05PWC0875 IFRS 06.12.2005 15:42 Uhr Seite 1 Challenge* · *connectedthinking International...

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International Financial Reporting Standardsfor the Oil & Gas and Utility Industries

ImplementationChallenge*

05PWC0875_IFRS 06.12.2005 15:42 Uhr Seite 1

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EU listed companies generally have had to preparetheir financial statements in compliance withInternational Financial Reporting Standards (IFRS)since the beginning of 2005. Many other countries,such as Australia, are also choosing to adopt IFRS astheir national regulatory bodies move to converge withthe standards. With the experience of IFRS becomingreal and widespread, we brought together over 80participants from 14 different countries and 23 oil, gasand utility companies to discuss the challenges,lessons and dilemmas of implementing IFRS withintheir businesses.

The roundtable event, held in Autumn 2005, came soonafter some of the companies had published their firstinterim information under IFRS. Others were furtherdown the IFRS road, having adopted the standards inprevious years. For all of them the decisions anddifficulties around applying IFRS are immediate andreal. The task of interpreting and applying IFRS in thecontext of their own companies and industries isespecially demanding at the point of first-timeadoption, but is also a continual challenge rather than a one-off. This report highlights both the leadingthemes and the specific issues that these companiesare grappling with as they use IFRS in the oil, gas and utility sector.


challenge

Implementation Challenge*

The IFRS journey: the view from roundtable participants 2

Inside the energy sector 4Shared issuesEmission rightsIFRIC 4Income statement presentation

Oil and Gas 8IFRS 6: how much shelter?Impairment and cash generating unitsOverlift and underliftJointly controlled assets, operations and entitiesProduction sharing contracts

Utilities 12IAS 39: executory contracts, embedded derivatives and hedgingCash generating unitsComponent approach

Looking ahead 14

Contact us 15


The IFRS journey: the view fromroundtable participants A big question for companies is where the currentstandards journey is leading us. Everyone shared thegoals of improved comparability, decision-usefulness,and understanding. As one participant from a largemulti-utility company put it: “IFRS is close to our basicbelief about how we want to present ourselves.Transparency to investors is better than it was in thepast. IFRS should not be seen as the negative that it isoften portrayed as in the press today. It has increasedcomparability globally and that is very important in thisindustry.” However, views were more mixed on whetherachievement of these goals is moving nearer in all areasor remains distant. The same IFRS practitioner said: “Weare seeing some distressing trends that are going to becritical for preparers and users.”

Worries about complexity

Oil, gas and utility companies alike expressed concernsabout increasing complexity and, alongside this, therisks of decreased reliability and understandability. AVice-President of one company wryly observed:“Changes in standards are getting more frequent. IFRS3, for example, is important but it is difficult even tohave enough time for people to read the statement.Indeed, I suspect IAS 39 is only understood by 1% ofthe accounting profession. We are losing the audience.It is becoming too complex.”

The importance of looking hard at the underlyingpurpose and framework driving the standards wasemphasised by some speakers. The Group Controller ofa leading oil and gas company pointed out: “Accountingstandards have changed quite quickly but now peopleare realising there can be problems with unexpectedeffects on financial indicators and apparentinconsistencies with the framework. It should be theother way round, there needs to be more attention tothe driving purpose of reporting.” Another participantechoed this: “Sometimes the solution is looking for aproblem to solve.”

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“we are seeing some distressing trends”*

*quotes from oil & gas and utility participants in the roundtable


Impact on companies

While there was little doubt that the IFRS journey wasraising difficulties of interpretation and anxieties aboutincreasing complexity, the actual impact withincompanies and on their reported figures was morepositive. In many respects, the larger the company, themore containable is the impact. However, while thescale of adjustment may not be particularly large, thethought and effort that needs to go into it can be quitebig. For one major oil and gas company, the transitionhas had only a marginal impact on the financial figures.In contrast, an early IFRS adopter in the utility sector,whose transition had coincided with utility marketliberalisation, reported: “The financial implications werehuge. The most challenging things looking back werethe nuclear and mining waste and environmentalrestoration provisions, interpreting issues that nobodyhad discussed before, with no real precedents aroundthe world. We had to book prior year adjustments,rethink equity accounting and consider how toharmonise internal and external reporting. The volume ofour footnote disclosures increased by 50%.”

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Addressing the uncertainties

The importance of moving now to reduce complexitieswas stressed time and time again: “If we don’t solve theuncertainties then there is a big challenge for the future.”The importance of resolving fundamental worries wasgiven extra emphasis by concerns about the dangers ofgeographical divergence in the IFRS family. “Manycountries are using IFRS but not all have adoptedwithout modification and we are seeing the rise of ‘local’IFRS. It would be good to see the IASB and IFRIC asthe single interpreting bodies but that would be difficultfor countries to accept, not least the US.”

Maintaining a focus on what investors and the capitalmarkets require was viewed as a fundamental part ofthe way forward. One participant put it: “Changes instandards need to be driven by their potential to giveuseful information to the marketplace, and I worry thatthat need is not being met. I can’t see, for example, howBC2 (Phase II of the IASB's Business CombinationsProject, with a new exposure draft on businesscombinations) is going to be useful to the markets.”Greater involvement of preparers and users of financialstatements in the process of standard setting was seenas critical and, here, it was acknowledged that the onusis as much on the investment community andcompanies to articulate their own proposed solutions asit is on the standards setters.

