Oil and Gas Accounting Assignment Help

Oil and Gas Accounting Assignment Help

INTRODUCTION TO OIL AND GAS Accounting

Oil and Gas Accounting Industry is different from other industries in many ways. Risk involves is usually very high compared to other traditional industries, Investments starts generating returns after a long period of time, regulations that guide this industry are very different compared to other industries. Taxing and accounting is also done differently.

A firm in Oil and Gas Accounting industry can be involved in various activities like exploration, acquisition, drilling, developing and producing oil and gas. Or it can be involved in activities like refining, processing or marketing and distribution. Based on the nature of these activities sometimes they are classified into upstream, midstream and downstream activities (CICAI, 2003).

Upstream activities include all the activities involving finding and production of oil and gas just before the point where oil and gas becomes ready to be used or sold.  Downstream activities typically involve the remaining activities like refining, processing, marketing and distribution. There are some activities which have traits of both upstream and downstream activities; they are referred as midstream activities.

Upstream activities are generally referred to as Exploration and Production (E & P) activities. Some firms are involved both in E & P and at least one of the downstream activity, they are known as an Integrated Company. Independent oil and gas companies are only involved in E & P activities.

PROBLEM DESCRIPTION

To study the impact of Oil and Gas accounting that affects the Strategic accounting of the firm and thus affecting the way finance managers make decisions.

COST INCURRED

Oil and Gas production incurs various costs at different stages in its life cycle.

  • Acquisition
  • Exploration and Appraisal
  • Development
  • Production

ACQUISITION

 1st step is to identify an area which has potential reserves. Once the company identifies such area, next logical step is to acquire the necessary rights for exploration, development and production from that sight. Rights must be acquired from the Government or the individual holding the rights for exploration, development and production in that area. Procedures of acquiring rights differ across geographies depending upon the laws of land.

Acquisition costs include the costs for the buying, leasing or for acquiring the mineral rights. Legal costs, costs for the relocation of the residents (If any) and other costs like brokerage are incurred at this stage (PWC, 2012).

EXPLORATIONS AND APPRAISAL

This activity includes the process of identification of areas which might have the reserves of oil and gas. Various exploration studies are conducted to identify such areas. Geological and geophysical exploration studies are important for such identification purpose. Seismic studies are also conducted to help in identifying such areas. Some other activities that are conducted are areal, geochemical, paleontological, palynological and topographic studies and their analysis is done. After the interpretation of results some test drilling is done, exploratory well and appraisal wells are drilled to identify the potential of the site.

Sometimes exploration cost may be incurred before the acquisition of the property also known as prospecting cost. Exploration costs include both direct and indirect costs like depreciation and all the applicable operating costs for the machinery and equipments needs for the purpose of exploration. Geological and Geophysical (G & G) cost which include surveys, salaries of all the employees engaged. Other costs incurred are cost of carrying the undeveloped properties and retaining them, licensing fees etc, drilling wells for exploration purpose and appraisal well. Cost of equipment needed for drilling purpose.

DEVELOPMENT

Development refers to establishing the necessary infrastructure needed for the purpose of extraction and transportation. Some of the activities involved are purchase, shipment and storage of the equipment, drilling different wells like testing wells, service wells etc. Laying the pipelines, building offshore platforms and all other transportation and storage related infrastructure is built in this stage.

Costs are incurred to acquire, construct and install the production facilities. All the costs incurred in drilling wells is considered in this stage. The entire support infrastructure that is built, its cost is also considered in development costs. Support infrastructure includes roads, power lines, clearing ground etc. All the operating costs and depreciation of the related equipment is considered as development cost (Charlotte &Gallun, 2008).

PRODUCTION

Once the development of the oil field is complete, production from the site can be started immediately. Production activities can be classified into 2 categories: Pre-wellhead and Post-wellhead. Pre-wellhead activities include bringing the oil and gas from underground wells to the surface. Other pre-wellhead activities are operation of well and maintaining those wells etc. Post-wellhead activities are gathering the oil and gas that has been brought to the surface, treating the gathered oil and gas, transportation and processing etc. upto the storage capacity.

All the costs whether direct or indirect those are incurred to operate and maintain the wells are considered here. Cost of labor, material, supplies, power, fuel, repairs and maintenance, taxes, insurance, royalty etc. are considered as production costs. Operating costs for any production facility goes up as the volume of reserves starts going down.

