How IFRS will influence oil and gas M&A activity

Brian A. Reed, CPA, CVA,Weaver, Dallas
Melvin F. "Trey" Hunt III, CPA, Weaver, Houston

Global oil and gas price fluctuations influence many oil and gas company decisions, as do numerous other international events. US oil and gas companies considering any merger and acquisition activity also need to be aware of the increasing use of International Financial Reporting Standards (IFRS) as a financial reporting standard.

The growing use of IFRS reflects efforts to converge US Generally Accepted Accounting Principles (GAAP) with international accounting standards as a means for making global commerce more efficient.

IFRS is used now by Royal Dutch Shell, BP, and other large international oil and gas companies, as well as smaller foreign entities. Some US-based companies are already preparing financial statements based on IFRS. The Securities and Exchange Commission (SEC) has continually expressed support for converging US and international reporting accounting standards, too.

Companies considering a merger or acquisition now need to be aware of how IFRS influences due diligence and such a transaction itself. Attaining that necessary awareness begins with understanding the history and general principles of IFRS and how it differs from US GAAP.

The emergence of IFRS

Efforts to establish IFRS as a global reporting standard were launched a decade ago by the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB).

In 2002, the FASB and IASB issued a memorandum of understanding, the Norwalk Agreement, which established a joint commitment to develop accounting standards for US and cross-border financial reporting. The SEC subsequently announced support for the Norwalk Agreement.

Adoption of IFRS grew. In 2005, The European Union (EU) began requiring companies in its member states to prepare statements in IFRS for securities listed on EU-regulated stock exchanges.

In 2006, the SEC announced its commitment to a "roadmap" for IFRS adoption within the United States. The SEC announced the following year it would accept financial statements prepared in IFRS – without reconciliation to US GAAP – from foreign private issuers. In 2010, the SEC reiterated its support for convergence, and said that the earliest year for adoption by US publicly-traded companies would be 2015.

Many Canadian companies must comply with 2011 requirements regarding use of IFRS for preparing financial statements. While the SEC has not established 2015 or any subsequent year as an exact starting date for requiring IFRS use, recent events illustrate its growing use and continuing adoption throughout the world.

Fundamental differences in GAAP and IFRS approaches

US GAAP is more of a rules-based standard while IFRS is based more on principles. The FASB offers far more detail, far more guidance for applying GAAP than what is offered by the IASB for IFRS.

IFRS does not provide the levels of industry-specific guidance found in GAAP. Applications of some IFRS standards vary from one country to another, so evaluating financial statements from companies sited in other countries requires recognition of such differences.

For US oil and gas companies, uncertainties exist in accounting for exploration and development efforts, asset componentization and other items. Overall, IFRS places greater emphasis than GAAP on applying professional judgment when assessing a transaction. There are specific differences between GAAP and IFRS, too, in how due diligence considerations are approached.

IFRS and due diligence

Potential buyers mulling an acquisition or merger need to understand crucial differences between GAAP and IFRS in cost recognition, business combinations, and other relevant concerns.

In many instances oil and gas companies utilize the "successful efforts" method, which capitalizes the costs associated with locating, purchasing and developing reserves. However, a number of exploration and production (E&P) companies account for development costs using the "full cost" method, which aggregates the costs based on geographic areas, such as a country or a specific region.

IFRS 6, Exploration for Evaluation of Mineral Interests, indicates "full cost" can only be used in connection with exploration and development. Subsequent to completing the exploration phase, oil and gas companies must switch to the "successful efforts."

Oil and gas companies enter into a variety of contractual relationships. GAAP and IFRS present substantial differences in how those relationships are recognized.

Under IFRS the impairment of assets may be recognized earlier than it otherwise would have been under GAAP. Also, IFRS allows for impairments to be reversed, which is prohibited under GAAP. To determine if there is a need to reverse the impairment the company should continually track the impairments of its assets.

Such differences between GAAP and IFRS may add complexity to analyzing the earnings of an oil or gas company targeted for a merger or acquisition transaction.

IFRS and business combination considerations

Guidance in the FASB's Accounting Standards Codification (ASC) 805 and IFRS 3 (R) provide greater convergence regarding business combination standards. Substantial differences, though, remain between ASC 805 and IFRS 3(R).

Those differences must be considered when a company is determining whether it wishes to purchase an entire entity, or just a collection of assets.

IFRS 3R offers a broader definition of what constitutes a business. That standard defines a business as "an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants."

Under IFRS guidance, a business simply needs to have inputs, processes applied to those inputs, and outputs. The outputs do not need to be present at the acquisition date. That means that as long as the acquired activities and assets can be integrated with the purchaser's activities, the transaction would meet the definition of a business acquisition. Among other concerns, the broader definition of what qualifies as a business combination affects whether or not a specific upstream activity is deemed an asset or a business.

IFRS also defines an entity as having control over another entity if it has the power to govern the financial and operational policies of another entity. Based on the IFRS principle, control over another entity can be the result of "de facto" control rather than legal power over voting rights. ASC 805 does not recognize that control definition or any form of "de facto" control over another entity.

IFRS also establishes the acquisition date as the primary measurement date. At that time, the purchase method is used to assign value to the acquiree's identifiable assets and liabilities.

Other IFRS accounting considerations

Other differences arise between GAAP and IFRS as well for determining the value and/or risks of an entity in a merger or acquisition transaction.

Another issue to consider under IFRS is asset componentization. IFRS requires that major components of an asset be separated and depreciated over the estimated useful life of the asset. In regards to upstream companies, items that are required to be replaced over the life of the asset would generally be depreciated based on the units of production over the life of the reserves. The treatment of the fixed assets under IFRS creates more complexity in determining inventory PP&E as well as identifying the applicable components of the various assets.

IFRS also defines whether various financial instruments would be recorded as assets or losses. A company should consider and determine whether there is a need to bifurcate and separately account for embedded derivatives within contracts classified as liabilities. This may require that in certain instances, payments generally regarded as dividends be accounted for as interest, thereby affecting earnings.

Borrowing costs related to acquiring, constructing or producing qualified assets are generally capitalized under GAAP. However, under IFRS small and medium businesses are required to expense these borrowing costs.

For IFRS, acquisition costs incurred in a transaction are generally expensed as they occur, rather than being included in goodwill. Restructuring costs are also recognized when such efforts are announced or commenced. That recognition is earlier than what is allowed under GAAP.

The increasing importance of IFRS awareness

While the SEC has not set any definite dates for requiring that US public companies prepare statements based on IFRS, an increasingly integrated global economy is prompting many US entities to recognize or prepare financial statements that adhere to those standards.

Oil and gas companies need to consider how the principles of IFRS would be applied to a specific merger or acquisition target. That awareness will become increasingly important as GAAP-IFRS convergence efforts continue.

About the authors