Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 31

 

Subject:

Issues in respect of Guidance Note on Accounting for Oil

and Gas Producing Activities.1

 

A. Facts of the Case

 

1. An exploration and production (E&P) company established under the Companies Act, 1956, has the core activities of exploration, development and production of hydrocarbons in onland as well as offshore areas.

 

 

2. The company had been generally following the ‘Successful Efforts Method’ of accounting as contained in the Statement of Financial Accounting Standard (FAS) 19, ‘Financial Accounting and Reporting by Oil and Gas Producing Companies’, issued by the Financial Accounting Standards Board (FASB) of USA. In the absence of any Accounting Standard for E&P industry in India, the company had requested the Institute of Chartered Accountants of India (ICAI) in August 1999 for developing an Accounting Standard for such industries in India. After a series of deliberations including discussions with the company, the ICAI issued a ‘Guidance Note on Accounting for Oil and Gas Producing Activities’ in March 2003, which lays down accounting treatment for costs incurred on acquisition of mineral interests in properties, exploration, development and production activities.

 

 

3. According to the querist, the company implemented the Guidance Note from the accounting year 2003-04 and compiled its financial statements as per the requirements of the Guidance Note. However, during implementation of the same, it faced some practical problems relating to creation of producing properties as referred to in paragraph 38 of the Guidance Note and regarding accounting treatment of wells which started producing (but had been written off in the past as per paragraph 39 of the Guidance Note).

 

4. The querist has also reproduced paragraphs 38 and 39 of the Guidance Note which are as follows:

"38. When a well is ready to commence commercial production, the costs referred to in paragraph 36 (ii) and (iii) corresponding to proved developed oil and gas reserves should be capitalised as ‘completed wells’ from capital work-in-progress to the gross block of assets. With respect to costs referred to in paragraph 36(i) the entire cost should be capitalised from capital work-in-progress to the gross block of assets. There is a rebuttable presumption that a well is ready to commence commercial production within two years from the establishment of proved developed oil and gas reserves. If the well is not ready for commercial production within the aforesaid period, the relevant costs included in capital work-in-progress should be capitalised on the expiry of the aforesaid period of two years.

 

39. If the cost of drilling exploratory well relates to a well that is determined to have no proved reserves, then such costs net of any salvage value are transferred from capital work-in-progress and charged as expense as and when its status is decided as dry or of no further use. Costs of exploratory wells-in-progress should not be carried over for more than a period of two years from the date of completion of drilling unless it could be reasonably demonstrated that the well has proved reserves and development of the field in which the well is located has been planned with required capital investment such as development wells, pipelines, etc., in which case the costs of the exploratory well can be carried forward without any time limit."

5. According to the querist, accounting policies of the company in this regard (contained in schedule 28, ‘significant accounting policies’ in the Annual Report for 2003-04) are as follows:

"2.2 Exploratory/ development wells- in-progress

2.2.1 All acquisition costs, exploration costs involved in drilling and equipping exploratory and appraisal wells, cost of drilling exploratory type stratigraphic test wells are initially capitalised as exploratory wells-in-progress till the time these are either transferred to producing properties on completion or expensed in the year when determined to be dry or of no further use, as the case may be.

 

2.2.2 All wells appearing as "exploratory wells-in-progress" which are more than two years old from the date of completion of drilling are charged to the profit and loss account except those wells which have proved reserves and the development of the fields in which the wells are located has been planned. Such wells, if any, are written back on commencement of commercial production.

 

2.2.3 All costs relating to development wells are initially capitalised as development wells-in-progress and transferred to producing properties on completion.

 

2.3 Producing Properties

2.3.1 Producing properties are created in respect of an area/ field having proved developed oil and gas reserves when the well in the area/field is ready to commence commercial production.

 

2.3.2 Cost of temporary occupation of land, successful exploratory wells, all development wells and all related development costs including depreciation on support equipment and facilities and estimated future abandonment costs are capitalised and reflected as Producing Properties."

 

6. According to the querist, as per the requirements of paragraph 38 of the Guidance Note, the cost of an exploratory well is to be transferred to gross block of assets (producing properties) when there are corresponding proved developed reserves in the well. As per the accounting practice of the company, the reserves are established for a field/area and not for each well. Producing properties are created in respect of successful exploratory wells if the reserves in respect of that field are of proved developed category. It is possible that a particular well may be of oil or gas bearing status but may require artificial lift and hence may not produce for the time being. As per the querist, the term ‘artificial lift’ refers to a method of recovery of oil from reservoir. When oil or gas is being produced, the reservoir pressure reduces. At a certain point of time, it can happen that the pressure in the reservoir becomes too low for production and artificial lift can be required. Artificial lift methods are required to drive oil to the wellbore.

