Based on recent statistics from the US Energy Information Administration, the United States is not only the biggest consumer in the world of petroleum and natural gas, but it is also the world’s biggest supplier of both petroleum and dry natural gas. With a significant number of oil and gas producers throughout the United States, auditing oil and gas entities is an important industry niche for many CPA firms.
While falling gas prices at the pump may be popular with consumers, they are problematic and potentially disastrous for oil and gas producers. Over the last two years, falling rig counts and crashing crude oil prices are stark reminders of the challenges oil and gas producers face.
And when clients face such challenges, their auditors also face risks associated with those issues that must be addressed as part of their audit engagements.
1. Operational Challenges
Declining revenue and a corresponding reduction in the value of proved reserves can have an exponentially negative effect on oil and gas producers, and some entities may not be nimble enough to respond to the related operational challenges.
Auditors should be alert to signs that an entity may not be set up to handle such a challenge, including:
- Losses greater than those of similar entities.
- Inability to meet the entity’s budget.
- Inability to obtain financing.
- Delays in performing routine repairs and maintenance.
- Loss of suppliers.
- Loss of key personnel.
- Lack of experienced finance personnel.
Note that because of the challenges facing oil and gas entities, the Public Company Accounting Oversight Board’s Division of Registration and Inspections stated in its July 2016 staff inspection brief that one of the key areas of inspection focus for audits of public companies in 2016 will be audit areas affected by economic trends, such as the effect of fluctuations in oil and gas prices.
2. Financial Statement Impact
The impact of falling oil and gas prices may cascade through the oil and gas entity’s financial statements, having an effect on any of the following:
- Revenue recognition.
- Valuation of oil and gas reserves.
- Impairment of oil and gas properties.
- Recoverability of deferred tax assets.
- Classification of debt due to restructuring or covenant violations.
- Modification to other contract terms.
- Measurement of asset retirement obligations.
- Collectibility of receivables.
- Changes in derivatives used for hedging, such as determining whether a cash flow hedge remains probable.
- Assessment of the ability of the entity to continue as a going concern.
- Disclosure of commitments and contingencies, such as long-term leases of drilling rigs that no longer make economic sense to use.
- Subsequent events disclosures.
3. Impairment of Oil and Gas Properties
Declines in oil and gas prices may be one indicator that there has been an impairment of an entity’s oil and gas properties. Evaluating the impairment of these properties can be challenging for auditors, who must determine whether any necessary impairment losses are properly calculated and recognized.
Operational items, such as the following, may also be indicators of an impairment loss:
- Impact of changes in drilling plans on lease expirations.
- Reduced economic viability of field development.
- Declines in credit for significant purchasers.
- Impact of financing availability on the ability to complete projects or commence production.
4. Asset Retirement Obligations
Oil and gas entities are required to record asset retirement obligations (ARO) in the period incurred, and auditors need to perform procedures to determine whether the obligations are properly recorded and disclosed in the financial statements.
The estimated amounts used to compute an ARO can be impacted in a down economy. Lower prices may lead operators to plug and abandon wells sooner, thus reducing the estimated expected cash flows used in the ARO estimate. Changes in ARO assumptions will also impact the costs used in the full-cost ceiling test.
5. Receivable Collectibility
When oil and gas entities are adversely affected by falling prices, so are their counterparts. As a result, collectibility of receivables from interest owners and purchasers can often become an issue.
Even though there are remedies available in certain circumstances, collectibility of receivable balances, such as the following, can become problematic, requiring the auditor to perform additional analysis or procedures on those amounts:
- Joint interest billing receivables, particularly if wells are only marginally economical or have been plugged and abandoned.
- Receivables related to cash calls (calls for nonoperating interest owners to advance funds to the operator generally to cover the coming month’s expenditures) if the interest owner is having financial difficulties.
- Receivables related to production imbalances (when revenue interest owners take their share of production in kind rather than being sold to purchasers on their behalf and have taken more production than they are entitled to at any given point in time) if the interest owner discontinues operations.
- Receivables from oil and gas purchasers with solvency issues.
6. Debt Compliance
An auditor’s procedures in the area of debt and debt covenants will likely be impacted by the current economic environment. With much of an oil and gas entity’s credit line being determined by the value of its underlying oil and gas reserves, the borrowing limits on credit lines have taken a hit because of the fall in oil and gas prices.
