Application of Critical Accounting Policies and Use of Estimates

The preparation of financial statements requires management to make estimates and assumptions that affect reported assets and liabilities, disclosures of contingencies and revenues and expenses. Management is also required to adopt accounting policies that require the use of significant estimates. Actual results could differ materially from those estimates. A summary of significant accounting policies adopted by Talisman can be found in note 1 to the Consolidated Financial Statements. In assisting the Company’s Audit Committee to fulfil its financial statement oversight role, management regularly meets with the Committee to review the Company’s significant accounting policies, estimates and any significant changes thereto, including those discussed below.

Management believes the most critical accounting policies, including judgments in their application, which may have an impact on the Company’s financial results, relate to the accounting for property, plant and equipment (PP&E), asset retirement obligations (ARO) and goodwill. The rate at which the Company’s assets are depreciated or otherwise written off and the asset retirement liability provided for, with the associated accretion expensed to the income statement, are subject to a number of judgments about future events, many of which are beyond management’s control. Reserves recognition is central to much of an oil and gas company’s accounting, as described below.

Reserves Recognition

Underpinning Talisman’s oil and gas assets and goodwill are its oil and gas reserves. Detailed rules and industry practice, to which Talisman adheres, have been developed to provide uniform reserves recognition criteria. However, the process of estimating oil and gas reserves is inherently judgmental. There are two principal sources of uncertainty: technical and commercial. Technical reserves estimates are made using available geological and reservoir data as well as production performance data. As new data becomes available, including actual reservoir performance, reserves estimates may change. Reserves can also be classified as proved or probable with decreasing levels of certainty as to the likelihood that the reserves will be ultimately produced.

Reserves recognition is also impacted by economic considerations. In order for reserves to be recognized, they must be reasonably certain of being produced under existing economic and operating conditions, which is viewed as being annual average commodity prices determined by the prices in effect on the first day of each month with a cost profile based on current operations (SEC requirements) or forecast prices and cost assumptions (NI 51-101 requirements). Any anticipated changes in conditions must have reasonable certainty of occurrence. In particular, in international operations, consideration includes the status of field development planning and gas sales contracts. As economic conditions change, primarily as a result of changes in commodity prices and, to a lesser extent, operating and capital costs, marginally profitable production, typically experienced in the later years of a field’s life cycle, may be added to reserves or, conversely, may no longer qualify for reserves recognition.

The Company’s reserves and revisions to those reserves, although not separately reported on the Company’s balance sheet or income statement, impact the Company’s reported net income through the DD&A of the Company’s PP&E, asset and goodwill impairments and the provision for future ARO.

The Reserves Committee of Talisman’s Board of Directors reviews the Company’s reserves booking process and related public disclosures and the report of the internal qualified reserves evaluator (IQRE). The primary responsibilities of the Reserves Committee of the Board of Directors include, among other things, reviewing the Company’s reserves booking process and recommending to the Board of Directors the Company’s annual disclosure of reserves data and other oil and gas information contained in the Company’s Annual Information Form. The IQRE reports the Company’s annual reserves data to the Reserves Committee and delivers a regulatory certificate regarding proved and probable reserves and their related future net revenue.

Depreciation, Depletion and Amortization Expense (DD&A)

A significant portion of the Company’s PP&E is amortized based on the unit of production method with the remaining assets being amortized equally over their expected useful lives. The unit of production method attempts to amortize the asset’s cost over its proved oil and gas reserves base. Accordingly, revisions to reserves or changes to management’s view as to the operational lifespan of an asset will impact the Company’s future DD&A expense. Depletion rates are updated annually unless there is a material change in circumstances, in which case they would be updated more frequently. Material changes in year-end reserves are reflected in the fourth quarter depletion rate.

As outlined in the Company’s Significant Accounting Policies and PP&E notes (notes 1(d), 1(e) and 8 to the Consolidated Financial Statements), $6.4 billion (2009 – $4.7 billion) of the Company’s PP&E is held in non-depleted capital and is not currently subject to DD&A. The balance of non-depleted capital relates to the costs of individually material land purchases ($2.7 billion) which will either be transferred to the depletable base when proved or written off if unsuccessful, development projects which will be amortized when production commences ($1.6 billion), the costs of acquired unproved reserves ($1.1 billion) and incomplete drilling activities, including those wells under evaluation or awaiting infrastructure ($1.0 billion). Uncertainty exists regarding the recoverability of these costs. For example, if the evaluation of the acquired probable reserves or recently drilled exploration wells is determined to be unsuccessful, the associated capitalized costs would be expensed in the year such determination is made, except that, in the case of acquired probable reserves associated with producing fields, these costs would be amortized over the reserves base of the associated producing field. Accordingly, the rate at which these costs are written off depends on management’s view of the likelihood of the existence of economically producible reserves.

Successful Efforts Accounting

Talisman uses the successful efforts method to account for its oil and gas exploration and development costs. Acquisition costs and development costs are capitalized and depleted using the unit of production method. Costs of drilling unsuccessful exploration wells (dry hole costs) and all other exploration costs, including geological and geophysical costs, are expensed.

