Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For

May 2011 diet

OIL AND GAS ACCOUNTING Introduction Activities in the oil industry are divided into two broad categories: a. Upstream activities; and b. Downstream activities. Upstream activities involve the acquisition of mineral interest in properties, exploration (searching) including prospecting (i.e. discovery and preparation for mining), development, and production of crude oil and natural gas; while Downstream activities involve transporting, refining, storing and marketing & distribution of oil, gas and derivatives. Regulation The following are the accounting standards that regulate preparation of financial statements of entities operating in the upstream sector of the petroleum industry: SAS 14 Accounting in the Petroleum Industry; upstream activities; and IFRS 6 Explorations for and Evaluation of Mineral Resources. While preparation of financial statements of entities operating in the downstream sector is governed by: SAS 17 Accounting in the Petroleum Industry; downstream activities. Classification of costs in the upstream sub-sector With reference to SAS 14, costs associated with oil and gas production in the upstream sector are classified into the following: i. Mineral rights acquisition cost ii. Exploration and Evaluation cost iii. Development cost iv. Production cost v. Support equipment and facilities cost; and vi. General/Admin. cost Mineral rights Acquisition Costs: These are costs of acquiring concession rights in a lease area. They include: Signature bonus (i.e. the initial consideration paid to the Federal Government) License fee in form of Oil Exploration License (OEL) (usually valid for 1 year or as may be determined by FGN from-time-to-time), Oil Prospecting License (OPL) (usually valid for 3-5 years or as may be determined by FGN from-time-to-time) and Oil Mining Lease (OML) (usually valid for 20-30 years or as may be determined by FGN from-time-to-time).
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Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For May 2011 diet

Legal fees Land-related Fees & levies; and Other incidental costs. Exploration and Evaluation Costs: These are costs incurred in identifying and examining specific areas that may possibly contain oil and natural gas reserves, i.e. petroleum prospects. This is achieved largely by drilling of the exploratory wells. The cost of drilling exploratory wells are usually capitalised provided sufficient quantity of reserve to justify its completion as a producing well exists and the drilling of additional wells has been firmly planned for the near future. Otherwise, the exploratory well is considered impaired and the related costs written off once accordingly. Examples of exploration and drilling costs include: acquisition of rights to explore, topographical i.e. mapping of the surface features of the exploration area, geological i.e. the study of the structure of the exploration area, geochemical i.e. the study of the chemical composition of the exploration area, geophysical studies; i.e. the study of the physical process of the exploration area, seismological study i.e. study of vulnerability or otherwise of the exploration area to earthquake particularly in the deep water zone. exploratory drilling to ascertain whether or not oil and gas exist in a particular field; trenching, sampling; and activities in relation to evaluating the technical feasibility and commercial viability of extracting the oil and gas. other associated costs such as resettlement of host communities, compensation for economic crops, surface rights and road construction. With reference to IFRS 6, where an entity incurs obligations for removal and restoration as a consequence of having undertaken the exploration for and evaluation of mineral resources, those obligations are recognised in accordance with the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Development Costs: These are costs incurred in order to gain access to proved reserves and also costs incurred to provide facilities for extracting, gathering, treating, and storing the oil and gas reserves. Examples of these costs are: drilling, equipping and testing development and production wells, production platforms, downhole (i.e. equipment used inside an oil well), wellhead equipment, pipelines, initial production and treatment, storage facilities and utilities; and waste disposal system.
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Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For May 2011 diet

Development costs are usually capitalised. Production Costs: These are costs incurred in lifting oil and gas reserves to the surface. They are usually associated with operation and maintenance of the production wells and related equipments and facilities. Nowadays, oil and gas companies operating in the deep water zone use Floating Production Storage and Off-loading Vessels (FPSO) for their production and storage activities. Examples of these costs are: staff costs of personnel engaged in the operation of the production wells and the related equipment and facilities, repairs and maintenance of the production equipment and facilities, depreciation of the production equipment and facilities, materials, supplies, fuel consumed and services utilised in such operations; and royalties payable on barrels produced. The current royalties rate are: a. In respect of Joint Venture Operations (JVO): On-shore production = 20% Off-shore production up to 100 metres water depth = 18.5% Off-shore production beyond to 100 metres water depth = 16.66% b. In respect of Production Sharing Contracts (PSC): In areas from 201 500 metres water depth In areas from 501 800 metres water depth In areas from 801 1,000 metres water depth In areas in excess of 1,000 metres water depth

= = = =

12% 8% 4% 0%

Production costs are usually written off in the year in which they are incurred and to which they relate. Admin Costs: These are the usual administration costs and expenses incurred in the normal cause of business. Admin costs are also written off in the year in which they are incurred and to which they relate. CONCEPT OF COST CENTRE There are two (2) types of costs centre concept in oil and gas activities. These are: 1. 2. Single cost centre Countrywide or continental cost centre.

