Audit and accounting guide entities with oil and gas producing activities, 2018

PREPARED BY THE ENTITIES WITH OIL AND GAS PRODUCING ACTIVITIES TASK FORCE Updated as of August 1, 2018 About AICPA Audit and Accounting Guides This AICPA Audit and Accounting Guide has b

August 1, 2018

Audit and

Accounting Guide Entities With Oil and Gas Producing Activities

American Institute of Certified Public Accountants All rights reserved

For information about the procedure for requesting permission to make copies of any part of this work, please email copyright@aicpa.org with your request Otherwise, requests should be written and mailed to Permissions Department,

220 Leigh Farm Road, Durham, NC 27707-8110.

1 2 3 4 5 6 7 8 9 0 AAP 1 9 8

PREPARED BY THE ENTITIES WITH OIL AND GAS PRODUCING

ACTIVITIES TASK FORCE

(Updated as of August 1, 2018)

About AICPA Audit and Accounting Guides

This AICPA Audit and Accounting Guide has been developed by the AICPA tities With Oil and Gas Producing Activities Task Force to assist practitioners

En-in performEn-ing and reportEn-ing on their audit engagements and to assist ment in the preparation of their financial statements in conformity with U.S.generally accepted accounting principles (GAAP)

manage-An AICPA Guide containing auditing guidance related to generally acceptedauditing standards (GAAS) is recognized as an interpretive publication as

defined in AU-C section 200, Overall Objectives of the Independent Auditor

and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards.1Interpretive publications are recommendations on the application

of GAAS in specific circumstances, including engagements for entities in cialized industries

spe-Interpretive publications are issued under the authority of the AICPA's diting Standards Board (ASB) after all ASB members have been provided anopportunity to consider and comment on whether the proposed interpretivepublication is consistent with GAAS The members of the ASB have found theauditing guidance in this guide to be consistent with existing GAAS

Au-Although interpretive publications are not auditing standards, AU-C section

200 requires the auditor to consider applicable interpretive publications inplanning and performing the audit because interpretive publications are rele-vant to the proper application of GAAS in specific circumstances If the auditordoes not apply the auditing guidance in an applicable interpretive publication,the auditor should document how the requirements of GAAS were compliedwith in the circumstances addressed by such auditing guidance

The ASB is the designated senior committee of the AICPA authorized to speakfor the AICPA on all matters related to auditing Conforming changes made tothe auditing guidance contained in this guide are approved by the ASB Chair(or his or her designee) and the Director of the AICPA Audit and Attest Stan-dards Staff Updates made to the auditing guidance in this guide exceeding that

of conforming changes are issued after all ASB members have been provided anopportunity to consider and comment on whether the guide is consistent withthe Statements on Auditing Standards (SASs)

Any auditing guidance in a guide appendix or exhibit (whether a chapter orback matter appendix or exhibit), though not authoritative, is considered an

"other auditing publication." In applying such guidance, the auditor should,exercising professional judgment, assess the relevance and appropriateness ofsuch guidance to the circumstances of the audit Although the auditor deter-mines the relevance of other auditing guidance, auditing guidance in a guide

1 All AU-C sections can be found in AICPA Professional Standards.

appendix or exhibit has been reviewed by the AICPA Audit and Attest dards staff and the auditor may presume that it is appropriate.

Stan-The Financial Reporting Executive Committee (FinREC) is the designated nior committee of the AICPA authorized to speak for the AICPA in the areas offinancial accounting and reporting Conforming changes made to the financialaccounting and reporting guidance contained in this guide are approved by theFinREC Chair (or his or her designee) Updates made to the financial account-ing and reporting guidance in this guide exceeding that of conforming changesare approved by the affirmative vote of at least two-thirds of the members ofFinREC

se-This guide does the following:

r Identifies certain requirements set forth in the FASB Accounting

Standards Codification®(ASC)

r Describes FinREC's understanding of prevalent or sole industrypractice concerning certain issues In addition, this guide may in-dicate that FinREC expresses a preference for the prevalent orsole industry practice, or it may indicate that FinREC expresses

a preference for another practice that is not the prevalent or soleindustry practice; alternatively, FinREC may express no view onthe matter

r Identifies certain other, but not necessarily all, industry tices concerning certain accounting issues without expressing Fin-REC's views on them

prac-r Provides guidance that has been supported by FinREC on theaccounting, reporting, or disclosure treatment of transactions orevents that are not set forth in FASB ASC

Accounting guidance for nongovernmental entities included in an AICPA Guide

is a source of nonauthoritative accounting guidance As discussed later in thispreface, FASB ASC is the authoritative source of U.S accounting and reportingstandards for nongovernmental entities, in addition to guidance issued by theSEC

AICPA Guides may include certain content presented as "Supplement," pendix," or "Exhibit." A supplement is a reproduction, in whole or in part, ofauthoritative guidance originally issued by a standard setting body (includ-ing regulatory bodies) and applicable to entities or engagements within thepurview of that standard setter, independent of the authoritative status of theapplicable AICPA Guide Both appendixes and exhibits are included for infor-mational purposes and have no authoritative status

"Ap-Recognition

AICPA Senior Committees Auditing Standards Board

Mike Santay, Chair

Financial Reporting Executive Committee

James Dolinar, Chair

The AICPA gratefully acknowledges Diane Kirk, Megan McFarland, Brian lock, and Josh Sherman, who reviewed or otherwise contributed to the devel-opment of this edition of the guide.

Mat-The AICPA also thanks Jeffrey Washington for his invaluable assistance inupdating the 2018 edition of the guide

Guidance Considered in This Edition

This edition of the guide has been modified by the AICPA staff to include tain changes necessary due to the issuance of authoritative guidance since theguide was originally issued, as well as other revisions as deemed appropriate.Relevant guidance issued through August 1, 2018, has been considered in thedevelopment of this edition of the guide However, this guide does not includeall audit, accounting, reporting, regulatory, and other requirements applicable

cer-to an entity or a particular engagement This guide is intended cer-to be used inconjunction with all applicable sources of relevant guidance

Relevant guidance that is issued and effective on or before August 1, 2018, isincorporated directly in the text of this guide Relevant guidance issued but notyet effective as of August 1, 2018, but becoming effective on or before December

31, 2018, is also presented directly in the text of the guide, but shaded gray andaccompanied by a footnote indicating the effective date of the new guidance.The distinct presentation of this content is intended to aid the reader in differ-entiating content that may not be effective for the reader's purposes (as part ofthe guide's "dual guidance" treatment of applicable new guidance)

Relevant guidance issued but not yet effective as of the date of the guide and notbecoming effective until after December 31, 2018, is referenced in a "guidanceupdate" box; that is, a box that contains summary information on the guidanceissued but not yet effective

