we note that the biggest mining companies, which the PKF survey excludes, provide better practice disclosures.

We were not surprised by the relatively low number of impairment charges recorded by mining companies over the last reporting period. Mining assets, whether in the exploration, development or the production phase are inherently long-lived assets, and so it is necessary to use long-term assumptions in the cash flow forecasts that are generally used in conducting impairment tests. In this respect, while mining companies must reflect changes in the pricing environment as they impact on short-term cash flows, they should equally use their best estimates of long-term prices in such forecasts.

As such, spot prices are typically not the most appropriate measure of long-term pricing, and our experience suggests that at December 2008, most companies’ expectations were in fact of longer-term prices higher than the spot prices at that time. These expectations have, with hindsight, been borne out by subsequent recovery in the prices of almost all commodities.

As highlighted in our recent publication, 'The Wall of Debt', there is a view that the current debt-funding crisis in the mining industry, and its resultant supply constraints, could lead to further price increases if demand in the developed economies revives post recession to supplement growing demand from China and other rapidly developing economies.

Furthermore, the majority of development and production-stage mining operations were begun, and so were determined to be commercially viable, well before the advent of the historically high commodity prices seen before the financial crisis in the first half of 2008. As a result, while current prices remain well below those historic highs, our experience indicates they are nevertheless in excess of the long-term pricing assumptions used in the feasibility studies of many current mining operations.

Yours sincerely,

Steve Dobson
Partner, UK Mining Assurance Leader
Ernst & Young LLP, UK

Grant Thornton response

Dear Sir,

I read with interest your comment on impairment, or lack of, in last weeks' edition and was reminded of similar research performed recently by Houlihan Lokey, an international investment bank, on goodwill impairment. Their overall findings were very similar in that across a large number of listed mining companies in Europe, few impairments - other than Rio Tinto in 2007 - had been recorded.

The report referred to in your article expressed surprise that, excluding diamond projects, the impairment rate for exploration projects was only 19% - what would have been interesting would have been to see how that compared to previous periods.

If we take exploration companies, in my experience in the last year or so when it came to having conversations around impairment the key determinants were not so much around the availability of finance - that took place in the context of going concern - or the current price of A, B or C, but the quality of what was in the ground. And there is a very good reason for this.

Whilst IFRS6 is not a perfect standard it does allow for a fair degree of judgement. Exploration companies do not typically generate cash flows and often there is insufficient information about their mineral resources to make a reasonable estimation around recoverable amount. On that very basis, the original draft of IFRS6 was amended to state that the assessment of impairment should be triggered by changes in facts and circumstances only, ie what is the asset's quality rather than what is the current market price.

Indeed the standard on impairment (IAS36) need only apply if it is determined that there is an impairment.

When it comes to development/producing companies - who are outside the scope of IFRS6 - I suspect a longer-term approach has been taken to valuation techniques, I suspect the hope of recovery in the near-term coupled with more competitive production costs being available has led to little if any impairment on a discounted cash flow basis.

Furthermore when taking a market-based approach to company valuation, and using that as a benchmark for accounting standards, there is a consensus that smaller AiM companies, again particularly those in exploration, receive little interest and hence coverage from analysts. This affects their share price and hence their market cap. Simply comparing net asset value to market cap is often, therefore, a very blunt tool and a better understanding of industries and trends is required.

What, therefore, does all of this mean? I would say that if asked 12 - 18 months ago I probably would have expected a greater level of impairments. The fact that there hasn't been suggests that there has been a pragmatic application of accounting standards - dare I say it in contrast to fair value accounting - and that those companies are holding out for a quick economic recovery. I would say that the 2010 audit season will be just as interesting as that of 2009 as companies look to get assurance on last year's assumptions from next year's prices.

Chris Smith
Mining Partner
Grant Thornton UK LLP

Deloitte response

I thought your comment on impairments in the mining industry and the related PKF study raised some interesting points. I thought you might be interested in some further thoughts I had based on the article:

• Valuation models for mining assets, particularly those in the development phase, are influenced more by the long-term commodity price outlook than the short-term outlook. Although 2008 and 2009 did see falling prices, for many companies the long-term outlook remained strong and therefore the absence of sweeping impairments was not unexpected.

• The companies with the greatest risk of impairment are those which made acquisitions late in the last cycle as the carrying value of these assets will typically be much higher than those which are internally developed. Whilst there may often be a greater commercial desire not to recognise an impairment in these instances, it is also often the case that an acquirer requires some time to analyse fully the geology and development options for what they have acquired, particularly in a time where infrastructure costs started to fall and access to capital became much more challenging. There may therefore be more impairments to come.

• It is also worth noting that whilst the recognition of impairment charges arising from issues such as adverse geological data, changes in the political or tax environment, an inability to renew licences or a public recognition that a company has insufficient funding to proceed with a project may have a significant affect on the share price, impairments based on lower commodity prices will often be of relatively little interest to the analyst community. Analysts, provided they maintain faith in the management team, usually consider the development cost to be sunk and determine their valuations based on an assessment of future cash flows calculated using their own price assumptions. Therefore, in addition to being an accounting standard requirement, being clear on the causes of any impairment is an important commercial concern.

• There are a number of instances where economically viable projects have been delayed as the funding was not available. The credit crunch should not automatically cause these projects to be impaired. For many companies the model was always to sell on their projects rather than obtain funding to take them through to production. Whilst there needs to be evidence of viability, mining has always been a long term game and accountants need to acknowledge that.

• Some companies who booked impairments now find them themselves in a stronger price environment than many would have predicted and facing the question whether they should reverse their previous write downs. Having taken the pain some may not be keen to reverse and see their return on capital employed fall and have their results distorted for a second year in a row.

• On a more technical note, the accounting standard that governs impairment, IAS36, only requires quantified sensitivity analysis (explaining how a reasonable change in the key assumption could give rise to impairment) to be disclosed if the asset carrying value includes goodwill or intangible assets with an indefinite life, whilst IAS 1 also requires general disclosure around key sensitivities and estimation uncertainty. As it is relatively unusual for a mining company, especially one in the exploration stage, (as a significant proportion of the PKF study was) to have goodwill or intangible assets with an indefinite life, detailed, quantified sensitivity analysis would not frequently be provided.

• It is also not surprising that many mining companies did not disclose their commodity price assumptions. Although clearly of interest to readers, it is understandable that many companies would not choose to disclose this information voluntarily. For exploration projects where there is not yet a mine plan or capital cost estimate, valuations are often based on an assessment of the recoverable amount derived from amounts paid per hectare in recent similar transactions and here, neither commodity prices nor discount rate disclosures are required or meaningful. The requirements are to describe management’s approach in determining the valuation, the key assumptions used and their basis for selecting them. The commercial sensitivity of price assumptions was acknowledged in the recent draft IASB discussion paper on extractive industries, where, in the very extensive disclosure proposed this requirement was excluded despite the importance of price and cut off grades to the reserves disclosures. It also often the case that price assumptions are only meaningful to readers when looked at in conjunction with foreign exchange assumptions, because of their inverse correlation, and that is worth considering when drafting any impairment disclosure.

• Finally, the high-level comparison of discount rates performed can be misleading, as country and project stage risk can be reflected in either the discount rate or the cash flows. Also companies are often unclear as to whether the discount rates used are nominal or real and in some cases pre or post tax. Being clear on these matters would I think be helpful to readers of accounts.

Yours sincerely,

Chris Thomas
Director – Deloitte Metals and Mining