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Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For May 2011 diet

Single Cost Centre: Single cost centre concept assumes that the company s entire operations worldwide are treated as a single cost centre. In this case, all the exploration and development costs incurred are capitalised into one account irrespective of where and when they are incurred. Countrywide or Continental Cost Centre: This concept assumes that the company s operations in particular countries are taken as a cost centre individually. METHODS OF ACCOUNTING Three methods of accounting for activities in the upstream sector are mentioned by SAS 14. These are: 1. 2. 3. Successful Efforts Accounting (SEA) Method Full Cost Accounting (FCA) Method Reserve Recognition Accounting (RRA) Method

Note that these 3 methods influence only 4 things though in different ways: amount recognised as revenue in the operating year, amount recognised as production cost in the operating year, amount recognised as depletion charge on exploration & evaluation costs; and amount recognised as impairment loss on exploration & evaluation costs. Successful Efforts Accounting Method (SEA) Under this method, oil reserves are categorised into 3 as follows: proved reserves i.e. wells with commercial quantity of oil and gas (successful effort) dry holes i.e. wells with below commercial quantity or empty oil and gas (failed effort); and unproved reserves i.e. wells whose actually status are yet to be ascertained. For proved reserves whose net value is higher than the related exploration and evaluation costs, the related exploration and evaluation costs incurred are capitalised and subsequently depleted on the basis of quantity of barrels sold on individual areaby-area basis. For proved reserves whose net value is lower than the related exploration and evaluation costs, the shortfall is treated as an impairment of the related exploration and evaluation costs. Such impairment is usually written off once to the Revenue Account in the year in which the impairment loss is recognised while the balance is capitalised. For dry holes, related exploration and evaluation costs incurred are written off once as impairment loss to the revenue account.
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Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For May 2011 diet

For unproved reserves, related exploration and evaluation costs are capitalised pending when the exact status of the well is ascertained. Full Cost Accounting Method (FCA) Under this method, oil reserves are grouped into 2 as follows: proved reserves and dry holes (combined); and unproved reserves. For proved reserves and dry holes, aggregate exploration and evaluation costs incurred are capitalised and subsequently amortised on the basis of aggregate quantity of barrels sold relative to aggregate quantity of oil & gas found. For unproved reserves, related exploration and evaluation costs are capitalised pending when the exact status of the well is ascertained. Reserve Recognition Accounting Method (RRA) Under this method, oil reserves are also grouped into 2 as follows: proved reserves and dry holes; and unproved reserves. For proved reserves and dry holes, aggregate exploration and evaluation costs incurred are written off once as depletion to the revenue account. Revenue is recognised at net realisable value of the aggregate reserves found in the entire field and not on the basis of quantity sold. The unsold barrels, also at net realisable value, are carried as inventory (current asset) in the balance sheet. For unproved reserves, related exploration and evaluation costs are capitalised pending when the exact status of the well is ascertained. One disadvantage of this method is that it allows the company to recognise unrealised profit. And it is for this reason that use of it is not permitted by SAS 14.

IFRS 6: EXPLORATION FOR AND EVALUATION OF MINERAL RESOURCES The International Accounting Standards Board (IASB) issued International Financial Reporting Standard (IFRS) 6 Exploration for and Evaluation of Mineral Resources on 9 December 2004. The Standard, which became effective January 1 2006 (with earlier application encouraged), applies to expenditures incurred by an entity in connection with the search for mineral resources. Accounting for extractive activities has been identified by the IASB as the topic for a future Standard although no fixed timetable for the project has yet been set. In the mean time, IFRS 6
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Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For May 2011 diet

permits entities to continue to use their existing accounting policies for exploration and evaluation assets, provided that such policies result in information that is relevant and reliable; and requires entities to assess any exploration and evaluation assets for impairment when facts and circumstances suggest that the carrying amount of the assets may exceed their recoverable amount. The recognition of impairment in respect of such assets is varied from that in IAS 36 Impairment of Assets but, once impairment has been identified, it is measured in accordance with IAS 36.

Scope of IFRS 6 IFRS 6 applies to exploration and evaluation expenditures, i.e. expenditure incurred by entities that engage in extractive activities in connection with the exploration for and evaluation of mineral resources (including minerals, oil, natural gas and similar nonregenerative resources). Affected activities include the search for mineral resources, as well as the determination of the technical feasibility and commercial viability of extracting those resources. The following are specifically excluded from the scope of IFRS 6: expenditures incurred before the entity has obtained legal rights to explore in a specific area; and expenditures incurred after the technical feasibility and commercial viability of extracting a mineral resource are demonstrable. Presentation Entities are required to classify exploration and evaluation assets as tangible or intangible, according to the nature of the assets. Examples of assets to be classified as tangible assets are vehicles and drilling rigs. Intangible assets will include items such as drilling rights. Once the technical feasibility and commercial viability of extracting a mineral resource becomes demonstrable, any previously recognised exploration and evaluation asset falls outside the scope of IFRS 6 and is reclassified in accordance with other relevant Standards. The assets should be assessed for impairment, while impairment loss is recognised before the reclassification. Initial measurement Exploration and evaluation assets are required to be measured at cost when they are first recognised in the balance sheet. Qualifying expenditure IFRS 6 lists the following as examples of expenditures that might be included in the initial measurement of exploration and evaluation assets (the list is not exhaustive): acquisition of rights to explore, topographical i.e. mapping of the surface features of the exploration area,
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Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For May 2011 diet