“the volume of our footnotedisclosures increased by 50%”*


IFRIC 3

1. Recognise allowances when able to exercise control; corresponding entryto government grant, at fair value if granted, at cost if purchased.

2. Allowances are subsequently carried at cost or revalued amount.

3. Government grant amortised on a systematic and rational basis overcompliance period.

4. Recognise liabilities when incurred.5. Liabilities are remeasured fully based

on the market value of allowancesat each period end, whether the allowances are on hand or would bepurchased from the market.

Alternative 1

1. Recognise allowances when able to exercise control; corresponding entryto government grant, at fair value if granted, at cost if purchased.


3. Government grant amortised on a systematic and rational basis overcompliance period.

4. Recognise liabilities when incurred.5. Remeasure liabilities at each period

end – for allowances on hand, atthe carrying amount of those allowances (i.e. market value at the date of initial recognition if cost model is used; market value at the date ofrevaluation if revaluation model is used)on either a FIFO or weighted average basis; any excess emission would be measured at the market value ofallowances at the period end.

Alternative 2

1. Recognise allowances when able to exercise control.

2. Allowances granted are initially recognised at zero.

3. Allowances purchased are initially recognised at cost.


5. Recognise liabilities when incurred.6. Remeasure liabilities at each period

end – for allowances on hand, at the carrying amount of those allowances (i.e. zero, cost or revalued amount) on a FIFO or weighted average basis; any excess emission would be measured at the market value of allowances at the period end.

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Inside the energysector Converting to IFRS was always likely to be a tough proposition,requiring sound judgement on how the new standards can fit within acompany’s unique operational and market environment. The difficultiesthat the IASB itself has faced in producing standards, for example, onemission rights where an interpretation was developed by IFRIC onlyto be withdrawn by the IASB, have added to the judgement calls thatcompanies have had to make. Oil, gas and utility companies operatein environments that can pose tricky questions for reporting. Here welook at the key issues from inside the sector that led to mostroundtable discussion.

Shared issues

Emission rightsEmission rights schemes pose dilemmas for reporting. The IASB haswithdrawn IFRIC 3 which addressed the issue, while confirming thatthe IFRIC 3 approach (see panel) is a valid interpretation of existingIFRS. The roundtable participants had little doubt of the difficulties ofapplying IFRIC 3, in particular its mixed measurement concept. “Welooked at what it would mean for our quarterly results. We were quitehappy that IFRIC 3 was withdrawn. It does not reflect economicsubstance since it is obvious that we will use our emission rights tocover our obligations,” observed one utility company executive.

Few companies have deemed IFRIC 3 to be an attractive choice toachieve IFRS compliance. The standard opens the prospect of afundamental mismatch in the income statement, exacerbated by thedifficulties the IASB have faced in developing standards onperformance reporting. Two alternative approaches are summarised inthe side panels.

A PricewaterhouseCoopers partner commented: “You can get verydifferent effects on the income statement with these different methods.The crucial thing is to look at the pattern of how you actually useallowances, the timing of purchases and their trading. Both methodswork and you need to model each against the operational plans foremissions.” The discussion also emphasised that it was important toaccount for emission rights on the basis of annual allocations andreturns of allowances and not to delay recognition of liabilities until theend of the three year life of the EU emissions trading scheme.

“look at the pattern of how you actuallyuse allowances”*



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IFRIC 4IFRIC 4, and the related IAS 17, is set to produce interesting resultsand changes to how companies have historically seen items such aspower purchase agreements presented, both on the balance sheetand on the income statement. IFRIC 4 helps companies assess if theyhave a mere ‘plain-vanilla’ supply contract or whether, in substance,there is actually a lease embedded in the contract.

The following power purchase example illustrates this well: anindustrial company is purchasing power from a generator, who mayhave four different power plants. A key question is whether power isbeing purchased from a specific plant or if the generator can providethe power from any of the plants. The former would point towards alease.

IFRIC 4, paragraph 9, sets out the criteria to determine whether anarrangement contains a lease, such as whether the purchaser (lessee)has the right to operate the asset, has physical control of the facilityand it is unlikely that another party will take ‘more than an insignificantamount’ of the output. There are two exceptions – where the price is‘contractually fixed per unit of output’ or where a purchaser is payingthe market price for the output. The issue was raised of what does‘contractually fixed per unit of output’ mean? For example does aprice that is index-linked qualify as fixed? The view was expressedthat this does not qualify as fixed because the indexation will lead to achange in the amount payable. Similarly, the market price is the spotprice on the day of delivery so if a contract price includes a cap or afloor, then in principle it would not qualify for the market priceexception.

In practice, the lease is not the only question that has to beconsidered. The reality of many power purchase agreements is thatthere is flow through of substantially all of the cost of the fuel that isused to power the station so the power purchaser probably has a fuelpurchase contract. It may also have a service contract for the actualrunning of the plant so there is an important judgement to be made onhow to treat the total cash flows under the electricity sales agreementand how to divide them into the individual components. In manyrespects, companies face a difficult choice. As aPricewaterhouseCoopers advisor put it: “It is a bit like a poisonedchalice. You have either a lease with a fuel purchase contract, aderivative energy contract, or an own-use energy contract with anembedded derivative. Each will generally have a significant impact onyour financial statements.”

