Expert Advisory Committee
ICAI-Expert Advisory Committee
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Query No. 16

Subject:

Accounting treatment in respect of side-tracking costs of wells. 1

 

A. Facts of the Case

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

2. The company had generally been following the Successful Efforts Method of accounting as contained in 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. The Institute of Chartered Accountants of India issued the ‘Guidance Note on Accounting for Oil and Gas Producing Activities’ in March 2003, which lays down the accounting treatment for costs incurred on acquisition of mineral interests in properties, exploration, development and production activities. According to the querist, the company implemented the above Guidance Note from the accounting year 2003-04 onwards and has been compiling its financial statements as per the provisions of the Guidance Note.

3. As oil fields mature, sustenance of production levels and techno-economics of hydrocarbon exploitation necessitate drilling of development wells and work-over in tandem for gas shut-offs, water shut-offs, layer transfer, inter-conversions between injectors and producers, etc. Also, with recently introduced technology induction, previously drilled well bores which are no longer producing or producing below economic levels, are ‘side-tracked’. This is accomplished by cutting a window in casing at appropriate depth and drilling a side-tracked hole at different angle and terminating them at the target depth within the same or different layer of the reservoir, with a purpose to utilise the same well to reach a different target to produce more oil and gas and at the same time to reduce well cost.

4. Drilling of wells is an integral part of exploration activity. Sometimes, due to complications in the drilled hole, the original hole is side-tracked to drill further to achieve the target depth. Side-tracking techniques are broadly covered under the application of directional drilling technology. In case of an exploratory or development well, side-tracking is carried out when an objective/ target could not be reached due to drilling complications like stuck pipe, loss of cementation, etc. In the process, certain portion of the drilled depth of the well or the entire well may have to be abandoned, in order to achieve the objective of drilling the well.

5. The querist has stated that the Guidance Note on Accounting for Oil and Gas Producing Activities does not specifically address the issue of accounting treatment of side-tracking costs.

6. The querist has also mentioned that there is no specific reference to the accounting treatment in the Significant Accounting Policies of the company. There are also no specific guidelines from any bodies like the Financial Accounting Standards Board, USA (FAS 19 does not deal specifically with the issue). The company, at present, is following the accounting treatment in this regard, as given below:


(i) In case of exploratory wells, the cost of abandoned portion of the well is considered as a part of the cost of the well considering the well as a single unit and capitalised as exploratory wells-in-progress.


(ii) In case of development wells, the cost of abandoned portion of the well is considered as a part of the cost of the well and capitalised under producing property.


(iii) In case of existing producing wells, the expenditure on side-tracking is classified as workover expenditure, i.e., repair of the well, and, accordingly, charged to the profit and loss account.

7. According to the querist, during the course of audit, a different view, based on the internationally accepted accounting practices given in (i) Fundamentals of Oil and Gas Accounting by Rebecca Gallun and others, (ii) Petroleum Accounting – Principles, Procedures and Issues – 4th Edition by Horace R Brock and others and (iii) Council of Petroleum Accountants Society (COPAS) Bulletin No. 10 and on the basis of treatment recommended under the Guidance Note on Accounting for Oil and Gas Producing Activities, issued by the Institute of Chartered Accountants of India (ICAI), emerged as follows:


        (i) Exploratory wells


 As per paragraph 39 of the Guidance Note, under the successful efforts method, costs incurred on exploratory dry wells are to be expensed. On the same analogy, as the cost of abandoned portion of the side-tracked exploratory well, i.e., from the point of side-tracking to the bottom of incomplete well does not add to the value of side-tracked well, such costs are to be expensed.


        (ii) Development wells

Under successful efforts method, the costs incurred in drilling development dry wells as well as development successful wells are to be capitalised. Since the costs incurred on both the successful and unsuccessful development wells drilled in proved area are capitalised, the cost of abandoned portion of the side-tracked well should also be capitalised.


        (iii) Producing wells


In case of existing producing wells, the expenditure on portion of side-tracking or portion of well drilled deeper below the producing horizon, which is proved successful, should be capitalised as its benefits will accrue over a number of years. However, unsuccessful side-tracked portion(s) or portion of well drilled deeper below the producing horizon (as mentioned in COPAS Bulletin No. 10) should be expensed as it does not add any value to the well. In case of side-tracking, if the portion below the point of side-tracking is abandoned/plugged, the cost should be expensed.

