Query No. 34

Subject:

Accounting treatment of expendable wells

in upstream oil industry.¹

A. Facts of the Case

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

2. The querist has stated that the company had generally been following the successful efforts method of accounting as contained in Financial Accounting Standard (FAS) 19, ‘Financial Accounting and Reporting by Oil and Gas Producing Companies’ of USA. In the absence of any accounting standard in India, the company had requested the Institute of Chartered Accountants of India (ICAI) for evolving an accounting standard for E&P industry in India. After a series of deliberations including discussions with the company, the ICAI issued the ‘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 above- mentioned Guidance Note from the accounting year 2003-04 and compiled its financial statements as per the requirements of the Guidance Note.

4. As a part of its exploration activities, the company has been drilling exploratory wells as well as exploratory type stratigraphic test wells (also termed as ‘expendable wells’). According to the querist, the company has been accounting for such expendable wells as per the requirements of the Guidance Note issued by the ICAI. An expendable well is basically a drilling effort, geologically directed, to obtain information pertaining to a specific geological condition. Such wells are drilled without the intention of being completed for hydrocarbon production. However, such wells provide a meaningful information for the purposes of further development/ planning of the field. The company has been treating such wells as exploratory wells-in-progress till these are completed. On completion of such a well, the cost of the well is expensed to the profit and loss account (as dry well) irrespective of the status of the well, as the well is of no further use after its completion.

5. According to the querist, during the course of audit, a view different from that stated in the above paragraph emerged. The auditors noted that while the expenditure incurred on non-expendable oil bearing wells is retained in the books under wells-in-progress till the status of results of drilling the well (i.e., whether drilling resulted in discovery of proved reserves or not), the cost of drilling expendable wells, even though they are oil bearing ones, is categorised under dry wells and the cost is written- off immediately on completion of drilling without waiting for the results of drilling. The auditors are of the view that since, at the date of the balance sheet itself, it is known that the expenditure incurred on expendable wells will be expensed, it should be charged to the profit and loss account even if these are not completed, i.e., during the work-in- progress stage itself.

6. The querist has drawn the attention of the Committee to the definition of the term ‘stratigraphic test well’ contained in paragraph 4 of the Guidance Note issued by the ICAI, which is reproduced below:

“Stratigraphic Test Well: A stratigraphic test is a drilling effort, geologically directed, to obtain information pertaining to a specific geologic condition. Such wells customarily are drilled without the intention of being completed for hydrocarbon production. This classification also includes tests identified as core tests and all types of expendable holes related to hydrocarbon exploration. Stratigraphic test wells (sometimes called expendable wells) are classified as follows:

(a) Exploratory-type stratigraphic test well: A stratigraphic test well not drilled in a proved area.

(b) Development-type stratigraphic test well: A stratigraphic test well drilled in a proved area.”

7. The querist has also drawn the attention of the Committee to paragraphs 8 and 9 of the Guidance Note, which are reproduced below:

“8. Exploration activities cover the prospecting activities conducted in the search for oil and gas. In the course of an appraisal programme these activities include but are not limited to aerial, geological, geophysical, geochemical, palaeontological, palynological, topographical and seismic surveys, analysis, studies and their interpretation, investigations relating to the subsurface geology including structural test drilling, exploratory type stratigraphic test drilling, drilling of exploration and appraisal wells and other related activities such as surveying, drill site preparation and all work necessarily connected therewith for the purpose of oil and gas exploration.

9. Principal types of exploration costs cover all direct and allocated indirect expenditure which include depreciation and applicable operating costs of related support equipment and facilities and other costs of exploration activities that are:

(i) costs of surveys and studies mentioned in paragraph 8 above, rights of access to properties to conduct those studies (e.g., costs incurred for environment clearance, defence clearance, etc.), and salaries and other expenses of geologists, geophysical crews and other personnel conducting those studies. Collectively, these are referred to as geological and geophysical or ‘G&G’ costs;

(ii) costs of carrying and retaining undeveloped properties, such as delay rental, ad valorem taxes on properties, legal costs for title defence, maintenance of land and lease records and annual licence fees in respect of Petroleum Exploration License;

(iii) dry hole contributions and bottom hole contributions;

 

(iv) costs of drilling and equipping exploratory and appraisal wells; and

 

(v) costs of drilling exploratory-type stratigraphic test wells.”

 

8. The querist has further drawn the attention of the Committee to the description and application of the ‘Successful Efforts Method’ as explained in the following paragraphs of the Guidance Note:

 

“15. Under the successful efforts method, generally only those costs that lead directly to the discovery, acquisition, or development of specific, discrete oil and gas reserves are capitalised and become part of the capitalised costs of the cost centre. Costs that are known at the time of incurrence to fail to meet this criterion are generally charged to expense in the period they are incurred. When the outcome of such costs is unknown at the time they are incurred, they are recorded as capital work-in-progress and written off when the costs are determined to be non-productive.”