ACCOUNTING METHODS:

There are two alternatives available for accounting of acquisition, exploration and development. They are:

  • Successful efforts method (SEM)
  • Full Cost Method (FCM)

HISTORY AND DEVELOPMENT OF OIL AND GAS ACCOUNTING

In the past several decades accounting practices has evolved for oil and gas producing entities and are changes significantly. Historical cost accountingmodel has been the most prevailing model through the present time. Successful efforts and full cost—are the two fundamentally different methods of applying historical cost and are continued to be widely accepted in accounting practice.

Following the Arab oil embargo in the 1970s, historical cost accounting models were challenged following the changes in the underlying economics of the oil and gas industries. Relevance and sufficiency of these models were questioned. This in turn led to new requirements for supplemental disclosures related to the standardized measure and quantity of oil and gas reserves. Increasing worldwide focus on environmental issues and remediation activities have questioned the accounting policies in place and are likely to change the accounting policies based on the underlying economics of environment.

OVERVIEW OF IFRS

IFRS6 specifies the way in which thefinancial accountingfor the “Exploration and Evaluation of mineral resources” is to be done. All the expenditures that are related to exploration and evaluation are the expenditures that the company incurs even before it is found that the project is technically feasible or not, and the expenses that are incurred even before the commercial viability of extraction project is justified. In line with the company’s accounting policies, Expenditure and Evaluation assets are the expenditures incurred in E&E activities that are treated as assets.

IMPLICATION OF IFRS

  • Accounting policies for E&E assets of their own can be developed according to the IFRS 6 norms. This exemption allows the entity to keep using the accounting policies that the company was using right before the adoption of IFRS 6.
  • According to the norms of IFRS 6, companies should perform an impairment test on those E&E assets when the facts suggest that the amount that can be recovered might exceed the amount that is incurred in carrying those assets.
  • IAS36 specifies a way in which impairment should be recognized, this may differ from company to company. After the recognition of impairment, Standards should be used in their measurement.
  • IFRS6 helps in identifying the cash generating units.
  • E&E assets should be treated as a separate class of assets and necessary disclosures should be made.

SUCCESSFUL EFFORTS METHOD

 In this method, only capitalization of those costs is done that are related to the discovery, acquisition or development of oil and gas reserves. All the costs that are known but can’t meet the criteria at the time of incurrence are charged as expenses for the period. Result of such costs is not known when they are incurred, they are recorded as capital WIP and we write off such costs when they turn out to be non-productive. In other words, this method allows the company to capitalize only those expenses that are associated with successful location of new reserves. Costs incurred for unsuccessful results are charged against the revenues for the period in which they are incurred(Garb, 1999).

ADVANTAGES OF SUCCESSFUL EFFORT ACCOUNTING

  1. SE method of accounting reflects the normal concept of an asset.
  2. Volatility gets reflected in this method.
  3. Concept of matching is used in this method
  4. It reflects management’s effectiveness in finding new reserves

DISADVANTAGES OF SUCCESSFUL EFFORT ACCOUNTING

  1. In this method, the Profit and Loss statement can give an incorrect impression about the performance
  2. Unsuccessful pre-production gets charged off, this results in an understatement of assets and net income.
  3. In the successful efforts accounting method, assessment of success or failureis done too early in the life of the project
  4. It fails in recognizing that in an Exploration and Production enterprise, financial management of allocated resources for finding new reserves

FULL COST METHOD

In this method, all costs are incurred while doing the prospecting, acquiring mineral interests; exploration and development are expensed in large cost centers irrespective of any geological factors. In this method cost centers are normally larger than a country except where unwarranted by major differences in economic, fiscal or other factors in country (Murray, 2003). Capitalized cost for each cost centers gets depreciated as the reserves are getting produced. In other words, this method allows the operating expenses incurred in finding new reserves no matter what the outcome is.

ADVANTAGES OF FULL COST METHOD

  1. This method tells the way in which enterprise perform acquisition, and development of mineral resources
  2. Income and expenditure are better matched.
  3. It is similar to the absorption costing of manufacturing industries.
  4. This method avoids the distortions of reported earnings

DISADVANTAGES OF FULL COST METHOD

  1. In this method, many of the capitalized costs do not meet the definition of assets.
  2. Full cost accounting method delays loss recognition
  3. It helps in measuring the effectiveness and efficiency of the exploration and development activities of the organization.

