IAS 36 goodwill impairment review, fvlcd basis, oil price and other assumptions, oil company

BP p.l.c. – Annual report – 31 December 2016

Industry: oil and gas

  1. Significant accounting policies, judgements, estimates and assumptions (extract)

Impairment of property, plant and equipment, intangible assets, and goodwill

The group assesses assets or groups of assets, called cash-generating units (CGUs), for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or CGU may not be recoverable; for example, changes in the group’s business plans, changes in the group’s assumptions about commodity prices, low plant utilization, evidence of physical damage or, for oil and gas assets, significant downward revisions of estimated reserves or increases in estimated future development expenditure or decommissioning costs. If any such indication of impairment exists, the group makes an estimate of the asset’s or CGU’s recoverable amount. Individual assets are grouped into CGUs for impairment assessment purposes at the lowest level at which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets. A CGU’s recoverable amount is the higher of its fair value less costs of disposal and its value in use. Where the carrying amount of a CGU exceeds its recoverable amount, the CGU is considered impaired and is written down to its recoverable amount.

The business segment plans, which are approved on an annual basis by senior management, are the primary source of information for the determination of value in use. They contain forecasts for oil and natural gas production, refinery throughputs, sales volumes for various types of refined products (e.g. gasoline and lubricants), revenues, costs and capital expenditure. As an initial step in the preparation of these plans, various assumptions regarding market conditions, such as oil prices, natural gas prices, refining margins, refined product margins and cost inflation rates are set by senior management. These assumptions take account of existing prices, global supply-demand equilibrium for oil and natural gas, other macroeconomic factors and historical trends and variability. In assessing value in use, the estimated future cash flows are adjusted for the risks specific to the asset group and are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money.

Fair value less costs of disposal is the price that would be received to sell the asset in an orderly transaction between market participants and does not reflect the effects of factors that may be specific to the group and not applicable to entities in general.

An assessment is made at each reporting date as to whether there is any indication that previously recognized impairment losses may no longer exist or may have decreased. If such an indication exists, the recoverable amount is estimated. A previously recognized impairment loss is reversed only if there has been a change in the estimates used to determine the asset’s recoverable amount since the last impairment loss was recognized. If that is the case, the carrying amount of the asset is increased to the lower of its recoverable amount and the carrying amount that would have been determined, net of depreciation, had no impairment loss been recognized for the asset in prior years. Impairment reversals are recognized in profit or loss. After a reversal, the depreciation charge is adjusted in future periods to allocate the asset’s revised carrying amount, less any residual value, on a systematic basis over its remaining useful life.

Goodwill is reviewed for impairment annually or more frequently if events or changes in circumstances indicate the recoverable amount of the group of CGUs to which the goodwill relates should be assessed. In assessing whether goodwill has been impaired, the carrying amount of the group of CGUs to which goodwill has been allocated is compared with its recoverable amount. Where the recoverable amount of the group of CGUs is less than the carrying amount (including goodwill), an impairment loss is recognized. An impairment loss recognized for goodwill is not reversed in a subsequent period.

Significant judgements and estimates: recoverability of asset carrying values

Determination as to whether, and by how much, an asset, CGU, or group of CGUs containing goodwill is impaired involves management estimates on highly uncertain matters such as the effects of inflation and deflation on operating expenses, discount rates, production profiles, reserves and resources, and future commodity prices, including the outlook for global or regional market supply-and-demand conditions for crude oil, natural gas and refined products. Judgement is required when determining the appropriate grouping of assets into a CGU or the appropriate grouping of CGUs for impairment testing purposes. See Note 13 for details on how these groupings have been determined in relation to the impairment testing of goodwill.

As disclosed above, the recoverable amount of an asset is the higher of its value in use and its fair value less costs of disposal. Fair value less costs of disposal may be determined based on similar recent market transaction data or, where recent market transactions for the asset are not available for reference, using discounted cash flow techniques. Where discounted cash flow analyses are used to calculate fair value less costs of disposal, accounting judgements are made about the assumptions market participants would use when pricing the asset, CGU or group of CGUs containing goodwill and the test is performed on a post-tax basis.

Irrespective of whether there is any indication of impairment, BP is required to test annually for impairment of goodwill acquired in business combinations. The group carries goodwill of pproximately $11.2 billion on its balance sheet (2015 $11.6 billion), principally relating to the Atlantic Richfield, Burmah Castrol, Devon Energy and Reliance transactions. In testing goodwill for impairment, the group uses the approach described above to determine recoverable amount. If there are low oil or natural gas prices for an extended period, the group may need to recognize goodwill impairment charges.

Details of impairment charges and reversals recognized in the income statement are provided in Note 4 and details on the carrying amounts of assets are shown in Note 11, Note 13 and Note 14.