geological i.e. the study of the structure of the exploration area, geochemical i.e. the study of the chemical composition of the exploration area, geophysical studies; i.e. the study of the physical process of the exploration area, exploratory drilling; trenching, sampling; and activities in relation to evaluating the technical feasibility and commercial viability of extracting the mineral resource.

Where an entity incurs obligations for removal and restoration as a consequence of having undertaken the exploration for and evaluation of mineral resources, those obligations are recognised in accordance with the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Subsequent measurement After recognition, entities can apply either the cost model or the revaluation model to exploration and evaluation assets. Where the revaluation model is selected, the rules of IAS 16 Property, Plant and Equipment are applied to exploration and evaluation assets classified as tangible assets, and the rules of IAS 38 Intangible Assets are applied to those classified as intangible assets Impairment Because of the difficulty in obtaining the information necessary to estimate future cash flows from exploration and evaluation assets, IFRS 6 modifies the rules of IAS 36 as regards the circumstances in which such assets are required to be assessed for impairment. A detailed impairment test is required in two circumstances: ` When the technical feasibility and commercial viability of extracting a mineral resource become demonstrable, at which point the asset falls outside the scope of IFRS 6 and is reclassified in the financial statements; and When facts and circumstances suggest that the asset's carrying amount may exceed its recoverable amount.
IFRS 6 includes

the following examples of facts and circumstances that may indicate that impairment testing is required (the list is not exhaustive): the period for which the entity has the right to explore in the specific area has expired during the period or will expire in the near future, and is not expected to be renewed, substantive expenditure on further exploration for and evaluation of mineral resources in the specific area is neither budgeted nor planned,
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Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For May 2011 diet

exploration for and evaluation of mineral resources in the specific area have not led to the discovery of commercially viable quantities of mineral resources, and the entity has decided to discontinue such activities in the specific area; and sufficient data exist to indicate that, although a development in the specific area is likely to proceed, the carrying amount of the exploration and evaluation asset is unlikely to be recovered in full from successful development or by sale.

QUESTION Allied Energy Limited was formed with an authorised share capital of 3 million units of ordinary shares of N1 each and 1 million units of redeemable preference shares of N1 each. All the shares were issued and fully subscribed to. Ordinary shares were issued at N1.50k each while the redeemable preference shares were issued at N1 each. The company engages in oil prospecting activities in the deep water zone in Nigeria. During its first year of operations, the following transactions took place. i. ii. Payment for oil prospecting license: N5,000,000 The licence has a term of 5 years. Direct Exploration and Evaluation costs were as follows:=N= Area I 4,000,000 Area II 3,300,000 Area III 500,000 Area IV 600,000

By the end of the year: Area I was fully explored yielding 45,000 barrels; Area II was also fully explored: 220,000 barrels were discovered out of which 120,000 barrels were extracted and produced. Area Area III IV exploration abandoned no oil found exploration has reached an advanced stage but the quantity of reserves was yet to be established.

Other information is: Average production cost in each of the areas of operation is estimated at N10.00 per barrel.

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Accounting for Oil & Gas Activity (SAS 14)/Exploration for and Evaluation of Mineral Resources (IFRS 6) For May 2011 diet

Staff cost was N3 million while other OPEX (operating expenses) was N1.8 million. Obligation for removal and restoration of site in five year time is estimated at N5 million.

For accounting policy, the Board considered three different alternatives approaches for accounting for exploration and well development costs:i. ii. iii. Successful efforts accounting. Full cost accounting; and Reserves recognition accounting

You are required to:a. Opening all necessary ledger accounts b. Prepare Revenue Accounts; and c. Statement of Financial Position (Balance Sheets), for the company s first year of operations on each of the three methods being considered. Assume that:i. The company is obliged to sell all of its oil to NNPC at N80 per barrel and that the company reckons that its selling price of crude oil and production costs will not change adversely in the foreseeable future in relation to the level in the first year. Royalties on production is payable at the rate of 16.66% License cost is amortized over its term. Discounting factor, where applicable at 10%.

ii. iii. iii.

Make all calculations to the nearest N 000. Ignore taxation.

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