In both the approaches exploration cost s are capitalized in the balance sheet under the long term assets. GAAP requires assets to be charged against the revenues.

WHY TWO METHODS ARE REQUIRED?

Supporters for each view claim that their method is more transparent in terms of earning and cash flows of an oil and gas firm.

Supporters of Successful Efforts method argues that the aim of an oil and gas company is to produce the oil and natural gas from reserve it locates and develops. Only the costs for the successful efforts should be capitalized. And for the costs related to unsuccessful efforts should be expensed as there is no change in the productive assets of the company (Garb, 1994).

Supporters of Full Cost methods hold the view dominant activity of any oil and gas Company is the finding and developing reserves. Thus any costs that are incurred doing this activity should be capitalized first and then they are written off during complete operating cycle.

DIFFERENCE BETWEEN THE TWO METHODS

The basic difference between the two approaches is how the cost of an unsuccessful effort is treated. This treatment results in the difference in net income for the period and the cash flow numbers.

  1. Acquisition costs: Both successful efforts and full cost method capitalize the costs incurred in the acquisition of rights for exploring, developing and production. All the expenses related to lease and purchase are capitalized in both the methods.
  2. Exploration Costs: Exploration costs can be either tangible or intangible. Intangible costs include all the costs that incurred in making site ready. Tangible costs are those that are incurred in installation and operation of the equipment.All the intangible costs are charged in the period’s income statement as a part of period’s operating expense when successful efforts method is followed. All the tangible costs are capitalized which were associated with the finding new reserves. Costs for unsuccessful efforts are written off as operating expenses for that period.Companies following full cost method, all the exploration costs irrespective of whether they are tangible or intangible are capitalized as long term assets and are added to balance sheet.
  3. Development Costs: All the development cost that are incurred in building all the support infrastructure gets capitalized in both successful effort and full cost methods.
  4. Production Costs: Costs incurred for extraction is accounted as periodic operating expense and are directly accounted in income statement in both successful effort and full cost accounting method.
CostsFull CostSuccessful Efforts
General costs prior to acquisition of licenseExpensedExpensed
Specific pre-license, license acquisition, exploration and appraisal costsCapitalizedCapitalize initially then write off, unless commercial reserve established
Development costsCapitalizedCapitalized
Production costsExpensedExpensed

IMPACTS DUE TO DIFFERENT LEVELS OF CAPITALIZED ASSETS

Due to the difference in the way the assets gets capitalized in the two methods there is a difference seen in the periodic financial statements. Both the methods treats the above mentioned categories of cost differently which results in a difference in income and cash flow statements.

“Depreciation, Depletion and Amortization of costs relating to expenditure for the acquisition, exploration and development of the reserves differ for the two accounting methods” (Barham, 2002).

IMPACTS ON FINANCIAL STATEMENT

INCOME STATEMENT

For the unsuccessful efforts of finding new reserves, the expenses that are incurred initially like Depreciation, Depletion and Amortization, production expenses and exploration costs are recorded on the income statement.

Both Successful Efforts and Full Cost net income is impacted by the periodic charges for the above mentioned expenses, but net income for the Successful Effortcompany gets impacted further due to the exploration cost. For two companies assuming identical operational results, company following the successful efforts method will report lower near term periodic net income compared to the other company following full cost method. At the later stage when no new reserves are discovered and with the depletion of existing reserves, the lower production rate will negatively impact revenues and the calculation of Depreciation, Depletion and Amortization for both the successful effort and full cost company. FC Company has capitalized costs that are higher, also higher depletion and amortization expense at the time of declining revenues, the periodic net earnings of the Successful Effort company will get better compared to full cost company, and with time they will surpass those costs.

STATEMENT OF CASH FLOWS

For the companies having similar outcomes from their operations but following different methods of accounting, company which is following the Full Cost accountingmethod short-term results (Cash flow from operations (CFO)) will be superior to the results of the company following the Successful Efforts method. Cash Flow from Operations non-cash charges like Depreciation, Depletion &Amortization added back; even though for the lower charge for DD&A, CFO for a Successful Efforts company’s net income reflects the expenses from exploration efforts.