The alternative method of accounting for oil and gas exploration and development costs is the full cost method. Under this method, costs of unsuccessful exploration wells as well as all other exploration costs are capitalized and added to the PP&E balance to be depleted on a unit of production basis in the future. In addition, future development costs are depleted over the total proved reserves.

The differences between the full cost and successful efforts methods of accounting make it difficult to compare net income between companies that use different methods of accounting.

Asset Impairments

The Company’s oil and gas assets and goodwill are subject to impairment tests. An impairment charge is recorded in the year an asset is determined to be impaired under the successful efforts method. Any impairment charge is the difference between the carrying value of the asset and its fair value. The determination of fair value requires management to make assumptions regarding cash flows into the future that are subject to revisions due to changes in commodity prices, costs, recoverable reserves, production profiles and discount rates. Due to the complexity of assumptions within the cash flow models used in a property-by-property impairment test, a sensitivity analysis in respect of the impact of changes in assumptions on the Company’s impairment assessment is not presented. Changes in any of the assumptions could result in an impairment of all or a portion of the carrying value of oil and gas assets and goodwill in future periods.

During the year, the Company recorded an impairment of oil and gas assets of $118 million (2009 – $70 million; 2008 – $4 million), which is included in other expenses on the Consolidated Statements of Income.

Goodwill Impairments

Goodwill represents the excess purchase price over the fair value of identifiable assets and liabilities acquired in business combinations. Goodwill is not amortized but is subject to impairment reviews in the fourth quarter of each year, or more frequently as economic events dictate. The impairment test requires that goodwill be allocated to reporting units which are determined by aggregating components having similar economic characteristics and/or are in similar geographic locations. These reporting units correspond with the segments described in note 24 to the Consolidated Financial Statements and have not changed during the year. No impairments to goodwill were recorded during the year.

Purchase Price Allocations

The costs of corporate and asset acquisitions are allocated to the acquired assets and liabilities based on their fair value at the time of acquisition. In many cases, the determination of fair value requires management to make certain assumptions and estimates regarding future events. Typically in determining fair value, management develops a number of possible future cash flow scenarios to which probabilities are judgmentally assigned. The acquired assets and liabilities may span multiple geographical segments and may be amortized at different rates, or not at all as in the case of goodwill or, initially, for acquired probable reserves. Accordingly, the allocation process impacts the Company’s reported assets and liabilities and future net income due to the impact on future DD&A expense and impairment tests.

In 2010, Talisman entered into or completed the following transactions:

• acquired 100% of the outstanding shares of Hess (Indonesia Jambi Merang) Limited, a company with a 25% interest in the Jambi Merang PSC;
• entered into an agreement to acquire a 49% interest in BP Exploration Company (Colombia) Limited. The transaction closed in January 2011;
• completed the acquisition of 78,000 net acres of land in the Eagle Ford shale play. Talisman and Statoil have created a joint venture across the Eagle Ford shale play, with Talisman as the initial operator; and
• acquired a 35% working interest in the PL378 Grosbeak discovery and a 20% interest in the PL375 Beta discovery.

In 2009, Talisman completed the following transactions:

• acquired all of the outstanding shares of Rift Oil plc, Horizon Oil (Kanau) Limited and Papua Petroleum Limited, companies having interests in exploration licences in Papua New Guinea, for $253 million in cash; and
• acquired an operated interest in Block K9 in the Kurdistan region of northern Iraq for $29 million in cash, plus additional payments which are dependent upon the level of estimated reserves.

In 2008, Talisman completed the following transactions:

• acquired all of the outstanding shares of RSX Energy Inc., a public company with natural gas assets located in the Outer Foothills and Peace River areas of northern Alberta, for cash consideration of $95 million and the assumption of $6 million of long-term debt; and
• acquired a 40% working interest in Block K44 in the Kurdistan region of northern Iraq. The Company also entered into a seismic services agreement related to Block K39 for a period of two years. In 2010, Talisman agreed to enter into a PSC as operator of Block K39.

Asset Retirement Obligations (ARO)

Upon retirement of its oil and gas assets, the Company anticipates incurring substantial costs associated with abandonment and reclamation activities. At December 31, 2010, the discounted fair value of the Company’s ARO liability was $2.3 billion (2009 – $2.1 billion) and is recorded as a liability on the Company’s balance sheet. In determining the fair value of the Company’s ARO liability, management developed a number of possible abandonment scenarios to which probabilities were assigned based on management’s reasonable judgment. The total undiscounted abandonment obligations were estimated at $4.5 billion at December 31, 2010 (2009 – $4.5 billion), which is based on management’s probability weighted estimate of costs and is in accordance with existing legislation and industry practice.

Estimates of the associated costs are subject to uncertainty associated with the method, timing and extent of future retirement activities. Accordingly, the annual expense associated with future abandonment and reclamation activities is impacted by changes in the estimates of the expected costs and reserves. Changes to these estimates in the past year resulted in an increase to the ARO liability of $146 million related primarily to changes in estimated field life in the UK. As an indication of possible future changes in the estimated liability, if all of the Company’s abandonment obligations could be deferred by one year, the net present value of the liability would decrease by approximately $95 million.

