Expert Advisory Committee

Query No. 1

Subject: 

Accounting treatment and disclosure in respect of cost recoverable in accordance with

the provision of Production Sharing Contract (PSC) which is already written off.¹

A.Facts of the Case

 1.A public limited company, which is wholly owned subsidiary of a listed government company (hereinafter referred to as ‘the 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) lies with respective governments and 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 acquiring such Rights and then to explore, develop and produce hydrocarbons. Such Rights are acquired 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. One such regime is Production Sharing Contract (hereinafter referred to as ‘PSC’), 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 work obligations/ payments by the contractor including sharing of the hydrocarbons (in case of success), with the government or its nominated agency as per the principles detailed in the PSC

2.The company is a participant in two such PSCs along with other companies (hereinafter referred to as ‘Contractor’) with the government of a foreign country Z (hereinafter referred to as ‘State’) in respect of certain geographical areas X and Y specified in the PSCs (hereinafter referred to as ‘Area(s)’). Under the PSCs, the State granted the exclusive Rights to the Contractor to conduct hydrocarbon operations in the Areas subject to the terms and conditions of the PSCs. The joint venture arrangements among the Contractor partners are governed by a Joint Operating Agreement (hereinafter referred to as ‘JOA’) entered into by the Contractor participants.

3. Relevant Article of the PSC provides that the Contractor is entitled to recover ‘Cost Petroleum’, i.e., petroleum costs as defined in the PSC out of ‘Available Petroleum’ produced from Development and Production Area. This recovery starts only on commencement of commercial production. The relevant paragraph of the PSC has been reproduced by the querist as below:

“Contractor  shall recover all Petroleum Costs in accordance with Annexure “C” in respect of all Petroleum Operations hereunder to the extent of and out of a maximum of fifty percent (50%) per Quarter of all  Available Petroleum from the Contract Area, provided, however, that all costs and expenses of Development and Production Operations (inclusive of pipeline cost to move Crude Oil and/or Natural Gas to the Delivery Point for sale or transfer of ownership) in respect of any Development and Production Area  shall be recovered from Available Petroleum produced from any Development and Production Area, and  further that all costs and expenses of Exploration Operations carried out in the Contract Area shall be recoverable from Available Petroleum produced from any Development and Production Area. Such Petroleum to which CONTRACTOR is entitled for the purpose of recovering its Petroleum Costs is hereinafter referred to as “Cost Petroleum”.  Such Petroleum Costs shall be recovered out of Cost Petroleum in the later part of the Quarter in which such expenditures are incurred or in the Quarter in which Commencement of Commercial Production first occurs within the Contract Area.”

As per the querist, ‘Available Petroleum’ is defined as petroleum produced and saved and not used in petroleum operations

4.The querist has clarified that the PSC is an agreement between the host government and contractor (including company) providing for various terms and conditions to carry out petroleum operation in the contract area. The PSC, inter alia, provides for the mechanism for sharing of total production volume from the contract area between contractor and the host government. The sharing mechanism in general provides for maximum volume of production available for recovering the total cost incurred by the contractor for the petroleum operation and the balance as the profit petroleum to be shared between contractor and government.   For example, in simple terms, if the total production is 100 barrel in a period and the Cost Petroleum Recovery limit in a year is 50%, then 50 barrels would be available for recovery of cost and the rest 50 barrels would be profit petroleum to be shared between the contractor and government as per a defined formula. Assuming crude oil price of USD 100 / barrel, the Cost Petroleum would be USD 5,000 (50bbl X USD l00/bbl) and contractor would be able to recover petroleum cost up to the maximum of USD 5,000 during such period. In case the actual unrecovered cost is lower than cost petroleum, the difference is taken to profit petroleum and in case the actual unrecovered cost is higher than the cost petroleum, the difference is carried forward for recovery in following years.

