Commodities_Energy

Going into annual report season, investors might have expected to see more writedowns on the value of resource assets on company balance sheets. After all, from September to March, the price of Brent crude dropped 40% and WTI was off by about 50%. Further, economic conditions remain challenged for companies in the mining and energy sectors, with financial instability in Europe and questions of growth in China still lingering. But, with earnings season done, there weren’t many writedowns seen. Why?

Companies can ignore market conditions

Firms have significant leeway when estimating whether their assets have been impaired, and to what degree. In fact, companies don’t test every asset every quarter, or write down the value of their assets to current market prices. Under IFRS accounting rules, impairment testing is a two-step process. First, management considers whether there are any factors that may have caused an impairment. These are known as triggers. If management doesn’t believe that any triggers exist, then that’s the end of the process; no impaired test is even carried out, and no writedown takes place. If a trigger occurs, the second step is to calculate whether an impairment exists.

The question in this market is whether the huge drop in energy prices represents an event that could trigger asset impairments. While the common sense answer is “yes,” the accounting answer is “maybe.” This stance is one of many release valves that are built into the accounting rules. The rules usually leave room for executives to wiggle out of situations, if they desire. For instance, how could management claim that a near halving of oil prices doesn’t trigger an impairment?

Background on oil

It’s generally accepted that Saudi Arabia (through OPEC) initiated the plunge in oil prices by targeting a production level that was designed to drive high-cost producers out of the market. Specifically, many shale gas producers have caused global supply to outstrip demand in recent years. In order to drive these producers out of the market, OPEC needs to push prices down and to keep them down for as long as it takes to force companies to make structural changes that can’t be easily reversed.

Given what some regard as artificial short-term price manipulation, it’s arguable that energy prices will rise again (as soon as the market regains some balance), either through lower production or increased demand.

This belief means management can look past the current low prices, and focus on where they think energy prices will be over the longer term. To do this, companies can point to forward price curves and estimates, or contemplate stopping production until prices return to higher levels. But, when prices stay low for a long period, companies have to undertake an impairment test, which determines the recoverable amount of the asset. Then, they’ll have to write the value down to that level.

With mining and energy companies, impairments tend to occur in long-lived assets, including exploration and evaluation assets, reserves and resources, intangibles, goodwill, and even property and equipment.

One reason companies don’t like recognizing writedowns is because if the conditions that caused the impairment reverse, the accounting rules require the impairment to reverse also (except for with goodwill). For instance, if the oil price rises back to $100 a barrel, an oil company would have to reverse its writedown of a resource property. No company wants its results tossed around every quarter based on gyrations in commodity prices.

What’s the recoverable amount?

The recoverable amount is the higher of the fair value, less costs to dispose (FVLCD) or the value in use (VIU). Each quarter, companies can choose whichever measure better helps them avoid an impairment charge.

The FVLCD approach is based on comparable prices, while the VIU represents a discounted cash-flow method. In both cases, however, the rules allow management to make optimistic assumptions about the future, which can keep value estimates high enough that they don’t trigger impairments.

For instance, the FVLCD method allows management to assume restructuring or investing in an asset will cause it to rise in value. The VIU approach is even more pliable, and allows management to consider the cash flow impact of synergies, including synergies that are not available to other market participants, such as close proximity to other company-owned assets or properties. Management can also assume that it has knowledge of its own assets that the market is not aware of. In effect, management has the ability to value an asset at a much higher amount than any other entity would pay for it.

Beware of latent impairment

The IFRS accounting rules provide management with significant ability to avoid writedowns of resource assets. When companies have taken writedowns in recent years, they’ve often been for impairments to goodwill. That’s because it’s more palatable to investors than writing down resource assets, and there is no requirement to reverse the impairment in the future, which would create volatility in reported results.

Advisors should be wary of the latent impairment of resource assets that could be slowly building in the books of some energy companies. Given that some writedowns have clearly been delayed, a prolonged downturn in energy prices will eventually trigger impairment tests, and start a deluge of writedowns and red ink.

Dr. Al Rosen, Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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