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A. Facts of the Case
1. A company is engaged in the exploration, development and production of oil and gas in various oil and gas fields across the country and has recently commenced commercial production in its Rajasthan block. The company has set up processing facilities at the oil and gas blocks, which are required to do an initial processing of the crude oil so as to separate water content from it, before transporting the crude oil to the refineries.
2. The various assets of the company, as per the querist, are broadly classified as under:
A. Well related assets
Well related assets consist of the following costs and assets:
• Costs incurred to gain access to and prepare well locations for drilling, including surveying well locations for the purpose of determining specific exploration/development drilling sites, clearing ground, draining including road building and relocating public roads, gas lines and power lines to the extent necessary in developing the proved oil and gas reserves; and
• Costs incurred to drill and equip exploration/development wells, development-type stratigraphic test wells and service wells including the cost of platforms and of well equipment such as casing, tubing, pumping equipment and the wellhead assembly.
B. Processing facilities
Includes cost to 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.
C. Support facilities and equipments
• Includes cost of equipment and facilities in the nature of service units, camp facilities, godowns (for stores and spares), workshops (for equipment repairs), transport services (trucks and helicopters), catering facilities and drilling and seismic equipment.
3. The querist has stated that paragraph 3(ii) of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’ and paragraph 1(ii) of Accounting Standard (AS) 6, ‘Depreciation Accounting’, specifically state that these Standards do not deal with the accounting for wasting assets including mineral rights, expenditure on the exploration for and extraction of minerals, oils, natural gas and similar non-regenerative resources. According to the querist, in the absence of specific Accounting Standard for oil and gas accounting, the company is guided by the Guidance Note on Accounting for Oil and Gas Producing Activities, (hereinafter referred to as the ‘Guidance Note’) issued by the Institute of Chartered Accountants of India (ICAI).
4. The querist has further stated that as per the above Guidance Note, development costs cover all the direct and allocated indirect expenditure incurred in respect of the development activities, including inter alia, costs incurred to 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. Further, the Guidance Note requires that depletion should be calculated using the Unit of Production (UoP) method and provided on all the oil and gas assets except support assets as defined above in (C) category.
5. The querist has also stated that sections 205, 349 and 350 of the Companies Act, 1956 (‘the Act’) require that depreciation should be provided as per the rates and manner given in Schedule XIV to the Act. Clause II(B)(7), II(D)(7) and footnote 8 of Schedule XIV have prescribed rates of depreciation for certain tangible assets used by a mineral oil concern which would be different from those arrived under the UoP method. The company believes that the requirement to provide depreciation as per the Act is only for the purpose of arriving at the profits under section 205, 349 and 350 of the Act, which in turn relates to profits available for distribution of dividend, managerial remuneration, etc. As per the querist, there is no other requirement in the Act which mandates charging off the minimum depreciation to the profit and loss account as per Schedule XIV rates.
6. The querist has also mentioned that the erstwhile Department of Company Affairs (DCA) (now known as Ministry of Corporate Affairs), vide its circular dated February 21, 2003, had disapproved the use of UoP method for providing depreciation under section 205 for companies engaged in the production of steel.
7. As regards the queries raised in paragraph 8 below, the company has provided its views as follows:
(i) The exclusion provided under paragraphs 3(ii) and 1(ii) of AS 10 and AS 6, respectively, deal with expenditure incurred for extraction of mineral oil. It would be a narrow interpretation to restrict the expenditure till the point the oil is brought to the surface of the earth. Once oil has been extracted, these would be required to be stored in tanks and processed, all of which precede the activity of distribution. In such a case, the company believes that the exclusion given under paragraph 3(ii) and 1(ii) of AS 10 and AS 6, respectively, encompass the entire activity which is related to or is incidental to the extraction of crude oil. Accordingly, incidental activities, like storage of crude oil and water separation processing should be excluded from the scope of AS 6 and AS 10 by virtue of paragraphs 3(ii) and 1(ii), respectively.
(ii) The requirement to provide depreciation under the Companies Act, 1956 is only for the purpose of arriving at profits to be computed under section 205, 349 and 350 of the Act. Hence, from an accounting standpoint, the company should abide by the provisions of the Guidance Note, which specifies that depletion on these assets is to be provided based on UoP method. From a regulatory compliance standpoint, the company should re-compute profits for the limited purposes of sections 205, 349 and 350 of the Act and disclose the same suitably in the financial statements. The intention of the DCA circular, according to the querist, also appears to be restricted to the limited purpose of calculation of profits under section 205 of the Act. Distribution of profit, managerial remuneration, etc., which are associated with the profits computed under section 205, 349 and 350 would be done in accordance with the re-computed profits and not book profits computed based on the UoP method of depreciation. Hence, there would be no violation of the Companies Act, 1956 in case depreciation is recomputed in the manner provided under Schedule XIV to the Act for the purpose of calculation of distribution of profit, managerial remuneration, etc., and the said treatment is disclosed in the financial statements.
