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Accounting in the energy sector

—an auditor’s view
Published: 
Thursday, April 20, 2017

Besides other well-documented threats brought about by the current economic climate and the low price of oil, many energy companies face the threat of impairment. For the benefit of non-accountants who may be users of the financial statements of energy entities, it is useful to describe in simple language some of the forces at play regarding this issue from the perspective of an auditor, our bespectacled friends in their crispy white shirts, who are the custodians of public trust.

In the energy sector, the main areas with impairment issues are property, plant and equipment (PPE), goodwill and receivables.

In simple language, an asset is impaired when the value to be derived from it is less than the amount at which is recorded in the financial statements. The following examples help to illustrate what impairment means.

Let’s say that an entity spent $10m to construct a plant. The plant has technical issues and is unable to operate as intended or it cannot get the raw material (natural gas) it needs to operate.

Further, the plant cannot readily be sold in whole or in parts. Its carrying amount of $10m may not be able to be realised in the future. The plant may be impaired and its value would need to be adjusted downwards.

Here’s another scenario.

Company A purchased Company B for $5m. Company B’s net worth at the time of purchase was $3m. Company A paid $2m more for Company B because it expected growth and profits. One year later, Company B went bankrupt and its assets were sold off for $3m. One can see clearly the loss of value, which is an impairment.

In example three, an entity has trade receivables from a customer who is known to be facing financial challenges. The receivables are unsecured, long overdue, and current sales to the customer are not on credit. Calls to the customer go unanswered and several deadlines by the customer to settle have passed. Clearly, there are doubts about the debts owed, and an impairment is on the cards.

Many entities in T&T prepare their financial statements under International Financial Reporting Standards (IFRS), which include all IFRSs and their predecessor standards, International Accounting Standards (IASs). The process of quantifying impairment charges is probably too technical to explain here quickly and simply, but it’s not an exact science. It involves making assumptions.

In most cases, except for revaluations, impairment charges hurt financial results, ie, they are an expense.

Impairments are generally bad news. They can raise eyebrows (and blood pressure) of management, shareholders, investors, bankers and analysts. So management may potentially be inclined to want to minimise its impact, and since independent external auditor needs to ensure the entity’s financial statements comply with the relevant IFRS requirements, this has often resulted battles between auditors and clients.

But it’s worth remembering that the impairment standard was created to avoid overstatement of an entity’s assets. This is of paramount importance and the main driver is to ensure the financial statements are not misleading. Also, since impairment assessments involve the use of estimates and assumptions, management who prepare impairment assessments need to ensure that those are reasonable and supportable.

Auditors need to apply appropriate levels of professional skepticism in auditing impairment assessments. They must challenge their clients in a respectful manner. This process has the potential to become adversarial, so it needs to be carefully managed. Pens can seem like swords; laptops can look like shields.

In some cases, in their effort to be independent and unbiased, the positions taken by auditors could end up being too rigid, so auditors must be also able to listen to their clients’ views, whilst maintaining their objectivity.

If circumstances change in the future, impairment losses can be reversed. So, there may be a silver lining and management should not think that impairments are the end of the world.

In T&T, depending on the items involved, impairment charges have varying treatments as regards tax deductibility. This subject is wide ranging and a lot more can be written.

As Trinidadians we are blessed (and some may say cursed) with the natural energy resources of oil and gas. The prices of these commodities and their downstream counterparts such as petrochemicals have been depressed for the last few years and this is forecast to continue in the short to medium term.

The low-price environment in the energy sector means lower returns for energy businesses. In accounting terms, this means that an entity’s assets may no longer be able to deliver the value anticipated in earlier times.

 

Wendell Ramoutar is an auditor, and ACCA’s international assembly representative for T&T

ACCA