“it is a bit like apoisoned chalice”*

IAS 39 – Embedded derivatives

One of IAS 39’s objectives is to ensurethat any foreign currency risk which anentity introduces outside of its normalbusiness activities should be ‘fair valued’,with changes in value reported in theincome statement.

However, IAS 39 states that foreigncurrency risks embedded in commercialcontracts need not be ‘fair valued’ if theforeign currency risk arises because thegood or service being purchased or soldis ‘routinely denominated’ in that currencyin commercial transactions around theworld. This has resulted in anomalousresults for many contracts, such asshipping, where no single currency isused worldwide, but in Europe the Eurodominates and elsewhere the US dollardominates. Similarly, while mostcommodity transactions are conducted inUS dollars, the buyer and seller may nothave US$ functional currencies. In suchcases, embedded derivatives may have tobe recognised even though the currencyused is the normal business currency forall such transactions in the region inwhich the company operates.

IAS 39 also allows for an embeddedforeign currency derivative not to bevalued if it is denominated in the samecurrency as the functional currency of anysubstantial party to the contract.However, in practice it is often difficult todetermine the functional currency of theother party to a contract.


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Income statement presentation1

Divergent practice has emerged this year on thepresentation of the income statement. The criticalquestion companies need to consider is which formatcommunicates best to the marketplace and complieswith the accounting standards. The roundtable heardthat companies new to IFRS are struggling with this,especially when they come from environments wheredifferent presentations of the income statement wereroutine. The difficulties have been exacerbated to someextent by the impact of IAS 39 which has led tosubstantial changes in energy company incomepresentation compared to previous reporting. The desireby companies to explain why results are so different hascreated a plethora of practices:

• use of subtotals, columns and boxes – ‘exceptional items’ and ‘underlying performance’ – the return of proformas

• mix of presentation by function and by nature• use of ‘EBIT’, ‘EBITDA’, and the like, on the face

of the Income Statement,

and varying approaches to the presentation of:

• finance costs• results of associates• derivative gains and losses• non-derivative assets and liabilities designated

at fair value through profit and loss• foreign exchange differences

The dilemma that companies face is whether to keeptheir income statements simple and conductmarketplace communications through other means. If they do this, however, the audited financial statementscan start to disconnect from the information that themarket is relying on. As one speaker put it: “This is ahuge challenge facing the accounting profession. Thegreater the divergence then the more you undermine thecredibility of the financial statements and financialreporting itself.”

“this is a huge challenge facing the accountingprofession”*

IAS 39 – Income statementpresentation

Commodity prices have been volatile overthe past two years. Since some changesin contract valuations are now recognisedin the income statement, this meansreported results will be more volatile aswell. The results for a year can besignificantly impacted by the forwardprice curve at the year end.

In the early stages of IFRSimplementation the instinct for somepreparers and users is to highlight theseitems and show the impact of the newstandard in a separate column. Theguidance on the extent to which this canbe done is unclear but in the transitionperiod whilst the standards are ‘beddingdown’ such an approach isunderstandable. Finding a consistentpresentational approach for energycompanies would be desirable but firstdifficult questions need to be addressed.

• Where should changes in fair value be reported in the income statement?

• Where these changes relate to sales contracts how do you link fair value movements with reported revenues? For instance, if a sales contract is fair valued and changes in fair value are shown in one line in the income statement then what value is turnover recorded at when the contract delivers? If contract price is used then could this be interpreted as ‘recycling’ an amount already reported in the income statement?

• Are columnar presentation approaches helpful or confusing?

• How should ‘recognised’ profits and unrecognised profits be clearly shown?

• Is there a way of clearly disclosing howmuch of the reported result is based upon management derived assumptions?

1 For guidance on income statement presentation see www.pwc.com/ifrs *quotes from oil & gas and utility participants in the roundtable


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Balance sheet – classification of a hedging derivative

If you have a contract that does not qualify for own use then, bydefault, it is a trading contract. The whole amount of a tradingcontract has to be presented as current. So once you are intoderivative accounting you are into current assets and currentliabilities. That’s for something that is trading. But you could alsohave a derivative that is used in a hedging relationship. In a hedgingrelationship, the classification of the derivative follows the hedgeditem. So if the hedge item is classified as non-current, the hedgingderivative is, too. However, for hedging contracts with multiplematurities, for example monthly gas derivatives for five years, thevalue of the portion of the contract that matures within 12 monthscould be classified as current whereas the portion that is due afterthe twelve months could be classified as non-current.

Trading – be clear about the income statement geography

The ‘gross vs. net’ and the ‘other income vs. turnover’ debate isgoing on apace. It is not just affecting oil and gas but many otherindustries – anyone who is exposed to commodities. It is also gettingattention from the regulator. What properly belongs in the top lineand what belongs somewhere else in the geography of the incomestatement? The standards indicate that the results of trading and useof financial instruments belong in a separate ‘other income’ line,unless the main business of the entity is trading. The critical thing isto be transparent about what is in the number and transparent inyour accounting policy on what you are doing.

Talking points


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IFRS 6: how much shelter?

IFRS 6 (exploration for and evaluation of mineralresources) allows companies to retain existing practicesin accounting for exploration and evaluationexpenditures.