In updating this guide, all guidance issued up to and including the followingwas considered, but not necessarily incorporated, as determined based on ap-plicability:

r FASB Accounting Standards Update (ASU) No 2018-08,

Not-For-Profit Entities (Topic 958): Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made

r SAS No 133, Auditor Involvement With Exempt Offering

Docu-ments (AU-C sec 945)

r Interpretation No 4, "Reporting on Audits Conducted in dance With Auditing Standards Generally Accepted in the UnitedStates of America and the Standards of the PCAOB" (AU-C sec

Accor-9700 par .04), of AU-C section 700, Forming an Opinion and

Re-porting on Financial Statements

r Statement of Position 17-1, Performing Agreed-Upon Procedures

Related to Rated Exchange Act Asset-Backed Securities Party Due Diligence Services (AUD sec 60)2

Third-r PCAOB Release No 2017-01, The Auditor's Report on an Audit of

Financial Statements when the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards

Users of this guide should consider guidance issued subsequent to those itemslisted previously to determine their effect on entities covered by this guide

In determining the applicability of recently issued guidance, its effective dateshould also be considered

The changes made to this edition of the guide are identified in the Schedule

of Changes appendix The changes do not include all those that might be sidered necessary if the guide was subjected to a comprehensive review andrevision

con-PCAOB quoted content is from con-PCAOB Auditing Standards and con-PCAOB Staff

Audit Practice Alerts, ©2015, Public Company Accounting Oversight Board All

rights reserved Used by permission

FASB standards quoted are from the FASB Accounting Standards Codification

©2015, Financial Accounting Foundation All rights reserved Used by sion

permis-FASB ASC Pending Content

Presentation of Pending Content in FASB ASC

Amendments to FASB ASC (issued in the form of ASUs) are initially rated into FASB ASC in "pending content" boxes below the paragraphs beingamended with links to the transition information The pending content boxesare meant to provide users with information about how the guidance in a para-graph will change as a result of the new guidance

incorpo-Pending content applies to different entities at different times due to ing fiscal year-ends, and because certain guidance may be effective on differ-ent dates for public and nonpublic entities As such, FASB maintains amendedguidance in pending content boxes within FASB ASC until the "roll-off" date.Generally, the "roll-off" date is six months following the latest fiscal year endfor which the original guidance being amended could still be applied

vary-Presentation of FASB ASC Pending Content in AICPA Audit and

Accounting Guides

Amended FASB ASC guidance that is included in pending content boxes inFASB ASC on August 1, 2018, is referenced as "pending content" in this guide.Readers should be aware that "pending content" referenced in this guide willeventually be subjected to FASB's roll-off process and no longer be labeled as

"pending content" in FASB ASC (as discussed in the previous paragraph)

2All AUD sections can be found in AICPA Professional Standards.

Terms Used to Define Professional Requirements in This AICPA Audit and Accounting Guide

Any requirements described in this guide are normally referenced to the plicable standards or regulations from which they are derived Generally theterms used in this guide describing the professional requirements of the refer-enced standard setter (for example, the ASB) are the same as those used in the

ap-applicable standards or regulations (for example, must or should) However,

where the accounting requirements are derived from FASB ASC, this guide

uses should, whereas FASB uses shall In its resource document "About the

Codification" that accompanies FASB ASC, FASB states that it considers the

terms should and shall to be comparable terms and to represent the same

con-cept — the requirement to apply a standard

Readers should refer to the applicable standards and regulations for more formation on the requirements imposed by the use of the various terms used

in-to define professional requirements in the context of the standards and tions in which they appear

regula-Certain exceptions apply to these general rules, particularly in those stances where the guide describes prevailing or preferred industry practices forthe application of a standard or regulation In these circumstances, the appli-cable senior committee responsible for reviewing the guide's content believesthe guidance contained herein is appropriate for the circumstances

circum-Applicability of Generally Accepted Auditing Standards and PCAOB Standards

Appendix A, "Council Resolution Designating Bodies to Promulgate TechnicalStandards," of the AICPA Code of Professional Conduct recognizes both theASB and the PCAOB as standard setting bodies designated to promulgate au-diting, attestation, and quality control standards Paragraph 01 of the "Com-pliance With Standards Rule" (ET sec 1.310.001 and 2.310.001)3requires anAICPA member who performs an audit to comply with the applicable standards.Audits of the financial statements of those entities not subject to the oversightauthority of the PCAOB (that is, those audit reports within the PCAOB's ju-risdiction as defined by the Sarbanes-Oxley Act of 2002, as amended) are to

be conducted in accordance with standards established by the PCAOB, a vate sector, nonprofit corporation created by the Sarbanes-Oxley Act of 2002.The SEC has oversight authority over the PCAOB, including the approval of itsrules, standards, and budget Inciting the auditing standards of the PCAOB, ref-erences generally use section numbers within the reorganized PCAOB auditingstandards and not the original standard number, as appropriate Audits of thefinancial statements of those entities not subject to the oversight authority ofthe PCAOB (that is, those audit reports not within the PCAOB's jurisdiction asdefined by the Sarbanes-Oxley Act of 2002, as amended) — hereinafter referred

pri-to as nonissuers4— are to be conducted in accordance with GAAS as issued bythe ASB The ASB develops and issues standards in the form of SASs through

3 All ET sections can be found in AICPA Professional Standards.

4 See the definition of the term nonissuer in the AU-C Glossary.

a due process that includes deliberation in meetings open to the public, publicexposure of proposed SASs, and a formal vote The SASs and their related inter-

pretations are codified in AICPA Professional Standards In citing GAAS and

their related interpretations, references generally use section numbers withinthe codification of currently effective SASs and not the original statement num-ber, as appropriate

The auditing content in this guide primarily discusses GAAS issued by the ASBand is applicable to audits of nonissuers Users of this guide may find the tooldeveloped by the PCAOB's Office of the Chief Auditor helpful in identifyingcomparable PCAOB Standards The tool is available at pcaobus.org/standards/auditing/pages/findanalogousstandards.aspx

Considerations for audits of entities in accordance with PCAOB standards mayalso be discussed within this guide's chapter text When such discussion is pro-

vided, the related paragraphs are designated with the following title:

Consid-erations for Audits Performed in Accordance With PCAOB Standards PCAOB

guidance included in an AICPA Guide has not been reviewed, approved, proved, or otherwise acted upon by the PCAOB and has no official or authori-tative status

disap-Applicability of Quality Control Standards

QC section 10, A Firm's System of Quality Control,5 addresses a CPA firm'sresponsibilities for its system of quality control for its accounting and auditingpractice A system of quality control consists of policies that a firm establishesand maintains to provide it with reasonable assurance that the firm and itspersonnel comply with professional standards, as well as applicable legal andregulatory requirements The policies also provide the firm with reasonableassurance that reports issued by the firm are appropriate in the circumstances

QC section 10 applies to all CPA firms with respect to engagements in their

accounting and auditing practice In paragraph 06 of QC section 10, an

ac-counting and auditing practice is defined as "a practice that performs

engage-ments covered by this section, which are audit, attestation, compilation, view, and any other services for which standards have been promulgated bythe AICPA ASB or the AICPA Accounting and Review Services Committee un-der the "General Standards Rule (ET sec 1.300.001) or the "Compliance WithStandards Rule" (ET sec 1.310.001) of the AICPA Code of Professional Con-duct Although standards for other engagements may be promulgated by otherAICPA technical committees, engagements performed in accordance with those

re-standards are not encompassed in the definition of an accounting and auditing

practice."

