CHAPTER 9 ACCOUNTING PROBLEMS INHERENT IN NET PROFITS INTERESTS

• Jurisdiction: United States

Mining Agreements II
(May 1981)
CHAPTER 9
ACCOUNTING PROBLEMS INHERENT IN NET PROFITS INTERESTS
William A. Bristol
Energy Fuels Corporation
Denver, Colorado

INTRODUCTION

Accounting for net profits interests, when examined in isolation, presents problems that are no more difficult than those encountered in accounting for any other entity. While mining operations and the associated regulatory, tax and management reporting requirements probably present a greater challenge to the accountant than some other more standardized areas of business, financial statements and cost reports have been prepared for hundreds of years with no apparent difficulty.

The calculation of a net profits distribution is usually uncomplicated. From gross revenues are substracted all of the allowable deductions, as defined in the agreement, to arrive at net profits. If the agreement has a capital recovery provision, the portion of net profits to be used to reduce the investment account is calculated and subtracted from net profits. The net profits interest percent is applied to the remainder to arrive at the distribution to be made to the owner of the interest.

The accountant's difficulty with net profits interests stems from the fact that accounting records are maintained to reflect, as accurately as possible, the financial health of the venture, while a net profits agreement only describes a method to calculate a distribution. Definitions of costs under the two can be very different and the inclusion of a capital recovery provision will usually require a change from the normal accrual basis accounting to cash basis. As a result, the maintenance of another set of records based on the provisions of the agreement may be required.

With the exception of the potential impasse resulting from definitions that lack the precision an accountant would prefer, most of the problem areas discussed in this paper can be resolved by additional accounting staff or systems. While not inexpensive, the solutions are readily available. The purpose of this

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paper is to provide some insight into the inner workings and hidden mechanisms of the accounting department, so that in future negotiations otherwise equivalent alternatives will be considered in light of administrative complexity.

Among the more important functions of the accounting department is the collection, organization and reporting of financial data on a periodic basis. The assortment of formal and informal systems that collect the revenues, pay vendors, calculate and allocate employee costs,..., and create reports for internal and external use is referred to as Corporate Accounting Policy and Procedures. Growth, regulation and budgeting policy are some of the factors that will generate the need for changes in these systems and changes do occur on a regular basis.

The geologist, engineer, attorney and accountant share a common sensory shortcoming in that during the drafting of most mining agreements, none can see far enough underground to enable them to predict, with any great accuracy, the conditions or costs that will be encountered during the recovery of the minerals, nor are many of them particularly gifted at predicting the impact, or the form, of new legislation that will no doubt be forthcoming during the life of the mine. Each has his own way of coping with the problem. For the accountant, the primary solution is to alter the accounting policies and procedures so that the resulting financial data accurately reflects the financial condition of the operation.

Contract language that would restrict the engineer's options in the development of a resource into a mine is usually limited to the general guidance to proceed in a safe and minerlike fashion, while the accountant, in reporting the financial impact of the engineer's activities, will find that the governing agreement may contain a number of restrictions. This is a curious situation since generally accepted accounting principles are considerably better documented than miner like fashions.

While the description of a net profits interest may be similar in form to that of a joint mining operation, it is more closely related to gross proceeds or net smelter return royalty in that revenues and expenses are defined terms. The agreement will be drafted with the intent of establishing the algorithm to be used to calculate "net profits" with the resulting definition

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probably not incorporating a number of costs and expenses that would be included if the intent was to fairly report the profitability of the venture. The inclusion of a detailed accounting procedure will go a long way toward reducing the difference between net profit and the net profit used to calculate distributions pursuant to a net profits agreement.

This benefit is offset by the fact that routine accounting procedures then become subject to negotiation. If the operator has a number of ventures, each with its own accounting procedures, administrative costs increase or the ability to provide timely data will be inhibited. Finally, the modification of accounting procedures for joint mining operations, where both parties contribute their proportionate share of the cash requirements, share in the liabilities of the venture and receive a share of the cash proceeds, is not nearly as difficult as negotiating a policy change that will result in a reduction in the cash distributions to the owner of a net profits interest who is not required to contribute cash and has limited responsibility for long term liabilities.

As the form of a net profits agreement approaches that of a joint mining operation, as opposed to a gross royalty with specified deductions, the distinction between net profit and cash flow becomes increasingly important. A common approach is to add provisions for the operator to recover invested capital and interest prior to net profits distributions. From the other side of the table, there will be requests for advance minimum payments to insure that the operator will bring the mine into operation as quickly as possible. These payments may be recoupable and in some cases bear interest. Administrative problems in...