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Query No. 4
Subject:
Accounting treatment of crude oil inventory pending passing of the title.1
A. Facts of the Case
1. A public limited company, which is a 100% subsidiary of a
government company (hereinafter referred as the ‘company’), is in
the business of overseas exploration and production of oil and gas
and other hydrocarbon related activities outside India. Usually, the
legal regimes applicable in most of the countries provide that the
ownership of mineral resources (hydrocarbons) is with the
governments. Accordingly, the host governments grant the rights
to explore, develop and produce hydrocarbons in certain specified
geographical areas within their territories (hereinafter referred to
as ‘Rights’) to the companies on some equitable consideration
under various regimes. The activities of the company thus include
securing such Rights and then to explore, develop and produce
hydrocarbons. Such Rights are secured either on a 100% basis,
wherein the company or its affiliates themselves take the entire
risks and rewards of such Rights or in consortium with other participants, such consortia usually being unincorporated joint
ventures wherein the joint venture participants share the risks and
rewards in certain agreed proportions. Such Rights are granted by
the host governments in accordance with the applicable legal and
fiscal regime in the host country which are incorporated into binding
contractual arrangements entered into with the host governments.
2. One such regime is Production Sharing Agreement (hereinafter
referred to as ‘PSA’), under which the host government, which has
the ownership rights over the hydrocarbons, grants to a company
or consortium (usually called contractor) the Rights subject to certain
obligations/payments by the contractor including sharing the
hydrocarbons, if produced with the government or its nominated
agency as per the principles detailed in the PSA.
3. The company is a participant in one such PSA along with
other companies (hereinafter referred to as ‘Consortium’), with the
government of a foreign country (hereinafter referred to as ‘State’)
in respect of certain geographical area specified in the PSA
(hereinafter referred to as the ‘Area’). Under the PSA, the State
granted the exclusive Rights to the Consortium to conduct
hydrocarbon operations in the Area subject to the terms and
conditions of the PSA.
4. The Area is offshore. The Consortium has drilled production
wells from nearby onshore location and also from an offshore
platform to produce oil and gas from the Area. Produced
hydrocarbons are brought to Onshore Processing Facility (OPF)
through a pipeline, processed in the OPF and then transported
through another pipeline to the storage tanks. Storage tanks have
stirring and heating facility which can be used to heat and/or to stir
the crude oil. After heating on a need basis in storage tanks, the
crude oil passes through a metering system and is then transported
through an undersea pipeline to Single Point Mooring facility (SPM)
where it is loaded into the tankers (ships) for transporting to the
export destination.
5. The querist has informed that Article 19.2 of the PSA provides
that the title to hydrocarbons to which the Consortium is entitled
to, shall, unless an earlier separation point is agreed upon between
the State and the Consortium, pass to the Consortium at the Delivery Point (DP). Article 1.23 of the PSA defines DP to mean
with respect to each type, grade or stream of hydrocarbons made
available for delivery to customers as part of hydrocarbon
operations, the outlet flange of the final stage of processing and
treatment facilities included in hydrocarbon operations used to
render that type, grade or stream of hydrocarbons suitable for sale
to customers, whether such facilities are located in offshore or
onshore areas. The querist has confirmed that no earlier separation
point has been agreed to between the State and Consortium under
Article 19.2.
6. Given the fact that the crude oil is rendered suitable for sale
in the storage tanks, the DP under the PSA shall be the outlet
flange of the storage tanks. As per Article 19.2 of the PSA, read
with the Article 1.23, the title to the crude oil to which the Consortium
is entitled to, shall pass to the Consortium only at the outlet flange
of the storage tanks, i.e., to the extent crude oil lies downstream
of the storage tanks, while the title to the crude oil produced from
the strata but situated upstream of the storage tanks remains with
the State, although the crude oil is no longer in its natural habitat
in strata.