If company is not able to add any new resources then the reported net income for longer term Successful Efforts and Full Cost, each company's Cash Flow from Operations will be the same. Non-cash charges are added back like DD&A and they negates impact on net income calculated using Full cost method of accounting.

APPLICATION OF SUCCESSFUL EFFORTS METHOD

  • All the acquisition costs, explorations costs, and development costs in respect of a cost center are charged as capital WIP when incurred.
  • All other costs are charges as expenses as and when incurred
  • When ready for commercial production, all the exploration costs and development costs are capitalized as ‘Completed Wells’ from capital WIP to assets. All the acquisition costs should be capitalized from capital WIP to assets.
  • All the costs incurred in drilling exploratory well which in the end turn out to be no proved reserves are charged as expenses.
  • Unit of production method is used to calculate Depreciation (Depletion). Depletion rates are revised when needed.
  • Depreciation base of the cost centre should include
  • Gross block of the cost centre (excluding acquisitioncosts)
  • Net estimated dismantlement and abandonment costs.
  • 'Proved Oil and Gas Reserves' for the depreciation of acquisition cost within cost center comprise proved oil and gas reservesestimated at the end of the period as increased by theproduction during the period.

APPLICATION OF FULL COST METHOD

  • When incurred all acquisition costs, all depreciation costs and all development costs should be treated as capital WIP.
  • All other costs other than mentioned above are charged as expenses as and when they are incurred
  • All acquisition, all depreciationand all development costs are that correspond to all the proved reserves and are ready to commence to commercial production should be capitalized to assets from capital WIP. For all the reserves that are proved subsequently, capital WIP for such reserves should be capitalized as reserves as and when they are proved. All the expenditure which turns out to be aunsuccessful discovery should be transferred to the assets from capital work-in-progress as and when determined.
  • For capitalized assets depreciation (depletion) is calculated according to the unit of productions method that is explained for Successful Efforts method above.
  • Base for calculation of depreciation at cost center should include

(a) Gross block of the cost centre;

(b) An estimate of expenditures that are to be incurred in future for developing the proved oil and gas reserves comprise developed and undeveloped oil and gasreserves

(c) An estimated for dismantlement and abandonment costs. This should be net of estimated salvage values.

'Proved Oil and Gas Reserves' for this purpose comprise developed and undeveloped oil and gasreserves estimated at the end of the period asincreased by the production during the period.

IMPAIRMENT OF NON-FINANCIAL ASSETS

IFRS6 requires E&E assets to be assessed for impairment in two circumstances:

  • If there are signs showing that the recoverable amount may be less than the amount which is incurred in carrying those E&E assets.
  • When E&E activities have been completed i.e when the commercial viability and technical feasibility of that asset have been determined and prior reclassification to development asset.

Trigger events for the impairment are:

  • Expiration of the right to explore
  • Commercially viable reserves not found and company decided not to continue operations in that area
  • Data showing that carrying amount of the E&E activities will not be recovered in full.

Relief is provided from the annual impairment testing for intangible assets that are not yet available for use. Time value of money is taken into account while doing the calculations.

DEVELOPMENT AND PRODUCTION ASSETS

For non-current assets IAS 36 Impairment of Assets, companies are required to make an assessment at the end of each reporting period to check if there are any signs showing that the asses is impaired. Recoverable amount needs to be assessed if any such indication is encountered.

In case of non determination of recoverable amount because an asset is not producing individual cash flows then loss due to impairment is recognized and is measured based on the cash generating unit to which the asset belongs.

CASH-GENERATING UNITS (CGUS)

A smallest group of assets capable of generating independent cash inflows from the cash flows that are generated from other assets or group of assets of the oil and gas company is known as a CGU.

Indicators of impairment

  • Market value has declined significantly or the company has operating or cash losses. •Technological obsolescence.
  • Competition.
  • Market capitalization
  • Significant regulatory changes
  • Physical damage to the asset
  • Significant adverse effect on the company that will change the way in which the asset is used/ expected to be used

GOODWILL

Oil and gas companies are required to test the goodwill at least once a year under new IFRS laws.