In addition to the provisions of QC section 10, readers should be aware of other

sections within AICPA Professional Standards that address quality control

con-siderations, including the following provisions that address engagement levelquality control matters for various types of engagements that an accountingand auditing practice might perform:

r AU-C section 220, Quality Control for an Engagement Conducted

in Accordance With Generally Accepted Auditing Standards

5All QC sections can be found in AICPA Professional Standards.

r AT-C section 105, Concepts Common to All Attestation

Engage-ments6

r AR-C section 60, General Principles for Engagements Performed

in Accordance With Statements on Standards for Accounting and Review Services7

Because of the importance of engagement quality, this guide includes appendix

C, Overview of Statements on Quality Control Standards This appendix

sum-marizes key aspects of the quality control standard This summarization should

be read in conjunction with QC section 10, AU-C section 220, AT-C section 105,AR-C section 60, and the quality control standards issued by the PCAOB, asapplicable

AICPA.org Website

The AICPA encourages you to visit its website at aicpa.org and the FinancialReporting Center at www.aicpa.org/frc The Financial Reporting Center sup-ports members in the execution of high-quality financial reporting Whetheryou are a financial statement preparer or a member in public practice, thiscenter provides exclusive member-only resources for the entire financial re-porting process and provides timely and relevant news, guidance, and exam-ples supporting the financial reporting process Another important focus of theFinancial Reporting Center is keeping those in public practice up to date onissues pertaining to preparation, compilation, review, audit, attestation, assur-ance and advisory engagements Certain content on the AICPA's websites ref-erenced in this guide may be restricted to AICPA members only

6 All AT-C sections can be found in AICPA Professional Standards.

7 All AR-C sections can be found in AICPA Professional Standards.

TABLE OF CONTENTS

The Industry’s History 01-.20Development of the Oil Industry 02-.07Development of the Natural Gas Industry 08-.10Prices for Oil and Gas 11-.13Recent Developments in the Oil and Gas Industry 14-.20Origin and Accumulation of Oil and Gas 21-.29Oil and Gas Reserves 30-.48

The SEC’s Definition of Proved Reserves 33-.37The Society of Petroleum Engineers’ Definitions of

Reserves 38-.40Determination of Reserves 41-.48Operations in the Upstream Petroleum Industry 49-.56Oil Sands 54-.56Sources of Capital and Organizational Structure of

Oil and Gas Entities 57-.66Joint Interest Arrangements 60Limited Partnerships 61-.63Royalty Trusts 64-.65Other Sources of Capital 66History of Accounting for Oil and Gas Producing

Activities 67-.76International Standards of Accounting for Oil and Gas 77-.78

2 Primary Business Activities of the Industry 01-.100

Acquisition of Mineral Interests 01-.48Important Provisions in Lease Contracts 10-.28Frequently Encountered Transactions for Transferring

Mineral Interests 29-.39Documents and Files Relating to Mineral Interests 40-.48Basic Concepts of Prospecting and Exploration Activities 49-.67Prospecting and Exploring for Potential

Hydrocarbon-Bearing Structures 53-.60Other Significant Aspects of Exploration Activities 61-.67Drilling and Development 68-.88The Drilling Contract 77-.80Completing the Well or Plugging and Abandoning

the Well 81-.85Developing the Reservoir 86-.87The Regulatory Environment 88Production 89-.100Workovers 97-.98Enhanced Recovery Methods 99-.100

Chapter Paragraph

3 Accounting for Common Oil and Gas Ownership Arrangements 01-.27

Ownership Arrangements 01-.04Ownership Arrangements — Mineral Interests 02Other Arrangements 03-.04Special Considerations 05-.08LLCs 05Partnerships 06-.08Accounting Models 09-.19Variable Interest Model ("Variable Interest Entities"

Subsections of FASB ASC 810-10) 12-.15Voting Interest Model 16-.19General Guidance on the Consolidation, Equity, and

Cost Methods 20-.27Equity Method 20-.26Cost Method 27

4 Successful Efforts Method and General Accounting for Oil and

General 01-.08Accounting for Acquisition, Exploration, and

Development Costs 09-.23Acquisition Costs 09Exploration Costs 10-.16Development Costs 17-.22Interest Capitalization 23Amortization of Capitalized Costs 24-.30Impairment Tests for Capitalized Costs 31-.40Unproved Properties 32-.36Proved Properties 37-.40Conveyances 41-.50Accounting for Production 51-.70Revenue 52-.62Inventory 63-.67Joint Operating Agreements — Operating Expenses 68-.70Asset Retirements, Environmental Liabilities, Abandonments,

Involuntary Conversions, Expropriations, and Joint andSeveral Liabilities 71-.90AROs 71-.78Environmental Liabilities 79Abandonments 80-.81Involuntary Conversions 82-.87Expropriations 88Joint and Several Liability Arrangements 89-.90Lease Arrangements 91-.92

Definition of Fair Value 122-.123

Application to Nonfinancial Assets 124-.126Application to Liabilities and Instruments Classified in a

Reporting Entity’s Shareholders’ Equity 127-.129Valuation Techniques 130-.132Present Value Techniques 133-.134The Fair Value Hierarchy 135-.137Fair Value Disclosures 138-.141Management’s Assessment of Going Concern 142Disclosure Requirements for Oil and Gas Entities 142-.163General 142-.145Accounting Policy Disclosures 146Suspended Well Disclosures 147-.148FASB ASC 932 Disclosures 149-.154Other Disclosure Matters 155Additional Disclosures for Entities Following the Full Cost

Method of Accounting 156SEC Disclosures — Subpart 1200 of Regulation S-K 157-.161Exchange Offer Disclosures 162-.163

5 Full Cost Method of Accounting for Oil and Gas Activities 01-.60

General 01-.06Accounting for Acquisition, Exploration, and

Development Costs 07-.08Capitalization of Interest 08Amortization of Capitalized Costs 09-.18Excluded Costs 15-.18Impairment Tests for Capitalized Costs 19-.35Cost Center Ceiling Test 19-.28Applications Involving a New Country 29-.35Accounting for Production 36Asset Retirements, Environmental Liabilities, Abandonments,

