Published in July 2014

• While commonly used quantitative measures or financial ratios serveas a good benchmark for investing in businesses, one should also beaware of the underlying assumptions used to draft such numbers.

• These benchmarks may sometimes paint a completely differentpicture under different norms.

• This may not only affect the accrual based numbers but also cashflows and lead one to erroneously see a business as being way betterin terms of profitability and/or creditworthiness than it is.

In case of mining or resource exploration companies, the full cost accounting method may be followed

by a company.

All costs incurred inproperty acquisition,drilling, exploration& completion arecapitalized.

This is aggressive compared to the successful effort method which

capitalizes the cost incurred on

successful property exploration.

When some resource company is engaged

in exploration of more properties, this

method may show profits, improve

interest cover and net worth, while

lowering D/E

Follows full cost accounting

Company’s debt was c. USD 13bn as of 2012 & 2013,

which was USD cash-paying with fixed coupons ranging 5%

to 7% on most bond issues.

Then how can only USD 227m hit the income statement in 2013 (and USD 77m in 2012)

Adjusted interest cover is PBT adjusted for extraordinary costsminus capitalized cost plus interest capitalized divided byinterest including capitalized interest.

Note: The mention of the above company serves as an example of ‘Mining Magic of Full Cost Accounting’. This does not indicate anyinvestment proposition in the company.

Source: Chesapeake 10K 2013

Source: Chesapeake 10K 2013

Operating cash flow appears high due to the classification of unsuccessful exploration cost in thecapex category.

Interest paid out goes mostly under the investing section as being capitalized than flowingthrough operating cash flows fully.

Had the company not been able to swap acreages to generate cash, it would have to borrowmore to develop existing properties.

• The net worth could have been lowerand Debt/Equity higher had thecompany been expensingunsuccessful exploration costsinstead of routing it as an unprovedproperty asset item.

• Note that cost capitalized on accountof unproved reserves is notamortized until properties areevaluated.

Source: Chesapeake 10K 2013

• Reserves estimate• Proven reserves get affected by price movements in the underlyingcommodity.

• In case of a ceiling test, depending on the company cost structure, ifcommodity prices decline materially, some portion of estimatedreserves may be found to have become uneconomical.

• Capex cycle• When the price of a commodity is rising steeply with anacceleration in profit margins, money may become easily available.

• Wherein, most players will expand not only with retained earningsor equity dilution but also with debt.

• When the cycle turns, this bloated cost structure may bite back.

Note: The mention of the above company serves as an example of ‘Mining Magic of Full Cost Accounting’. This does not indicate anyinvestment proposition in the company.

Generated goodwill of $3.5 billion by acquiring Equinox

Faced impairments as recoverable gold selling price

lowers

Sometimes write offs and impairments are indicative of lax accounting standards and poor

capital allocation practices.

Such impairments are followed by equity dilution.

• Some mining companies have nearly all tangible book valueequal to unproved reserve cost capitalized. They areswapping acreage to generate profit as optimism for theshale boom continues.

• Hence, this is the result of accounting wizardry and shouldnot necessarily be used as an indicator of the health of acompany.

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