As a chartered accountant active in Canada’s junior mining scene, I decided to tackle the subject of accounting for flow-through shares under International Financial Reporting Standards (IFRS) for four main reasons.
Firstly, the new IFRS accounting standards contain no specific guidance on how flow-through share accounting should be done.
Secondly, the Canadian Institute of Canadian Accountants (CICA) Guideline EIC-146 will expire soon – this is the current Canadian generally accepted accounting principles, or GAAP. The accounting standard-setter in Canada (AcSB) is not promoting a single solution for this Canada-specific IFRS accounting issue, which impacts many junior resource firms starting in the first quarter of 2011.
Thirdly, U.S. guidance on flow-through share accounting exists but it may not be sufficient for IFRS use, as is.
And finally, in their own internal publications for staff and clients, the larger Canadian accounting firms have steered away from making any definitive recommendations on how to do flow-through share accounting.
In short, my intention is to help readers understand the issues and offer a possible solution for flow-through share accounting under IFRS.
By way of an introduction to the topic, flow-through shares allow a junior resource firm to issue shares that transfer the tax deductibility of qualifying resource expenditures (i.e. Canadian exploration expenses) to investors, on a potentially accelerated basis.
The accelerated basis comes from the fact that the investors usually get the tax write-offs in the first year, possibly even before some or all of the related flow-through expenditures are incurred by the junior resource firm. The investor’s accelerated deduction timing is a political concession to investors and not necessarily a key consideration for the junior resource firm’s own accounting.
The gross proceeds received in a flow-through issue equals the flow-through expenditure commitment. Costs of issue (e.g. legal/filing/finders’ fees) do not reduce the commitment.
The flow-through shares are made attractive to investors since the transfer of the tax deductibility produces an immediate tax shelter and thereby reduces the at-risk investment amount. Often, a complementary offering of additional warrants to acquire non-flow-through shares provides an extra incentive to invest. If the underlying stock does well, investors may exercise the warrants and buy additional shares at a discount, leading to potential additional capital gains.
The junior resource firm determines what portion of the resource expenditures will be renounced using the “General Rule” vs. the “Look-back Rule.” This is usually done in a subsequent period (i.e. after the December 31 effective date of renunciation) through the filing of official renunciation forms.
For accounting purposes, the transfer of the tax deductibility of the qualifying resource expenditures to investors gives rise to a taxable temporary difference and therefore produces a future tax (in IFRS terminology: a “deferred tax”) liability, that the junior resource firm would not otherwise have, without the transfer.
At this point, four key accounting questions arise: How to allocate gross proceeds of a flow-through share issue to appropriate equity and liability accounts? When to recognize the future tax liability for the junior resource firm’s associated with resource expenditures renounced to investors? How to properly disclose the junior resource firm’s flow-through commitment in its financial statements? And how to recognize previously unrecorded future tax assets by using them to offset future/deferred tax liabilities associated with flow-through renunciations.
Under current Canadian GAAP (EIC-146), the CICA’s Emerging Issues Committee chose to promote the following accounting policy: “Record the future tax effect on the date the Company files its renunciation documents, as a reduction of shareholders’ equity, provided there is reasonable assurance that the expenditures will be made.”
As such, the committee chose not to support two alternative times for recognizing the tax effect: when the flow-through shares are issued; and when the resource expenditures are incurred.
Meanwhile under current U.S. GAAP, there is the Financial Standards Accounting Board’s (FASB) Statement 109, Accounting for Income Taxes.
Here, the FASB chose to support the following accounting policy for Canadian issuers reporting under U.S. GAAP: “Allocate the gross proceeds of the flow-through financing to the offering of shares and the sale of tax benefits to investors. The allocation is based on the difference between the quoted price of the Company’s non-flow through shares and the amount the investor pays for the flow-through shares (given no other differences between the securities). Recognize a current liability for this difference (reflecting the premium associated with the flow-through shares). The liability is reversed ‘when tax benefits are renounced’ and a deferred tax liability is recognized at that time. Income tax expense is the difference between the amount of the deferred tax liability and the liability recognized on issuance.”
Here, I’d like to make a few observations:
- IFRS is unlikely to support the current Canadian GAAP in which equity accounts are reduced for future tax effects.
- Canadian GAAP does not support recording the deferred taxes on the basis of when the resource expenditures are incurred. U.S. GAAP is silent on this or, at least, is not specific.
- The two existing GAAPs appear to focus on the “date of renouncement” as the point in time at which the deferred taxes should be recorded. As such, they both suggest that the full deferred tax liability be recorded, even though the company is not yet in a position to deliver the tax benefits promised, since the supporting expenditures have not yet been fully incurred.
- With respect to U.S. GAAP, I believe it is conceptually sound that the premium paid by investors for the flow-through feature should be handled in a different manner than the rest of the issue’s proceeds. However, it should be acknowledged that in some flow-through financings there may be no identifiable premium.
Now let’s establish the foundations of my proposed solution
From a legal and tax perspective, it’s safe to argue that two things need to happen for a junior resource firm to reduce its flow-through expenditure commitment and deliver the promised tax benefits. Namely, it has to incur qualifying resource expenditures, and then renounce them. Doing only one or the other does not reduce the commitment and transfer the promised tax benefits. In my opinion, both existing GAAPs ignore this sentiment.