Involuntary Conversions, and Expropriations 37-.41Abandonment of Unevaluated (Unproved) Properties 37Revisions and Settlements of AROs 38-.41Fair Value Measurements 42Lease Arrangements 43

Chapter Paragraph

5 Full Cost Method of Accounting for Oil and Gas Activities—continued

Conveyances 44-.47Discontinued Operations 48Goodwill 49-.54Goodwill — Property Disposals 50-.54Other Matters 55Management Fees and Other Income 55Commodity Derivative Activities 56Disclosure Requirements 57-.60Additional Disclosure Requirements for Full Cost Entities 58-.60

6 Accounting for International Oil and Gas Activities 01-.43

Overview 01-.04International Contractual Arrangements 05-.14Concessions 07Production Sharing Contracts 08-.09Service Contracts 10-.11Other Arrangements 12-.14Royalty, Production Taxes, and Income Taxes 15-.28Royalty 17-.18Production Tax 19-.20Income Tax 21-.28Reporting International Proved Reserves 29-.34Asset Retirement Obligations in International Operations 35-.40The Foreign Corrupt Practices Act of 1977 41-.43

Overview 01-.03Planning Related Auditing Considerations 04-.20Objectives of the Auditor 04-.05The Importance of Exercising Professional Skepticism 06Audit Planning 07-.08Audit Risk 09-.13Determining Materiality and Performance Materiality

When Planning and Performing an Audit 14-.17Use of Specialists 18-.20The Use of Assertions When Identifying and Assessing the

Risks of Material Misstatement 21-.24Understanding the Entity, Its Environment, and Identifying

and Assessing the Risks of Material Misstatement 25-.56Risk Assessment Procedures 29-.31Industry, Regulatory, and Other External Factors 32Nature of the Entity and Its Operations 33-.49Understanding of Internal Control 50-.56

Chapter Paragraph

7 Auditing—continued

Assessment of Risks of Material Misstatement and the Design

of Further Audit Procedures 57-.77Assessing the Risks of Material Misstatement 57-.60Designing and Performing Further Audit Procedures 61-.69Auditing Accounting Estimates and Related Disclosures 70-.77Evaluating the Sufficiency and Appropriateness of the

Audit Evidence Obtained 78Written Representations From Management 79-.80Evaluating Misstatements Identified During the Audit 81-.84Additional Audit Considerations 85-.88Audit Documentation 85Audit Evidence 86-.88Communication With Those Charged With Governance 89Additional Considerations for Specific Audit Areas 90-.158Oil and Gas Properties — Acquisition, Exploration, and

Development Activities 91-.108Depreciation, Depletion, and Amortization 109-.111Impairment 112-.117Oil and Gas Property Conveyances 118-.122Production 123-.144Payables 145-.151Asset Retirement Obligations 152Tax and Other Regulatory Matters 153-.154Derivatives and Hedging Activities 155-.157Auditing Fair Value Measurements 158Other Audit Considerations 159-.166Statement of Cash Flows 159-.160Commitments and Contingencies 161-.163Risks and Uncertainties 164Related Parties 165-.166Going Concern 167Supplementary Oil and Gas Reserve Disclosure

Considerations and Related Procedures 168-.178Reserve Quantity and Value Disclosures 168-.174Supplementary Oil and Gas Reserves Procedures 175-.178

8 Internal Control Considerations 01-.82

Definition of Internal Control and Internal Control

Framework 03-.09Internal Control Framework 03-.05Internal Control Over Financial Reporting 06-.09Internal Control Considerations for Audit of a Nonpublic

Entity 10-.11Reporting Requirements for a Public Entity 12-.17

Chapter Paragraph

8 Internal Control Considerations—continued

Evaluating the Effectiveness of Internal Control byManagement 18-.22Components of Internal Control 18-.22Common Control Activities for Oil and Gas Entities 23-.72Acquisition of Mineral Interests 24-.32Exploration and Development Activities 33-.49Exploration, Development, and Production — Nonoperator 50Production 51-.62Other Control Areas 63-.69Computer Based Controls 70-.72Control Over Financial Statement Disclosures Specific to Oil

and Gas Entities 73-.82Control Over Compliance With Tax and Regulatory

Requirements 80-.82

Appendix

A Summary of the Successful Efforts and Full Cost Methods of Accounting

B Sample Management Representations for EntitiesWith Oil and Gas

Producing Activities

C Overview of Statements on Quality Control Standards

D The New Leases Standard: FASB ASC 842

E Accounting for Financial Instruments

F The New Revenue Recognition Standard: FASB ASC 606

G Schedule of Changes Made to the Text From the Previous Edition

Glossary and Other Commonly Used Industry Terms

Index of Pronouncements and Other Technical Guidance

Subject Index

Chapter 1

Overview of the Industry

The Industry’s History

1.01 To gain an understanding of oil and gas producing activities, a brief

review of the history of the industry is helpful The following discussion is tended to be basic, and the interested reader is encouraged to refer to otheravailable sources, as necessary

in-Development of the Oil Industry

1.02 The first commercial oil drilling venture occurred near Titusville,

Pennsylvania, in 1859 A steam powered, cable tool drilling rig, which liftedand dropped a heavy piece of metal to pound a hole into the earth, was used todrill a 59-foot well, which yielded 5 barrels of oil per day At that time, the price

of crude oil was about $10 per barrel This well set off a boom of sorts, and thecable tool drilling rig was used to drill other wells in the area Oil soon sold forabout $0.10 per barrel because of the dramatic increase in supply

1.03 In the 1850s and early 1860s, oil was used chiefly as fuel for lamps.

The Industrial Revolution and the Civil War greatly increased the uses of oiland, therefore, the demand — so much so that annual production in 1870 ex-ceeded 25 million barrels Early transportation of crude oil was cumbersome,

requiring (a) wooden barrels (each with a capacity of 42 gallons, which is the present measurement of a barrel of crude oil); (b) horse-drawn wagons; (c) river barges; and (d) the railroads The first pipeline, completed in the 1860s, was

made of wood and was less than 1,000 feet long

1.04 One of the first persons to rise to power in this infant industry was

John D Rockefeller In 1870, Rockefeller merged his firm with four others toform the Standard Oil Company During the 1880s, Standard Oil dominatedthe global production industry and controlled approximately 90 percent of therefining industry in the United States Standard Oil's market dominance even-tually led to its forced dissolution in 1911 because of federal and state antitrustlegislation that had been enacted as a response to its size