Income Taxes

Talisman uses the liability method to account for income taxes. Under the liability method, future income taxes are based on the differences between assets and liabilities reported for financial accounting purposes from those reported for income tax. The determination of the income tax provision is an inherently complex process, requiring management to interpret continually changing regulations and to make certain judgments. Issues in dispute for audited years and audits for subsequent years are ongoing and in various stages of completion in the jurisdictions in which the Company operates around the world. As a consequence, the balance in unrecognized tax benefits can be expected to fluctuate from period to period. It is reasonably possible that such changes could be significant when compared with the Company’s total unrecognized tax benefits. However, the amount of change cannot be quantified.

Future tax assets are recognized only to the extent that it is considered more likely than not that there will be suitable taxable profits from which the underlying temporary differences can be deducted. Based on expectations for the future and available tax-planning strategies, management expects remaining future tax assets will be realized as offsets to reversing future tax liabilities and as offsets to the tax consequences of future taxable income.

Foreign Exchange Accounting

Talisman’s worldwide operations expose the Company to transactions denominated in a number of different currencies, which are required to be translated into one currency for financial statement reporting purposes. Talisman’s foreign currency translation policy, as detailed in note 1(j) to the Consolidated Financial Statements, is designed to reflect the economic exposure of the Company’s operations to the various currencies. The Company’s functional currency is US$, a reflection of Talisman’s overall exposure to US$ denominated transactions, assets and liabilities; oil prices are largely denominated in US$ as is much of the Company’s corporate debt and international capital spending and operating costs.

The Company’s self-sustaining operations in the UK (and, prior to January 1, 2010 in Canada and Norway) were translated from UK£, C$ and NOK respectively into US$ using the current rate method whereby assets and liabilities were translated at year-end exchange rates, while revenues and expenses were converted using average rates for the period. Gains and losses on translation to US$ relating to self-sustaining operations were deferred and included in a separate component of shareholders’ equity described as accumulated other comprehensive loss. As a result of a reorganization of the Company’s operations at the end of 2010, changes in the composition of revenue and costs and changes in intercompany loan arrangements, management has determined that the functional currency of the Company’s UK, Canada and Norway operations is more closely linked to the US$. Accordingly, effective January 1, 2010 for Canada and Norway and January 1, 2011 for the UK, these operations have been accounted for as US$ functional currency entities. As a result, foreign currency translation adjustments remain in accumulated other comprehensive loss until Talisman reduces its net investment in those subsidiaries. Following the change in the functional currency of the UK operations, the debt denominated in UK£ will no longer be designated as a hedge of Talisman’s net investment in the UK and, accordingly, future foreign exchange gains and losses will be recorded in the Consolidated Statement of Income.

Production Sharing Contract (PSC) Arrangements

A significant portion of the Company’s operations outside North America, the UK and Scandinavia are governed by PSCs. Under PSCs, Talisman, along with other working interest holders, typically bears all risk and costs for exploration, development and production. In return, if exploration is successful, Talisman recovers the sum of its investment and operating costs (cost oil) from a percentage of the production and sale of the associated hydrocarbons. Talisman is also entitled to receive a share of the production in excess of cost oil (profit oil). The sharing of profit oil varies between the working interest holders and the government from contract to contract. The cost oil, together with the Company’s share of profit oil, represents Talisman’s hydrocarbon entitlement (working interest less royalties). Talisman records gross production, sales and reserves based on its working interest ownership. The difference between the Company’s working interest ownership and its entitlement is accounted for as a royalty expense. In addition, certain of the Company’s contractual arrangements in foreign jurisdictions stipulate that income tax payments are to be withheld from the Company and paid to the government out of the respective national oil company’s entitlement share of production. The Company includes such amounts in income tax expense at the statutory tax rate in effect at the time of production.

The amount of cost oil required to recover Talisman’s investment and costs in a PSC is dependent on commodity prices and, consequently, Talisman’s share of profit oil is also impacted. Accordingly, the amount of royalty paid by Talisman over the term of a PSC and the corresponding net after royalty oil and gas reserves booked by the Company are dependent on the amount of initial investment and past costs yet to be recovered and anticipated future costs, commodity prices and production. As a result, when year-end prices increase, the amount of net reserves after royalty the Company books may decrease and vice versa.

Risk Management

The Company enters into derivative financial instruments in order to manage risks associated with fluctuations in commodity prices, interest rates and foreign currency exchange rates. As detailed in Talisman’s financial instruments accounting policy described in note 1(l) to the Consolidated Financial Statements, derivative instruments are recorded at fair value on the Consolidated Balance Sheets, with unrealized changes in fair value recorded in income or other comprehensive loss. Realized gains or losses on financial instruments are recognized as hedging gains or losses or held-for-trading gains or losses in net income. Fair values are determined based on third party market information and are subject to a degree of uncertainty.

Estimates of fair value are subject to change with fluctuations in commodity prices, interest rates, foreign currency exchange rates and estimates of non-performance risk. Cash settlement of derivative financial instruments may vary from fair value estimates, depending on the underlying market prices at the date of settlement.