D Murali
Even as the field personnel of oil and gas (O&G) companies continue to battle with many complexities to get us the fuel, their accounting colleagues are toiling with a different difficulty: how to apply the Accounting Standard on asset impairment.
“The requirements of the standard create many complications for companies in the O&G sector, not the least of which is the application of the CGU (cash generating unit) concept,” says Mr Sandeep Sharma, a Senior Professional in a member firm of Ernst & Young Global. “Given that each operation is unique, it may be some time before a clear industry practice is established.”
While the requirements of IAS (International Accounting Standard) 36, and more recently AS 28 (of the Institute of Chartered Accountants of India) on impairment of assets have endeavoured to clarify general ambiguities and provided direction in this matter, the finer points are yet to be understood and documented in the form of a complete accounting policy, adds Mr Sharma, during a recent interaction with Business Line. “Most of the O&G companies mention basic facts in their impairment accounting policy but report no more than the explicit requirements of AS.”
Excerpts from an email interview.
What is asset impairment?
A dreaded phrase in accounting parlance! In layman terms, an asset is considered impaired when its book value becomes irrecoverable, either through its use or sale. With the world today, run by fossil fuels as it is, one would think that the risk of impairment of O&G assets would be minimal if not ‘zero’.
Why then should we be talking about ‘impairment’ issue in O&G?
Because, surprisingly some companies have recognised huge impairment losses upon the introduction of IAS 36, wiping millions of dollars from their balance sheets. This, despite there being relatively low risk of impairment triggers requiring testing for many assets, given pervasive high oil prices.
Interestingly, in most cases, it is not explicitly disclosed as to how CGUs are defined! Historically, with little guidance on the table for this broad principle, its application would be taken only by boldest of accountants, with measured steps. The basic premise of impairment testing is that each individual asset must be tested. Perhaps the biggest practical difficulty in application of the standard is the determination of the CGU.
How is CGU explained in the standard?
AS 28 introduces the concept of a CGU as “the smallest identifiable group of assets that generates cash inflows from continuing use that are largely independent of the cash inflows from other assets or groups of assets.” But the application of CGU concept to the O&G sector is not straightforward and may prove troublesome.
Why so?
An O&G operation normally consists of extraction, processing, transportation, distribution and corporate assets (or some combination thereof). It is reasonable to conclude that the entire production field is a single CGU as it normally takes the interaction of all assets to generate cash inflows. However, as we vary the circumstances we may find that this default position may not be applicable.
For example?
Say, what if there is an active market for intermediate products? Or there are external users of the processing assets? Does this mean that the processing assets are now independent of the extraction assets? Or what if several fields owned by an entity are operated as one “complex” through the use of shared infrastructure? Or, where the fields, each with its own infrastructure, are managed on a ‘portfolio’ basis?
What happens then?
In these situations, the CGU assessment may be larger or smaller than an individual field. A company with loss-making field facing impairment testing could avoid recognising losses simply by demonstrating the field to be subset of a larger CGU. In such a scenario, it would be prudent to delve a little deeper and identify other contributing factors.
Other factors?
For instance, if the field has little remaining reserves, or reserves that can only be produced for marginal cash flows, can it be concluded that an entity will extract greater value from continuing to produce rather than selling? If not, then the field should not be included in a larger CGU.
Any other worries that O&G accountants face with regard to the AS?
Another challenge is faced when determining the ‘recoverable amount’ to be compared with the asset’s book value. The standard defines recoverable amount as the higher of ‘value in use’ and ‘net selling price’. Value in use (VIU) is determined using a discounted cash flow method.
Sounds simple enough. Are there VIU knots, in your view?
Yes, there are many complexities, as follows:
The standard does not allow the impact of future enhancements in the assets performance, such as an asset expansion, to be included in the analysis. This may have a significant impact on relatively new assets. For the VIU calculation, AS 28 requires foreign currency cash flows to be translated based on exchange rate at the balance sheet date. This will mean that the VIU will fluctuate with movements in the exchange rate. This is inconsistent with most companies’ internal DCF (discounted cash flow) models, which normally apply long-term exchange rate assumptions. Which discount rate should be used for upstream assets? The starting point should be company’s weighted average cost of capital, adjusted with risks of the asset being tested for impairment.
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