Case 5-1

Accounting for BP PLCs Deepwater Horizon Oil Spill

On April 20, 2010, an explosion at BP PLCs Macondo well in the Gulf of Mexico caused the largest oil spill and one of the worst environmental disasters in U.S. history. Because the incident occurred at the Deepwater Horizon drilling rig, this incident is often referred to as the Deepwater Horizon spill. Approximately 4.9 million barrels of oil were released, threatening the marine environment of the Gulf of Mexico as well as the environment and communities of the Gulf Coast region of the United States. In addition, 11 workers died and 17 were injured in the explosion. While BP bore primary legal responsibility for the spill, Transocean Corporation (the drilling rig operator) and Halliburton Company (the construction contractor) were also held partially responsible.

The spills financial costs to BP were enormous but also highly uncertain in the years that followed. Initially, the company incurred large costs to respond to the explosion and contain the spill. As time passed, the disaster set in motion a complex set of investigations and court cases that resulted in numerous fines and damage awards. In addition, BP made expensive commitments to support various environmental initiatives in the Gulf Cost region.

BPformerly named British Petroleum and headquartered in Londonreports under IFRS and accounted for many of the spills costs using IAS 37, Provisions, Contingent Liabilities, and Contingent Assets. As noted earlier in this chapter, IAS 37 requires accrual of contingent liabilities when they are probable and can be reliably estimated. From the 2010 fiscal year onward, the company disclosed among its significant judgments and estimates those required to account for the spill under IAS 37. Through 2014, KPMG, BPs auditor, included warnings of the uncertainties presented by these contingent liabilities in its auditors reports. The following passage taken from KPMGs audit opinion in the 2014 annual report expresses these concerns:

In forming our opinion on the group financial statements we have considered the adequacy of the disclosure in Note 2 to the financial statements concerning the provisions, future expenditures which cannot be reliably estimated and other contingent liabilities related to the claims, penalties and litigation arising from the Gulf of Mexico oil spill. The total amount that will ultimately be paid by BP in relation to all obligations arising from this significant event is subject to significant uncertainty and the ultimate exposure and cost to BP is dependent on many factors, including but not limited to, the determinations of the Courts and Regulatory authorities in the US. Significant uncertainty exists in relation to the amount of claims that will become payable by BP and the amount of fines that will be levied on BP (including any ultimate determination of BPs culpability based on negligence, gross negligence or willful misconduct). The outcome of litigation and the cost of the longer term environmental consequences of the oil spill are also subject to significant uncertainty. For these reasons it is not possible to estimate reliably the ultimate cost to BP. Our opinion is not qualified in respect of these matters.

The following table reports the costs recognized by BP through 2014 across four categories. The firstspill responsesummarizes the amounts spent directly responding to the explosion and spill. The other three categories are costs initially recorded as contingent liabilitiesenvironmental, litigation and claims, and Clean Water Act penalties. As of December 31, 2014, expenses recognized in the four categories had totaled $47.8 billion.

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The following are summaries of the main spill-related contingent liabilities disclosed in BPs 2014 annual report:

Environmental - As of December 31, 2014, provisions in the Environmental category included the following significant items:

• A commitment to fund the Gulf of Mexico Research Initiative (GoMRI). This was originally a $500 million dollar commitment, of which $279 million had yet to be paid out as of December 31, 2014. The GoMRI is a 10-year environmental research program to study the impact of the spills long-range environmental impacts. Grants were made to a variety of research institutes, including those affiliated with Louisiana State University, the University of South Florida, Mississippi State University, and the National Institutes of Health.

• A framework agreement between BP, the federal government, and five Gulf Coast states to fund restoration projects in the Gulf Coast region. As of December 31, 2014, $798 million remained of commitments to fund assessment costs and early restoration projects. However, BPs disclosure for this commitment notes that cost of later restoration projects has not been accrued, or even estimated:

  Until the size, location and duration of the impact is assessed, it is not possible to estimate reliably either the amounts or timing of the remaining natural resource damages claims other than the assessment and early restoration costs noted above, therefore no additional amounts have been provided for these items.

Litigation and claims - The litigation and claims provision includes estimates of payments to i) individuals and businesses for property damage, lost profits and the impairment of earning capacity, and ii) state and local governments for removal costs, property damages, lost tax revenue and increased public services. Through 2014, this cost category was by far the largest, containing $26.8 billion of recognized costs. This amount was more than half of total recognized costs and approximately 80% of costs recorded in the three contingent liability categories.

Despite the large accruals already made for this category, BP noted that no reliable estimate could be made for future costs and warned that the liability could go much higher. Chief among the lingering uncertainties was the simple fact that many claims had not yet been received, and for those that had been received, many still had not been fully evaluated. The company summarized this uncertainty with the following observation:

There is very little data to build up a track record of claims determinations under the policies and protocols that are now being applied. We therefore cannot estimate future trends of the number and proportion of claims that will be determined to be eligible, nor can we estimate the value of such claims. A provision for such business economic loss claims will be established when these uncertainties are resolved and a reliable estimate can be made of the liability.

page 213As of December 31, 2014, BP had accrued a balance sheet liability for this category of $9.9 billion. However, the company noted:

The total cost is likely to be significantly higher than the amount recognized to date of $9.9 billion because the current estimate does not reflect business economic loss claims not yet received, or received but not yet processed, or processed but not yet paid.

Clean Water Act Penalties - Soon after the spill, BP recorded a contingent liability of $3,510 million for estimated future penalties under Section 311 of the Clean Water Act. It made no subsequent adjustments to this accrual throughout the lengthy court trial that later ensued. A key issue in the trial was whether BPs actions in connection with its operation of the Deepwater Horizon well amounted to gross negligence and willful misconduct. In September 2014, the U.S. District Court for the District of Eastern Louisiana ruled that BP had acted with gross negligence and willful misconduct. As of the end of 2014, BP was appealing this finding in higher courts. If its appeal were to be unsuccessful, the Clean Water Act penalty could rise to as high as $13.7 billion.

The table above indicates that BP did not make any adjustment to its balance sheet accrual of $3,510 million in response to the district courts ruling. It did not raise the accrual because it claimed that the ultimate amount of the penalty for gross negligence and willful misconduct could not be reliably measured. Given this new uncertainty, one might reasonably ask the technical accounting question, Why maintain any accrual at all, given that it is subject to so much uncertainty? BP answered this question, citing a specific provision of IAS 37:

Under IFRS, a provision is reversed when it is no longer probable that an outflow of resources will be required to settle the obligation. With regard to the Clean Water Act penalty obligation, it continues to be probable that there will be an outflow of resources and therefore, in the absence of the ability to identify the best estimate of the liability, the previously recognized provision of $3,510 million has been maintained.

Required:

1. How did the spill-related costs recognized by BP in its financial statements through 2014 differ from a statistical estimate of the total expected costs that the companys senior management might have prepared and used internally over the same time frame?