Worldwide Minerals (WM) Kaplan – Lecture Note pg 259

P1
Worldwide Minerals (WM) is a large listed multinational company that deals with natural
minerals that are extracted from the ground, processed and sold to a wide range of industrial
and construction companies. In order to maintain a consistent supply of minerals into its
principal markets, an essential part of WM’s business strategy is the seeking out of new
sources and the measurement of known reserves. Investment analysts have often pointed out
that WM’s value rests principally upon the accuracy of its reserve reports as these are the best
indicators of future cash flows and earnings. In order to support this key part of its strategy,
WM has a large and well-funded geological survey department which, according to the
company website, contains ‘some of the world’s best geologists and minerals scientists’. In
its investor relations literature, the company claims that:
‘our experts search the earth for mineral reserves and once located, they are carefully
measured so that the company can always report on known reserves. This knowledge
underpins market confidence and keeps our customers supplied with the inventory they need.
You can trust our reserve reports – our reputation depends on it!’

P2
At the last board meeting, the head of the geological survey department, Ranjana Tyler,
reported that there was a problem with the latest report because one of the major reserve
figures had recently been found to be wrong. The mineral in question, mallerite, was WM’s
largest mineral in volume terms and Ranjana explained that the mallerite reserves in a deep
mine in a certain part of the world had been significantly overestimated. She explained that,
based on the interim minerals report, the stock market analysts were expecting WM to
announce known mallerite reserves of 4.8 billion tonnes. The actual figure was closer to 2.4
billion tonnes. It was agreed that this difference was sufficient to affect WM’s market value,
despite the otherwise good results for the past year.

P3
Vanda Monroe, the finance director, said that the share price reflects market confidence in
future earnings.

P4
She said that an announcement of an incorrect estimation like that for mallerite would cause a
reduction in share value. More importantly for WM itself, however, it could undermine
confidence in the geological survey department. All agreed that as this was strategically
important for the company, it was a top priority to deal with this problem.
P5
Ranjana explained how the situation had arisen. The major mallerite mine was in a country
new to WM’s operations. The WM engineer at the mine said it was difficult to deal with
some local people because, according to the engineer, ‘they didn’t like to give us bad news’.
The engineer explained that when the mine was found to be smaller than originally thought,
he was not told until it was too late to reduce the price paid for the mine. This was
embarrassing and it was agreed that it would affect market confidence in WM if it was made
public.

P6
The board discussed the options open to it. The chairman, who was also a qualified
accountant, was Tim Blake. He began by expressing serious concern about the
overestimation and then invited the board to express views freely. Gary Howells, the
operations director, said that because disclosing the error to the market would be so
damaging, it might be best to keep it a secret and hope that new reserves can be found in the
near future that will make up for the shortfall. He said that it was unlikely that this
concealment would be found out as shareholders trusted WM and they had many years of
good investor relations to draw on. Vanda Monroe, the finance director, reminded the
board that the company was bound to certain standards of truthfulness and transparency by its
stock market listing.

P7
She pointed out that they were constrained by codes of governance and ethics by the stock
market and that colleagues should be aware that WM would be in technical breach of these if
the incorrect estimation was concealed from investors. Finally, Martin Chan, the human
resources director, said that the error should be disclosed to the investors because he would
not want to be deceived if he were an outside investor in the company. He argued that
whatever the governance codes said and whatever the cost in terms of reputation and market
value, WM should admit its error and cope with whatever consequences arose. The WM
board contains three non-executive directors and their views were also invited.

P8
At the preliminary results presentation sometime later, one analyst, Christina Gonzales,
who had become aware of the mallerite problem, asked about internal audit and control
systems, and whether they were adequate in such a reserve-sensitive industry. WM’s
chairman, Tim Blake, said that he intended to write a letter to all investors and analysts in
the light of the mallerite problem which he hoped would address some of the issues that Miss
Gonzales had raised.

P9
Tim Blake has asked you, as an external consultant, to help him draft the letter.
Required:
Draft a letter for Tim Blake to send to WM’s investors to include the following:
(a) why you believe robust internal controls to be important; and
(b) proposals on how internal systems might be improved in the light of the
overestimation of mallerite at WM.
(Total: 12 marks)

Professional skills marks will be awarded for demonstrating communication skills

in constructing a persuasive document to reassure investors and analysts over the
mallerite problems. (2 marks)

(Total: 14 marks)
Answer – Letter (Format)
(a) Letter for Tim Blake to send to WM’s investors

Worldwide Minerals Plc

2045 Royal Road,
06570 St Paul,
England.

10 April 2021

Dear Investors,

Estimation of mallerite reserves

You will be aware of the importance of accurate resource valuation to

Worldwide
Minerals (WM). Unfortunately, I have to inform you that the reserve of
mallerite, one of our key minerals in a new area of exploration, was found to
have been overestimated after the purchase of a mine. It has been suggested
that this information may have an effect on shareholder value and so I thought it
will be appropriate to inform you of how the board intends to respond to the
situation.

