Recent headlines have asked questions about when a company should recognize impairment of its assets as part of its accounting for oil and gas properties under ASC Topic 932, Extractive Activities – Oil and Gas and ASC Topic 360, Property, Plant and Equipment. Regulators pointed out that most major oil companies have incurred impairment write-downs, and the New York attorney general inquired into why some did not.
The situation brings renewed focus to accounting for impairment for Exploration and Production (E&P) companies. Regulators like the Securities and Exchange Commission (SEC) monitor impairment accounting practices closely because ASC Topic 360 involves estimation and assumptions about price changes and other matters.
In light of the recent attention paid to impairment accounting, companies should evaluate their own practices to ensure they meet the applicable standards.
When Do Oil and Gas Companies Test for Impairment?
Oil, natural gas and other energy reserves are considered long-lived assets for accounting purposes. Companies are required to perform impairment testing on a periodic basis or when events or changes in circumstances occur that indicate the carrying amount may not be recoverable. Most companies have a policy that spells out the types of occurrences that would trigger impairment consideration, such as changes in crude oil prices, the effects of inflation and technology improvements on operating expenses, the outlook for global or regional market supply-and-demand and numerous other matters. Under ASC Topic 932, companies can use one of two methods to account for their oil and operations: the successful-efforts method or the full-cost method. The successful efforts method differs from the full-cost method when it comes to accounting for successful and unsuccessful oil and gas drilling activities and its oil and gas reserves. Most oil and gas companies utilize the successful-efforts method of accounting. As such, the successful-efforts method will be the focus of this high-level discussion.
How the Successful-Efforts Impairment Method Works
The successful-efforts method requires entities to group their assets by type: proved or unproved properties. Proved properties are required to be tested for impairment when events or circumstances indicate the carrying amount may not be recoverable, however, many companies choose to test them annually in conjunction with the receipt of an annual reserve report. Proved properties contain estimated quantities of oil and gas that geoscience and engineering data demonstrate with reasonable certainty to be economically producible in the future under existing economic conditions, operating methods and government regulations, also referred to as proved reserves. The impairment test for proved properties considers developed and undeveloped reserves, including a risk-adjusted measurement of probable and possible reserves. Unproved properties must be assessed for impairment on a periodic basis, at least annually, to determine if they have been impaired. Entities generally group proved properties together on a field-by-field basis. Unproved properties are typically done on a property-by-property basis.
The reporting entity then evaluates each asset group for impairment using the two-step approach under ASC Topic 360. First, the entity evaluates the estimated fair value using its annual reserve report and other information and evaluates how its asset group's undiscounted cash flows compare to the asset group's carrying value. If the undiscounted cash flows are less than the asset group's carrying amount, the assets are likely impaired. The entity would then proceed to step two of the impairment test.
In step two, a fair value assessment of the asset group is performed. There are three methods for determining the fair value of their asset groups: the income approach, the market approach and the cost approach. Most companies use the income approach, which converts future cash flows or earnings to a single present amount, typically utilizing a discounted cash flow model. The income method can be difficult in practice because it involves significant assumptions about future expected performance. These assumptions include cash flow projections, pricing differentials, discount rate, risk factors and the tax effect.
Many smaller companies use third parties to prepare the future cash flow information because the underlying assumptions in the future cash flow analysis tend to be a focal point for auditors and regulators due to the subjectivity involved.
Entities compare the fair value to the asset group's carrying amount. If the fair value of the asset group is less than the carrying value, companies would write down the carrying value and recognize an impairment loss on those assets. The loss is allocated to proved properties on a pro-rata basis to the group of assets so long as the loss would not reduce the carrying amount of an individual asset below the fair value, if the fair value for the individual asset is known or reasonably determinable. For unproved properties, companies use qualitative factors and recognize the loss with a valuation allowance.
Are Write-Downs Always Necessary?
In most cases, write-downs occur when oil and gas reserves cannot be extracted economically, such as on properties where drilling hasn't started or where properties were expected to be developed based on significantly higher oil prices than are currently estimated. If the price for oil and gas drops too low, the cost to begin drilling or develop the properties may outweigh the revenue the product would generate in the market. Proved reserves where extraction is already occurring are less likely to have impairment unless the costs to develop the field were high and will not be recovered through the current expected price of the oil and gas to be produced. Major oil companies have efficiencies in place to extract the oil, so the cost of production may be low enough to withstand fluctuations in oil and natural gas prices. However, most companies have recorded significant impairment charges over the past years for both proved and unproved properties.
Whether your company has recently taken an impairment write-down, it should be prepared to defend its position. Although most companies use the income approach to determine their fair value, regulators and auditors may also look at the market approach in determining fair value of the oil and gas properties. They will also be looking at the accounting practices of other companies and questioning why there are differences in the policies that your company follows, which is what triggered recent headlines.
To address scrutiny, companies with products with volatile market prices need to take a careful approach to impairment accounting. Be sure that the assumptions that you are using as part of our impairment analysis are based on reliable data, and be prepared to discuss why you have or have not taken write-downs on certain assets.
For more information about accounting for impairment, please contact Rick Angell of MHM's Professional Standards Group. Rick can be reached at email@example.com or 720.200.7051.
Published on October 18, 2016