1.05 The U.S oil industry began exploration internationally (the Middle

East, South America, Africa, and the Far East) in the 1920s as a result of creased demand However, the East Texas oil field discovery of 1930 ultimatelycreated an oil surplus that caused entities to cut back foreign operations Dur-ing and after World War II, the worldwide demand again increased, and enor-mous capital investments were made to develop the Persian Gulf area, otherMiddle East countries, Africa, South America, and the Far East

in-1.06 In 1960, the Organization of Petroleum Exporting Countries (OPEC)

was formed by five countries The original founding members were Iran, Iraq,Kuwait, Saudi Arabia, and Venezuela The stated objective of the organization

is to "coordinate and unify the policies of member countries, in order to securefair and stable prices for petroleum producers; an efficient, economic and reg-ular supply of petroleum to consuming nations; and a fair return on capital

to those investing in the industry." Since that time, OPEC membership and

By AICPA Copyright © 2018 by American Institute of Certif

influence has continued to increase The 2018 membership is shown in the lowing table:

fol-Country

Year Joined Country

Year Joined

Iraq 1960 United Arab Emirates 1967

The members of OPEC have controlled a substantial portion of the world's oilreserves, production, and excess productive capacity and, as a result, OPEChas been able to exercise a great deal of control over oil prices by decreasing orincreasing the output of member nations through a production quota system

1.07 Even with new technology and the emergence of shale oil and gas

production in North America, the geopolitical landscape of OPEC's control ofoil reserves has remained constant into recent years Large oil reserves havebeen discovered in Africa, Russia and the former Soviet states, on-shore NorthAmerica, the Gulf of Mexico, and the North Sea; however, OPEC members con-tinue to have significant influence over the world oil market

Development of the Natural Gas Industry

1.08 Natural gas demand increased significantly in the United States in

the 1960s and has continued to increase, facilitated by improved transportationsystems In the United States, electricity generation, the growth of the petro-chemical industry (which produces plastics and synthetics), and the heating oflarge scale office buildings create the primary demand for natural gas

1.09 The use of natural gas has continued to grow throughout the world,

although the lack of pipelines has impeded growth of production and tion of natural gas in many areas of the world One of the primary issues facingthe international natural gas industry is that many of the largest discoveriesare in countries that are remote from the primary consuming markets in NorthAmerica, Europe, and Japan, as well as the growing markets in China and In-dia Efforts to resolve this issue have been made through the development ofimproved techniques for liquefying natural gas, converting natural gas to syn-thetic fuels, and transporting the resulting liquids, with liquefied natural gasplaying a more critical role in worldwide supply and demand balance

consump-1.10 A recent important source of natural gas in the United States is shale

gas, a natural gas that is found trapped within shale formations Althoughshale gas is not new, the advancements of new technologies, such as horizon-tal drilling and hydraulic fracturing have enabled the exploration of unconven-tional resources Since 1998, the date of the first economical shale fracture, nat-ural gas from shale has been the fastest growing contributor to total primaryenergy in the United States and prompted other countries across the globe to

assess their unconventional natural gas resources Shale gas contributed about

60 percent of total U.S dry natural gas production in 2017, compared to only 1percent in 2000 The U.S Energy Information Administration estimates that in

2017 about 16.76 trillion cubic feet of gas was produced from shale resources 1trillion cubic feet of natural gas will heat approximately 15 million homes forone year, the equivalent of generating 100 billion kilowatt hours of electricity

Prices for Oil and Gas

1.11 One of the most important factors in the development of the industry

has been changes in oil and gas prices The Arab oil embargo of 1973 focusedpublic attention on the industry, largely because of its effect on previously stableprices In 1973, before the embargo, the average barrel of crude oil sold for about

$3 By December 1973, crude oil prices had risen to over $11 per barrel In theUnited States, oil prices were placed under federal government control in late

1973 In 1975, the US congress passed the Energy Policy and Conservationact, which banned the export of crude oil which was lifted in December 2015allowing for renewed oil exports

1.12 In 1979, the Iranian revolution resulted in a sharp increase in oil

prices to $42 per barrel In late 1979, the U.S government announced "phaseddecontrol" of oil prices, and in January 1981, all price controls on crude oil werelifted Natural gas prices continued to be subject to controls created by the Nat-ural Gas Policy Act of 1978, but initial deregulation of gas prices began on Jan-uary 1, 1985, with complete deregulation occurring on January 1, 2003

1.13 By the early 1980s, the price for a barrel of oil ranged from $30 to

$40 (and sometimes higher), but prices declined in the mid-1980s in the face

of a world oil surplus These fluctuations were further complicated by the U.S.government's earlier price controls that designated different prices for differentgrades of oil and created a complex pricing structure As a result, producingentities grew increasingly reluctant to explore and drill This reluctance mayhave stemmed from the fact that a barrel of domestically produced oil often had

a sale price significantly less than the price of imported oil In the decades of the1990s and 2000s, crude oil prices have fluctuated from a low of $13 per barrel

to a high well in excess of $100 per barrel North American natural gas pricesalso have fluctuated significantly, ranging from a low of about $1 per millionBritish thermal units (MMBTUs) in 1992 to more than $15 per MMBTUs inlate 2005 Since that date, natural gas prices have continued to fluctuate As

a result of the increase in supply of shale gas production, for the past severalyears they have been below $3 per MMBTU

Recent Developments in the Oil and Gas Industry

1.14 Increase in demand For a number of years, countries like China and

India have seen double-digit demand growth and are expected to continue ing at a high pace The rapid economic expansion in much of the world, includ-ing China and India, has led to increased demands for energy and changes inthe competition for new hydrocarbon resources In particular, China and Indiaare actively pursuing opportunities in their geographic region, as well as inAfrica and South America

grow-1.15 The decline in traditional sources of natural gas in Western Europe,

together with Russia's significant oil and gas reserves, have led to an increaseddependence in Western Europe on the supply of hydrocarbons (especially gas)from Russia

1.16 Problems with supply of hydrocarbons In recent years, the global

crude oil market supply has seen a number of disruptions These include warand security issues in the Middle East (particularly Iran and Iraq) and politicalissues in Russia, the newer republics of the former Soviet Union, Nigeria, andVenezuela These factors, combined with a weaker dollar (global oil trade isprimarily dollar based), have led to instability in oil prices beginning in 2015when crude oil prices began to drop sharply lower Crude prices rebounded inthe first half of 2018 in part due to production limits imposed by OPEC membernations, continued political instability in Libya, and U.S sanctions imposed onVenezuela

1.17 New opportunities — offshore drilling Although offshore wells were

drilled before 1900, including the use of piers and pilings in the Baku region

of Azerbaijan in the Caspian Sea and piers extending into the Pacific Ocean

in California, significant technological advancements have occurred in recentyears Such technology allows wells to be drilled in water depths greater than9,000 feet and over 175 miles from shore In more recent times, companies haveinvested billions of dollars in deep water drilling projects off the coasts of Africa,Australia, Brazil, the U.S Gulf of Mexico, and the North Sea Africa remains abright spot for hydrocarbon opportunities Offshore West Africa has been one ofthe most active areas in the world for new discoveries and significant projects.The oil discoveries have been sizeable, and the offshore operating conditionshave been relatively mild and, due to the distance from the shore, somewhatinsulated from the political and security unrest that occurs in onshore areas Inaddition, significant hydrocarbon discoveries have been made in Offshore EastAfrica, as well as in the Mediterranean Sea