8. The querist has stated that if the accounting treatment proposed in paragraph 7 above is followed and in case, it is decided that abandoned portion of the side-tracked well adds no utility / value to the well actually completed then the proportionate portion of the well costs will have to be charged to expense either on meterage basis or per drilling day basis or allocated costs on any other reasonable basis which will have to be decided. On the same principles, the side-tracking in respect of a producing well (which proved successful) would have to be capitalised.

9. The querist has drawn the attention of the Committee to the following references taken from two of the petroleum accounting books on the Industry, which broadly incorporate the accounting practices prevalent in the US:


          (i) As per The Fundamentals of Oil & Gas Accounting by Rebecca Gallun and Others,


 “Costs of sidetracking are generally considered a part of drilling costs and are capitalised or expensed, depending upon whether the well is a development well or an exploratory well and whether proved reserves are found. However, if the well is an exploratory well, expensing the costs of the abandoned portion of the well regardless of whether proved reserves are found (emphasis provided by the querist) appears more consistent with the theory of successful efforts because that portion of well obviously has no future economic benefit”.


          (ii) As per Petroleum Accounting-Principles, Procedures & Issues, 4th Edition, by Horace R Brock and others


 “Sometimes in the drilling of an exploratory well with a specific formation or trap as an objective, difficult drilling conditions may be encountered, making it necessary to abandon the hole already drilled and to start a new well nearby. If the second hole is completed as a producer, the question arises for successful efforts as to whether the costs incurred on the abandoned hole should be charged to expense or should be capitalised as part of the cost of the completed well that found proved reserves.


It appears that the former treatment is preferable and that the costs applicable to the abandoned hole should be charged as an exploratory dry-hole expense because the abandoned hole added nothing to the utility or value of the well actually completed. If the well originally being drilled were classified as a development well, all costs involved would be capitalised. If in drilling a well, difficulties are encountered and it is necessary to abandon the lower portion of the well in order to plug-back and side-track to reach the same objective through directional drilling, the cost of abandoned portion should likewise be charged to expense as dry-hole cost. (Emphasis provided by the querist.)


Some companies do, however, capitalise costs of an abandoned well if the target of the second well (or the side- tracking) is the same as that of the abandoned well. The second well (or the twin well) and the side-tracking are simply unexpected additional costs, like fishing for stuck drill pipe, to get a well drilled to the target.”

 

10. The querist has stated that there is no uniform standardised practice as far as the accounting treatment of such cost is concerned. A survey published in the Journal of Extractive Industries Accounting, reported how companies are handling similar situations in practice (Survey of Successful Efforts Accounting Techniques – Summer 1982). In most of the situations, there appears to be little agreement as to whether to expense or capitalise the cost of such wells.

B. Query

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

 

(i) The appropriate accounting treatment in respect of cost incurred on side-tracking and the abandoned portion of well due to side-tracking of exploratory wells, development wells and producing wells.


(ii) In case it is decided that the abandoned portion of the side-tracked well adds no utility to the well actually completed then the basis on which the costs will have to be charged to the expenses may also be advised, i.e., whether on the basis of meterage or drilling days or any other reasonable basis.

C. Points Considered by the Committee

12. The Committee is of the view that although the Guidance Note on Accounting for Oil and Gas Producing Activities, issued by the Institute of Chartered Accountants of India, does not specifically deal with the accounting treatment in respect of costs incurred on side-tracking and abandoned portion of oil well due to side-tracking of exploratory wells, development wells and producing wells, the treatment in respect thereof can be derived from the treatment given in respect of the exploratory costs, development costs and production costs given in the Guidance Note.

13. With regard to accounting treatment in respect of costs incurred on side-tracking and the abandoned portions of the wells due to side-tracking of exploratory wells, the Committee notes paragraph 39 of the Guidance Note which recommends as below:


 “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.”

14. On the basis of the above, the Committee is of the view that in case of side-tracking of an exploratory well, the abandoned portion of the exploratory well is similar to that of an exploratory well that is determined to have no proved reserves. Accordingly, the treatment thereof should be the same as that of an exploratory well that is determined to have no proved reserves, i.e., the costs in respect of the abandoned portion of the exploratory well should be transferred from capital work-in-progress and charged as expense as and when its status is decided as dry or of no further use. Further, the costs incurred on drilling of side-tracked exploratory well is similar to the costs of drilling and equipping exploratory wells (paragraph 9(iv) of the Guidance Note) and, therefore, should be capitalised as recommended in paragraph 36 of the Guidance Note (reproduced in paragraph 16 below) as part of the capital work-in-progress when incurred.

