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A. Facts of the Case
1. A public limited company (hereinafter referred to as the ‘company’), which is a wholly owned subsidiary of a listed government company, is in the business of 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 respective 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 the ‘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 the Rights to a company or consortium (usually called contractor) subject to certain obligations/ payments by the contractor including sharing of the hydrocarbons, 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 the ‘consortium’) with the government of a foreign country (hereinafter referred to as the ‘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. The joint venture arrangements among the consortium partners are governed by the Joint Operating Agreement (hereinafter referred to as the ‘JOA’) entered into by the consortium participants.
4. The area consists of offshore fields. 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 through a pipeline, processed in the onshore processing facility 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 need basis in storage tanks, crude oil passes through metering system and 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 stated that relevant article of the PSA provides that the title to hydrocarbon to which consortium is entitled to shall, unless an earlier separation point is agreed upon between the State and the consortium, pass to consortium at the delivery point. Further, according to the querist, relevant article of the JOA provides that each participant shall have the right and obligation to offtake (i.e., of crude oil) in kind and separately dispose of its participating interest share of total production due to the participants pursuant to the PSA. JOA contains provisions enabling participants to enter into an ‘Offtake Agreement for Crude Oil’ (hereinafter referred to as the ‘COA’) to cover the offtake of crude oil produced under PSA and lays down the following principles (among others) on which the COA is to be based:
(A) Title and risk of loss of each participant’s participating interest share of crude oil shall pass to that participant at the delivery point.
(B) As between the participants, each participant shall have the right to offtake in each period a volume equal to its participating interest share of the total participating production of crude oil for the period (such volume is hereinafter referred to as a participant’s ‘basic entitlement’). A participant shall have the right to request either a deferral of lifting of a portion of such participant’s basic entitlement or an overlift of such participant’s basic entitlement, provided such deferral or overlift does not adversely affect the production and/or lifting schedule. The operator shall have the right to approve or disapprove such underlift or overlift; provided, however, approval shall not be unreasonably withheld.
(C) To the extent that distribution of basic entitlement on such basis is impracticable due to unavailability of facilities or minimum cargo sizes, a method of making period adjustments shall be determined which provides substantially equivalent economic benefits to all the participants.
6. Accordingly, as per the querist, ‘Crude Offtake Agreement (COA)’ has been entered into by the participants. COA contains provisions (among others) for lifting schedule determination, cargo allocation and overlift/underlift.
7. ‘Allocation Rules of the COA’, inter alia, provide for the following:
(a) In developing each lifting schedule, the operator shall take into consideration the type and rate of production from the area, storage capacity at the terminal, the total number of the liftings from the terminal, the cumulative overlift and underlift of each party, and other operational and technical details pertinent to avoiding a shutdown or reduction of production.
(b) The operator shall have the discretion to allow the lifting of a cargo of a size less than, or more than, a standard cargo, provided that such lifting would not affect or unreasonably risk the lifting of another party, unless any party that would be affected by such lifting has notified the operator that such party does not disapprove such lifting.
(c) Overlift/Underlift:
(i) Each party may be designated to lift quantities, which would cause such party to overlift for the month when the operator has assigned the party a lifting of a standard cargo and the party’s entitlement is not sufficient to load a full standard cargo plus any allowable upward operational tolerance.
(ii) Each party may be designated to lift quantities which would cause such party to underlift for the month when the final lifting schedule developed according to relevant article of the COA has the party not lifting its full entitlement for the month.
(iii) Any arrangements with other parties which violate the overlift/underlift restrictions set forth in this agreement shall be rejected by the operator, unless in the reasonable judgment of the operator, such arrangements will not affect the lifting of another party, or unless each party, that in the reasonable judgment of the operator, will be affected by such overlift or underlift has notified the operator that it does not disapprove of such overlift or underlift.
(iv) The operator shall be authorised to reject any arrangement with other parties, which results in an overlift or underlift position of one or more parties, if in the reasonable judgment of the operator, rejecting such nomination is necessary in order to avoid shutting down or reducing production from the Area or exceeding the storage capacity tolerance of the Terminal.
8. Thus, according to the querist, given the fact that title and risk of loss of each participant’s participating interest share of crude oil shall pass to that participant at the delivery point, the participants are entitled to overlift/underlift crude oil in accordance with the provisions of JOA and COA. The underlift/overlift of a participant is adjusted in lifting schedule for the next month.
9. The querist has stated that in view of the above provisions of the PSA, JOA and COA, the company is accounting for the overlift/underlift quantity of its basic entitlement as per its declared accounting policy reproduced below:
“15. Revenue Recognition:
15.1 Revenue from sale of products is recognised on transfer of custody to customers. Any difference as of the reporting date between the entitlement quantity minus the quantities sold in respect of crude oil (including condensate), if positive is treated as inventory and, if negative, is adjusted to revenue by recording the same as liability.”
10. The querist has further stated that as on 31st March, 2009, the company overlifted quantity over and above its basic entitlement. Following the above-stated accounting policy, the company reduced the sales arrived at by multiplying overlift quantity by the sale price of crude oil realised by the company for its last sold cargo during March 2009 and created liability for the same.
11. The querist has also stated that had there been a case of underlift as on the balance sheet date, the company would have treated the underlift quantity as inventory of the company and would have valued it in accordance with the requirements of Accounting Standard (AS) 2, ‘Valuation of Inventories’ at cost or net realisable value, whichever is lower.