5. The querist has stated that the Contractor drilled 22 exploratory wells in the  Areas out of which 10 wells were declared dry and cost of these dry wells amounting to Rs. 211.92 crore was charged off to the profit and loss account (P&L Account) during the period 01.04.2004 to 31.03.2010 following the ‘Successful Efforts Method’ (SEM) and the cost of remaining 12 wells which are found gas bearing has been accounted as Exploratory Wells in Progress (EWIP), i.e., Capital Work in Progress, as stipulated in the Guidance Note on Accounting for Oil and Gas Producing Activities,² issued by Institute of Chartered Accountants of India. The cost of such successful exploratory wells will be capitalised to ‘Producing Property’ asset when ready to commence production in accordance with the SEM accounting prescribed in the Guidance Note. As per the querist, this accounting treatment was given effect irrespective of the stipulation in the PSC that the cost of such exploratory dry wells will be recovered out of Available Petroleum on commencement of commercial production from the field in accordance with the above referred provisions of the PSC. As per the terms of the PSC, both the areas X & Y were declared commercial on 1st November, 2009.

6. The above accounting treatment was accepted by the statutory auditors as well as the Comptroller and Auditor General of India (C&AG) till financial year 2008-09. However, C&AG auditors while carrying out their review under section 619(3)(b) of the Companies Act, 1956 for the year 2009-10 opined that since commercially viable reserves have been discovered and development plan of the fields has also been approved by the host government,  dry wells cost should not have been written off and such costs written off in previous periods should be written back as ‘Amount Recoverable’  crediting the same to P&L Account as ‘Miscellaneous Receipts’ as per the provisions of the PSC due to non-existence of uncertainty about recovery of costs.

7. The company replied stating that the company has correctly accounted for the costs of dry wells in accordance with the Guidance Note on Accounting for Oil and Gas Producing Activities, following the Successful Efforts Method. The PSC  allows for cost recoverability or otherwise of various costs that go into exploration, development and operations stage; these costs are taken into account for the computation of hydrocarbon entitlement (Cost Petroleum)  of the contractor as per the provisions of PSC and get recognised for the purposes of revenue from produced hydrocarbons.

8. Based on the reply of the company, C&AG auditors suggested taking up the matter with the Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India (ICAI) for guidance. They further suggested that pending receipt of opinion from ICAI, such costs may be computed and appropriately disclosed in the books of account. C&AG Half Margin and reply given by the company have been provided by the querist for the perusal of the Committee as Annexure 1.

B. Query

9. In view of the above facts, the opinion of EAC of the ICAI is sought on the following issues:

(i). Whether the accounting treatment given by the company in respect of unsuccessful exploratory wells (dry wells) following the successful efforts method as per the Guidance Note  is appropriate; or

 

(ii). Whether the accounting treatment suggested by the C&AG auditors, i.e., to recognise expenses relating to dry exploratory wells  written off in past as ‘Miscellaneous Income’ in the P&L Account and equivalent amount to be carried in the balance sheet as ‘Amount Recoverable’ on declaration of commerciality on 1st November, 2009 and/or approval of the development plan by the host government is appropriate,

 

(iii). if answer to (ii) above is in the affirmative, whether all expenses subsequent to declaration of commerciality and/or approval of the development plan should be booked as ‘Recoverable’ only irrespective of the accounting treatment prescribed in the Guidance Note on Accounting for Oil & Gas Producing Activities, as the costs are recoverable under PSC provisions,

 

iv). Whether disclosure of the recoverable cost, as suggested by C&AG auditors, is appropriate; or

 

(v).Whether there is any other appropriate accounting treatment / disclosure in respect of cost recoverable in accordance with the provision of Production Sharing Contract

C. Points considered by the Committee

10. The Committee notes that the basic issue raised in the query relates to accounting for unsuccessful exploratory dry wells’ costs and accounting, if any, for the costs earlier expensed which became recoverable subsequent to the discovery of commercial viable reserves and approval of the development plan by the host government as per the Production Sharing Contract. Therefore, the Committee has examined only these issues and has not examined any other issue that may arise from the Facts of the Case, such as, quarterly reporting of the recovery of petroleum costs, determination of the company’s share while recognising expenses, assets, income and liabilities in its financial statements, propriety of determination of exploratory and development dry wells, accounting for development wells, producing properties, etc. as per the provisions of the Guidance Note on Accounting for Oil and Gas Producing Activities, impairment of various assets recognised, etc. The Committee notes that the terms ‘declaration of commerciality’ and ‘discovery of commercial reserves’ have been used interchangeably.  However, since this does not affect the opinion of the Committee expressed hereinafter, the Committee has not examined this issue