1.18 Further development of offshore technologies Offshore drilling and

production technology has advanced at a steady pace For many decades, shore oil and gas operations were restricted primarily to platforms affixed tothe seafloor, with some limited use of subsea wells tied back to those plat-forms Platform costs increase rapidly with water depth, but floating platform

off-concepts, such as tension leg platforms and spars, have been used successfully

in deeper water Deepwater discoveries are now being developed with subseawells with production being piped either to floating production, storage, andoffloading tankers; central production hubs serving multiple fields; or directly

to shore

1.19 Alternative sources of hydrocarbons As markets and producers have

reacted to imbalances in demand and supply, the perceived need for tive sources of energy also has boosted the prospects for alternative produc-tion techniques and technology As a result, resources produced from oil sands,oil shales, coal, and several improved recovery techniques have become moreimportant sources of hydrocarbons in recent years Activities to extract thesealternative or nontraditional resources are now considered to be oil and gasproducing activities under the new oil and gas reporting requirements of theSEC and, therefore, hydrocarbons extracted from oil sands, shales, coal beds,and other nonrenewable natural resources, which are intended to be upgradedinto synthetic oil or gas, are now deemed to be oil and gas reserves

alterna-1.20 Modernization of oil and gas reporting On December 31, 2008

(ef-fective fiscal 2010), the SEC issued Final Rule No 33-8995, Modernization of

Oil and Gas Reporting, adopting revisions to oil and gas reporting requirements

and disclosures that existed in Regulation S-K under the Securities Act of 1933and in Regulation S-X under the Securities Exchange Act of 1934 The FinalRule also eliminated Industry Guide 2 and incorporated certain of these disclo-sure requirements in Subpart 1200 of Regulation S-K In 2010, FASB issued

Accounting Standards Update (ASU) No 2010-03, Extractive Activities—Oil

and Gas (Topic 932): Oil and Gas Reserve Estimation and Disclosures ASU

No 2010-03 includes changes to accounting and disclosure requirements thatare consistent with SEC Final Rule 33-8995

Origin and Accumulation of Oil and Gas

1.21 An oil or gas reservoir is often erroneously viewed as a large cave

containing liquids or gas beneath the earth, like a subterranean pond In reality,

an oil or gas reservoir is porous rock capable of containing oil, gas, or water inthe microscopic pore spaces of the rock For an oil or gas reservoir to be formed,the following features must be present:

r There must have been an original source bed of organic materialsubjected to the proper temperature and pressure over sufficienttime

r There must be a reservoir rock filled with pores (having porosity)

so the oil, gas, or both, can collect

r The rock's pores must be interconnected (having permeability) sothe oil or gas can move or migrate

r There must be a trap that will cause the oil or gas to collect andprevent the hydrocarbons from moving upward

1.22 Oil and gas originated from organic matter in sedimentary rocks.

Layer upon layer of sediment and animal and plant deposits were buried cessively until the accumulation became thick, sometimes thousands of feet.Bacteria took oxygen from the trapped organic residues and gradually brokedown the matter into substances rich in carbon and hydrogen The weight cre-ated high pressure and temperature, compacted and squeezed the sediment

suc-into hard shales, turned the organic material suc-into oil and gas, and expelled theoil and gas from the shale into porous and permeable reservoir beds.

1.23 Source rocks, in which the organic material was originally trapped,

are fine grained and relatively impermeable The oil and gas normally movefrom the source rock into more porous rocks; they then migrate upward throughthe porous rocks until reaching a structural closure or an impermeable barrier

These closures and barriers are called traps, and they cause oil and gas to

ac-cumulate into a pool or field

1.24 Oil and gas traps may be classified in several different ways One

commonly used system for classifying traps is based on the one of two ways in

which they were formed: (a) structural traps and (b) stratigraphic traps.

1.25 Structural traps formed by vertical or horizontal movement, or both,

in the earth's crust, are the most important sources of hydrocarbons A commonstructural trap is the anticline, which has been the most productive type ofstructure for oil and gas production An anticline is a dome usually formed

by upthrusts from below Anticlines containing oil and gas are covered by animpervious cap rock layer Oil, gas, and water migrate upward through porouslayers until they reach the cap rock and are trapped

1.26 Another structural trap of special importance as a source of oil and

gas is the fault Faults are created by shifts in the earth's crust that cause aporous strata containing hydrocarbons to shift and break so that a strata onone side of the fault is higher than the strata on the other side of the break Atthe fault line, the strata containing hydrocarbons is sealed off by an imperviouslayer, trapping the oil, gas, and water

1.27 A third common form of a structural trap is the salt dome In these

structures, a nonporous salt bed pushes upward and pierces porous strata, ing an uplifting of the strata and faults along the sides of the dome Also, some

caus-of the impervious overriding formations are merely bent, creating anticlines atthe top of the domes Both faults and anticlines are excellent traps for hydro-carbons

1.28 Another common structural trap is an unconformity or truncation

trap, in which a portion of reservoir strata has been eroded away and replacedwith impermeable sediments to form a trap Different forms of truncation areinvolved in the large oil fields in Saudi Arabia and the Prudhoe Bay field inAlaska

1.29 Stratigraphic traps are created by abrupt changes in the porosity of

the strata Areas of strata containing oil and gas may be cut off by irregulardispositions of sand and shale or changes in the rocks in the strata, causing theoil and gas to be trapped

Oil and Gas Reserves

1.30 The discovery and preparation for production of oil and gas reserves

is the primary objective of exploration and development activities In addition,reserve information is critical to an oil and gas producer's financial statements

1.31 Historically, only reserves classified as proved were disclosed in

ac-cordance with accounting principles generally accepted in the United States ofAmerica (GAAP) and the disclosure requirements of the SEC However, for in-ternal purposes, entities generally identify proved and unproved categories of

reserves The most common additional categories are known as probable and

possible reserves In connection with the SEC reporting requirements contained

in Final Rule No 33-8995, probable and possible reserves are now permitted(although not required) to be disclosed outside of the financial statements in fil-ings with the SEC Proved reserves are required to be disclosed in accordancewith the disclosure requirements of the SEC

1.32 Reserve determinations have a significant effect on an entity's results

of operations and financial position because they are used in the calculation ofthe amortization of capitalized costs, the assessment of impairments, and theestimation of the timing of settlements of asset retirement obligations GAAPgenerally requires that only proved reserves be used for accounting purposes(such as the amortization of capitalized costs.) However, probable and possiblereserves are used (after adjusting for the risk of uncertainty of existence) inevaluating impairment of oil and gas properties for entities following the suc-cessful efforts method of accounting Such reserves also are used in the deter-mination of the fair value of assets in acquisition and disposition transactions

