AICPA Accounting

Standards Executive
Committee

Oil & Gas Guide Educational

Session

Thomas E. Smith Todd M. Roemer

Overview of Session

• Discuss differences between successful efforts and full cost

accounting
• Identify and account for mineral interests (i.e. royalty,
working interest, overriding royalty interest, etc.)
• Identify classification and grouping of certain property costs
and the treatment of these costs under successful efforts
and full cost
• Discuss differences of DD&A rules under successful efforts
and full cost
• Discuss the joint operations process
• Discuss the oil and gas revenues process
2
Overview of Session - continued

• Identification of production costs and related accounting

treatment
• Provide participants with an understanding of oil and gas
reserves (including FAS 142 and FAS 143 review) and FAS 69
disclosures

• Familiarize participants with FAS 144 issues

• Review alternative methods of accounting for exploration and

production companies

3
 AICPA Accounting
Standards Executive
Committee

Oil and Gas Accounting

Background and Accounting
Methods
Oil & Gas Accounting Background

• 1950’s and 1960’s: Diversity in practice in accounting for oil

and gas activities. Two methods - Full Cost and Successful
Efforts

• 1970’s: FAS No. 19, “Financial Accounting and Reporting

for Oil and Gas Producing Activities,” is issued. Prescribes
SE method be followed

• SEC issues several Accounting Series Releases that allow

companies to follow either method and provide guidance on
applying the different methods

• FAS No. 25 issued. Makes the SE method of accounting

preferable, but not mandatory.
5
Two Types of Accounting Methods

• FULL COST - Basic Concept

– All costs associated with property acquisition, exploration
and development activities shall be capitalized by
country-wide cost center.
• SUCCESSFUL EFFORTS - Basic Concept
– Costs associated with property acquisition, exploration
and development activities shall be capitalized if they
directly result in the finding or development of proved
reserves. Costs not directly resulting in proved reserves
shall be expensed.

6
 AICPA Accounting
Standards Executive
Committee

Acquisition and Retention

Costs
Acquisition and Retention Costs

• Acquisition Costs
• Retention / Holding Costs
– Delay Rentals
– Ad Valorem Taxes
– Shut-in Royalties
– Legal Costs for Title Defense
– Maintenance of Land and Lease Records
• Disposition of Capitalized Acquisition Costs
– Impairment
– Abandonment
– Transfer (Reclassification) to Proved Property
8
The Lease Agreement

Mineral interest owner (fee owner or lessor) leases E&P rights to the
working interest owner (lessee), the lease agreement:
– Defines the lessee and lessor
– Clearly defines the leased property
– States the consideration (“bonus”) paid by lessee to lessor
– States the amount of royalty retained by the lessor (e.g.,1/8 of
production sales proceeds)
– States the “primary term” (e.g., three years)
– Calls for annual “rentals” or delay rentals if drilling has not yet
commenced or production established
– Contains a clause perpetuating the lease if oil or gas production is
established
9
Types of Mineral Interests

• Fee interest
• Mineral interest
• Working interest (Operating Interest)
• Royalty interest (Non-operating Interest)
• Overriding royalty interest (Non-operating)
• Net profits interest (Non-operating)
• Production payment (Non-operating)
• Farm-out
• Free well agreement
• Reversionary or carried (a.k.a. Disproportionate or promoted interests)
• Unitization

10
Accounting for Acquisition and Retention
Costs – Successful Efforts Method

• Lease acquisition (CAPITALIZE DIRECT ACQUISITION COSTS)

– Bonus payments, advance payments, options
• Retention Costs (EXPENSE AS INCURRED)
– Delay rentals, property taxes, defense costs, shut-in royalties
• Disposition of capitalized acquisition costs
– Impairment
– Abandonment
– Transfer to proved properties

11
Accounting for Acquisition and Retention
Costs – Full Cost Method

• Lease acquisition (CAPITALIZE DIRECT ACQUISITION

COSTS)
– Bonus payments, advance payments, options
• Retention Costs (CAPITALIZE RETENTION COSTS)
– Delay rentals, property taxes, defense costs, shut-in
royalties
• Disposition of capitalized acquisition costs
– Impairment and Abandonment

12
Impairment – Acquisition Costs
Successful Efforts and Full Cost

• Assess periodically (at least annually)