11. With regard to the accounting treatment in respect of costs incurred on unsuccessful exploratory dry wells, the Committee notes paragraphs 36, 37 and 39 of the Guidance Note which recommends as below:

“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.

37. All costs other than the above should be charged as expense when incurred.”

 

“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.”

12. On the basis of the above, the Committee is of the view that pending determination of proved reserves, as per paragraph 36 of the Guidance Note, exploration costs, in respect of a cost centre, should be capitalised as part of the capital work-in-progress. Whenever an exploratory well is determined to have no proved reserves, i.e., dry, the costs incurred in respect thereof 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. Accordingly, in the extant case, the accounting treatment followed by the company to write-off the costs incurred on dry wells would be appropriate provided the above-reproduced provisions of the Guidance Note are followed.

13. As regards accounting for dry exploratory well’s  cost expensed earlier following SEM but subsequent to discovery of commercially viable reserves and approval of the development plan by the host government, the company becoming entitled to recovery as per the Production Sharing Contract, the Committee notes that the Guidance Note on Accounting for Oil and Gas Producing Activities provides guidance on accounting for costs incurred on activities relating to acquisition of mineral interests in properties, exploration, development and production of oil and gas and does not deal with the contractual rights with regard to recovery of these costs  as per the PSC with the  host government, which, in the view of the Committee, should be recognised independently  considering the specific terms and conditions of the PSC as per the generally accepted accounting principles (GAAPs) applicable to such industry.

14. The Committee notes that as per the given PSC, the contractor agrees to pay for and bear the risk of all the exploration, development and production costs in respect of Areas X and Y. On discovery of commercially viable reserves and approval of development plan by the host government, the contractor is entitled to receive a share of production for recovery of its cost (‘cost petroleum’) and the balance (‘profit petroleum’) is shared between the contractor and the Government in agreed ratios. The Committee is of the view that since the risks and rewards relating to exploration activity are retained by the contractor (including the company) and the host government is entitled to its share being the owner of the property, the recovery mechanism prescribed in the PSC is only a mode of determining share of various parties to the contract in the quantity of hydrocarbons developed and produced in a period.  Accordingly, the costs in respect of exploration, development, production, etc. should be recognised as per the guidance provided by the above-mentioned Guidance Note. Further, the Committee is of the view that such recovery mechanism is only a formula to determine the share of parties to the contract since the Government is not paying anything for such share that may be recognised as ‘amount receivable’ in the books of the company. Accordingly, the company is not required to credit the P&L Account as ‘Amount Recoverable’ under ‘Miscellaneous Receipts’, in respect of cost of dry wells already written off in its books of account.

D. Opinion

15.On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 9 above:

(i) Subject to paragraph 10 above, the accounting treatment given by the company in respect of unsuccessful    exploratory wells (dry wells) is appropriate as discussed in paragraphs 11 and 12 above.

 

(ii) The accounting treatment suggested by the C&AG auditors, i.e., to recognise expenses relating to dry exploratory wells written off in past as ‘Miscellaneous Income’ in the P&L Account and equivalent amount to be carried in the balance sheet as ‘Amount Recoverable’ on declaration of commerciality on 1st November, 2009 and approval of the development plan by the host government is not appropriate as discussed in paragraphs 13 and 14 above.

 

(iii) to (v) Answer to these questions do not arise in view of (ii) above

Annexure-1

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¹Opinion finalised by the Committee on 4.4.2012.

²Guidance Note on Accounting for Oil and Gas Producing Activities has since been revised. The revised Guidance Note comes into effect in respect of accounting periods commencing on or after 1.4.2013.