IFRS 6 confirms that the requirements of all IFRSs areapplicable to entities involved in the exploration for andevaluation of mineral resources, except where specifictypes of transaction and activities are excluded fromIFRS. The accounting for exploration and evaluation ofmineral resources is explicitly excluded from the scopeof IAS 16: Property, plant and equipment and IAS 38:Intangible assets. The IASB did not have time todevelop a comprehensive standard on extractiveindustries in time for entities converting to IFRS in 2005.IFRS 6 provides an interim solution by allowing entitiesto continue applying their accounting policy in respectof exploration and evaluation until a morecomprehensive solution is developed. The standardenables accounting policies to be retained even if theyare inconsistent with the treatment of similarexpenditures that are addressed by existing IFRSs or ifthey are inconsistent with the IFRS framework. However,an entity that chooses to make changes in itsaccounting policies can only do so if those changesbring the policy closer in line with the treatment ofsimilar expenditures set out in IFRSs and the IFRSFramework.

IFRS 6 is applicable to accounting periods beginning onor after 1 January 2006. First time adopters of IFRS whochoose to apply IFRS 6 before 1 January 2006 are notrequired to present the disclosures required by IFRS 6for comparative periods in their first IFRS annualaccounts.

The main purpose of the standard is to allow mostcompanies to continue with their recognition policies butto specify the circumstances in which entities shouldtest exploration and evaluation costs for impairment.The recent period of high oil prices has meant that, tosome extent, companies have not had to contend somuch with impairment and, thus, the potential impact ofthis part of IFRS has been masked. This makes it evenmore important that companies consider this carefullysince the policy decisions that are made now will needto be sustainable for a long time, including periods whenoil prices may not be so favourable.

“high oil prices have masked IFRSimpairment impact”*

Full Cost Accounting

It is difficult to see how full costaccounting as applied in the past can besustained beyond the exploration andevaluation phase. Companies cancontinue to use different policies toaccount for exploration and evaluationcosts, including full cost. This makescomparison of different companiesdifficult, and some narrowing of thealternatives is necessary. However, it willbe difficult to establish a single approachthat caters for all mining and upstream oiland gas companies – given that thegeological and economic characteristicsof exploration and evaluation can varysignificantly from commodity tocommodity.

Once a project has progressed to theproduction phase, the requirements of IAS8 and IAS 16 become relevant. For the oiland gas industry, in particular, this may bedifficult to reconcile with the ‘full costpools’ of exploration and evaluation costsalready incurred if the pool embracesmany different areas of interest. Oncepast the exploration and evaluationphase, the special cash generating unit(CGU) rules fall away; costs must beallocated to CGUs. The CGU is usuallythe field or a group of fields supported byshared infrastructure. This may result inpooled expenditure being written off.

Oil and gas



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Roundtable participants were keen to check that theunit of production (UOP) approach for depreciating andamortising additional assets was compatible with IFRS.Compatibility can be achieved, in principle, but itrequires the carrying value based on UOP to achieve asalvage value at the end of the life of each individualasset component respectively. This is difficult inpractice. The UOP charge needs to reflect the way inwhich economic benefits are consumed through use. Ifthe life of an asset component is shorter than the life ofthe related field (for instance 5 years vs 10 years) anddepreciation is based upon units of production,companies would need to determine the life based uponexpected/planned production for the first five years,when the component will be replaced. There is theadded complication that production volume in the firstfive years is often greater than in the subsequent period.For larger companies these variations across fields willeven out but smaller companies are more exposed. All companies need to ensure that they do not run therisk of failing to match the depreciation with theconsumption of benefits and thus inappropriatelypostponing impairment charges to the end of the field'slife. Some companies may need to make manualadjustments as they don't have accounting systems tocomply with component accounting.

A few exploration companies use the ‘full cost’approach. It is important to emphasise that IFRS 6 onlycovers the exploration and evaluation phase, allowinglarger CGUs only until the point when reserves havebeen determined. If a full cost company had reached theend of the exploration and evaluation phase and nocommercial viable reserves had been detected, it mightbecome appropriate to reclassify the activities out ofe&e and the items would then be subject to otherstandards. However, as a PricewaterhouseCooperspartner stressed: “IFRS doesn’t give you any specialrules for development or production. What is clear,however, is that you only get the shelter in the e&ephase and not when you move beyond that.”

Impairment and cash generating units

The roundtable had a broader discussion ofimpairment, in particular, in respect of theidentification of CGUs. There was a lively interest inthe definition and scope of the CGU for IFRSpurposes. A PricewaterhouseCoopers presentercommented: “My sense is that market practice inretail business is moving to define the individualretail outlet as the CGU, so in downstream thatmeans the individual petrol station.” Someparticipants pointed out the need for each retailer tobe supported by a logistics network. A critical test asto whether this constitutes a distinct CGU is does ithave separately identifiable cash flows (see the‘exploded’ question below). ThePricewaterhouseCoopers presenter went on toobserve: “We are likely to see a move to individualoutlets as the CGU but, at the same time,management will tend to monitor them on a regionalbasis. So you would probably become aware oftriggers for impairment at a regional level, and thentest individual petrol stations for impairment”.

A question was raised on how to go about reflectingsynergies in CGUs and impairment tests. Theprincipal difficulty is ensuring that the allocation ofsynergies to CGUs does not exceed 100% of thosesynergies when determining value-in-use.