The SEC’s Definition of Proved Reserves

1.33 The definition of proved reserves used by the SEC is found in Final

Rule 33-8995 and FASB ASC 932 This definition is the only definition currentlyacceptable under both the successful efforts method and the full cost method ofaccounting when preparing financial statements and disclosures in accordancewith GAAP

1.34 Determination of proved reserves is based on whether the estimated

oil and gas quantities are reasonably certain to be recoverable under existingeconomic and operating conditions The concept of reasonable certainty of re-covery under existing economic and operating conditions is subject to manyinterpretations and judgments, including, but not limited to, having the nec-essary transportation infrastructure; the existence of a market or market ar-rangements, or both; sufficient resources to fund development costs; and othercriteria, each of which would need to be addressed The inability of an entity todemonstrate that these criteria are reasonably certain to occur may affect itsability to recognize proved reserves

1.35 Certain key terms used in the definition of proved reserves include

the following:

r The economic recoverability assessment of proved reserves isbased on a 12-month average price used to determine reserves (in-cluding proved reserves), calculated as the unweighted arithmeticaverage of the first day of the month price for each month withinthe company's 12-month period prior to the end of the reportingperiod, unless prices are affected by contractual arrangements, asdefined

r The definition of oil and gas producing activities includes the

ex-traction of nontraditional resources, such as bitumen extractedfrom oil sands and hydrocarbons extracted from coal beds andshales, which are intended to be upgraded into synthetic oil orgas

r The use of new reliable technologies is allowed to establish proved,

probable, and possible reserve estimates Reliable technology is

de-fined as technology (including computational methods) that has

been field tested and has demonstrated consistency and bility in the formation being evaluated or in an analogous forma-tion.

repeata-Additional SEC staff guidance related to the determination of reserves can

be found on the SEC's website at www.sec.gov/divisions/corpfin/guidance/oilandgas-interp.htm This guidance is in the form of Compliance and Disclo-sure Interpretations (C&DIs) on the oil and gas rule of the SEC These C&DIscomprise the interpretations of the SEC's Division of Corporation Finance.The SEC reporting requirements contained in Final Rule No 33-8995 also can

be found on the SEC's website at www.sec.gov/rules/final/2008/33-8995.pdf

1.36 Proved, probable, and possible reserves can be classified as developed

and undeveloped, in accordance with the following definitions:

r Developed oil and gas reserves are reserves of any category that

can be expected to be recovered

— through existing wells with existing equipment and ating methods or in which the cost of the required equip-ment is relatively minor compared to the cost of a newwell and

oper-— through installed extraction equipment and ture operational at the time of the reserves estimate ifthe extraction is by means not involving a well

infrastruc-r Undeveloped oil and gas reserves are reserves of any category that

are expected to be recovered from new wells on undrilled acreage

or from existing wells where a relatively major expenditure is quired for recompletion

re-1.37 The SEC definition of undeveloped oil and gas reserves includes the

following provision: "Undrilled locations can be classified as having oped reserves only if a development plan has been adopted indicating that theyare scheduled to be drilled within five years, unless the specific circumstancesjustify a longer time."

undevel-In addition, the disclosures required under Item 1203 of Subpart 1200 of ulation S-K require disclosure for proved undeveloped reserves, including thereasons why material amounts of proved undeveloped reserves have remainedundeveloped for five years or more after disclosure as proved undeveloped re-serves See the "SEC Disclosures—Subpart 1200 of Regulation S-K" section ofchapter 4, "Successful Efforts Method and General Accounting for Oil and GasActivities," for further information regarding disclosure requirements Addi-

Reg-tional guidance related to the definition of undeveloped oil and gas reserves

has been provided by the SEC in Section 131 of its C&DIs In particular, tion 131.03 provides guidance regarding the SEC's views about the "specificcircumstances" that would justify a time period longer than five years to begindevelopment of proved undeveloped reserves

ques-The Society of Petroleum Engineers’ Definitions of Reserves

1.38 In March 2007, the Society of Petroleum Engineers, the WorldPetroleum Council, the American Association of Petroleum Geologists, and theSociety of Petroleum Evaluation Engineers announced a new framework for de-termining oil and gas resources: the Petroleum Resources Management System

(PRMS) The PRMS provides a definition for proved reserves, as well as other source categories, such as probable and possible reserves The PRMS definitions

re-are not acceptable for use in the preparation of financial statements in dance with GAAP; however, entities may utilize them for internal purposes

accor-The PRMS defines proved reserves as

those quantities of petroleum, which, by analysis of geoscience and gineering data, can be estimated with reasonable certainty to be com-mercially recoverable, from a given date forward, from known reser-voirs and under defined economic conditions, operating methods, andgovernment regulations If deterministic methods are used, the termreasonable certainty is intended to express a high degree of confidencethat the quantities will be recovered If probabilistic methods are used,there should be at least a 90% probability that the quantities actuallyrecovered will equal or exceed the estimate

en-1.39 Historically, although the PRMS and SEC definitions of proved

re-serves were consistent across many areas, certain differences did exist between

the two sets of definitions The SEC definitions provided in Final Rule No

33-8995 were significantly influenced by the PRMS and have eliminated some ofthese historical differences However, differences do remain, including the factthat proved reserves under the PRMS are determined based on management's

"defined" economic and operating conditions (that is, management's own pricingassumptions) as opposed to the "existing" economic and operating conditions re-quired by the SEC (that is, historical 12-month average) Many companies stilluse the PRMS definition in their own internal reserves analyses

1.40 For further information, readers can refer to the 2007 PRMS

on the SPE's website at www.spe.org/industry/docs/Petroleum_Resources_Management_System_2007.pdf

Determination of Reserves

1.41 Reserve estimates are prepared by persons with the requisite

spe-cialized knowledge and experience to estimate oil and gas reserve quantities,such as petroleum reservoir engineers and geologists The reserve estimatorsmay either be employees of the oil and gas entity or consulting engineers Whenreserve estimates are prepared by employees of the entity, consulting engineerswill often be hired to audit or review the estimates

1.42 The assumptions that may vary include fixed or escalated prices,

different price and cost scenarios, different development scenarios, probabilitybased or deterministic methods of reserves estimates, and so on