7. Since the title to the crude oil lying upstream of the storage
tanks remained with the State, the company did not recognise the
crude oil lying in (i) the pipelines from the wells to OPF; (ii) OPF;
(iii) the pipeline from OPF to the storage tanks; and (iv) the storage
tanks, as its inventory in its accounts for the financial year 2006-
07. The company also disclosed the following in the notes to the
accounts for the relevant PSA:
“The closing stock of crude oil till the Delivery Point has not
been considered in view of the contractual arrangement that it
remains the property of the State until the Delivery Point.”
8. The above treatment did not attract any adverse comment/
observations either from the statutory auditors or from the C&AG
also during its review under section 619(3)(b) of the Companies
Act, 1956.
9. A doubt has now been raised on the appropriateness of the
aforesaid accounting treatment of the crude oil inventory lying upstream of the storage tanks on the basis of ‘substance over
form’. It has been stated that although the title to hydrocarbons to
which the Consortium is entitled to, passes from the State to the
Consortium at the outlet flange of the storage tanks under the
contractual arrangement, i.e., PSA, for all economic purposes, the
Consortium is assured of receiving its share of crude oil lying
upstream of DP. Thus, in substance, the crude oil produced from
the strata but lying upstream of the outlet flange of the storage
tanks as on the balance sheet date, belongs to the Consortium,
although the title is yet to pass from the State to the Consortium.
B. Query
10. The querist has sought the opinion of the Expert Advisory
Committee on the following issues:
(i) Whether the accounting treatment carried out by the
company in not recognising the crude oil inventory lying
upstream of the Delivery Point is appropriate.
(ii) Whether such inventory needs to be valued and recorded
by the company in its accounts with suitable disclosure
regarding the lack of title thereto applying the principle
of ‘substance over form’.
(iii) Whether there is any other appropriate accounting
treatment/disclosure for such inventory.
C. Points considered by the Committee
11. The Committee notes that the basic issue raised by the querist
relates to recognition of crude oil inventory lying upstream of the
delivery point (‘DP’). Therefore, the Committee has not touched
upon any other issue that may be contained in the Facts of the
Case, such as, treatment of production cost related to unrecognised
inventory in accounts.
12. From the annual report of the company for the year 2006-07,
the Committee notes that the company follows the policy of valuing
crude oil (including concentrate) at the lower of cost and net
realisable value. Though Accounting Standard (AS) 2, ‘Valuation
of Inventories’, is applicable to such inventories, that Standard does not deal with the timing of recognition of inventories in the
financial statements. The Committee also notes that while
Accounting Standard (AS) 27, ‘Financial Reporting of Interests in
Joint Ventures’, deals, inter alia, with accounting by the venturer
of any income from the sale or use of its share of output of a joint
venture, that Standard also does not deal with the timing of
recognition of the same in the financial statements. Accordingly,
the company should account for its share of crude oil inventory in
the joint venture in accordance with generally accepted accounting
principles.
13. The Committee also notes that as per Accounting Standard
(AS) 1, ‘Disclosure of Accounting Policies’, notified under the
Companies (Accounting Standards) Rules, 2006 (hereinafter
referred to as the ‘Rules’), one of the major considerations
governing the selection and application of accounting policies is
‘substance over form’. The Committee notes that as per paragraph
17(b) of AS 1, “the accounting treatment and presentation in
financial statements of transactions and events should be governed
by their substance and not merely by the legal form”.