 

 

7. There are certain areas/fields in the company particularly gas fields in north east and southern region, where there are proved developed reserves and wells are ready to commence commercial production, but for want of consumers, the wells are not producing and have been capped.

 

8. In respect of the exploratory wells which were written off in the past and started producing subsequently thereby generating sales revenue, the querist has stated as below:

(i) As per paragraph 39 of the Guidance Note, costs of exploratory wells-in-progress should not be carried over for more than a period of two years from the date of completion of drilling unless it could be reasonably demonstrated that the well has proved reserves and development of the field in which the well is located has been planned with required capital investment such as development wells, pipelines etc., in which case the costs of the exploratory well can be carried forward without any time limit.

 

(ii) In the case of the company in question, certain exploratory wells were written off in the past as these were more than three years old (as per the then existing accounting policies) and there were no definite plans at that point of time for development of such wells. Subsequently, the company developed those fields and started producing from those wells. In the past, keeping in view the matching concept of accounting, since these wells started producing significant revenues, the same were written back on commencement of commercial production from those wells. As per the querist, the Guidance Note is silent on accounting treatment of such wells (emphasis supplied by the querist).

9. Accounting treatment followed by the company in respect of development dry wells is as below:

(i) According to the querist, as per paragraph 22 of FAS 19 of USA, all costs incurred to drill and equip development wells, development-type stratigraphic test wells, and service wells are development costs and should be capitalised, whether the well is successful or unsuccessful (emphasis supplied by the querist). Paragraph 22 has been reproduced by the querist which is as follows:

"Development costs shall be capitalised as part of the cost of an enterprise’s wells and related equipment and facilities. Thus, all costs incurred to drill and equip development wells, development-type stratigraphic test wells, and service wells are development costs and shall be capitalised, whether the well is successful or unsuccessful. Costs of drilling those wells and costs of constructing equipment and facilities shall be included in the enterprise’s uncompleted wells, equipment, and facilities until drilling or construction is completed."

(ii) The querist has further mentioned that in Appendix B, Basis for Conclusions, of FAS 19 of USA, it is given that there is an important difference between exploratory dry wells and development dry wells. The purpose of an exploratory well is to search for oil and gas. The existence of future benefits is not known until the well is drilled. Future benefits depend on whether reserves are found. A development well, on the other hand, is drilled as a part of the effort to build a producing system of wells and related equipment and facilities. Its purpose is to extract previously discovered proved oil and gas reserves. By definition, a development well is a well drilled within the proved area of a reservoir to a depth known to be productive (emphasis supplied by the querist). The existence of future benefits is discernible from reserves already proved at the time well is drilled. The cost of a development well is a part of the cost of a bigger asset – a producing system of wells and related equipment and facilities intended to extract, treat, gather and store known reserves. Moreover, because these are drilled only in proved areas to proved depths, a great majority of development wells are successful and a smaller percentage as compared to exploratory wells may be dry holes. Development dry holes/wells occur principally because of structural faults or other unexpected conditions or because of a problem which arose during drilling or simply the inability to know precisely the limits and nature of proven reservoir. Development dry wells are similar to normal, relatively minor wastage in manufacturing or construction. As per the querist, the Guidance Note does not specifically address this issue.

B . Query

 

10. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i) Whether creation of producing properties as referred to in paragraphs 6 and 7 above (transfer from exploratory wells-in- progress to gross block of assets (producing properties) in respect of wells which need artificial lift and which have been capped for want of consumers) is correct.

 

(ii) Whether accounting treatment for wells referred to in paragraph

 

8(ii) above, i.e., write back of exploratory wells which were written off in the past and started producing subsequently and generating revenues, is correct.

 

(iii) Whether accounting treatment of development dry wells as referred to in paragraphs 9(i) and 9(ii) above, is correct.

C. Points considered by the Committee

 

11. With regard to creation of producing properties as referred to in paragraphs 6 and 7 above, i.e., transfer from exploratory wells-in-progress to producing properties in respect of wells which need artificial lift, the Committee notes that paragraph 10 (reproduced below) of the Guidance Note on Accounting for Oil and Gas Producing Activities, issued by the Institute of Chartered Accountants of India, considers artificial lift facilities as a part of development activities.