In many industries, credit lines may only be reviewed once a year. In the oil and gas industry, however, lenders review borrowing limits more frequently. Continued declines in oil and gas prices may have a twofold effect on an oil and gas entity’s debt, including reducing the entity’s credit line borrowing limits and triggering reclassifications of portions of long-term debt to current debt if the entity will have to pay off a portion of the existing debt to comply with the new, lower borrowing limits.
Making a bad situation worse, the reclassification of amounts to current debt may trigger debt covenant violations with the remaining balance of long-term debt because it could impact other debt covenants, such as a requirement to maintain a certain amount of working capital. Also, there can be changes in guarantees or collateral in debt agreements, which could also have an impact on recorded amounts or disclosures in the financial statements.
7. Financing Options
Financing options typically become more limited in an economic downturn. There are a number of financing strategies for oil and gas entities to consider if they are facing more limited financing options:
Negotiating new debt terms. This may be difficult, as many traditional lenders look to reduce their exposure in the energy sector.
Obtaining private equity financing. Many private equity firms are ready to invest in the energy sector, as they see potential lower prices creating good investment opportunities. Those firms also can provide large infusions of quick cash and are eager to assist the oil and gas investee in succeeding.
However, not all oil and gas entities are desirable investment candidates, and additional infusions from an outside private equity firm will dilute the original owners’ stake in the business. From an audit perspective, some private equity arrangements may require more detailed analysis to determine whether they represent financing or equity transactions or a combination of both.
Negotiating settlements. Some oil and gas entities are able to negotiate settlements with all of their creditors to either forgive a portion of their debt or extend the due date on payments. If all of the entity’s creditors aren’t on board with a plan to negotiate a settlement, however, the settlement plan may be derailed and the entity could be forced into bankruptcy.
8. Contract Modifications
Oil and gas entities may seek to modify the terms of a number of different types of contracts. Those renegotiations may provide immediate or short-term relief.
Here are some situations where contract modifications may be considered:
- Leases nearing expiration may be extended in order to delay upcoming drilling plans.
- Operators may enter into farm-out agreements or other arrangements with entities to assign a portion of their rights to explore a property in return for a revenue share on the property.
- Purchaser contracts may be renegotiated to change specified sales prices.
- Some contracts for items, such as equipment leases or purchases, may be terminated if the entity decides to forgo the lease or purchase and the associated costs exceed the termination payment.
- Employment contracts may be severed.
Auditors should pay attention to any contract modifications identified during the audit and determine that they are properly accounted for and disclosed in the financial statements.
9. Going Concern Considerations
The Financial Accounting Standards Board Codification requires management of all entities to assess their entity’s ability to continue as a going concern. In the oil and gas sector, that assessment is even more critical due to the current economic environment.
The drop in oil and gas prices, coupled with the inability by some entities to obtain financing and comply with debt covenants, may make it challenging for those entities to continue to operate as a going concern, and management will need to develop a plan to deal with the adverse effects of those conditions or events.
10. Bankruptcy and the Liquidation Basis of Accounting
The decrease in oil prices since 2014 has erased a significant amount of the value of US energy entities, according to Reuters. As a result, the last 18 months have seen a large number of oil and gas entities file for bankruptcy, with nearly 50 North American oil and gas producers filing in the first seven months of 2016.
In addition, according to Reuters, the number of US bankruptcy filings to date may only be the first half of the wave of entities that will eventually file.
Once an entity either elects or faces imminent liquidation (such as with a Chapter 7 bankruptcy filing), it is no longer considered a going concern, and GAAP requires the entity to prepare its financial statements using the liquidation basis of accounting. Under the liquidation basis of accounting, the historical bases of assets and liabilities are no longer relevant. Instead, assets are measured at net realizable value, and liabilities are measured at net settlement value (with values discounted when the effect is significant).
Tailored Guidance for Oil and Gas Auditors
In the end, it’s important for auditors of oil and gas entities to understand the impact of the economy on their clients and take advantage of specialized tools to address their unique audit and accounting requirements. The result is customized service and support that truly assists these entities during challenging economic times.