• Triggering Events include dry hole(s), little time left on primary
term, development not in the budget
• May amortize costs in a group of properties if individually
insignificant
Accounting Differences:
• Successful Efforts (FAS No 19) – impairment charged to
exploration expense
• Full Cost (SEC Reg. S-X 4-10) – impairment included in the
amortization base (full cost pool) and amortized prospectively

13
 AICPA Accounting
Standards Executive
Committee

Exploration and
Development Costs
Exploration Costs Defined

• Costs incurred to find proved reserves, including identifying

areas that may warrant examination, examining specific areas,
and drilling exploratory wells and exploratory stratigraphic type
test wells
• Costs may be incurred prior to obtaining the lease
• Include costs of:
– Carrying and retaining undeveloped properties
– Topographical or geophysical studies and salaries related
to these studies

15
Development Costs Defined

• Obtain access to proved reserves

• Provide facilities for extracting, treating, gathering, and storing oil
and gas
• All phases of drilling development wells (from preparing well
locations to placing on production) whether tangible (having
salvage value) or intangible (a tax term of not having salvage
value, such as making a hole)
• “Acquire, construct, and install production facilities such as lease
flow lines, separators, treaters, heaters, manifolds, measuring
devices, and production storage tanks, natural gas cycling and
processing plants, and utility and waste disposal systems.”
• “Provide improved recovery systems”

16
Accounting for Exploration and
Development Costs

Exploration Costs
– Successful Efforts – Expense all exploration costs as incurred,
except those applicable to exploratory wells that result in
discovery of proved reserves (i.e. capitalize successful
exploratory wells and expense exploratory dry holes)
– Full Costs – Capitalize

Development Costs
– Successful Efforts - Capitalize
– Full Cost - Capitalize

17
 Exploration and Development Costs -
Illustration
Site Well
D 1 Discovery, exploratory well establishes offset sites C and E as proved.*
E 2 Offset, development producing well. Well 2 proves Site F.*
F 3 Offset, development producing well. Assume data does not prove Site G.*
B 4 Step-out,exploratory producing well on unproved drill site. Assume data proves Site A.
C 5 Offset, development producing well.
A 6 Offset, development dry hole. Costs remain capitalized as dev. costs. Well is plugged.
G 7 Offset, exploratory dry hole. Costs are expensed (SE). Well is plugged.

Site A B C D E F G

WELL 6 4 5 1 2 3 7

*Proving a site means that geological and

engineering data indicate with reasonable
certainty that the site has sufficient
reserves to economically justify (at
current prices) drilling the site. Usually a
successful well and G&G data prove only Gas Cap
sites offsetting the successful well’s site.
The data may or may not prove all offset Oil
locations.
Enchroaching Salt Water
18
 What if . . .
Case 4-1: G&G Library

• What if a company buys a library of G&G data on many geographic

areas, with an estimated useful life of 3 years? Must the cost be
expensed under SE?
• Example: XYZ Co. pays $10,000 for seismic studies of undeveloped acreage in the Gulf of
Mexico
• The Rule [Oi5.109 aka FAS 19, par. 18 ]
 “Geological and geophysical costs, costs of carrying and retaining undeveloped
properties, and dry hole and bottom hole contributions shall be charged to
expense when incurred.”
• Guidance/Accounting
 Seismic studies to enhance or evaluate development of a proved field may be
capitalized as development costs. If seismic study relates to exploration
activities, expense as incurred. Seismic related to both exploration and
development activities should be allocated between development costs
(capitalized) and exploration costs (expensed). Full Cost companies capitalize
all costs.

19
 What if . . .
Case 4-2: Development / Exploratory Well
• What if a development well is drilled below the proved

reservoir, looking for deeper reservoirs, yet unproven, and
finds no new reserves? Are the added costs exploratory?
• Example: XYZ Co. spends $1 million to access proved reserves at
10,000 feet and continues down to another stratigraphic region,
spending another $400,000 to go to 15,000 feet, only to find no proved
Developmen
reserves.
t
• Rule [Oi5.401 aka FAS 19, par. 274 ]
 A “development well is a well drilled within the proved area of an oil or
gas reservoir to the depth of a stratigraphic horizon known to be
proved.”
 Comment: A portion of a well (hole) can be a “development well” and the 10,000 ft,
remaining portion of the hole is an exploratory well for accounting purposes.
• Accounting for the example above
 Under Successful Efforts, XYZ expenses the $400,000 (spent to explore Exploratory
below the proved horizon) as unsuccessful exploratory well costs and
capitalizes the $1 million as development costs.
15,000 ft,
20
 What if . . .
Case 4-3: At first you don’t succeed…

• What if a twin (replacement) exploratory well is needed?