12. The above treatment, as per the querist, did not attract any adverse comment/ observations either from the statutory auditors or the Comptroller and Auditor General of India (C&AG) till the financial year 2007-08. However, C&AG auditors while carrying out their review under section 619(3)(b) of the Companies Act, 1956 for the financial year 2008-09 objected to the accounting for overlift quantity as liability and contested that the company should treat overlift quantity as its own share of production and should have booked sales of Rs. 789 million for the overlift quantity simultaneously recognising expenditure (cost of hydrocarbon, transportation charges and royalty etc.) amounting to Rs. 248 million on the basis of its recent cost figures, i.e., for fourth quarter (Q4) of the financial year 2008-09 in the extant case. Further, the C&AG auditors contended that government’s take of profit oil should have also been reduced from the sales on the basis of applicable percentage of government’s share of profit oil (i.e., for Q4 2008-09) as was recognised for normal sales of the company in accordance with its practice of showing sales ‘net of government share of profit oil’, as stated by way of footnote in Schedule-15, Sales to the company’s final accounts.
B. Query
13. The querist has sought the opinion of the Expert Advisory Committee of the Institute of Chartered Accountants of India on the appropriate accounting treatment of overlift/underlift quantity of crude oil by the company, i.e., whether
(i) the accounting policy of the company in recognising overlift quantity as liability and underlift quantity as inventory is appropriate and whether the accounting treatment carried out by the company in respect of overlift quantity of crude oil by recognising the same as liability at recent sales price of the crude oil realised by the company is appropriate; or
(ii) the production quantity related to overlift quantity should be treated as the company’s share and accounted for in the manner specified by the C&AG auditors; or
(iii) there is any other appropriate accounting treatment / disclosure of such overlift/underlift quantity.
C. Points considered by the Committee
14. The Committee notes that the basic issue raised in the query relates to the accounting for overlift and underlift quantity of crude oil. 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, accounting for government’s share of profit oil, interpreting the terms of the PSA, JOA and COA, accounting for the joint operations, propriety of recognition of revenue on the transfer of custody of oil to customers, etc. In the absence of any information to the contrary, the Committee presumes that the company is being charged for its proportionate share in the production cost of the oil as per its basic entitlement and not as per the quantity lifted during the period.
15. As far as accounting for overlift quantity of crude oil is concerned, the Committee notes that the definition of the term ‘revenue’, as provided by Accounting Standard (AS) 9, ‘Revenue Recognition’ states that “Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and …”. Accordingly, in the view of the Committee, the total amount of consideration arising from the sale of crude oil (including the sold quantity from the overlift of crude oil) should be recognised as revenue.
16. The Committee further notes the definition of the term ‘liability’, as provided in paragraph 10 of Accounting Standard (AS) 29, ‘Provisions, Contingent Liabilities and Contingent Assets’, which states as follows:
“A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.”
The Committee notes from the Facts of the Case that the underlift/overlift of a participant is adjusted in the lifting schedule for the next month. Thus, the Committee is of the view that the overlift of crude oil gives rise to an obligation on the company to transfer future economic benefits (by foregoing the right to receive equivalent future entitlement in the crude oil). Accordingly, a liability should be provided for by the company by way of charge to the profit and loss account for overlift quantity keeping in view the presumption stated in paragraph 14 above that the company is charged only for the proportionate share of production cost as per its basic entitlement and not for the actual quantity lifted. The above treatment is based on the fundamental accounting principle of ‘accrual’ as contained in paragraph 10(c) of Accounting Standard (AS) 1, ‘Disclosure of Accounting Policies’, which provides as below:
“c. Accrual
Revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate.”
17. The amount of provision for the liability in respect of overlift quantity should be determined on the basis of the best estimate of the expenditure required to settle the present obligation at the balance sheet date as per the requirements of paragraph 35 of AS 29. In the extant case, it would be the best estimate of the company’s proportionate share of production expenses as per the JOA/PSA in respect of the quantity of crude oil foregone in future period towards settlement of the overlift quantity of crude oil.
18. As regards underlift situation, the Committee is of the view that to the extent it is the settlement of an overlift situation of the earlier periods, it should be recognised by debiting the liability provided for under the overlift situation and crediting/reducing the company’s proportionate share in the production cost. In respect of other underlift situations (i.e., not arising due to settlement of an overlift of crude oil in an earlier period), the Committee notes that the Framework for the Preparation and Presentation of Financial Statements, issued by the Institute of Chartered Accountants of India, provides that “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 an enterprise”. Accordingly, the Committee is of the view that an underlift represents a right to future economic benefit through entitlement to receive equivalent production in the future and is therefore, an asset. In respect of the nature of that asset, the Committee notes the definition of the term ‘pre-paid expense’, as provided under the ‘Guidance Note on Terms Used in Financial Statements’, issued by the Institute of Chartered Accountants of India, which states as follows:
“13.07 Pre-paid Expense
Payment for expense in an accounting period, the benefit for which will accrue in the subsequent accounting period(s).”
Since in the present case, the company is charged for the proportionate share of production cost as per its basic entitlement, but the quantity of crude oil lifted is less than its basic entitlement, the amount paid in excess is ‘prepaid expense’. The Committee is of the view that under the underlift situation, the company should recognise a pre-paid expense by crediting its proportionate share of production cost as per the joint operating agreement/production sharing agreement.
19. In situations where an overlift situation has arisen due to settlement of an earlier underlift, the Committee is of the view that the same should be recognised by crediting the earlier recognised ‘pre-paid expense’ for the underlift and debiting the share of production cost for the current period.
D. Opinion
20. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 13 above:
(i) The accounting policy of the company in recognising overlift quantity as liability is appropriate, however, recognition of liability by reversing the sales/revenue of the company at the recent sales price of the crude oil is not appropriate. The accounting policy of recognising the underlift quantity as inventory is also not appropriate.
(ii)&(iii) Refer to paragraphs 15 to 19 above.
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