Specific judgements and estimates made in impairment tests in 2016 relating to discount rates, oil and gas properties and oil and gas prices are discussed below.

Discount rates

For value-in-use calculations, future cash flows are adjusted for risks specific to the cash-generating unit and are discounted using a pre-tax discount rate. The pre-tax discount rate is based upon the cost of funding the group derived from an established model, adjusted to a pre-tax basis. Fair value less costs of disposal calculations use the post-tax discount rate.

The discount rates applied in impairment tests are reassessed each year. In 2016 the discount rate used to determine recoverable amounts based on fair value less costs of disposal was revised to 6% (2015 7%). The discount rate used to determine recoverable amounts based on value in use was revised to 9% (2015 11%). In both cases, where the cash-generating unit is located in a country which is judged to be higher risk an additional 2% premium was added to the discount rate (2015 2%).

Oil and natural gas properties

For oil and natural gas properties, expected future cash flows are estimated using management’s best estimate of future oil and natural gas prices and production and reserves volumes. The estimated future level of production in all impairment tests is based on assumptions about future commodity prices, production and development costs, field decline rates, current fiscal regimes and other factors.

Reserves assumptions for value-in-use tests are restricted to proved and probable reserves.

When estimating the fair value of our Upstream assets, assumptions reflect all reserves and resources that a market participant would consider when valuing the asset, which in some cases are broader in scope than the reserves used in a value-in-use test. In determining a fair value, risk factors may be applied to reserves and resources which do not meet the criteria to be treated as proved. Depending upon the classification of the reserves and resources, this can result in associated forecast cash flows being reduced by a factor of between 10% and 90% from their estimated full potential value. Changing the risk factor applied will in some cases have an impact upon the carrying value of the asset concerned. A 10% increase in the risk factors used in any single test could have an impact of up to $0.4 billion upon the carrying value of that asset.

The recoverability of intangible exploration and appraisal expenditure is covered under Oil and natural gas exploration, appraisal and development expenditure above.

Oil and gas prices

During the third quarter of 2016, the price assumptions used in impairment tests were revised.

The long-term price assumptions used to determine recoverable amount based on fair value less costs of disposal from 2022 onwards are derived from $75 per barrel for Brent and $4/mmBtu for Henry Hub (both in 2015 prices) inflated for the remaining life of the asset. For 2015 the equivalent values were $80 per barrel for Brent and $5/mmBtu for Henry Hub. To determine recoverable amount based on value in use, the price assumptions were inflated to 2022 but from 2022 onwards were not inflated.

For both value-in-use and fair value less costs of disposal impairment tests, the price assumptions used for the five-year period to 2021 have been set such that there is a gradual transition from current market prices to the long-term price assumptions as noted above. For 2015, market prices were used for the first five years ranging from $40 per barrel for Brent and $2.38/mmBtu for Henry Hub in 2016 to $56 per barrel for Brent and $3.18/mmBtu in 2020. Prices used this year were revised due to a lack of liquidity in the market beyond the very near term.

Current market prices for oil reflect the elevated level of oil stocks following strong growth in US shale and OPEC production volumes in recent years. US production fell during 2016 in response to lower prices and, towards the end of the year, OPEC and a number of non-OPEC countries announced an agreement to reduce production volumes. BP’s long-term assumption for oil is higher than current market prices because prices are expected to increase as the current record level of oil inventories is gradually unwound, underpinned by solid demand growth and muted increases in supply.

US gas prices have fallen back recently in response to the unusually mild winter. BP’s long-term price assumption for US gas is higher than current market prices because we expect demand for US gas to grow with increased exports of liquefied natural gas (LNG), underpinned by strong growth in the global demand for gas. We expect natural gas to be the fastest growing fossil fuel over the next 20 years, supported by increasing environmental regulation encouraging a switch from coal to cleaner, lower carbon fuels including gas, as well as renewables.

  1. Goodwill and impairment review of goodwill

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Goodwill acquired through business combinations has been allocated to groups of cash-generating units that are expected to benefit from the synergies of the acquisition. For Upstream, goodwill is allocated to all oil and gas assets in aggregate at the segment level. For Downstream, goodwill has been allocated to Lubricants and Other.

For information on significant estimates and judgements made in relation to impairments see Impairment of property, plant and equipment, intangibles and goodwill within Note 1.

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The table above shows the carrying amount of goodwill for the segment at year-end and the excess of the recoverable amount, based upon a fair value less costs of disposal calculation, over the carrying amount (the headroom) at the date of the test.