IMPAIRMENT REVERSALS

Losses due to impairment of goodwill cannot be reversed. For other assets companies need to do an assessment if there are signs showing that the impairment loss that has already been recognized has reversed. For such indications losses caused due to impairment are reversed if the recoverable amount has increased.

IMPACTS OF IFRS

IFRS 6 was developed to permit an entity to determine an IFRS accounting policy based on its current national GAAP policies It also provides guidance on the testing for impairment of amounts recognized as E&E assets and specifies disclosures for these assets and related expenditure.

INTERNATIONAL ACCOUNTING STANDARDS

International Financial Reporting Standards (IFRS) are issued by the International Accounting Standards Board (IASB). All the countries that are part of European Union follow International Accounting Standards. Most of the other countries in the world also follow the similar standards issued by IASB. Countries that are still using the GAAP standards are slowly shifting towards IFRS standards.

If a subsidiary of a parent company is operating in some foreign country, most of the foreign governments require companies operating in their land to prepare the financial statements according to the standards that are being followed in that country. So, the subsidiary reports is financial statements in accordance with the local accounting principles being followed where as the parent company reports according to the standards being followed in its own country (KPMG, 2011).

Similarly, if a company is traded in some other country, then it should present the financial statements to the securities commission of that country prepared according to the local standards. If the accounting principles followed are different then they should be modified accordingly.

 FUTURE DEVELOPMENTS

In 2005, IASB started reviewing the accounting for provisions. Based on the reviews an exposure draft was issued, which would have resulted in changes to both the timing of recognition and the measurement of provisions. In 2010 the IASB issued a limited re-exposure of the 2005 proposals, proposal mainly focused on how to measure provisions involving services, e.g. decommissioning. Currently the project is inactive, and it is up to IASB to take a call on how to go about the project. (KPMG, 2011)

US Securities and Exchange Commission is proposing changes to oil and gas reserves and estimation and disclosure requirements but the changes that are proposed are not consistent with the ISAB proposal and SEC is reluctant on converging its requirements with ISAB’s requirements.

CONCLUSION

On critical analysis of Oil and Gas Accounting, we have understood the two important methodologies of Full Cost method versus Successful efforts. There are advantages and disadvantages that could be attributed to both these methods. IFRS also has an impact on these accounting methods. To conclude we can say that the critical difference between the two methods is whether certain costs are capitalized or expensed and how the capitalized costs are depleted.

In full cost method all the well are first capitalized and with time they are depleted. For the purpose of depletion companies can use units of production method. All the costs are realized from the proven well whether they are incurred in development of unsuccessful or successful well. This method is allowed by the SEC but not preferred by the FASB and is intended as an incentive for the exploration of further oil and gas resources since costs related to unsuccessful exploration can be expensed over time rather than as incurred.

While using the successful efforts method, grouping of costs is done by some smaller basis. Generally the costs are grouped on the basis of fields. If these costs result into the direct development of the proved reserves then they get capitalized by group. If the costs incurred do not result in proved reserves, they are expensed when they are incurred.

REFERENCES

  • PWC (2012). “Financial Reporting of Oil and Gas Company”. http://www.pwc.com/gx/en/oil-gas-energy. Accessed on June 23, 2012
  • CICAI (2003), Guidance Note On Accounting for Oil and Gas Producing Activities, Pg 930-938.
  • Charlotte J. Wright & Rebecca A. Gallun (2008) - Fundamentals of Oil and Gas Accounting, Pg 1-32, 555-579
  • KPMG (2011), Impact of IFRS: Oil and Gas, Pg 10-11http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/ILine-of-Business-publications/Documents/Impact-of-IFRS-oil-and-gas.pdf. Accessed on June 23, 2012
  • Murray, Mark A. (2003), “Putting a Value on Oil and Gas Properties,” Cano Energy Pipeline, 26-27.
  • Garb, F.A., (1999) "Is the Domestic Petroleum Industry Viable in the Next Millennium," Speech for North American Petroleum Accounting Conference, May 19-21, , Dallas, TX.
  • Garb, F.A., (1994) "Why Prior Sales Transactions May Not Provide Good Estimate Of Fair-Market Value for Oil and Gas Properties," presented to annual meeting of Society of Petroleum Evaluation Engineers.