1.7       Query

Disclosure of expenditure on exploration of oil and gas

in the financial statements of a company

1.A wholly owned Government undertaking is engaged in exploration, production and transportation of crude oil, natural gas and production of LPG. Exploration for crude oil and natural gas is one of the principal activities of the company. Accordingly, it incurs substantial expenditure on exploration activities such as seismic surveys and drilling in exploration areas. This exploration expenditure, which is intangible in nature, is amortised over a period of three years as per the terms of an agreement with the Central Government u/s 42 of the Income-tax Act, 1961. It has been the practice of the company, ever since its inception in 1959, to disclose in its balance sheet, the unamortised portion of the exploration expenditure immediately after “fixed assets”. The company considers this disclosure appropriate for the reasons that (i) the discovery of oil and gas is the significant activity of a crude oil company, and (ii) the exploration expenditure represents the ‘discovery value’ of oil and gas and is, therefore, expected to yield a benefit of an enduring benefit and as such is akin to capital expenditure.

2.In support of the above manner of disclosure adopted by the company, the querist has drawn the attention of the Expert Advisory Committee to the following two alternative approaches generally followed in the USA and the U.K.

(i)            Full Costing Approach: Under this approach all costs incurred in acquiring, exploring and developing mineral properties within an area are capitalised under the head ‘properties’ as and when they are incurred and, thereafter amortised over the oil and gas produced from all the fields. It thus recognises that expenses incurred for unsuccessful exploration are as much necessary as those for successful exploration.

(ii)            Successful Costing Approach: Under this method the exploration expenses are carried forward in the accounts as ‘construction work-in-progress’ until it is conclusively proved that the expenditure has become abortive. The portion representing successful exploration expenditure is capitalised under the head ‘properties’ and the abortive portion charged off in full to revenue.

3.The querist has argued that both the aforesaid approaches recognise that the exploration expenditure is ‘capital’ in nature and not ‘revenue’. In support of his arguments, he has drawn attention of the Committee to the balance sheets of certain foreign oil companies.

4.The Company has now been advised that the said manner of disclosure is not appropriate and that the amount should be shown under ‘Miscellaneous Expenditure’ as per Schedule VI to the Companies Act, 1956 as has been done by a sister organisation of the company engaged in similar business. The querist however is of the view that the manner of disclosure followed by the company is correct since he feels that the “miscellaneous expenditure” as envisaged under Schedule VI relates only to expenses incurred for the formation of company, issue of shares and debentures and other expenses of deferred revenue nature. The querist has further argued that whereas the “miscellaneous expenditure” is normally a one-time expenditure, the exploration expenditure is of recurring type representing the discovery value of the operating lease property.

5.The opinion of the Expert Advisory Committee has been sought as to whether the unamortised exploration expenditure of a mineral oil company can be disclosed immediately after fixed assets or should it be shown under the head “Miscellaneous Expenditure”.

                                                            Opinion                                                       April 30,1984

1.The Committee notes that, in India, there is no authoritative pronouncement on the treatment and disclosure of exploration expenditure of companies carrying on oil and gas producing activities. The Committee further notes that Financial Accounting Standard (FAS) 19 on “ Financial Accounting and Reporting by Oil and Gas Producing Companies”, issued by the Financial Accounting Standards Board (FASB) in the United States of America, advocated the use of successful costing method described in para 2 above. However, the effective date for application of certain portions of the FAS was suspended by the issue of FAS 26 at the instance of Securities Exchange Commission (SEC), which was in favour of allowing companies to use full costing method also as an alternative. The Committee thus notes that even in the USA the accounting principles in this regard have not been fully settled and that “both ‘full costing’ and ‘successful efforts costing’ have been considered as conforming to generally accepted accounting principles, and both, in various forms, are widely used today”.1

2.The Committee has considered the arguments advanced for and against both the methods. The principal argument for ‘full costing’ method is that the oil and gas reserves cannot be found without incurring the exploration costs therefore the costs of unsuccessful exploration are necessary for the discovery of such reserves. The main argument against ‘full costing’ method is that  “even costs that are known not to have resulted in identifiable future benefits are nonetheless capitalised as part of the cost of assets to which they have no direct relationship”.2  On the other hand, it is argued in favour of the successful costing method that it seeks to establish direct relationship between costs and results, therefore, it is more scientific. However, this method is difficult to apply in practice due to various complexities involved e.g. in deciding the point of time of success or failure of the exploration attempt.

3.The Committee notes that Part I of Schedule VI to the Companies Act, 1956, requires disclosure of certain items of expenditure under the head “Miscellaneous Expenditure”, that are not necessarily of revenue nature, e. g., “Development expenditure not adjusted”. Such expenditures are generally not immediately related to any asset. The Committee is of the view that expenditure incurred on exploration of oil and gas is of this nature since such an expenditure cannot be considered a fixed asset until the exploration attempt proves successful. The Committee is therefore of the view that the exploration expenditure may be shown under the head “Miscellaneous Expenditure”. The Committee however is also of the view that since full costing method is also generally accepted in other countries the exploration expenditure can be capitalized as and when incurred and disclosed under the head “Fixed Assets”, provided proper amortisation is being done.

4.On the basis of above, the Committee is of the opinion that the unamortized exploration expenditure of a mineral oil company should be shown under the head “Miscellaneous Expenditure”. The practice of treating it as a “Fixed Asset” is also permissible provided it is properly amortised. In any case the accounting policy in this regard should be disclosed.

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