Questions were also raised on which discount rateshould be used for upstream assets. One companymentioned that it should be adjusted for risks. UnderIFRS, risk needs to be recognised, and, while theresult should reflect the weighted average of allpossible future outcomes, this can be done throughadjusting the discount rate or the cash flows. Inpractice the latter is quite difficult and it is usuallyeasier to adjust the discount rate. The starting pointfor the discount rate will usually be the Company’sWACC, but when the company is more than just asingle-asset company the WACC needs to beadjusted to arrive at a discount rate that reflects therisks of the asset being tested for impairment.

“Hurricane Katrina was proof that a CGU is not awhole continent. It is pretty hard to justify defining itwider than the field or the reservoir...”

“If it exploded, could you runthe rest of the business? Yes?Well, then it has separatelyidentifiable cash flows”*


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Overlift and underlift

One effect of IFRS is that more items are likely to fall underderivative standards than in US GAAP. Overlift and underliftwith net settlement at a future date moves companies intothe scope of IAS 39. There are various solutions,depending on whether the settlement is by product or bycash. A reporting goal is to avoid a ‘meaningless’ grossprofit line. The PricewaterhouseCoopers’ view is that theunderlifter has generally sold its share to the overlifter.Subsequently, the overlifter sells this output to third partiesand recognises it as sales, but recognises no margin to theextent the sold volumes are attributable to the underlifter.In effect the combined revenues reported by the jointventurers are more than 100% of actual output.

At each balance sheet date, overlift/underlift balances thatfall within the scope of IAS 39 get remeasured to thecurrent oil price. The net gain or loss on remeasurement isincluded in the income statement. One company askedwhere to present these net movements? The answer isthat this should be under ‘other income’/‘other expense’,rather than in revenue.

It was assumed that most companies would have netsettlement agreements included in their joint ventureagreements. However, this appears not to be the case forexample in Norway. The accounting treatment in thesecircumstances is still under debate. Can the underlifterrecognise a sale? Should balances be revalued in theintermediate period until settlement? If the overlift/underliftis always physically settled, a cost-based approach tovaluation can be applied.

If, instead of a sale of the overlifted quantity, it were to berecorded in inventory at market value or at cost, should thefair value route (IAS 39) be followed? However, does IFRSallow fair value accounting for items outside IAS 39? Onecompany observed that, in their experience, underlift andoverlift balances can be substantial, especially for gascompanies. Here again, the effect is more significant forsmaller companies who are less likely to be able to evenout the impact across different fields and by being bothunderlifter and overlifter in different situations in the same period.

“again, the effect is more significant forsmaller companies”*

Definitions

Overlift and underlift occurs when two ormore parties jointly control a productionproperty. In any particular period theamount of output taken by each partywon’t always equal their share ofproduction as set out in a joint ventureagreement. The extent to which thisdiffers is described as overlift or underliftand needs to be accounted for. The termsof production contracts vary andunderlift/overlift can sometimes be settledin cash and sometimes through deliveryof additional oil. In practice these types ofcontract are often within the scope of IAS39 (if there is net settlement) which needsto be followed in conjunction with IAS 18on revenue recognition to determine theappropriate accounting.

Types of production sharingcontracts (PSCs)

Upstream companies enter intocontractual arrangements where a foreigngovernment owns reserves and, in somecases, equipment, but provides thecompany with a licence to be a contractorto perform or manage specified oil andgas activities. The upstream companymay earn a fee under a productionsharing contract (PSC) designed toreimburse the company for operationaland capital costs incurred, and to providea return. PSCs may include terms whichrequire payment of royalties based uponvolumes produced or sales amounts,along with cost recovery and profitsharing mechanisms. They may alsostipulate the amounts of income tax to bepaid. PSCs vary considerably by countryand the accounting for these contractsunder IFRS needs careful consideration.



Snapshot: revenue

1. Substance over form – accounting must reflect the true nature of the item and not necessarily the legal form of wording in the contract

2. Royalties – normally excluded since contractor is purely collecting amountson behalf of government

3. Income Taxes – which are paid on investor’s behalf are included in revenue and taxes provided the tax is based on income

4. Reminder: only contractor’s share is presented as revenue since the rest is collected on behalf of government

Snapshot: IFRS & US GAAP – commonreconciling items for SEC filers

1. Impairment of assets: One step approach (IFRS) vs. two stepapproach (US GAAP)

2. Reversals of impairment losses required under IFRS, prohibited under US GAAP

3. (Upward) Revaluations of intangible assets and property, plant and equipment permitted under IFRS, prohibited under US GAAP

4. Inventory valuation: LIFO prohibited under IFRS, permitted under US GAAP

5. Decommissioning: under IFRS discount rate updated at each balance sheet date, but not permitted under US GAAP

6. Use of enacted tax rates under IFRS and US GAAP, but substantively enacted rates only under IFRS

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Jointly controlled assets, operationsand entities

Arrangements that fully meet the IFRS definition of ajoint venture do not generally cause significantaccounting and reporting problems. Difficulties arisewith ventures and alliances that are not true jointventures. This would be the case, for example, whereresolutions can be passed without the agreement of allof the ‘partners’. As IAS 31 makes clear: “Joint controlexists only when the strategic financial and operatingdecisions relating to the economic activity require theunanimous consent of the parties sharing control”.