P2L3
The mineral in question, mallerite, was WM’s largest mineral in volume terms
and Ranjana explained that the mallerite reserves in a deep mine in a certain
part of the world had been significantly overestimated.

In particular, I would like to address two issues. It has been suggested that the
overestimation arose because of issues with the internal control systems at WM.
I would firstly like to reassure you of the importance that your board places on
sound internal control systems and then I would like to highlight improvements
to internal controls that we shall be implementing to ensure that the problem
should not recur.

(a) Importance of internal control

Internal control systems are essential in all public companies and Worldwide
Minerals (WM) is no exception.
If anything, WM’s strategic position makes internal control even more
important, operating as it does in many international situations and dealing with
minerals that must be guaranteed in terms of volume, grade and quality.
Accordingly, your board recognises that internal control underpins investor
confidence.

P1L12
This knowledge underpins market confidence and keeps our customers supplied
with the inventory they need.

Investors have traditionally trusted WM’s management because they have

assumed it capable of managing its internal operations. This has, specifically,
meant becoming aware of and controlling known risks. Risks would not be
known about and managed without adequate internal control systems.

P1L9
WM has a large and well-funded geological survey department which,
according to the company website, contains ‘some of the world’s best
geologists and minerals scientists’.

Internal control, furthermore, helps to manage quality throughout the

organisation and it provides management with information on internal
operations and compliance. These features are important in ensuring quality
at all stages in the WM value chain from the extraction of minerals to the
delivery of product to our customers. Linked to this is the importance of internal
control in helping to expose and improve underperforming internal
operations. Finally, internal control systems are essential in providing
information for internal and external reporting upon which, in turn, investor
confidence rests.

(b) Proposals to improve internal systems at WM

As you may be aware, mineral estimation and measurement can be
problematic, particularly in some regions.

P5L1
The major mallerite mine was in a country new to WM’s operations. The WM
engineer at the mine said it was difficult to deal with some local people
because, according to the engineer, ‘they didn’t like to give us bad news’. The
engineer explained that when the mine was found to be smaller than originally
thought, he was not told until it was too late to reduce the price paid for the
mine.
Indeed, there are several factors that can lead to under or overestimation of
reserves valuations as a result of geological survey techniques and regional
cultural/social factors. In the case of mallerite, however, the issues that have
been brought to the board’s attention are matters of internal control and it is to
these that I would now like to turn.

In first instance, it is clear from the fact that the overestimate was made that
we will need to audit geological reports at an appropriate level in the
organisation in future.

P2L5
She (head of the geological survey department, Ranjana Tyler) explained that, based on
the interim minerals report, the stock market analysts were expecting WM to announce
known mallerite reserves of 4.8 billion tonnes. The actual figure was closer to 2.4 billion
tonnes. It was agreed that this difference was sufficient to affect WM’s market value, despite
the otherwise good results for the past year.

Once a claim has been made about a given mineral resource level, especially
one upon which investor returns might depend, appropriate systems will be
implemented to ask for and obtain evidence that such reserves have been
correctly and accurately quantified.

P1L11
‘our experts search the earth for mineral reserves and once located, they are carefully
measured so that the company can always report on known reserves. This knowledge
underpins market confidence and keeps our customers supplied with the inventory they need.
You can trust our reserve reports – our reputation depends on it!’

We will recognise that single and verbal source reports of reserve quantities
may not necessarily be accurate. This was one of the apparent causes of the
overestimation of mallerite. A system of auditing actual reserves rather than
relying on verbal evidence will rectify this.

P5L4
The engineer explained that when the mine was found to be smaller than
originally thought, he was not told until it was too late to reduce the price paid
for the mine.
The purchase of any going concern business, such as the mallerite mine, is
subject to due diligence. WM will be examining its procedures in this area to
ensure that they are fit for purpose in the way that they may not have been in
respect of the purchase of the mallerite mine. I will be taking all appropriate
steps to ensure that all of these internal control issues can be addressed in
future.

Thank you for your continued support of Worldwide Minerals and I hope the
foregoing goes some way to reassure you that the company places the highest
value on its investors and their loyalty.

Yours faithfully,
Tim Blake – Chairman