Are the costs of the abandoned first well expensed as

unsuccessful?
• Example: Drilling problems require XYZ Co. to stop short with
exploratory well #1, and immediately start over with a nearby “twin” well
which successfully discovers the reservoir. Is the $700,000 spent on
well #1 unsuccessful exploration cost?
Successful
• FAS 19 does not specifically address this case. Twin
– Arguably, it’s just another cost overrun of drilling “the well”.
• Accounting for the example above
 Follow established accounting for such cases.
 Likely expense the $700,000.

21
 Variations of Case 4-3

• Side tracking (preferable to expense the unsuccessful costs)

• Producing well re-entered and drilled deeper (an exploratory cost to be Side tracking

expensed if unsuccessful)
• Exploratory well finds no reserves at target formation, drilling
continues and discovers a deeper reservoir (capitalize all costs as
successful exploratory well)
• Exploratory well finds no reserves at target formation, plugged back to
shallower discovery (preferable to expense the costs of drilling beyond
the shallower discovery).
Multi-lateral well
• Exploratory well is a multi-lateral well
– Wells can be described as vertical (traditional), directional, horizontal, or multi-lateral

22
 What if . . .
Case 4-4: Well in Progress at End of Reporting Period

• What if an exploratory well is in-progress at year-end whereby

success cannot be determined at that time? What if it’s found to 
be dry soon thereafter? Are costs expensed as of period-end?
• Example: XYZ Co. spent/accrued $400,000 for well in progress at
period-end. After period-end XYZ spent $200,000 more but found no
reserves. Deemed a dry hole prior to issuance of financial statements.
• Rule [Oi5.130 / FAS 19, par 39 ] paraphrased: Well in
– Use information available before financial statements are issued to evaluate conditions at progress at
balance sheet date.
year-end
• Rule [Oi5.130 / FIN 36, par 2] paraphrased:
– If such information indicates well was unsuccessful, expense costs as of period-end, net
of any salvage value 
• Accounting for the example above:
– Expense the $400,000 as of period-end. Expense the $200,000 in the next period (the
period incurred).

23
 AICPA Accounting
Standards Executive
Committee

Amortization of Proved
Property Costs
What is DD&A?

• Oil & gas property costs are “amortized” using a “unit of

production” method whereby. . .
– Amortization Base x production / beginning of year (BOY)
reserves = amortization expense
– $200,000 net book value x 10,000 bbls / 100,000 bbls =
$20,000 amortization

25
What is DD&A?, continued

Federal income tax law and regulations call for:

–“Depreciation” of capitalized well equipment cost (over a
stated life or on the unit of production basis),
–“Depletion” of capitalized property acquisition costs (on a
unit of production basis), and
–“Amortization” over 60 months of certain other costs, such
as intangible drilling costs that are not immediately deducted

Financial reporting (FAS No.19 and Regulation S-X Rule 4-10)

requires all costs be “amortized” on the unit of production
method

26
Amortization - Simple Example

• Amortization Base (NBV)

– Capitalized Costs, end of period $1,200,000
– Less prior accumulated amortization (200,000)
 $1,000,000 “Base”

• Production (quantity sold) for the period 30,000 bbls “P”

• Oil & Gas reserves at period’s beginning:
– Latest reserve estimate (end of period) 270,000 bbls “R”
– Add production for the period (above) 30,000 bbls “P”
 300,000 bbls “R+P”

• Amortization = Base x P / (R +P) = $100,000

27
Calculating Amortization – Oil and Gas
Produced

• What if both oil and gas are being produced? How is amortization
calculated?
• Example: Production (P) is 4,000 bbls and 6,000 mcf

• Successful Efforts Rule (Oi5.129 / FAS 19, par 38) paraphrased:

- Convert to common unit of measure [boe or mcfe] based on relative
energy content,but…
- OK to use either oil or gas if it dominates or if P of oil to P of gas is
expected to remain relatively constant (answers about the same)
• Full Cost Rule (Rule 4-10[c](3)(iii) paraphrased:
- Same as for SE but allowed to use “gross revenue” method of P$/R$

Example solution: 4,000 bbl + 6,000 mcf x 1/6 = 5,000 boe; or

4,000 bbl x 6 + 6,000 mcf = 30,000 mcfe
28
Successful Efforts Amortization

• Costs grouped by field usually

• Field’s property acquisition costs amortized over total proved
reserves (developed and undeveloped)
• Field’s “well equipment and development” costs (including
IDC) amortized over proved developed reserves (excluding
undeveloped reserves)

