A gas purchase explodes into thin air

An interesting story came out the other day about BHP Billiton’s CEO refusing his bonus since the company was going to record a $3 billion write down of some of its oil and gas assets.  $3 billion sounds like a lot to you and me but when you look at the last few years of BHP’s performance, total revenue over the past three years: $175 billion; total net income over the same period: $43 billion.  If the write down seems insignificant to you, that’s partially a result of seemingly massive government debts that has transformed the scale of money for us – for instance look at the US debt ($15 Trillion!!) or the Greek debt (at the time of writing, €355 billion ~ $436 billion Cdn).

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Nonetheless, Mr. Kloppers, the CEO of BHP, is willing to give up his bonus of a few million dollars, presumably as a sign of solidarity with the shareholders.  It’s a nice gesture although I suspect he’s not suffering too much from the financial hit.  Still, leadership should involve a bit of sacrifice and personally I like his forfeiture.

Millionaire bonuses aside for a minute, where did the write down actually come from?  Similar to the post about Microsoft, BHP’s write down is related to recent acquisitions.  In this case, BHP purchased significant oil and gas companies in the past few years, particularly Fayettville in the US for $4.75 billion last year (2011).  When you look at the natural gas commodity price, you see that prices have fallen roughly 25% in the past year.  

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The sage advice, “buy low, sell high” rings true for all corporate acquisitions, even when we’re talking billions of dollars.  Let’s break this down into smaller steps:

  • Feb 2011: BHP purchases the Fayettville project when natural gas is trading at $4.50 per mmbtu (a million BTUs – the common measure for gas) and pays $4.75 billion.
    • DR Long Term Asset $4.75 Billion, CR Cash $4.75 Billion
  • July 2012: The commodity price has fallen, BHP does not expect it to rebound in the near term.  They must believe that the Long Term Asset cannot recover the full price paid, in fact they believe they will only recover approximately 1/2 the price.  Accounting rules require them to write the asset down:
    • CR Long Term Asset $2.8 Billion, DR Writedown expense $2.8 Billion

I’ve seen many of these commodity-based massive write downs and corporate crises.  For instance, take a look at Inco Ltd.’s write down (or lack thereof) on its Voisey’s Bay nickel project or Teck Cominco’s crisis after purchasing Fording Coal in 2008.  While these are massive dollar amounts on fairly complex business deals involving huge tracts of land, the accounting concept is relatively simple and applies equally to mining companies and all other businesses equally.  Assets cannot be shown on the balance sheet (statement of financial position) for more than they are likely going to earn.  We refer to this concept as impairment (see for example IAS 36 and ASPE 3063) – its a fundamental concept of financial accounting.  Research in Motion may have inventory it can’t sell?  That’s impairment.  BHP has millions of BTUs of natural gas that it will sell for less than it expected?  That’s impairment. In my opinion, impaired asset write downs are one of the most important concepts.  Unfortunately the information required to determine if an asset is impaired is usually highly asymmetric; that is, management has much better information than most other stakeholders.  Hopefully management is ethical and takes their financial reporting responsibilities seriously. Without that level of trust, the value of financial statements quickly falls apart.

Note: this blog was originally posted on my site hosted by Pearson Education (http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)