“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.”

 

“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.”

9. The querist has drawn the attention of the Committee to the following accounting policy of the company in this regard:

“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”.

10. The querist has stated that the auditors are of the view that since at the date of the balance sheet itself, it is known that the expenditure incurred on expendable wells are to be written off irrespective of its outcome (i.e., whether dry or oil bearing), the expenditure incurred during the year on all expendable wells should be charged to the profit and loss account during the year as per normal accounting practice.

11. The views of the company on the views of the auditors are as follows:

(i) The auditors have raised the issue regarding expensing of expenditure incurred on expandable wells even if those wells are still in progress as on the balance sheet date. The accounting treatment was done strictly as per the accounting policy of the company as referred to in paragraph 9 above.

(ii) The above policy was finalised in the year 2003-04 when the company implemented the Guidance Note on Accounting for Oil and Gas Producing Activities issued by the ICAI. The policy has been devised strictly as per the requirements of paragraphs 36, 38 and 39 of the Guidance Note and the same is equally applicable to expendable wells also.

(iii) From the above paragraphs of the Guidance Note, it is relevant to mention that the cost is initially to be shown under capital work-in-progress (reference paragraph 36 (ii)) and is to be expensed only when the status of the well is decided or the well is of no further use. (reference paragraph 39).

(iv) Expendable well (exploratory-type stratigraphic test well) is basically a drilling effort, geologically directed, to obtain information pertaining to a specific geological condition. It is also well known that such wells are drilled without the intention of being completed for hydrocarbon production. Such wells provide a meaningful information for purposes of further development/planning of the field. It is evident that unless and until the well is completed, no meaningful information can be derived for the purposes of decision-making.

(v) Such wells are subsequently expensed as soon as the purpose for which such wells were drilled is over.

(vi) This practice is being followed by the company consistently.

B. Query

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

(i) Whether the accounting treatment of capitalising the cost incurred on expendable wells as exploratory wells-in-progress and charging-off the same to expense on its completion should be continued; or

(ii) Whether the cost of expendable wells should be charged off to the profit and loss account as and when incurred, i.e., without waiting for completion thereof.

C. Points considered by the Committee

13. The Committee notes the paragraphs of the ‘Guidance Note on Accounting for Oil and Gas Producing Activities’, issued by the Institute of Chartered Accountants of India, as reproduced by the querist, in the ‘Facts of the Case’. The Committee also notes paragraph 38 of the Guidance Note, as reproduced below:

“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.”

14. The Committee notes from the definition of the term ‘exploratory- type stratigraphic test well’ as contained in paragraph 6 above that once the drilling of such a well is complete, the same would be of no further use even if proved reserves are found as the purpose of such a well is not to use it for any development/production of oil. The Committee also notes from paragraph 38 of the Guidance Note that the cost of drilling the exploratory-type stratigraphic test wells is to be accounted for as capital work-in-progress. If proved reserves are found, the cost of the said wells should be transferred from capital work-in-progress to producing property when the well(s) in the field is/are ready to commence commercial production. The Committee is of the view that discovery of proved reserves establishes the existence of future benefits and justifies the capitalisation of the cost of the exploratory-type stratigraphic test wells that find proved reserves. However, if it is declared dry or of no further use, the cost of drilling such a well is expensed in the year in which it is so declared. The Committee is of the view that the phrase ‘of no further use’ as used in paragraph 39 of the Guidance Note refers to the situation when the well is not completed/no conclusion is drawn but is declared of no further use due to any technical/non-technical reason. Accordingly, the Committee is of the view that ‘expensing the cost of drilling the exploratory-type stratigraphic test well in all cases irrespective of their status’, as being done by the company, is not as per the recommendations of the Guidance Note. The Committee is also of the view that expensing the cost of drilling such wells when incurred, is also not as per the recommendations of the Guidance Note. The Committee notes that the treatment of such costs as suggested above is also supported by paragraph 15 of the Guidance Note reproduced in paragraph 8 above.

D. Opinion

15. On the basis of the above, the Committee is of the view that the accounting practice followed by the company, viz., expensing the cost of exploratory-type stratigraphic test wells on their completion irrespective of their status, as also the views of the auditors to expense the cost when incurred, are not as per the provisions of the Guidance Note on Accounting for Oil and Gas Producing Activities. The cost of drilling such a well should be accounted for as capital work-in-progress which should be capitalised if proved reserves are found (as producing property when the well(s) in the field is/are ready to commence commercial production), and the same should be expensed if the well is declared dry or is declared otherwise of no further use (when it is so declared), subject to other considerations contained in paragraphs 38 and 39 of the Guidance Note on Accounting for Oil and Gas Producing Activities.

¹ Opinion finalised by the Committee on 25.1.2006