29
What is a Field?

• Oi5.403 / FAS 19, par. 272

– “An area consisting of a single reservoir or multiple
reservoirs all grouped on or related to the same individual
geological structural feature or stratigraphic condition or
both.”
– Reservoirs may be separated laterally or vertically.
– Geological structure is not intended to include an entire
“basin”, “trend”, “play”, “area of interest”, etc.
– A reservoir is a “porous and permeable underground
formation containing a natural accumulation of producible
oil or gas . . . separate from other reservoirs.”
30
Developed vs. Undeveloped Proved
Reserves

• Proved oil and gas reserves are

- estimated quantities which “geological and engineering data
demonstrate with reasonable certainty to be recoverable in the future
years from known reservoirs under existing economic and operating
conditions, i.e., prices and costs as of the date the estimate is made.”
(excerpt from SEC S-X Rule 4-10)
• Developed reserves are those expected to be recovered through existing
wells, using existing equipment and operating methods
• Undeveloped reserves (PUDs) are those expected to be recovered from:
- New wells on undrilled acreage, or
- Existing wells requiring major expenditure

31
Full Cost Amortization

Broader parameters for capitalized oil & gas costs

– Governed by SEC S-X Rule 4-10(c)
– Amortized costs are grouped by country, not field
– Amortization base includes all acquisition, exploration, and
development costs, including future development and
abandonment costs
– Includes company internal costs directly identified with
acquisition, exploration and development activities (not
G&A or production)
– Some costs may be temporarily excluded from amortization
– Amortized over total proved developed and proved undeveloped
reserves

32
 AICPA Accounting
Standards Executive
Committee

Disposition of Oil & Gas

Assets
Dispositions - Successful Efforts

• Accounting - Successful Efforts

• General Rules:
– No gain if -
– Pooling of assets in a joint venture
– No gain, but a loss may be recognized if -
– Recovery of costs is in doubt or future performance is required
– Gain or loss if not described above

34
Dispositions – Full Cost

• Accounting - Full Cost

• General Rule:
– No gain or loss calculated
– Exception - Significantly alters the relationship between
costs and reserves

35
Sale of Entire Unproved Property

• Full Cost
– Credit proceeds to cost pool . . .
• Successful Efforts
– If impaired individually, recognize gain or loss
– If in an impairment group, no gain or loss recognition
– except to the extent sales price exceeds original cost

36
Sale of Part of an Unproved Property

• Full Cost
– Credit proceeds to cost pool . . .
• Successful Efforts
– Recovery of remaining cost is uncertain, so treat sales
proceeds as a recovery of cost…
– Except to the extent sales price exceeds
– original cost (if in an impairment group)
– carrying value net of impairment (if individually assessed for
impairment)

37
Sale of Entire Proved Property

• Successful Efforts
– Recognize Gain or Loss
• Full Cost
– Credit sales proceeds to full cost pool
– unless DD&A rate significantly distorted (greater than 10%)

38
Sale of Part of a Proved Property (or
Amortization Group)

• Successful Efforts
– Recognize Gain or Loss
– Option: Do not recognize gain or loss (asset retirement) if
amortization rate not significantly changed
– No gain recognized if significant continuing involvement,
however loss may be recognized
– Apportion book value based on fair values

• Full Cost
– Credit sales proceeds to full cost pool
– unless DD&A rate significantly distorted (greater than 10%)

39
Example – Sale of Part of a Proved
Property – No continuing involvement

XYZ Company sells half of a 2% ORRI in a proved property with

a NBV of $10,000 for $1 million.

– Rule: Oi5.138(j) [FAS 19 par. 47j]: Recognize gain or loss.

Allocate cost between portion sold and portion retained on
the basis of fair values.

– Accounting: [selling 50%, FV of sold = FV of retained]

Cash $1,000,000
Proved property costs [$10,000 x 50%] $5,000
Gain on sale $995,000

40
Example – Sale of Part of a Proved
Property – Continuing involvement

XYZ Company sells a 10% ORRI carved from a working interest

on proved property with a NBV of $100,000 and a remaining FV
of $120,000 for $40,000.