The interest in a joint venture is recorded usingproportionate consolidation, or the equity method inaccordance with IAS 28. A participation that does notqualify as a joint venture may fall under IAS 39. This isthe case if the arrangement can be identified to be aseparate entity, for example, because it is able to holdcash or generates cash inflows to its participants. Ifthere is no separate entity, the venture will not fall underIAS 39, as is commonly the case with joint assets suchas oil platforms, power plants and pipelines that are notowned by a legal entity. Here there is an undividedinterest in the asset and it probably would qualify asnon-current investments.

“participations in entitiesthat do not qualify asjoint ventures may fallunder IAS 39”*

Production sharing contracts

Every jurisdiction is different with regard to productionsharing contracts, and these must be considered on acase-by-case basis. Critical questions at the roundtablerevolved around reserves and the issue of who is takingthe risk.

There was some discussion around grossing-up ofreported sales revenues for income tax paid in kind andthe view was that there would need to be robust groundsto support it. One consequence of grossing-up is thatcompanies then move into the tax accounting standard,IAS 12. Under US GAAP grossing-up is sometimesappropriate if prescribed by the tax authorities and taxregimes (creditable taxes).


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IAS 39: executory contracts, embeddedderivatives and hedging

IAS 39 (revised 2003) poses arguably some of the hardestchallenges, among all IAS/IFRS standards, for IFRSpreparers in the industry. Considerable conceptual andpractical difficulties arise as a result of the ‘mixed’measurement bases associated with executory contracts,derivatives and generation assets. Commodity derivativesthat can be settled net in cash are, in principle, measuredat fair value. Accrual accounting, though, is permittedwhere an executory contract is held for the purpose of theentity’s normal purchase, sale or usage requirements.Much of the discussion between utility companies at theroundtable centred on the difficulties of categorisingcontract types. For example, a company will typically havecontracts for many different purposes, such as own-use,optimisation and trading. If there are no clear policy andrelated organisational and book structures to separatecontracts into the respective categories, a company has totreat all contracts as similar contracts under IAS 39. Thus,both contracts selling to final customers (own use, andnormally requiring accrual accounting) and contractsselling to the spot market (trading, to be recorded at fairvalue) are treated as trading contracts.

A further difficulty arises because, under IAS 39,companies are unable to claim ‘own use’ treatments forcontracts that contain a written option. Electricity supplycontracts often give the buyer the right to take anyamount of energy based on the contract requirements.Different views were expressed around the table on whenvolume flexibility in a gas or electricity supply contractconstitutes a written option. A critical issue is whether aprice premium is paid to compensate the supplier for theadditional risk incurred. A PricewaterhouseCoopers partnerobserved that “a contract does not contain a writtenoption if the buyer did not pay any premium to receive theflexibility and, where this is the case, the contract mayqualify for the own-use exemption”. One participantpointed out that even a paid premium might not alwayslead to the conclusion that a written option existed, a viewwhich is hard to support given the text of the standard.

“discussion betweenutility companies at theroundtable centred onthe difficulties ofcategorising contracttypes”*

‘Own use’ vs. valuation

A company sources gas for its customersfrom long- and short-term purchasecontracts, storage, and from its own gasfields. Its overall aim is to optimise itsportfolio to derive maximum value.Demand from its customers is seasonal.To optimise its position it will vary what ittakes under contracts, from fields, andfrom the wholesale market, in response tophysical demand and market prices. Gasis also sold on the wholesale marketwhen this is economic. Under IAS 39 thismeans some contracts need to be valued(because not all the gas is going to thecompany’s customers) but differentiationis problematic. If all are managed within asingle risk management framework, theyare all to be treated as trading contractsas it is impracticable to identify whichcontracts are settled net.

A power generator makes decisions abouthow much power to generate and howmuch to purchase for its customers undercontracts, based upon levels of demandand the differential between gas andelectricity prices: ‘the spark spread’. Itbuys and sells in the market as thesefactors change in the run up to thedelivery period. This process of‘reoptimisation’ or constant churning ofpurchase and sales contracts makes itdifficult to identify which contracts aresettled net and which are not under IAS39. Identifying some contracts forvaluation and treating others as executorycontracts for accrual accounting appearsinconsistent with the business model ofmany companies; however this is what isrequired under the standard.

Utilities



13

The roundtable then considered issues of embeddedderivatives and IAS 39, in particular the assessment ofthe ‘closely related’ test to determine whether aderivative needs to be separated from the host contractand accounted for at fair value. Proper assessmentrequires a qualitative evaluation, which then may needto be supplemented by quantitative analysis. Forexample, qualitative analysis may initially suggest thatelectricity be linked to the price of coal since coal is amajor input to the electricity generation process. But thismight not be supported in a market environment byquantitative analysis which in certain regions shows thatcoal prices are not highly correlated with electricityprices, as the price of electricity is impacted by supplyand demand as well as other fuel sources. Companiesalso need to consider when to assess contracts forembedded derivatives. IFRIC D15 indicates that theassessment should take place at the time the entity firstbecomes a party to the contract and cannot besubsequently reassessed unless and until a newassessment is required by ‘significant modifications’ tothe contract terms.

