BP Annual Report and Form 20-F 2011 - Company Reporting

Additional information for shareholdersFor oil and natural gas properties, the expected future cash flows areestimated using management’s best estimate of future oil and naturalgas prices and reserves volumes. Prices for oil and natural gas used forfuture cash flow calculations are based on market prices for the firstfive years and the group’s long-term price assumptions thereafter. As at31 December 2011, the group’s long-term price assumptions were $90per barrel for Brent and $6.50/mmBtu for Henry Hub (2010 $75 per barreland $6.50/mmBtu). These long-term price assumptions are subject toperiodic review and modification. The estimated future level of productionis based on assumptions about future commodity prices, productionand development costs, field decline rates, current fiscal regimes andother factors.The future cash flows are adjusted for risks specific to the cashgeneratingunit and are discounted using a pre-tax discount rate. Thediscount rate is derived from the group’s post-tax weighted averagecost of capital and is adjusted where applicable to take into account anyspecific risks relating to the country where the cash-generating unit islocated, although other rates may be used if appropriate to the specificcircumstances. In 2011 the rates ranged from 12% to 14% nominal(2010 11% to 14% nominal). The rate applied in each country isreassessed each year.Irrespective of whether there is any indication of impairment, BP isrequired to test annually for impairment of goodwill acquired in a businesscombination. The group carries goodwill of approximately $12.1 billionon its balance sheet (2010 $8.6 billion), principally relating to the AtlanticRichfield, Burmah Castrol, Devon Energy and Reliance transactions. Intesting goodwill for impairment, the group uses a similar approach to thatdescribed above for asset impairment. If there are low oil prices or naturalgas prices or refining margins or marketing margins for an extended period,the group may need to recognize significant goodwill impairment charges.In 2009, an impairment loss of $1.6 billion was recognized to write off allof the goodwill allocated to the US West Coast fuels value chain (FVC).The prevailing weak refining environment, together with a review of futuremargin expectations in the FVC, led to a reduction in the expected futurecash flows.Refer to Oil and natural gas accounting above for a discussion onthe recoverability of intangible exploration and appraisal expenditure.Details of impairment charges recognized in the income statementare provided in Financial statements – Note 5 and details on the carryingamounts of assets are shown in Financial statements – Note 21, Note 22and Note 23.Business combinationsAccounting for business combinations using the acquisition methodrequires the determination of the fair value of the consideration transferred,together with the fair value of the identifiable assets acquired and liabilitiesassumed at the acquisition date. Goodwill is measured as being the excessof the aggregate of the consideration transferred, the amount recognizedfor any minority interest and the acquisition-date fair values of anypreviously held interest in the acquiree over the fair value of the identifiableassets acquired and liabilities assumed at the acquisition date.Judgement is required in determining whether a transaction meetsthe criteria to be treated as a business combination or not. Judgementsand estimates are also required in order to determine the fair values of theassets acquired and the liabilities assumed, and the group uses all availableinformation, including external valuations and appraisals where appropriate,to determine these fair values. If necessary, the group has up to one yearfrom the acquisition date to finalize the determinations of fair value.Details of the business combinations undertaken by the group in2011 are provided in Financial statements – Note 3 on page 194.TaxationThe computation of the group’s income tax expense and liabilityinvolves the interpretation of applicable tax laws and regulations in manyjurisdictions throughout the world. The resolution of tax positions takenby the group, through negotiations with relevant tax authorities or throughlitigation, can take several years to complete and in some cases it isdifficult to predict the ultimate outcome.In addition, the group has carry-forward tax losses and tax credits incertain taxing jurisdictions that are available to offset against future taxableprofit. However, deferred tax assets are recognized only to the extentthat it is probable that taxable profit will be available against which theunused tax losses or tax credits can be utilized. Management judgement isexercised in assessing whether this is the case.To the extent that actual outcomes differ from management’sestimates, income tax charges or credits, and changes in deferred taxassets or liabilities, may arise in future periods. For more information seeFinancial statements – Note 18 on page 210 and Note 43 on page 249.Derivative financial instrumentsThe group uses derivative financial instruments to manage certainexposures to fluctuations in foreign currency exchange rates, interestrates and commodity prices as well as for trading purposes. In addition,derivatives embedded within other financial instruments or other hostcontracts are treated as separate derivatives when their risks andcharacteristics are not closely related to those of the host contract. Allsuch derivatives are initially recognized at fair value on the date on which aderivative contract is entered into and are subsequently remeasured at fairvalue. Gains and losses arising from changes in the fair value of derivativesthat are not designated as effective hedging instruments are recognized inthe income statement.In some cases the fair values of derivatives are estimated usinginternal models and other valuation methods due to the absence of quotedprices or other observable, market-corroborated data. This applies to thegroup’s longer-term, structured derivative products and complex options,as well as to the majority of the group’s natural gas embedded derivatives.The group’s embedded derivatives arise primarily from long-term UK gascontracts that use pricing formulae not related to gas prices, for example,oil product and power prices. These contracts are valued using modelswith inputs that include price curves for each of the different products thatare built up from active market pricing data and extrapolated to the expiryof the contracts using the maximum available external pricing information.Additionally, where limited data exists for certain products, prices areinterpolated using historic and long-term pricing relationships. Pricevolatility is also an input for the models.Changes in the key assumptions could have a material impact onthe fair value gains and losses on derivatives and embedded derivativesrecognized in the income statement. For more information see Financialstatements – Note 33 on page 224.Details of the value-at-risk techniques used by the group tomeasure market risk exposure arising from its derivative trading positionsis provided in Financial statements – Note 26 on page 217. An analysis ofthe sensitivity of the fair value of the embedded derivatives to changesin the key assumptions is provided in Financial statements – Note 26 onpage 217.Additional information for shareholdersBP Annual Report and Form 20-F 2011 155