B. Query
8. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(i) Whether the assets/facilities described under paragraph 2B above would be covered under the exclusion scope given under paragraph 3(ii) of AS 10 and paragraph 1(ii) of AS 6 keeping in view that these are essential and built at any oil and gas exploration field and without these assets/facilities, crude oil cannot be processed and sold and transported to the refineries.
(ii) Whether the company can provide depreciation based on the UoP method on assets described under paragraph 2B above and charge the same to the profit and loss account. For the limited purpose of computation of profits for sections 205, 349 and 350 of the Companies Act, 1956, whether the company can re-compute depreciation in accordance with Schedule XIV to the Act.
C. Points considered by the Committee
9. The Committee notes that the basic issue raised in the query relates to depreciation on assets/facilities as described under paragraph 2B above (hereinafter referred to as the ‘processing facilities’). The Committee has, therefore, considered only this issue and has not examined any other issue that may arise from the Facts of the Case, such as, depreciation on other assets and facilities, viz., well related assets, support facilities and equipments, etc.
10. The Committee is of the view that the accounting for processing facilities in the instant case would depend on whether the processing carried out by such processing facilities is a part of production process during the extraction of crude oil or after its extraction for the purpose of transportation and distribution thereof. In this context, the Committee notes paragraph 12 of the Guidance Note on Accounting for Oil and Gas Producing Activities, issued by the Institute of Chartered Accountants of India, which provides as follows:
“12. Production activities consist of pre-wellhead (e.g., lifting the oil and gas to the surface, operation and maintenance of wells, extraction rights, etc.,) and post-wellhead (e.g., gathering, treating, field transportation, field processing, etc., upto the outlet valve on the lease or field production storage tank, etc.,) activities for producing oil and / or gas.”
The Committee notes from the Facts of the Case that the processing facilities in the instant case are required to do an initial processing (separation of water content from crude oil) before transporting and distributing the crude oil. However, it is not clear from the Facts of the Case as to whether such processing is a part of production process (i.e., processing upto the outlet valve on the lease or field production storage tank as per the above-reproduced paragraph 12 of the Guidance Note) or whether such processing is carried out thereafter.
11. The Committee further notes paragraph 3(ii) of AS 10, notified under the Companies (Accounting Standards) Rules, 2006 and paragraph 1(ii) of the notified AS 6, which provide as below:
AS 10
“3. This standard does not deal with accounting for the following items to which special considerations apply:
(i) …
(ii) wasting assets including mineral rights, expenditure on the exploration for and extraction of minerals, oil, natural gas and similar non-regenerative resources;
…
Expenditure on individual items of fixed assets used to develop or maintain the activities covered in (i) to (iv) above, but separable from those activities, are to be accounted for in accordance with this Standard.”
AS 6
“1. This Standard deals with depreciation accounting and applies to all depreciable assets, except the following items to which special considerations apply:–
(i) …
(ii) wasting assets including expenditure on the exploration for and extraction of minerals, oils, natural gas and similar non-regenerative resources;
…”
The Committee notes from the above that the exclusions under AS 6 and AS 10 have been made in respect of expenditure on the exploration for and extraction of oil and gas and not in respect of processing after the extraction of oil and gas. Accordingly, in case processing in the extant case is done after extraction, the Committee is of the view that these Standards shall apply in respect of accounting for the ‘processing facilities’. With respect to charging of depreciation, the Committee notes that AS 6 requires in paragraph 20 that depreciation on an asset should be charged on a systematic basis during the useful life of the asset. The Committee also notes that paragraph 13 of AS 6 provides as below:
“13. The statute governing an enterprise may provide the basis for computation of the depreciation. For example, the Companies Act, 1956 lays down the rates of depreciation in respect of various assets. Where the management’s estimate of the useful life of an asset of the enterprise is shorter than that envisaged under the provisions of the relevant statute, the depreciation provision is appropriately computed by applying a higher rate. If the management’s estimate of the useful life of the asset is longer than that envisaged under the statute, depreciation rate lower than that envisaged by the statute can be applied only in accordance with requirements of the statute.”
Accordingly, the Committee is of the view that in case the processing in the extant case is done after extraction of crude oil, depreciation should be provided at the rates prescribed under Schedule XIV to the Companies Act, 1956.