The fair value less costs of disposal is based on the cash flows expected to be generated by the projected oil or natural gas production profiles up to the expected dates of cessation of production of each producing field, based on current estimates of reserves and resources, appropriately risked for the purposes of goodwill impairment testing. Midstream and supply and trading activities and equity-accounted entities are generally not included in the impairment review of goodwill, because they are not part of the grouping of cash-generating units to which the goodwill relates and which is used to monitor the goodwill for internal management purposes. Where such activities form part of a wider Upstream cash-generating unit, they are reflected in the test. The fair value calculation is based primarily on level 3 inputs as defined by the IFRS 13 ‘Fair value measurement’ hierarchy. As the production profile and related cash flows can be estimated from BP’s experience, management believes that the estimated cash flows expected to be generated over the life of each field is the appropriate basis upon which to assess goodwill for impairment. The estimated date of cessation of production depends on the interaction of a number of variables, such as the recoverable quantities of hydrocarbons, the production profile of the hydrocarbons, the cost of the development of the infrastructure necessary to recover the hydrocarbons, production costs, the contractual duration of the production concession and the selling price of the hydrocarbons produced. As each producing field has specific reservoir characteristics and economic circumstances, the cash flows of the fields are computed using appropriate individual economic models and key assumptions agreed by BP management. Capital expenditure, operating costs and expected hydrocarbon production profiles are derived from the business segment plan. Estimated production volumes and cash flows up to the date of cessation of production on a field-by-field basis are developed to be consistent with this. The production profiles used are consistent with the reserve and resource volumes approved as part of BP’s centrally controlled process for the estimation of proved and probable reserves and total resources. Intangible assets are deemed to have a recoverable amount equal to their carrying amount.

The 2016 review for impairment was carried out during the third quarter following the change in price assumptions and discount rate as disclosed in Note 1. In prior years the review was carried out during the fourth quarter. In the absence of any indicators of impairment in other quarters, the review will be carried out in the third quarter in future years. The key assumptions used in the fair value less costs of disposal calculation are oil and natural gas prices, production volumes and the discount rate. Price assumptions and discount rate assumptions used were as disclosed in Note 1. The fair value less costs of disposal calculations have been prepared solely for the purposes of determining whether the goodwill balance was impaired. Estimated future cash flows were prepared on the basis of certain assumptions prevailing at the time of the test. The actual outcomes may differ from the assumptions made. For example, reserves and resources estimates and production forecasts are subject to revision as further technical information becomes available and economic conditions change, and future commodity prices may differ from the forecasts used in the calculations.

The sensitivities to different variables have been estimated using certain simplifying assumptions. For example, lower oil and gas price sensitivities do not reflect the specific impacts for each contractual arrangement and will not capture fully any favourable impacts that may arise from cost deflation. Therefore a detailed calculation at any given price or production profile may produce a different result.

It is estimated that if the oil price assumption for all future years (the first five years, and the long-term assumption from 2022 onwards) was approximately $13 per barrel lower in each year, this would cause the recoverable amount to be equal to the carrying amount of goodwill and related net non-current assets of the segment. It is estimated that if the gas price assumption for all future years was approximately $2 per mmBtu lower in each year, this would cause the recoverable amount to be equal to the carrying amount of goodwill and related net non-current assets of the segment.

Estimated production volumes are based on detailed data for each field and take into account development plans agreed by management as part of the long-term planning process. The average production for the purposes of goodwill impairment testing over the next 15 years is 889mmboe per year (2015 911mmboe per year). It is estimated that if production volume were to be reduced by approximately 4% for this period, this would cause the recoverable amount to be equal to the carrying amount of goodwill and related net non-current assets of the segment.

It is estimated that if the post-tax discount rate was approximately 9% for the entire portfolio, an increase of 3% for all countries not considered ‘higher risk’ and 1% for countries considered ‘higher risk’, this would cause the recoverable amount to be equal to the carrying amount of goodwill and related net non-current assets of the segment.

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Cash flows for each cash-generating unit are derived from the business segment plans, which cover a period of two to five years. To determine the value in use for each of the cash-generating units, cash flows for a period of 10 years are discounted and aggregated with a terminal value.

Lubricants

As permitted by IAS 36, the detailed calculations of Lubricants’ recoverable amount performed in the most recent detailed calculation in 2013 were used for the 2016 impairment test as the criteria in that standard were considered satisfied: the headroom was substantial in 2013; there have been no significant changes in the assets and liabilities; and the likelihood that the recoverable amount would be less than the carrying amount at the time was remote.

The key assumptions to which the calculation of value in use for the Lubricants unit is most sensitive are operating unit margins, sales volumes, and discount rate. The values assigned to these key assumptions reflect BP’s experience. No reasonably possible change in any of these key assumptions would cause the unit’s carrying amount to exceed its recoverable amount. Cash flows beyond the two-year plan period were extrapolated using a nominal 3% growth rate.

 

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