As the commitment is reduced, the deferred tax liability should be recorded, since that is proof that the company has “effectively transferred” the tax benefits to investors.
A renunciation form signed by the junior resource firm after the end of a financial statement reporting date should be considered to be an “adjusting event” as at the reporting date, if it includes resource expenditures incurred prior to the reporting date. This covers those expenditures renounced for tax purposes under the General Rule.
A renunciation form signed by the junior resource firm before a reporting date should also be considered to be an “adjusting event” as at the reporting date, if it includes resource expenditures incurred prior to the reporting date. This covers those expenditures previously renounced for tax purposes under the Look-back Rule.
IFRS talks about “events occurring after the reporting date” as either “adjusting” or “non-adjusting” events. Canadian and U.S. GAAP refer to these events as “subsequent events.”
My use of the term “adjusting event” is a little broader than the true IFRS definition of an “adjusting event,” since I am also using it to include the scenario of a renunc
iation form filed before the reporting date, which is not a “subsequent event.”
The following is my proposed solution for accounting for flow-through shares under IFRS, using U.S. GAAP as a starting basis, along with some modifications:
SIGNIFICANT ACCOUNTING POLICIES
Accounting for Flow-through Shares
The Company finances a significant portion of its exploration activities through financings in which flow-through common shares are issued. These shares transfer the tax deductibility of qualifying resource expenditures to investors. While IFRS contains no specific guidance on accounting for flow-through shares, the Company has chosen to adopt the following accounting policy.
At the time of closing a financing involving flow-through shares, the Company allocates the gross proceeds received (i.e. the “flow-through commitment”) as follows:
a) warrant reserve – if warrants are being issued, based on the valuation derived using the Black-Scholes option-pricing model;
b) flow-through share premium – recorded as a liability and equal to the estimated premium, if any, investors pay for the flow-through feature; and
c) share capital – the residual balance.
Thereafter, as qualifying resource expenditures are incurred, these costs are capitalized to exploration and evaluation assets.
At the end of each reporting period, the Company reviews its tax position and records an adjustment to its deferred tax expense/liability accounts for taxable temporary differences, including those arising from the transfer of tax benefits to investors through flow-through shares. For this adjustment, the Company considers the tax benefits of qualifying resource expenditures already incurred to have been effectively transferred, if it has formally renounced those expenditures at any time before or after the end of the reporting period. Additionally, the Company reverses the liability for the flow-through share premium to income, on a proportionate basis, as an offset to deferred tax expense.
As at Dec. 31, 2010, the Company is committed to incur, on a best efforts basis, $X in qualifying resource expenditures pursuant to a private placement for which flow-through proceeds have been received (see Note X, Capital Stock). The Company filed its renunciation forms in Feb. 2011. As at Dec. 31, 2010, the Company had incurred qualifying resource expenditures of $X. The Company must incur the $X balance of qualifying resource expenditures before January 1, 2012.
If the Company does not spend these funds in compliance with the Government of Canada flow-through regulations, it may be subject to litigation from various counterparties. The Company intends to fulfill its flow-through commitments within the given time constraints.
In applying the significant policy above, if interim financials were being prepared after a flow-through financing but before a renouncement had occurred, no deferred tax adjustment would be booked for qualifying resource expenditures incurred, the flow-through share premium would not be reduced, and the contingent liability note would be modified accordingly.
The end result is that the proposed IFRS Solution is essentially a timing variation of U.S. GAAP. As such, some users may simply choose to go with U.S. GAAP by default.
However, it is unclear that IFRS principles would support the recording of the deferred tax strictly on the basis of the date of renouncement. U.S. GAAP suggests that all deferred taxes be booked at the same time, even though not all of the required expenditures may have been incurred. Under the proposed IFRS solution, that would only happen after the entire flow-through commitment had been extinguished and all expenditures were thus incurred.
Both Canadian and U.S. GAAP focus on the “renouncement of resource expenditures by the Company” in order to record the future (IFRS: deferred) taxes. In the IFRS solution proposed here, the focus is on “the transfer of the tax benefits of resource expenditures by the Company.” Deferred taxes are recorded when the tax benefits are effectively transferred and this involves a time period, which typically crosses multiple reporting dates, and not just a single date (i.e. the date of renouncement).
It is my hope that the chief financial officers, audit committees and auditors of junior resource firms will find this article helpful in understanding the issues and in formulating an appropriate IFRS accounting policy for flow-through shares. Some may choose to adopt the solution proposed here.
Note: Visit www.inbusys.com/ifrs.asp for an expanded version of this article that includes a full working example with journal entries and sample financial statements in multiple periods, prepared under Canadian GAAP, U.S. GAAP and IFRS.
The author extends his thanks to Koko Yamamoto, C.A., of McGovern, Hurley, Cunningham LLP Chartered Accountants, for her assistance in developing the ideas presented in the article, and for her editing help.
– A chartered accountant based in Toronto, the author is president of inbusys inc., and the CFO of three TSX-Venture Exchange junior resource firms.