Finally, there was a lively discussion about hedging andthe use of hedge accounting to reduce volatility in theprofit and loss account from derivative instruments.Companies were reminded of the importance of formaldesignation and documentation of the hedgingrelationship and an objective/strategy for undertakingthe hedge (including identification of the hedginginstrument, the hedged item, the nature of the risk beinghedged and the design of prospective and retrospectiveeffectiveness tests). Evidence must be gathered of theprospective and retrospective effectiveness of the hedge(at inception and in subsequent periods) and theforecast transaction must be assessed as highlyprobable to occur to quality for hedge accounting.

“Practical problemsarise as IAS 39 does notprovide extensiveguidance on assessingwhether economiccharacteristics and risksare ‘closely related’ forcommodity and energycontracts.”*

Cash generating units (CGUs)

A key practical issue revolves around thedetermination of CGUs, which should be approachedtop-down from the perspective of the highest level ofexecutive management until the ‘smallest identifiablegroup of assets’ is reached.

The accounting policy decision as to whether to treatjoint ventures (JVs) at equity or to consolidate theirassets proportionately could be highly significant forimpairment testing in the utilities sector. In the formercase, for example, technological obsolescencetriggering a write-down of significant plant of the JVcould affect the carrying value of the investor in theJV only indirectly, whereas proportionateconsolidation of JV assets would result in a directeffect on the investor.

Component approach

New challenges arise from IAS 16 which requires themandatory application of the component approach. Ifthe costs of separate components of property, plantand equipment are recognised, the carrying amountsof those components replaced have to bederecognised. If subsequent costs are to becapitalised, these costs have to meet the generalrecognition criteria. Where property, plant andequipment is recognised for the first time, eachmaterial component of the greater asset must berecorded and measured separately. A PricewaterhouseCoopers expert emphasised theimportance of “identifying property, plant andequipment with separate components that have to berecognised separately and setting up correspondingaccounts for the fixed asset detail ledger.”

Practical implementation issues are associated withnecessary internal control process changes, indeveloping internal group guidelines for settingmateriality thresholds to define ‘significant’components and for performing accountingallocations. Further, for a turnkey power plantinvestment, the qualitative identification of individualcomponents may be reasonably straightforward, butthe apportionment of a total project value to thesecomponents in the absence of detailed knowledge ofthe constructor’s margin will require some estimates.


14

As companies move forward with IFRS, it is clear that theinterpretation and application of the standards will evolve and moveon rather than remain static. The roundtable raised many questions.In some cases, the answers are clear. In others, they are less so. Weare closely studying emerging practice as companies implement IFRSand, in Spring 2006, will be publishing a follow-up to our Crunch Timereport on how best to embed IFRS in the oil and gas, utility andmining industries.

It is also clear that many challenges and issues close to the heart ofthe industry will move to centre stage as the standard setting processitself moves on to new ground. Part of the challenge for energy andutility companies is to highlight the particular issues the sector isfacing at a time when a lot of the standards' focus is elsewhere – onindustries such as financial services and issues such as financialinstruments. The IASB extractive industries group is central to thisprocess. The roundtable heard, for example, that some IASBmembers believe that reserves are assets and deserve recognition.Concerted industry engagement with the board through the extractiveindustries working group will be important for companies who want tohave input. A discussion paper from the group is scheduled for late2006 so engagement now, early in the process, will be timely. It willalso be important to broaden the focus on the group’s work – forexample to paragraphs 5, 6, 7 and 8 in IAS 39 which have a majorimpact on power commodity contracts.

Much of the onus is placed on the standard setters, not least inmedia coverage of some of the implications of the standard settingprocess for companies. However, if standards are to develop in aneffective way that brings us closer to the goals of transparency,comparability and bringing useful information to the market, preparersand users need to engage in a proactive dialogue with the standardsetters. Oil, gas and utility companies need to play their part in thisprocess as the agenda of the IASB and its extractive industry groupgains momentum.

“there’s a danger ofreserves being pickedoff and put into the fairvalue world”*

Looking ahead



15

Contact us

Global contacts

Richard PatersonGlobal Oil & Gas LeaderTelephone: +1 972 444 1229Email: [email protected]

Mark KingOil & Gas IFRSTelephone: +44 20 7804 6878Email: [email protected]

Manfred WiegandGlobal Utilities LeaderTelephone: +49 211 981 2812Email: [email protected]

Lutz GranderathUtilities IFRSTelephone: +49 211 981 2140Email: [email protected]

Territory contacts

Europe

AustriaGerhard Prachner Telephone: +43 501 88 1800Email: [email protected]

Belgium Ronald Tiebout Telephone: +32 2 710 7428Email: [email protected]

Central and Eastern EuropeTibor AlmassyTelephone: +36 1 461 9644Email: [email protected]

Czech RepublicHelena CadanovaTelephone: +420 251 152 011Email: [email protected]

Petr SobotnikTelephone: +420 251 152 016Email: [email protected]

Tomas BastaTelephone: +420 251 152 087Email: [email protected]

DenmarkPer Timmermann Telephone: +45 39453945Email: [email protected]

FinlandMika AlavaTelephone: +358 9 6129 110 Email: [email protected]

Juha TuomalaTelephone: +358 9 2280 1451 Email: [email protected]

Jari PolojärviTelephone: +358 9 2280 1318 Email: jari.polojä[email protected]

FranceJean GaignonTelephone: +33 1 56 57 40 28Email: [email protected]

Emmanuelle LevardTelephone: +33 1 55 56 12 61Email: [email protected]