12. In case the processing in the extant case is a part of the production process, the Committee is of the view that the ‘processing facilities’ would be covered under the exclusion paragraphs of AS 6 and AS 10 as reproduced in paragraph 11 above. Therefore, the accounting treatment recommended under the Guidance Note on Accounting for Oil and Gas Producing Activities would be applicable to the company. However, the Committee is of the view that since the provisions of a statute prevail over the pronouncements issued by the Institute of Chartered Accountants of India, requirements of Schedule XIV to the Companies Act, 1956 shall prevail over the provisions of the Guidance Note. Accordingly, the company should charge deprecition on the ‘processing facilities’ on the basis of the rates prescribed under Schedule XIV instead of on the basis of the UoP method of charging depreciation recommended under the Guidance Note.
13. As regards re-computation of depreciation in accordance with Schedule XIV to the Companies Act, 1956 for the limited purpose of computation of profits for sections 205, 349 and 350 of the Act, the Committee notes paragraphs 7, 8, 9 and 10 of the Guidance Note on Accounting for Depreciation in Companies, issued by the Institute of Chartered Accountants of India, which provide as follows:
“7. Section 205 of the Companies Act requires that no dividend shall be declared or paid by a company except out of the profits of the company arrived at after providing for depreciation in accordance with the provisions of sub-section 2 of that Section. This sub-section allows the company to provide for depreciation either in the manner specified in Section 350 of the Act or in the alternative manners specified in that sub-section itself. Part II of Schedule VI further provides that if no provision for depreciation is made, the fact that no provision has been made shall be stated and the quantum of arrears of depreciation computed in accordance with Section 205(2) of the Act shall be disclosed by way of a note.
8. A question may arise as to whether it is obligatory on a company to provide for depreciation only on the basis mentioned in Section 205(2) read with section 350 and Schedule XIV of the Act or whether these bases can be considered as indicating the minimum depreciation which must be provided by the company, insofar as the accounts of the company are concerned and insofar as it is required to exhibit a true and fair view of the state of affairs of the company as on a given date and of the profit or loss for the year.
9. The Committee is of the view that in arriving at the rates at which depreciation should be provided the company must consider the true commercial depreciation, i.e., the rate which is adequate to write off the asset over its normal working life. If the rate so arrived at is higher than the rates prescribed under Schedule XIV, then the company should provide depreciation at such higher rate but if the rate so arrived at is lower than the rate prescribed in Schedule XIV, then the company should provide depreciation at the rates prescribed in Schedule XIV, since these represent the minimum rates of depreciation to be provided. Since the determination of commercial life of an asset is a technical matter, the decision of the Board of Directors based on technological evaluation should be accepted by the auditor unless he has reason to believe that such decision results in a charge which does not represent true commercial depreciation. In case a company adopts the higher rates of depreciation as recommended above, the higher depreciation rates/lower lives of the assets must be disclosed as required in Note No. 5 of Schedule XIV to the Companies Act, 1956.
10. This view is supported by the Department of Company Affairs and it has clarified that “the rates as contained in Schedule XIV should be viewed as the minimum rates, and, therefore, a company will not be permitted to charge depreciation at rates lower than those specified in the Schedule in relation to assets purchased after the date of applicability of the Schedule. If, however, on the basis of bona fide technological evaluation, higher rates of depreciation are justified, they may be provided with proper disclosure by way of a note forming part of annual accounts”2 .”
From the above, the Committee is of the view that in order to provide true and fair view of the state of affairs of the company and of the profit or loss for the year, depreciation should be provided as per the rates given in Schedule XIV to the Companies Act, 1956, which represent the minimum rates of depreciation. Depreciation rates higher than the rates prescribed under Schedule XIV can be adopted only if such higher rates are justified on the basis of bona fide technological evaluation.
D. Opinion
14. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8 above:
(i) Whether the assets/facilities as described under paragraph 2B above would be covered under the exclusion scope given under paragraph 3(ii) of AS 10 and paragraph 1(ii) of AS 6 would depend upon whether the processing performed by these assets/facilities is a part of production process during the extraction of oil or whether such processing is carried out thereafter as discussed in paragraphs 10, 11 and 12 above.
(ii) In order to provide true and fair view of the state of affairs of the company and of the profit or loss for the year, under both the situations described in (i) above, depreciation should be provided at the rates given under Schedule XIV to the Companies Act, 1956, which prescribes the minimum rates of depreciation instead of on the basis of the UoP method of charging depreciation recommended under the Guidance Note on Accounting for Oil and Gas Producing Activities. Depreciation rates higher than the rates prescribed under Schedule XIV can be adopted only if such higher rates are justified on the basis of bona fide technological evaluation. Refer paragraphs 11, 12 and 13 above. The question of re-computation of depreciation in accordance with Schedule XIV to the Companies Act, 1956, for the purpose of computation of profits for sections 205, 349 and 350 of the Act, therefore, does not arise.
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