14. The Committee also notes the following paragraphs of the
‘Framework for the Preparation and Presentation of Financial
Statements’, issued by the Institute of Chartered Accountants of
India:
“An asset is a resource controlled by the enterprise as a
result of past events from which future economic benefits are
expected to flow to the enterprise.” [Paragraph 49 (a)]
“Many assets,… are associated with legal rights, including the
right of ownership. In determining the existence of an asset,
the right of ownership is not essential; …Although the capacity
of an enterprise to control benefits is usually the result of
legal rights, an item may nonetheless satisfy the definition of
an asset even when there is no legal control. ...” [Paragraph 56]
“An asset is recognised in the balance sheet when it is probable
that the future economic benefits associated with it will flow to
the enterprise and the asset has a cost or value that can be
measured reliably.” [Paragraph 88]
15. From the above, the Committee is of the view that the company
should recognise its share of inventory of crude oil lying upstream
of the delivery point pending the passing of the title to the
Consortium, if all of the following three conditions are met:
(i) The company and other participants of the Consortium
have control over their share of inventory and their
respective shares are clearly ascertainable;
(ii) It is probable that future economic benefits associated
with the company’s share of inventory will flow to it; and
(iii) The cost of the company’s share of inventory can be
measured reliably.
16. The Committee is of the view that condition (i) above will be
met if the company and other participants of the Consortium have
the power to obtain the future economic benefits flowing from the
underlying resource and can also restrict others from access to
those benefits. This will be the case when the participants of the
Consortium have assumed their share of significant risks and
rewards of ownership in the inventory, which need not necessarily
coincide with the transfer of legal title from the State to the
Consortium. Risks could include risk of loss due to evaporation,
spillage, fire, price fluctuation, etc., while rewards could include
entitlement to lift the agreed share of the inventory. In this regard,
the Committee notes paragraph 6.1 of Accounting Standard (AS)
9, ‘Revenue Recognition’, notified under the ‘Rules’, which is
reproduced below:
“6.1 A key criterion for determining when to recognise revenue
from a transaction involving the sale of goods is that the seller
has transferred the property in the goods to the buyer for a
consideration. The transfer of property in goods, in most cases,
results in or coincides with the transfer of significant risks and
rewards of ownership to the buyer. However, there may be
situations where transfer of property in goods does not coincide
with the transfer of significant risks and rewards of ownership.
Revenue in such situations is recognised at the time of transfer
of significant risks and rewards of ownership to the buyer.
Such cases may arise where delivery has been delayed through the fault of either the buyer or the seller and the
goods are at the risk of the party at fault as regards any loss
which might not have occurred but for such fault. Further,
sometimes the parties may agree that the risk will pass at a
time different from the time when ownership passes.”
The Committee is of the view that the abovementioned principle
recognises the primacy of substance over form which should also
be applied in recognition of acquisition of inventory. Whether
significant risks and rewards of ownership in the inventory have
been transferred is a question of fact to be determined on the
basis of prevailing circumstances including the terms of the
Production Sharing Agreement. What is important is actual
assumption of risks and rewards of ownership and not possible
future assumption of risks and rewards of ownership. It is stated
(in paragraph 9 above) that for all economic purposes, the
Consortium is assured of receiving its share of crude oil lying
upstream of DP. This refers to possible future assumption of
significant risks and rewards of ownership. The company should
assess the point of time when the significant risks and rewards of
ownership in the inventory pass on to the participants of the
Consortium de hors the future receipt of its share of inventory and
the consequent transfer of legal title.
17. The Committee is further of the view that in case the company’s
share of inventory of crude oil is recognised on satisfaction of all
the three conditions stated in paragraph 15 read with paragraph
16 above, pending transfer of legal title, a suitable disclosure of
the fact should be made in the accounts.
D. Opinion
18. On the basis of the above, the Committee is of the following
opinion on the issues raised in paragraph 10 above:
(i) The accounting treatment carried out by the company
in not recognising the crude oil inventory lying upstream
of the delivery point would be correct, only if any one or
more of the three conditions stated in paragraph 15
read with paragraph 16 above is (are) not met.
(ii) Such inventory should be valued and recorded by the
company in its accounts with suitable disclosure, only if
all the three conditions stated in paragraph 15 read with
paragraph 16 above are met.
(iii) There is no other appropriate accounting treatment/
disclosure for such inventory.
1Opinion finalised by the Committee on 17.3.2008
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