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COVID-19 Impact on Asset Impairment in the Energy Sector

asset impairment in the energy industry

The coronavirus pandemic infused unprecedented levels of uncertainty into our economy. When the virus became more widely spread in March, businesses closed, workers self-isolated, and customers abstained from the marketplace. Even today, operations are not back to normal, and many businesses are still struggling. These changes are going to affect each organization differently, but one thing is certain: businesses hit with adverse effects from COVID-19 will need to identify the consequences on their asset base and reflect those outcomes in their financial statements.

Triggering Events

External events and pressures can put an organization’s financial performance at risk. The energy sector is no stranger to this phenomenon. Just like geopolitics and changes in demand can upset the entire supply chain, the coronavirus-induced market downturns have left producers, transporters, importers/exporters, and facilitators unable to predict when their operations will fully recover. When triggering events like these have been identified, management may be required to evaluate their long-lived assets, intangibles, and goodwill for impairment. 

The criterion for a triggering event is met when it is more likely than not that your asset or reporting unit’s recoverable amount (or fair value) is less than its book (or carrying) value. Determining the existence of triggering events requires significant judgment from management, and business leaders must weigh all mitigating factors to determine if the event was significant enough to meet this criterion. Triggering events can be as simple as unfavorable changes in raw material availability and prices or as severe as a natural disaster. Some common indicators of triggering events are:

  • Shifts in market forecasts
  • Fluctuations in materials or labor costs
  • Increases in costs of borrowing
  • Changes in availability of financing
  • Company is experiencing or expecting future net losses in operations
  • Shifts in stock prices
  • Changes in management or losses of key employees
  • Changes in foreign exchange rates
  • Supply chain shortages 
The downturn in economic conditions caused by the coronavirus pandemic may or may not be considered a triggering event for your business . Even if you determine that no triggering event occurred, it’s important to analyze what impact the event had on your operations and document the factors considered that lead to your conclusion.  Here at LaPorte, we are expecting that substantially all of our energy clients will need an impairment analysis at the end of 2020 due to the broad impact of the decline in commodity prices and demand. 

Impairment Testing

On its face, impairment testing is not very complex: businesses should record an impairment loss if the carrying amount of their asset or reporting unit exceeds its recoverable amount. For most assets, carrying costs are calculated as the acquisition cost less accumulated depreciation or amortization. However, the recoverable amount may be more difficult to ascertain, since it is often based on inputs that require significant knowledge and judgment exercised by management. Three acceptable asset valuation methods are:
  1. Market Approach
    The recoverable amount is determined by considering recent sales transactions of similar assets or by using market information available to the public (like a stock exchange or sale listing).
  2. Cost Approach
    The recoverable amount is determined using the cost it would take for you to build or acquire a replacement asset.
  3. Income Approach
    The recoverable amount is determined by calculating the discounted cash flows anticipated from the asset.
The discounted cash flow method (i.e. income approach) is used by most oil and gas companies. The company’s reserves balance is often split into two categories: proved reserves and unproved reserves. Proved reserves are those that can be accurately estimated by modern geoscience or by engineering data and that are almost certainly going to be recovered. Unproved reserves are those whose values are less certain, or those where the likelihood of recovery is less certain. Management should calculate discounted cash flows for each category separately, and triggering events may only affect one or the other.
Once you’ve determined both the carrying costs and recoverable amounts for each asset or group of assets, you can perform the calculations to see if there has been impairment, but you must do so systematically in the following order: After testing all regular assets first, you should test indefinite-lived intangible assets, then long-lived assets, and finally goodwill.

Regular Assets
Assets not included in the other three categories should be tested (and, if necessary, adjusted) first. This includes receivables, debt and equity securities, other investments, and inventories. Groups of similar assets can be tested together, but others (like many investments) may need to be tested separately.

Indefinite-Lived Intangible Assets
Indefinite-lived intangibles (like trademarks, brand names and licenses with no expiration date) have to be tested for impairment as soon as indicators of impairment are identified, at least annually. 

Long-Lived Assets
Long-lived assets include tangible assets (like property and equipment) and finite-lived intangible assets (like patents and commodity reserves).

Tangible Assets
The new lease accounting standard made this section of asset impairment testing all the more relevant. since many leases are now reflected on your balance sheet. If leased equipment is reflected on your balance sheet as a right of use asset, you may need to record an impairment if you determine that it is unlikely the leased asset will be used at the same frequency as you expected before. The testing for leased equipment may need to be performed on an asset-by-asset basis, but grouping like equipment may make sense if those assets are used in the same manner on the same (or similar) property.

Intangible Assets
Intangible assets are notoriously more difficult to value than tangible assets, and even among intangibles some asset values will be simpler to ascertain than others. Proved oil and gas reserves can be evaluated on a field-by-field basis whereas unproved reserves will likely need to be evaluated at each property based on qualitative factors.

While certain accounting elections relieve management from the requirement of an annual impairment assessment, goodwill must be tested as soon as indicators of impairment are identified. But goodwill needs to be valued last, because a reporting entities’ carrying value is the sum of all asset values. Only once all the other assets are reflected at their recoverable values can you determine impairment of goodwill. 
Traditionally, the goodwill impairment test is a two-step approach, where a shortfall of fair value over carrying value requires a hypothetical purchase price allocation. However, companies who elected to adopt ASU 2014-02 “private company alternative” or ASU 2017-04 “Simplifying the Test for Goodwill impairment” may use the following decision tree obtained from FASB as a roadmap when performing asset impairment testing:
COVID-19 impact on asset impairment

Reporting Requirements

Recording impairment losses will affect both your balance sheet and your income statement. In general, impairment adjustments are recorded as an impairment charge (loss) on the income statement, offset with a reduction to the asset or with a credit to a contra-asset account. If a contra-asset account is used, the asset and contra-asset accounts should be netted on the face of the financials. Impairment charges are reflected as a separate line item, if material. Classification as operating or non-operating is determined by the character of the underlying asset.
Impairment adjustments for proved and unproved reserves have more specific reporting requirements. Impairment adjustments to proved reserves should reduce the reserve’s carrying amount. When reserves have been tested for impairment as a group, the impairment can be allocated to each asset on a pro-rata basis using each asset’s carrying amount. Impairment adjustments to unproved reserves should be recorded as a valuation allowance (i.e. a contra-asset).

In addition to recording the actual impairment losses, you will be required to disclose information about how the impairment charge was determined. You should disclose in the footnotes to the financials information about the triggering events, how you determined it was a triggering event, and the methods you used to calculate the impairment.

Impairment testing is a particularly difficult task right now. Triggering events related to the pandemic likely occurred over a series of weeks or months. Should you take advantage of the simplified impairment tests? Or if you already determined that your assets have been impaired, should you report those losses in the first, second, or third quarter of 2020? And if the triggering event hit in the first quarter, should you report a subsequent event on your 2019 financials? Answers to these questions will look different for each organization. For help in addressing questions specific to your situation, contact one of the professionals at LaPorte CPAs & Business Advisors.