CA Garima Mittal
In this article, author attempts to highlight the IFRS importance and its few impacts on Oil & Gas sector. A closer look at IFRS requires in depth discussion, however this article is written for giving readers the basic overview and hence is not an exhaustive view for taking any opinion. For any queries, author can be reached at firstname.lastname@example.org .
International Financial Reporting standards (IFRS) are a set of accounting standards developed by the International Accounting Standard Board (IASB). IFRS is based more on principles when compared with US GAAP which is more rule based standard. One of the reasons for adapting to IFRS is the need for a business to present its financial statements on the same basis as its foreign competitors in order to make comparisons easier. IFRS is inevitable and will be the final destination for public companies in the U.S. and for most companies around the globe. Hence, it is very crucial to understand the impact of IFRS.
IASB and FASB jointly issued in May 2014 IFRS 15 “Revenue from contract with Customers” which will replace the existing IFRS revenue guidance. The new standard takes effect in January 2017 for calendar year companies though IFRS preparers can choose to apply it earlier.
IFRS 15 excludes from its scope contract with a collaborator or a partner that are not customers.
Five steps approach the entity need to apply when determining the timing and the amount of revenue recognition:
Entities are required to provide disclose about amount, timing and uncertainty of revenue (and related cash flows) from contracts with customers and the judgments (including if change in judgement) used in applying the revenue model.
Challenges: It may be challenging for Oil & Gas companies to determine whether counterparties to contracts are collaborators or customers due to its entering into complex arrangements. Performance obligation identification of upstream, midstream & downstream contracts may be complex. Oil & Gas entities need to evaluate accounting for certain arrangements including commodity exchange arrangements, production imbalances, take or pay arrangements, drilling contracts etc. in light of new revenue recognition standard, i.e., Oil & Gas entities need to assess importantly whether refining or processing counterparty meets the definition of customer or not.
Under US GAAP companies can apply LIFO rules to their inventory balances, application of which lead to higher cost of sales and thus reduce taxable income. LIFO method is very useful in saving tax in period of rising commodity prices. However, IFRS does not permitted LIFO accounting, which in turn require the companies a need to recast recorded inventory balances under weighted average or FIFO rules for financial reporting purpose.
Exploration and Evaluation Assets
IFRS 6 applies to Exploration and Evaluation expenditure.
Exploration and evaluation expenditure are those costs that are incurred by oil & gas companies in connection with the exploration for and evaluation of mineral resources before the technical feasibility and the prospect of extracting a commercially viable quality of oil, natural gas and similar non-regenerative resources are established. Exploration is a risky and complex activity.
Exploration and evaluation cost are categorized into pre-exploration costs, exploration and evaluation costs and development costs. IFRS 6 excludes pre-licence expenditure from the scope of Exploration and evaluation cost. However, IFRS does not define the accounting methods: the successful efforts method or full cost method for exploration and evaluation activities which was defined under US GAAP. Please note: The most significant difference between the two methods relates to the accounting treatment of drilling costs for unsuccessful exploration cost. Full cost method capitalizes both successful & unsuccessful efforts, however successful effort method capitalizes only the cost of successful activities.
IFRS 1 (First time adoption of IFRS) assist oil & gas companies in preparing their first IFRS financial statements by allowing them to measure exploration and evaluation assets at the amount determined under previous GAAP at the date of transition to IFRS. IFRS 6 relaxes the asset recognition requirement and allows the capitalization of exploration and evaluation costs by expenditure class.
Both IFRS and US GAAP require firms to write down impaired assets by recognizing a loss in income statements.
Under US GAAP, determining the impairment and calculating the loss potentially involves two steps. Firstly, carrying value of asset is compared with the undiscounted value of expected future cash flows to be generated from asset. Secondly, when the carrying amount is higher, the asset is written down to fair value.
Under IFRS, asset is impaired when its carrying value (original cost less accumulated depreciation) exceeds the recoverable amount.
The difference approach of calculations for impairment under US GAAP and IFRS leads to the effect that impairment may be recorded earlier under IFRS.
Reversal of impairment loss permitted under IFRS if external or internal indicators no longer exist or have decreased. However, US GAAP does not allow the reversal of impairment loss.
IFRS 11 prescribes the accounting for joint arrangement.
Joint arrangement is the contractual arrangement which gives two or more of those parties joint control of the arrangement. Joint arrangements are classified under two types: Joint operation and joint venture.
How this IFRS could impact Oil & Gas sector? Projects within oil & gas industry sometimes undertaken by many parties, with one party being designated as the “operator” who has the responsibility of running the project on a day to day basis. Contract need to be reviewed to determine whether the operator is a principle (having control) or an agent for the correct application of IFRS.
Depletion, Depreciation & Amortization (including componentization)
What do you mean by the three terms “depletion, depreciation & amortization”? Depletion is the actual physical depletion of natural resource by a company. Depreciation is the means of allocating the cost of material assets over its useful life. Amortization is the deduction of capital expenses over a specified time period, for example, tangible non drilling cost sustained while developing the reserves.
IFRS requires the firm to depreciate the component of an asset separately, thereby requiring the useful life estimates for each component. Under component depreciation, useful life of each component is estimated and depreciation expense is computed separately for each. However, component accounting is seldom used under US GAAP.
The determination of what constitutes a component starts with individual assets and should be based on discussions with operations personnel familiar with design, construction and maintenance of the asset. Further, identification of number of components having different useful lives is a complex and time consuming process. Large oil & gas companies have installations containing many components; few examples are like offshore platforms, pipelines etc.
There is no preferable depreciation method under IFRS; companies need to choose the most appropriate method. Oil & Gas companies have the option to choose SLM, reducing balance or unit of production method as long as it reflects the pattern in which economic benefits associated with the asset are consumed. Unit of production method is most commonly used to deplete upstream oil & gas assets.