GermanyManfred WiegandTelephone: +49 211 981 2812Email: [email protected]

David ThomasTelephone: +49 89 5790 5318Email: [email protected]

Michael DreckhoffTelephone: +49 201 438 2258Email: [email protected]

GreeceDinos MichalatosTelephone: +30 1 6874 730Email: [email protected]

IrelandCarmel O’ConnorTelephone: +353 1 6626417Email: [email protected]

ItalyJohn McQuistonTelephone: +390 6 57025 2439Email: [email protected]

LuxembourgRudy Hemerlees Telephone: +352 4948481Email: [email protected]


United KingdomPaul RewTelephone: +44 20 7804 4071Email: [email protected]

Mark KingTelephone: +44 20 7804 6878Email: [email protected]

Ross HunterTelephone: +44 20 7804 4326Email: [email protected]

Roger HarringtonTelephone: +44 20 7804 4066Email: [email protected]

The Americas

United StatesMartha Z. Carnes, US Oil and GasTelephone: +1 713 356 6504Email: [email protected]

Paul Keglevic, US UtilitiesTelephone: +1 213 356 6309Email: [email protected]

Randol JusticeTelephone: +1 713 356 8009Email: [email protected]

CanadaAngelo ToselliTelephone: +1 403 509 7581Email: [email protected]

Alistair BrydenTelephone: +1 403 509 7354Email: [email protected]

Latin AmericaJorge BacherTelephone: +54 11 5811 6952Email: [email protected]

Asia-Pacific

AustralasiaDerek KidleyTelephone: +61 2 8266 6927Email:[email protected]

Derrick RyleyTelephone: +61 2 8266 3578Email: [email protected]

Nathan BalbanTelephone: +61 2 8266 2086Email: [email protected]

ChinaRaymund ChaoTelephone: +86 10 6505 3333Email: [email protected]

IndiaKameswara RaoTelephone: +91 40 2330 0750Email: [email protected]

SingaporeRobert MontgomeryTelephone: +65 6236 4178Email: [email protected]

MaltaFrederick Mifsud Bonnici Telephone: +356 2564 7604Email: [email protected]

NetherlandsAad GroenenboomTelephone: +31 26 3712 509Email: [email protected]

Fred KoningsTelephone: +31 70 342 6150Email: [email protected]

Olaf BrenninkmeijerTel: +31 10 407 6853Email: [email protected]

Jan BachhuijsTelephone: +31 20 568 6212Email: [email protected]

Edo KienhuisTelephone: +31 70 342 6325Email: [email protected]

NorwayKetil Reed AasgaardTelephone: +47 23 16 0507Email: [email protected]

Didrik Thrane-NielsenTelephone: +47 95 26 0437Email: [email protected]

PolandWilhelm SimonsTelephone: +48 22 523 4150Email: [email protected]

PortugalLuis FerreiraTelephone: +351 213 197 15Email: [email protected]

Russia and the Former Soviet UnionJohn GrossTelephone: +7 095 967 6260Email: [email protected]

SpainFrancisco MartinezTelephone: +34 91 590 47 04Email: [email protected]

SwedenMats EdvinssonTelephone: +46 8 555 33706Email: [email protected]

Eva TörningTelephone: +46 42 377224Email: eva.tö[email protected]

SwitzerlandLucas MonnTelephone: +41 1 630 27 00Email: [email protected]

Ralf SchlaepferTelephone: +41 1 630 11 11Email: [email protected]

Middle East and Africa

Middle EastPaul SuddabyTelephone: + 968 563 717 122Email: [email protected]

Dale SchaeferTelephone: + 966 1 465 4240 115Email: [email protected]

United Arab EmiratesK SrinivasanTelephone: +971 4 3043 123Email: [email protected]

Southern AfricaStanley SubramoneyTelephone: +27 11 797 4380Email: [email protected]

Sub-Saharan AfricaNick AllenTelephone: +254 20 285 5000Email: [email protected]

Global Accounting ConsultingServices

Mary DolsonTelephone: +44 20 7804 2930Email: [email protected]

Kevin KleinTelephone: +44 20 7212 4028Email: [email protected]

Michael StewartTelephone: +44 20 7804 6829Email: [email protected]

Ralph WelterTelephone: +44 20 7212 7991Email: [email protected]

For further information about PricewaterhouseCoopers’roundtables, please contact:

Olesya Hatop, Global MarketingEnergy, Utilities and Mining Telephone: +49 211 981 2123Email: [email protected]


© 2005 PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers refers to the network ofmember firms of PricewaterhouseCoopers International Limited, each of which is a separate and independentlegal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP.

For further information, please visit www.pwc.com/energywww.pwc.com/ifrs

*connectedthinking

PricewaterhouseCoopers (www.pwc.com) provides industry-focusedassurance, tax and advisory services for public and private clients. More than 130,000 people in 148 countries connect their thinking, experience and solutions to build public trust and enhance value for clients and their stakeholders.

PricewaterhouseCoopers refers to the network of member firms ofPricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.

The Global Energy, Utilities and Mining group (www.pwc.com/energy) is the professional services leader in the international energy, utilities and mining community, advising clients through a global network of fully dedicated specialists.


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05PWC0875 IFRS 06.12.2005 15:42 Uhr Seite 1 Challenge* · *connectedthinking International...

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