15. With regard to the treatment in respect of costs incurred on side-tracking and the abandoned portion of the well due to side- tracking of development wells, the Committee notes the definition of the term ‘development wells’, as per paragraph 4 of the Guidance Note 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 of the Guidance Note as below:

 

“36. Under the successful efforts method, in respect of a cost center, 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.”


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 area of proved oil or gas reserves and, therefore, are different from the exploration wells in respect of which it is still to be determined whether the area has proved oil reserves. The Committee is of the view 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. The Committee is of the view that side-tracking of a developed well is also like a normal loss/expenditure on the developing well and, accordingly, the costs incurred on side-tracking as well as the costs related to the abandoned portion of well due to side-tracking of developing well should be capitalised as part of the capital work-in-progress.

18. With regard to accounting treatment in respect of costs incurred on side-tracking and the abandoned portion of wells due to side- tracking of producing wells, the Committee notes that the Guidance Note contemplates charging-off of the capitalised cost to the profit and loss account by way of depreciation over the period of its economic use. In this context, the Committee notes the definition of ‘proved developed oil and gas reserves’ and paragraphs 42 and 44 of the Guidance Note, related to charging-off of the depreciation on the producing wells as reproduced below:

 

"Proved Developed Oil and Gas Reserves: Proved developed oil and gas reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. Additional oil and gas expected to be obtained through the application of advanced recovery techniques for supplementing the natural forces and mechanisms of primary recovery should be included as proved developed reserves only after testing by a pilot project or after the operation of an installed programme has confirmed through production response that increased recovery will be achieved.”

 

“42. The depreciation charge or the Unit of Production (UOP) charge for all capitalised costs excluding acquisition cost within a cost center is calculated as under:


                             UOP charge for the period = UOP rate x Production for the period


                            UOP rate = Depreciation base of the cost center/ Proved Developed Oil and Gas Reserves”

 

“44. ‘Proved Oil and Gas Reserves’ for the purpose of paragraph 41 comprise proved oil and gas reserves estimated at the end of the period as increased by the production during the period. ‘Proved Developed Oil and Gas Reserves’ for the purpose of paragraph 42 comprise proved developed oil and gas reserves estimated at the end of the period as increased by the production during the period. Additional reserves from advanced recovery techniques are to be considered as proved developed oil and gas reserves only after the required investments have been capitalised.”



19. On the basis of the above, the Committee is of the view that in case of side-tracking of producing wells, if the proved developed oil reserves do not increase because of side-tracking, the cost of side-tracking the producing wells is of the nature of ‘work-over’ which is defined in Clause 15 of the Appendix to the Guidance Note as “Remedial work to the equipment within a well, the well pipework or relating to attempts to increase the rate of flow”. Accordingly, such cost of side-tracking should be expensed in the year in which it is incurred. The depreciation charge on the cost of the original producing well would continue to be charged as before. However, in case the side-tracking results in additional proved developed oil reserves, the side-tracking should be treated in the same manner as advanced recovery techniques and the additional cost should be capitalised in respect thereof. Consequently, the depreciation charge would also have to be revised as indicated in paragraph 44 of the Guidance Note reproduced above.

20. With regard to measurement of expenditure regarding abandoned portion of the side-tracked well for the purpose of accounting treatment given above, i.e., whether it should be on the basis of the meterage or drilling days, the Committee is of the view that the company in question should assess the relationship of the costs with the basis and select the appropriate method in this regard.

D. Opinion

21. On the basis of the above, the opinion of the Committee on the issues raised by the querist in paragraph 11 above are as below:


            (i) The appropriate accounting treatment should be as below:


(a) Exploratory wells


Costs incurred on side-tracking should be treated as capital work-in-progress and the abandoned portion due to side-tracking should be expensed.


(b) Development wells


Costs incurred on the side-tracking should be capitalised and the cost related to abandoned portion due to side- tracking of development wells should continue to be capitalised.

 

(c) Producing wells

 

--In case the side-tracking does not result in increase in proved developed oil and gas reserves, the cost of side-tracking should be charged to expense and the cost of abandoned portion should be depreciated in the normal way.


--In case the side-tracking results in additional proved developed oil and gas reserves, the cost of side- tracking should be capitalised and the cost related to the abandoned portion of well due to side-tracking should be expensed.

 

(ii) The basis on which the costs have to be charged as expense in respect of the abandoned portion should be determined on a rational basis according to which the costs relate best to the basis selected.

1 Opinion finalised by the Committee on 15.5.2006