– Rule: Oi5.136(b), .138(j), .138(k), & .138(a): May recognize

loss, but no gain. .138(j): Calculate using relative fair values

– Accounting:
– Gain or loss? $100m x [40m / (40m + 120m)] = $25m cost
– $40m proceeds - $25m cost = $15m gain. Do not recognize.

Cash $40,000
Property cost $40,000

41
 AICPA Accounting
Standards Executive
Committee

Impairment of Oil & Gas

Assets
 General Rules – Comparison Between
Successful Efforts and Full Cost
Element Successful Efforts Full Cost

• Authoritative Guidance • FAS No. 144 • Regulation S-X 4-10

• Performance Criteria • Trigger event • Quarterly

• Price and Cost • Management’s internal • Constant (based on year end

Assumptions pricing prices)

• Grouping • Usually field-level • Country by country

• Property Types • Proved properties only • Proved properties only

• Typically excluded • Included
• Income Tax Considerations

• Component of Income from continuing • Component of Income from continuing

operations presented either separately or operations presented either separately or
• Presentation and Disclosure disclosed in notes disclosed in notes

43
 General Impairment Rules

Property Type Successful Efforts Full - Cost

• Proved • SFAS 144 • S-X 4-10(C)(4) “Ceiling Test” - If country-

wide costs less deferred taxes exceed
discounted after-tax cash flows at current
pricing (plus costs not being amortized),
write-off excess

• Unproved • FAS No. 19 and S-X 4-10; judgmental, • S-X 4-10(C)(3)(II)(1) and (C)(4)
systematic amortization, based on “Asset Impairment” as for successful
lease terms, dry holes, and drilling efforts and reclassify impairment to
intent amortization base (reducing ceiling)

44
Assessing Impairment – Step 1

• Assess impairment when events or circumstances indicate the

asset carrying amount may not be recoverable.
• Usually quarterly because mere passage of time is an indicator.
• Types of “Trigger Events”:

• Passage of time
• Decrease in prices
• Higher than anticipated development costs
• Decrease in reserve estimates (“downward revisions”)
• Environmental issues
• Adverse political; legislative; or regulatory changes

45
Assessing Impairment - Step 2

• Compare carrying amount to undiscounted, expected

future cash flows (UEFCF)
• If carrying amount exceeds UEFCF, go to Step 3.

46
Assessing Impairment - Step 3

• Write off carrying amount in excess of fair value

– No requirement to get an appraisal
– No specific guidance in determining FV
• Usually fair value reflects discounted, expected future cash
flows
• Discount rate is usually greater than 10% when applied to
truly expected future cash flows

47
Example FAS No. 144 Impairment
Analysis for Proved Properties

Step 1 - Assumed occurrence of trigger event

Determination of NBV Field A Field B Field C

Step 2 - Capitalized cost of proved properties $ 5 $ 20 $10
Comparison Accumulated DD&A (2) (8) (3)
against Liability for plugging & abandonment nil (2) (1)
undiscounted
cash flow
Net book value $ 3 $ 10 $ 6

Recognition test
Future UEFCF before taxes $4 $ 8 $8
Impairment loss no yes no

Step 3 -
Measurement Measurement of impairment
of impairment Fair value (Discounted Expected Future Cash Flows) (5)
Impairment $ 5

48
Full Cost Ceiling Test

CEILING COMPONENTS:
• Present value of of future cash flows from proved reserves
– Current sales prices and cost rates as of the balance sheet date
– Proved reserves (no probable or possible reserves)
– Future revenues less (operating, development, and P&A) costs
– Future net revenues are discounted at 10% per annum
• Current capitalized costs of properties not amortized
– Cost of unproved properties not being amortized
– Cost of unusually significant development projects not being
amortized

49
Full Cost Ceiling Test

CEILING COMPONENTS (continued)

• Lower of cost or fair value of unproved properties amortized
– Usually zero if unproved properties are excluded from
amortization since impaired costs moving into amortization base
have a fair value of zero
• Income tax effects of the first three components
– Exemptions for purchased property and favorable events prior to
auditor’s report

50
Full Cost Ceiling Test - Other Topics

• Ceiling Test Exemption for Proved Purchased Property:

– SAB Topic 12D, Question 3: Explains how ASR 258 ceiling exemption can be obtained
– Request temporary waiver from SEC
– Registrant requesting waiver should be prepared to demonstrate the additional value
exists beyond a reasonable doubt

• Subsequent Events:
– SAB Topic 12D, Question 3
– Ceiling test write-down avoided if:
– Additional proved reserves added before audit report
– Price increases become known before audit report

