Crude oil production: royalty rates, profit-sharing, and accounting arrangements

(Part II)

In last week’s article, we referred to the two recognized methods of accounting for costs relating to the exploration, development and production of crude oil and natural gas: the “successful efforts” (SE) method and the “full cost” (FC) method. The SE method allows a company to capitalize only those costs associated with successfully locating new oil and natural gas reserves. Such costs are recorded in the company’s balance sheet as long-term assets. Using a predetermined rate, usually based on units of production, these costs, otherwise known as depreciation, depletion and amortization (DD&A) expenses, are transferred to expenditure and charged against revenue over the life of the investment. For unsuccessful (or “dry hole”) results, the associated costs are immediately charged against revenues for the accounting period in question. This is because there is no change in productive assets with unsuccessful results, and therefore the related costs should be expensed.

The alternative FC method allows all costs relating to locating new oil and gas reserves to be capitalized, regardless of the outcome. The rationale behind this approach is that, in general, the dominant activity of an oil and gas company is the exploration and development of oil and gas reserves. Therefore, all costs incurred in pursuit of this activity should first be capitalized and then written off over the life of the project.

It is evident that the periodic results of operation, financial position and cash flows of an oil and gas company will vary, depending on which of the two methods the company chooses to use. If the FC approach is adopted, profits in the earlier years will be greater than those of later years, assuming the same level of production and no significant variance in costs and revenue. The issue is one of timing difference, and in the long run, all costs associated with the exploration, development and production of crude oil and gas are recovered against revenue over the life of the project. Suffice it to state that the SE approach is more commonly used.

Types of costs associated with oil and gas production

The costs associated with oil and gas production are of four types: acquisition costs, exploration costs, development costs and production costs.

Acquisition costs: These relate to the acquisition of rights to explore, develop and produce oil or natural gas. They include expenses relating to either the purchase or leasing of the right to extract the oil and gas from a property not owned by the company. Under both SE and FC accounting methods, acquisition costs are capitalized.

Exploration costs: These are costs associated with the collection and analysis of geophysical and seismic data involved in the initial examination of a targeted area and later used in the decision of whether to drill at that location. They include costs relating to drilling a well, and can be both intangible and tangible. Intangible costs in general are those incurred to prepare the site prior to the installation of the drilling equipment whereas tangible drilling costs are those incurred to install and operate drilling equipment.

The SE method allows all intangible drilling costs to be charged against income as part of operating expenses for a company for the period in question. Tangible drilling costs associated with the successful discovery of new reserves are capitalized while those incurred in an unsuccessful effort are included in the operating expenses for that period. On the other hand, the FC method allows all exploration costs, including both tangible and intangible drilling costs, to be capitalized and included in the balance sheet as long-term assets to be amortised over the expected useful economic life of the assets.

Development Costs: These are costs associated with the preparation of discovered reserves for production such as those incurred in the construction or improvement of roads to access the well site, with additional drilling or well completion work, and with installing other needed infrastructure to extract (e.g., pumps), gather (pipelines) and store (tanks) the oil or natural gas from the reserves. Both SE and FC methods allow for the capitalization of all development costs.

Production Costs: All costs incurred in extracting oil or natural gas from the reserves are considered production costs. These include wages and salaries for workers and electricity for operating well pumps. Production costs are considered part of periodic operating expenses and are charged directly against income under both accounting methods.

Which method should oil and gas companies use?

To answer the question, we need to look to internationally recognized standards for the necessary guidance. There are two such standards that are applicable to private sector organisations: national standards that are promulgated either by the recognised professional accounting bodies in the country or by legislation; and the International Financial Reporting Standards (IFRSs).

In the United States, the independent accounting standard setting body, the Financial Accounting Standards Board (FASB), issues generally accepted accounting principles (GAAPs). This is in addition to formulating a conceptual framework that provides an underlying theoretical and conceptual structure for accounting standards. On the other hand, the Securities and Exchange Commission (SEC) regulates the financial reporting format and content of publicly-traded companies. These two regulatory bodies are at variance as to which method should be used in the accounting and financial reporting of oil and gas expenditure. FASB has issued Statement of Financial Accounting Standard 19 requiring all oil and gas companies to use the SE method. On the other hand, the SEC allows companies to use the FC method, no doubt because of higher earnings in the early with consequent boost in share prices. Notwithstanding the disagreement, there is recognition of the need for a single and uniform accounting approach. However, not much progress has so far been achieved is this direction.

The International Accounting Standards Board (IASB) is the standard-setting body for IFRSs.  As of 2013, the European Union and more than 100 other countries have adopted IFRSs or some variant of it. However, there is no dedicated, stand-alone IFRS for the accounting and financial reporting for oil and gas expenditure, though proposals are under active consideration for the promulgation of accounting standards for extractive industries. The closest guidance is provided by IFRS 6 – Exploration and Evaluation of Mineral Resources. While the standard supports the capitalization of E&E costs, it offers an interim solution, which is to treat E&E costs before obtaining legal right to explore as an expense.

The SE method is nevertheless more compatible with the IASB Framework, especially as regards the definition of an asset being a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity.  This inflow of economic benefits must be probable, and the related cost/value can be measured reliably. Virtually, all entities transitioning to IFRSs have chosen to adopt IFRS 6 instead of developing accounting policies consistent with the IASB Framework. But this is only an interim solution, and they will have to develop detailed accounting policies until such time that a stand-alone dedicated IFRS standard is issued.

Since October 2002, the IASB and FASB have been working to remove differences between international standards and US GAAPs and to have a common set of high quality global accounting standards. However, significant disagreements remain to the extent that global accounting convergence may no longer be achievable.

The way forward

Whichever of the two methods is used by oil and gas companies, it would be entirely appropriate for these companies to highlight within their financial reporting frameworks, the implications if the alternative method was used, especially in terms of results of operation, financial position and cash flows. Such disclosure will enable all users of the financial statements to have a greater understanding and appreciation of these statements when making investment and other decisions. Meanwhile, FASB should accelerate its efforts to promulgate standards for extractive industries in order to avoid what may be viewed as a stop-gap approach in dealing with the accounting and financial reporting of oil and gas companies.

Finally, the two standard-setting bodies – FASB and IASB – should renew their efforts aimed at achieving a convergence within the earliest possible time period so that preparers as well as users of financial statements can have the benefit of a common and unified set of globally recognized accounting standards.

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