Annual Financial Report of BG Group - Coursework Example

An assessment of the Annual Financial Report of BG Group plc Introduction to BG Group plc BG Group plc, formerly called British Gas is one of the world’s largest energy companies focused on natural gas. In 2011, the company had revenues of $ 21 billion and profits of $ 7.3 billion. The three business segments are Exploration and Production (E&P), Liquefied Natural Gas (LNG) and Transmission and Distribution (T&D) (BG Report 2011, pp 4-7). Most of BG plc’s E&P activities are conducted through subsidiaries, associates and joint ventures (BG Report 2011, pp 134-135). This is a common practice in the oil and gas industry to reduce business risks (KPMG, 2008). The financial reports of the company have been framed based on the IFRS (International Financial Reporting Standards) adopted by the European Union and prepared in accordance with the UK Companies Act 2006 (BG Report 2011, pp 88). 2. An analysis of the Accounting Policies of the Company A. Policies relating to impairment of non-current assets Of the three business segments of the company, the E&P segment is the largest in terms of non-current assets subject to impairment issues. Oil and gas exploration is a capital intensive activity and all costs incurred are capitalized as intangible assets until oil or gas is discovered. Once the reserves are proven, these costs are transferred to property, plant and equipment in the company balance sheet. Costs incurred on unsuccessful oil and gas fields are written off in the in the income statement (BG Report 2011, pp 89). This method of accounting based on “successful efforts” is not a term defined in the IFRS 6 but used by the oil and gas industry as a carry over from previous GAAP practices (KPMG, 2008). BG plc does not differentiate between development fields and production fields. This too is inline with accepted industry practice (KPMG, 2008). Non current assets are reviewed at least once a year for impairment. As on 31 December 2011, BG Group held a balance of $ 4,383 million in expenditure related to unproved oil and gas reserves within the category of intangible assets. In the previous accounting year, this figure was higher at $5,342 million (BG Report 2011, pp 89). Since this impairment is based solely on management judgement, there is risk of these being inflated in years of high profits and deflated in years of low profits. For assessment of impairment, BG plc combines oil and gas production fields into cash generating units based on geographical location, use of common facilities and marketing arrangements (BG Report 2011, pp90). This disclosure is not usually made in Oil company reports (KPMG, 2008) and is therefore an improvement on industry practice. BG plc uses the net present value of future cash flows for impairment assessment using certain short term and long term assumptions depending on the nature of the asset. The Exploration & Production business segment is particularly sensitive to commodity prices. Impairment testing of oil and gas properties is based on assessment of proven and probable reserve estimates using the SEC definition (BG Report 2011, pp90). The SEC 2008 rules for filings in the US now permit probable reserves to be included whereas the earlier 1978 rules only permitted inclusion of proved resources (KPMG, 2008). BG plc defines Goodwill as the difference between the purchase price paid and the fair value of assets that have been capitalised in the financial books. Goodwill is treated as an asset for the relevant entity (such as a subsidiary company or a specific oil or gas production field). The value of goodwill is reviewed annually or when any significant event or changes in circumstances occur as in the case of the non-current assets. This practice appears entirely fair and reasonable. Impairment losses are written off in the income statement causing the company’s operating profits to decrease. In the fiscal year 2011, operating profits were lower by $ 374 million due to impairment losses and it was lower by $ 927 million in the previous year 2010. The impairment losses also cause a reduction in the value of non-current assets shown in the balance sheet. The total of Goodwill and intangible assets in the balance sheet as of 30 Dec 2011 was $ 6,911 million or 11.25% of the total assets of $ 61.32 million. In the previous year it was 15.9 %. The impairment policy followed by BG plc conforms to the requirements of the IAS 36 Impairment of assets issued 1 January 2012. The IAS 36 also provides for reversal of impairment losses provided for in previous years if warranted in the annual assessment except that goodwill impairment cannot be reversed (IAS 36, 2012). The BG plc financial statements do not show any reversals either in 2011 or 2010. B. Financial Instruments and management of financial risk BG plc has appointed a Chief Risk officer who leads the effort at creating an Enterprise Risk management Framework. A tool named Cash Flow at Risk has been developed and out to use for this risk management process. This tool is being used to build resilience of the group in responding to unexpected events and economic uncertainty (BG Report 2011, pp43). This is an important forward step since the oil and gas industry has a high risk profile. BG plc uses a number of derivative financial instruments in its treasury operations including interest rate swaps, foreign currency swaps, cross-currency interest rate swaps and forward exchange contracts. Movements in the values of these financial instruments are recognised in the income statement (BG Report 2011, pp90). The use of derivative instruments is common practice in the oil and gas industry (KPMG, 2008). The risks that the company is exposed to include credit risk, interest rate risk, exchange rate risk and liquidity risk. Credit risk is managed by contractual and other forms of protection including cash collaterals, letters of