51
 AICPA Accounting
Standards Executive
Committee

FAS No. 143 - Asset

Retirement Obligations
FAS No. 143 - Overview

• Obligations of an entity that are unavoidable as a result of the

acquisition, construction or the normal operation of a tangible
long-lived asset
• Designed to end diversity in practice
• Retirement obligation (liability) recognized when incurred
• Fair value method of calculating liability
• Retirement costs are capitalized (and depreciated)

53
FAS No. 143 – Qualifying Obligations

Qualifying Obligations:
• Dismantlement of offshore platform
• Plugging and abandonment of oil and gas well bores
• Production facilities
• Underground storage facilities
• Distribution and transmission assets
• Others. . .

54
FAS No. 143 – Full Cost Implications

• Impact on the Full Cost Ceiling Test

– Asset retirement costs are recorded in the full cost pool
and subject to ceiling limitation; when calculating the
ceiling, ARO (abandonment obligation) is deducted from
future cash flows, resulting in “double counting”
– SAB 106 requires companies to exclude abandonment
obligation from future cash flow analysis
• Impact on DD&A calculation related to future asset retirement
costs expected to result from future development activities
– SAB 106 provides that companies must estimate the asset
retirement costs associated with future development
activities (for ARC not recorded in the balance sheet)

55
 AICPA Accounting
Standards Executive
Committee

Oil & Gas Revenues and

Production Costs
Determinants of Revenue

• Ownership
• Volumes
• Prices

57
Ownership

• Division Order
– Contract between all of the owners of an oil and gas
property and the company purchasing production from
the property.
– Sets forth the interest of each owner and serves as the
basis on which the purchasing company pays each
owner’s respective share of the proceeds of the oil and
gas purchased.

58
Ownership - Example

Working interest (WI): Cost Sharing

Net revenue interest (NRI): Revenue

Sharing

Example: WI NRI

E&P, Inc. 60% 51%

Mee2 oil and gas 40% 34%

Geologist (ORRI) 0% 2.5%

Lessor (royalty, RI) 0% 12.5%

100% 100%

59
Volumes

Oil BBL - barrels (42 gallons)

Gas MCF - thousand cubic feet

- MMCF - million cubic feet
- BCF - billion cubic meet

• Gas may also be expressed in heat quantity (Btu or MMBtu)

rather than volume
• Ratio of MMBtu to Mcf varies from 1:1 to 1.3:1. The wetter the
gas, the higher the ratio.

60
Volumes

• Oil Volumes
– Stored In “Lease Tanks" at the field until enough
accumulated to sell
• Gas Volumes
– Produced into a pipeline or gathering system
– Often sold downstream, out of a pipeline or processing plant
(pipelines usually act as transporters, not purchasers)
– Meters (pipeline meter and operator's check meter) measure
volume movement
– Lease-use gas and shrinkage

61
Oil Prices

• Evergreen contract tied to posted price bulletins

• Price may also be
- Fixed
- New York mercantile exchange futures (NYMEX)
- Other indices
• Bulletin's pricing determinants:
- Geographic location
- Date of sale
- Sulfur content (i.e., sweet or sour)
- Density (API gravity)

62
Gas Prices

• Typically per MMBTU

• Marketing charges
- Gathering
- Dehydration
- Processing
- Transportation
- Marketing fees
- Pipeline capacity reservation
- Storage
- Hub services (banking)
• Sales points

63
Production Costs (aka Lease Operating
Expense)

• Definition - Costs incurred to operate and maintain wells and

related equipment and facilities, including depreciation and
applicable operating costs of support equipment and facilities
and other costs of operating and maintaining those wells and
related equipment and facilities (SX Rule 4-10(a)(17))

64
Types of Production Costs

• Direct Production Costs

– Salaries and wages, including related employee benefits
– Contract pumping services
– Well services and workover
– Repairs and maintenance of surface equipment
– Ad Valorem (property), production and severance taxes

• Indirect Production Costs

– Depreciation of support facilities
– Salt water disposal

65
Accounting for Production Costs

• Expensed as incurred, except

– Recording oil and gas inventory at cost
– Workover costs that qualify for capitalization

66
Workover Costs

• Expense
– Costs to restore or maintain production
– Increases production

• Capitalize
– Costs to explore to an unproved formation
– Costs to access a proved formation
– Increases reserves

67
 AICPA Accounting
Standards Executive
Committee

Joint Interest Billing

Joint Venture – Defined

• An association of two or more persons or companies to drill,

develop, and operate jointly owned properties. Each owner
has an undivided interest in the properties.