 

"10. Development activities for extraction of oil and gas include, but are not limited to the purchase, shipment or storage of equipment and materials used in developing oil and gas accumulations, completion of successful exploration wells, the drilling, completion, re-completion and testing of development wells, the drilling, completion and re- completion of service wells, the laying of gathering lines, the construction of offshore platforms and installations, the installation of separators, tankages, pumps, artificial lift and other producing and injection facilities required to produce, process and transport oil or gas into main oil storage or gas processing facilities, either onshore or offshore, including laying of infield pipelines, the installation of the said storage or gas processing facilities."

 

12. On the basis of the above, the Committee is of the view that since the said exploratory wells-in-progress need artificial lift before oil can be recovered from the reservoir, the said wells cannot be considered to be ready to commence commercial production and, accordingly, these wells cannot be considered as producing properties.

 

 

13. With regard to wells-in-progress, which are capable of producing oil, but which have been capped for want of consumers, the Committee notes from paragraph 7 above that the said wells are ready to commence commercial production. The Committee presumes that since the querist has stated that the said wells are ready to commence commercial production, technically the wells are capable to produce commercially feasible quantities in a commercially practicable manner. In such a case, the Committee is of the view that the wells so capped should be considered to be complete and, accordingly, be considered as producing properties although they are not being utilised for want of consumers. However, this situation provides an indication for the relevant fields to be tested for impairment in accordance with the requirements of Accounting Standard (AS) 28, ‘Impairment of Assets’, issued by the Institute of Chartered Accountants of India.

 

 

14. With regard to the exploratory wells, which were written off in past as these were more than 3 years old and there were no definite plans at that point of time for development of such wells, the Committee is of the view that, conceptually, such a write off is effected only where the expenditure incurred does not have any future economic benefit. In such a situation, in the view of the Committee, if some more expenditure is incurred after the write off as a consequence of which a resource comes into existence having future economic benefit, only the latter expenditure can be capitalised as per the existing generally accepted accounting principles. Accordingly, the expenditure in this regard which was written off earlier cannot be reinstated subsequently.

 

 

15. With regard to development of dry wells, the Committee notes the definition of the term, ‘development wells’, as per paragraph 4 of the Guidance Note on Accounting for Oil and Gas Producing Activities, which is reproduced below:

 

"Development Well: A well drilled, deepened, completed or recompleted within the proved area of an oil or gas reservoir to the depth of a stratigraphic horizon known to be productive."

16. The Committee further notes paragraph 36 and the extracts from paragraph 38 of the Guidance Note as below:

"36. Under the successful efforts method, in respect of a cost centre, the following costs should be treated as capital work-in-progress when incurred:

 

(i) All acquisition costs;

 

(ii) Exploration costs referred to in paragraph 9 (iv) and (v); and

 

(iii) All development costs."

 

"38. When a well is ready to commence commercial production, the costs referred to in paragraph 36(ii) and (iii) corresponding to proved developed oil and gas reserves should be capitalised as ‘completed wells’ from capital work-in-progress to the gross block of assets.…"

 

17. From the definition of the term ‘development well’, the Committee notes that the said wells are drilled and developed in an area within the proved area of oil or gas reserves and, therefore, are different from the exploration wells in respect of which the area is still to be considered to have proved oil reserves. The Committee agrees with the querist that expenditure incurred on developing dry wells is like a normal loss/ expenditure during construction or creation of an asset and, therefore, should be capitalised.

 

D. Opinion

 

18. On the basis of the above, the Committee is of the following opinion in respect of the issues raised by the querist in paragraph 10 above:

(i) Exploratory wells-in-progress, which need artificial lift cannot be capitalised as producing properties. Exploratory wells-in- progress, which are ready to commence commercial production as discussed in paragraph 13 above but which have been capped for want of consumers, should be transferred to producing properties and in such event, they should be tested for impairment within the meaning of AS 28.

 

(ii) Expenditure incurred on exploratory wells which were written off in past and started producing subsequently, cannot be reinstated as explained in paragraph 14 above.

 

(iii) Expenditure incurred on developing dry wells should be capitalised as explained in paragraph 17 above.

1 Opinion finalised by the Committee on 28.1.2005