credit, security over asset or parent company contracts. In transactions with related counter parties, netting arrangements are used to reduce risk. Interest rate risks are met generally by using floating rates of interest. The BG Group also has a revolving credit facility totalling $ 4.5 billion at the end of 2011 with a set of major banks to provide for short term funding needs (BG Report 2011, pp47) The BG Group’s cash flows and profitability are sensitive to commodity prices for oil and gas and it uses futures contracts, financial and physical forward based contracts and swap contracts. The value changes in these contracts are recognised quarterly in the income statements (BG Report 2011, pp48). Kevin Price of Societe Generale says that “commodity price volatility is the single biggest variable in forecasting EBIT for exploration and production companies” (Price, 2012). The total values of derivatives in the BG plc 2011 report are $ 1,345 million as current liabilities and $ 696 million as non-current liabilities. These are small compared to borrowings and are also small in relation to the cash and equivalents the company has on hand (BG Report 2011, pp95). John Mitchell is his 2012 book on the future of the oil and gas industry says that new oil and gas finds are moving to third world countries each with its own sets of priorities and rules. This is making the financial risks for oil and gas companies much larger than they have been in the past and there is need to find new means of risk management instead of extrapolating from the past (Mitchell, et al, 2012). C. Provisions for post-employment obligations Prior to 2007, BG plc provided its employees with a “defined benefit retirement plan” through a trust established for the purpose. BG contributed 32.5% of the pensionable pay and employees could contribute an additional 3% though salaries sacrifice. The trust uses independent actuarial assessment every three years to determine if the assets of the trust together with the payments by the employer and the employee are sufficient to meet the future pension payments. The previous actuarial audit on 31 March 2008 showed that the trust’s assets covered 83% of the accrued liabilities. BG plc is committed to making annual payments of £ 27 million from 2009 for 6 years to reduce the deficit (BG Report 2011, pp 130). From 2007, new employees have been shifted to a “defined contribution plan” where the employee can choose various options for the investment of the contributions to the pension fund but the actual retirement benefits he will get are subject to the funds performing as projected. An independent actuarial evaluation of this pension plan has been carried out in accordance with the requirements of IAS 19 and based on this valuation, BG plc has provided for a current liability of $ 214 million. In the previous year, the liability was larger at $ 260 million (BG Report 2011, pp 130). The BG balance sheet will be exposed to making provisions for the difference year to year. The fair value of the pension plan’s assets on 31 December 2013 was $ 1, 289 million. These funds are proposed to be invested 60% in Equities with an expected rate of return of 7.3%, with the remaining funds in safer but lower yield instruments. The overall return for 2011 was 6.8% (BG Report 2011, pp 132). This return will be difficult to sustain over the long term given the uncertainties in equity returns increasing BG’s exposure towards making up the shortfalls. As a January 2012 paper by Srichander Ramaswamy of the Bank for International Settlements points out, “Poor financial market returns and low real interest rates in recent years have created challenges for the sponsors of defined benefit pension schemes. Amendments to pension accounting rules now require corporations to regularly report the valuation differences between their defined pension benefit assets and plan liabilities”. The shift from a defined benefit plan to a defined contribution pension plan makes the pension benefits for the employee uncertain, especially with longer life spans and rising costs of living (Ramaswamy, 2012). 3. The quality and usefulness of the BG plc annual report The BG plc annual report does an excellent job of presenting information about the company and the average reader is able to get a good picture of the upstream oil and gas industry. The oil and gas industry is very capital intensive and there is the need for investors in companies such as BG plc to be presented with clear and transparent information to make informed judgements about the company. The BG plc annual report certainly does a good job of presenting its business model including risks and their mitigation plans in clear language. The major risks for the company are in the exploration and production segment both due to the large investments needed and the uncertain outcome from those investments. Perhaps the LNG and the T&D businesses are a means of reducing the overall risk for the company. BG plc appears to meet the requirements of IFRS both in letter and spirit, exceeding industry norms in certain cases. References: 1. BG report, (2011). “Annual Report of BG plc for 2011”. (Accessed on 26 March 2013 at www.bgplc.com) 2. IAS 36, (2012). “IAS 36 Impairment of assets”, 2012. (Accessed on 27March 2013 at www.ifrs.org) 3. KPMG, (2008). “The Application of IFRS: Oil and Gas”, October, 2008. (Accessed on 28 March 2013 at www.kpmg.com). 4. Mitchell, J., Marcel, V. and Mitchell, B., (2012). “What next for the Oil and Gas Industry”, Chatham House, October 2012 (Accessed on 28 March 2012 at www.chathamhouse.org) 5. Price, K., (2012). “Hedging is an effective risk management tool for upstream companies”, Oil & Gas Financial Journal, 1Nov 2012. (Accessed on 28 March 2013 at www. ogfj.com). 6. Ramaswamy, S., (2012). “The sustainability of pension schemes”, BIS Working Papers No 368, January 2012. (Accessed on 27 March 2013 at www.bis.org). Read More