69
Why Joint Operations?

• Companies desire to share the risk and high costs

involved in exploration and development
• Economic sense
• Necessity
– Secondary or tertiary recovery techniques

70
Joint Operations - Overview

• Joint ventures are common in the industry, therefore, joint

interest billing (JIB) systems are essential
• Agreements
– Joint venture agreement
– Who is in what venture?
– Joint operating agreement (JOA)
– Designates an operator (others are non-operators)
– Rules for going “non-consent”
– JOA’s accounting exhibit
– Billing and audit protocol

71
Joint Operations - Overview

• JIB system
– Operator obtains partners’ approvals for major costs
(using an authorization for expenditure “AFE”)
– Operator billed for venture costs and bills its partners for
their share
– Operator records its net share
– Operator pays venture’s costs and bills partners their
share
– Most JOAs allow partners (non-operators) to audit the
operator’s billings within two years of the related
expenditures

72
Joint Operating Agreement

JOA provides:
• Parties’ interests in costs (working interest “WI”) and production (Net revenue
interest “NRI”)
• Operator
– Designation, removal
– Rights and duties
• Protocol for joint venture conducting drilling and development
– Initial well
– Deepening, sidetracking, completion, reworking, recompleting, plugging back
and abandoning wells
– Non-consent provisions
• Taking production in kind

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Joint Operating Agreement

• Gas balancing
– Gas balancing agreement (GBA)
• Operator’s remedies for failure of non-operator to pay
– Pay and take over interest
– Have rest of JV pay and take over interest
– Net billings against revenues
• Election to not be a partnership for income tax purposes
• Insurance to be carried by operator
• Sharing of costs for suits against the joint venture

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JOA Accounting

• Operator bills non-operators monthly

– By AFE, lease, or project
– Sufficient detail for financial & tax accounting
– May bill in advance, major approved projects (“cash calls”)
• Non-operators allowed two years after billing date to challenge
paid billings.
– Conduct expenditure audit to uncover and substantiate
adjustments
– Adjustments argued and negotiated

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JOA Accounting

• Operator bills for:

– Direct charges
– Operator’s employees directly employed
– Materials
– Use of operator’s equipment and facilities
– Overhead recovery (determined by COPAS)
– At a fixed rate (e.g. $3,000/mo/drilled well and
$300/mo/producing well), adjusted for inflation annually
using escalation factors; or
– At a percentage of direct costs

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 AICPA Accounting
Standards Executive
Committee

Oil & Gas Reserves and

Related Disclosures
Oil & Gas Reserve Classifications

• Society of Petroleum Engineers defines reserves as

discovered and recoverable
– Proved (“reasonably certain” - 90% probability)
– Developed
– Undeveloped
– Unproved
– Probable (“likely” - as in 51% to 90% probability)
– Possible (“reasonably possible” - less than likely)

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Proved Reserves

• Proved oil and gas reserves

 Estimated quantities which “geological and engineering
data demonstrate with reasonable certainty to be
recoverable in the future years from known reservoirs
under existing economic and operating conditions, i.e.,
prices and costs as of the date the estimate is made.”
(excerpt from SEC S-X Rule 4-10)

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Proved Reserves – Developed vs.
Undeveloped

• Developed reserves:
– Expected to be recovered through existing wells, using
existing equipment and operating methods
• Undeveloped reserves:
– Expected to be recovered from
- New wells on undrilled acreage; or
- Existing wells requiring major expenditure

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Key Definitions

• Economically Recoverable:
– Reserves that can be extracted from reservoir and delivered to
market in an economically beneficial way to the producing entity
• Shut-in:
– Reserves expected to be recovered from completion intervals that
were open at the time of the reserve estimate but are not producing
• Behind pipe:
– Reserves expected to be recovered from completion interval(s) not
yet open but still behind casing in existing wells. Such wells are
usually producing, but from another completion interval. Additional
completion work is needed before these reserves are produced.

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Determination of Oil & Gas Reserve
Quantities

• Estimates may be performed internally

• Estimates may be performed internally and data reviewed or
audited by external engineer based on Standards Pertaining
to the Estimating and Auditing of Oil and Gas Reserve
Information by the Society of Petroleum Engineers
• Estimates may be performed externally with certain data
provided by the oil and gas company

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Reserve Estimation and Valuation Process

Data Points
Technical Economic
• Porosity • Proved determination Reserve Volume
• Permeability • Year end pricing and SMOG
• Gas to liquids ratio • Historical lifting costs Value Calculations
• Product quality • Future development costs
/characteristics
• Future abandonment
• Well logs costs/ reclamation costs
• Seismic data • Production/severance tax
• Interpretations rates
Transactional
• Decline curves • Historical production volumes
• Feasibility
Reserve
• New well/property sale/property
assumptions abandonment/property Quantity
• Recovery techniques purchase Information
• PZ factor • Division orders/title opinions
• Curtailments/shut-ins
SMOG
• Net profit interests
• Payouts/reversionary interests
• Take-or-pay
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Is Disclosure of Oil & Gas Reserve
Information Required?

Disclosure required for “significant” oil and gas producing activities if O&G
activities are at least 10% of company’s total activities, based on any one of the
following ratios:

– Revenues from oil and gas > 10% of combined revenues of all segments
– Identifiable assets of oil and gas activities > 10% of the assets, excluding assets used exclusively for general corporate purposes
– Results of operations of oil and gas activities > 10% of the larger of:

(a) Combined operating profit or all industry segments that did not incur an operating loss;
or
(b) Combined operating loss of all industry segments that did incur an operating loss

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Supplemental Disclosures Required by
FAS No. 69

– Capitalized costs
– Costs incurred
– Results of operations for oil & gas related activities
– Proved reserves and changes in proved reserves
– Standardized Measure of Discounted Future Net Cash Flows (SMOG)
and related changes therein
– Special disclosures for companies using full cost
– Disclosures only for PROVED oil and gas reserves

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SMOG Overview

• FAS 69 requires disclosure of “a standardized measure of

discounted future net cash flows relating to proved O&G reserve
quantities
• Intended to be a comparative benchmark tool
• SMOG disclosures:
– Required for publicly traded oil and gas companies
– Must be disclosed in aggregate
– Must be disclosed for each geographic area for which reserve
quantities are disclosed
– Changes in SMOG also must be disclosed

86
 AICPA Accounting
Standards Executive
Committee

Other Property
Conveyances
Property Conveyance Types

• 4 Types
– Loan
– Prepaid Commodity Sale
– Volume Production Payment (VPP)
– Outright Sale

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What is a Borrowing? What is a Sale?

Who assumes Who assumes

production risks pricing risks
Loan “Seller” (cash “Seller” (cash
recipient) recipient)
Prepaid
commodity sale Seller Buyer
Volumetric
Prod. Pmt. Buyer, mostly Buyer

Outright Sale Buyer Buyer

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What is a Borrowing? What is a Sale?

• Loan - borrowings are repaid usually through money received

from production
• Prepaid - borrowings are repaid through volumes of production.
Seller must make up short fall
• VPP - same as Prepaid except there is no obligation to make up
short fall
• Outright Sale - buyer assumes all risk

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Special Cases

• Production Payment: Conveyor’s obligation to pay – (holder’s

right to receive) specified cash or deliver specified production
from specified production only
– If specified cash, production payment is conveyor’s payable
(loan) and holder’s receivable
– If specified quantity, the Volumetric Production Payment (VPP) is
a mineral interest sale but proceeds received are credited as
deferred revenue.

• Prepaid: Conveyor’s obligation to deliver specified quantity (no

required source)

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Volumetric Production Payment (VPP)
Accounting

• Full Cost:
– SX Rule 4-10c(6i) literally says credit the full cost pool (The
VPP is a sale).
– Off-balance sheet financing
• Successful Efforts:
– FAS 19, par. 47(a) says to treat as unearned revenue to be
recognized as the oil and gas is delivered.
– EITF 88-18 states that these financing arrangements are
advances for future production and should be classified as
debt unless conditions justify otherwise.

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Volumetric Production Payment (VPP)
Accounting

• Both credit deferred revenue

• VPP is sale of a mineral interest. Conveyor sells reserves to
holder.
• Prepaid is NOT a sale of a mineral interest but prepayment for
future sale of oil or gas. Conveyor sells no reserves to holder.

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Volumetric Production Payment (VPP)

• Sale. No gain recognition; seller has substantial future

obligation (disproportionate LOE burden + delivery obligation)
• Buyer has oil and gas reserves. UOP amortization of property
cost.
• Seller records deferred revenue! Not deferred gain.

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QUESTIONS

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