1.43 Reserve estimates or studies are widely used in managerial decisions.

They also are used in financial statement information or supplemental sures to the financial statements The most common uses are the following:

disclo-r A basis for computing the depreciation, depletion, and tion rates used

amortiza-r A basis to assign capitalized costs to oil and gas properties

r Disclosure of proved reserve quantities and discounted presentvalue of future net cash flows information about a producingentity's proved reserves, in accordance with GAAP for publiclytraded entities

r A basis for preparing cost ceiling test calculations for entities lowing the full cost method of accounting

fol-r Undiscounted and discounted cash flow calculations for asset pairment purposes for entities following the successful effortsmethod of accounting

im-1.44 The initial evaluation of a well or wells is made to determine whether

sufficient reserves have been discovered to justify developing the property Thisevaluation is usually prepared by employees of the entity based on well log andformation core data, drill stem tests, and other available information

1.45 Oil and gas entities should revise reserve estimates at least annually

or whenever an indication of the need for revision exists, such as significantdifferences in actual production versus earlier estimates, changes in ownership,

or significant decreases in cash flows

1.46 The following is only a part of the supply of information that may be

used to develop reserve quantity information:

r Area and thickness of the productive zone

r Porosity of the reservoir rock

r Permeability of the reservoir rock to fluids

r Oil, gas, and water saturation

r Physical characteristics of oil and gas

r Depth to the producing formation

r Reservoir pressure and temperature

r Production history of the reservoir

r Ownership of the oil and gas property

1.47 The methods used to estimate recoverable reserves vary with the

amount and nature of the preceding information that is available Estimates ofthe reserve quantities that are economically recoverable are made for internaluse Estimates for internal use may be based on estimated selling prices, devel-opment costs, and production costs; however, those used for financial reportingpurposes are required to be based on historical prices and production costs, asrequired by the SEC

1.48 Precision of estimates According to the SPE, the reliability of reserve

information is affected considerably by several factors It is important to notethat reserve information is imprecise because of the inherent uncertainties in,and the limited nature of, the data upon which the reserve estimate is predi-cated Moreover, the methods and data used in estimating reserve informationare necessarily often indirect or analogical in character rather than direct ordeductive The persons estimating reserve information make numerous judg-ments based solely on their educational background, training, and experience.The extent and significance of the judgments to be made are, in themselves,sufficient to render reserve information inherently imprecise

Operations in the Upstream Petroleum Industry

1.49 Financial statements of an oil and gas producing entity will include

many transactions and accounts not commonly found in other types of economicenterprises This is a result of the unique nature of the principal assets — oil

and gas reserves — and the ways in which these reserves are acquired, oped, and produced The high risks and high costs of acquiring, developing, andproducing oil and gas and the unique nature of the ownership rights result inunique contractual relationships between oil and gas producing entities andowners of mineral rights Chapter 2, "Primary Business Activities of the In-dustry," provides fundamental information about the most important contractsand operations encountered in the United States Some of the most importantcontracts frequently encountered in petroleum activities in other countries arediscussed in greater detail in chapter 6, "Accounting for International Oil andGas Activities."

devel-1.50 Operating activities in the oil and gas industry are commonly divided

into the following categories: upstream activities and midstream and stream activities Upstream activities, which are the subject of this guide, may

down-be broadly descridown-bed as the following:

r Acquiring mineral rights

r Exploring for oil and gas

r Drilling wells and installing production equipment

r Lifting the oil, gas, and water from the wells to the surface

r Separating the oil, gas, and water sufficiently to prepare the drocarbons for transport to pipelines or oil refineries

hy-Midstream and downstream activities include the following:

r Transporting the petroleum from the producing wells to the cessing plants and refineries

pro-r Refining and processing activities necessary to produce ketable products, such as natural gas, gasoline, and petrochem-icals

mar-r Transporting, distributing, and storing the refined products

r Marketing activities, which get the refined products, natural gasliquids, and natural gas into the hands of consumers

The activities involved in transporting the petroleum to processing plants and

refineries are generally referred to as midstream activities, and the other tivities are generally referred to as downstream activities.

ac-1.51 Entities engaged in both upstream and downstream activities are

referred to as vertically integrated entities, with the largest of these grated entities often referred to as majors A common term used in the indus-

inte-try to describe entities solely or primarily engaged in upstream activities is

independents.

1.52 Within the petroleum industry, there have been continuing changes

in entity structures and identities Throughout the industry, mergers and quisitions occur at all size levels These transactions are entered into in order

ac-to acquire reserves, gain efficiencies, reduce costs, and gain operations in newareas

1.53 The accounting and auditing principles and procedures related to

re-fining activities, most gas processing activities, petrochemical operations, tribution, storage, and retail marketing activities are similar to those appli-cable to other manufacturing and marketing activities As a result, this guidedeals almost solely with accounting for, and reporting on, upstream activities,with only limited discussion of other related industry activities

dis-Oil Sands

1.54 Beginning in the late 1990s and early 2000s, the industry began to

partner with joint venture partners in Canada in order to develop oil sand posits Potentially, oil sand projects can have a productive life that covers multi-ple decades Many of these nonconventional operations involve the production

de-of bitumen, which is transported from the mining operation via pipeline to anupgrader or directly to a refinery that processes heavy oil An upgrader pro-cesses the bitumen into a lighter degree of synthetic crude oil that can be sold

to the marketplace as-is or further refined and converted into an array of fined products Bitumen is a tar-like form of crude petroleum that is so viscousthat it must be heated before it will flow

re-1.55 The production techniques used to extract bitumen can be a mixture

of nonconventional production techniques (referred to as truck and shovel or

surface mining operations) and conventional drilling techniques, such as steam

assisted gravity drainage (SAGD or in-situ operations) The surface mining erations can be used to recover only a certain percentage of the total resourcevolume Conventional drilling techniques, such as SAGD, are applied in order

op-to produce the resource volumes that are located on deeper horizons and notavailable for the mining type of production Historically, oil and gas entitieshave accounted for and disclosed truck and shovel operations as mining activ-ities and SAGD operations as oil and gas producing activities

1.56 In SEC Rule No 33-8995 and ASU No 2010-03, the definition of

oil- and gas-producing activities was expanded to include the extraction of

saleable hydrocarbons, in the solid, liquid, or gaseous state, from oil sands,shale, coalbeds, or other nonrenewable natural resources that are intended to

be upgraded into synthetic oil or gas, and activities undertaken with a view

to such extraction Accordingly, the accounting guidance for nonconventionalproduction meeting the preceding criteria are now within the scope of FASB

Accounting Standards Codification (ASC) 932, Extractive Activities—Oil and Gas.

Sources of Capital and Organizational Structure of Oil and Gas Entities

1.57 Oil and gas producing entities require large amounts of capital,

espe-cially in their exploration and development activities As in most industries, thetraditional sources of capital are internal financing and equity and other forms

of external financing However, the various and sometimes unique adaptations

in the oil and gas industry warrant discussion

1.58 In the past, oil and gas entities, especially those that were large and

financially strong, were able to fund a large amount of their exploration anddevelopment activities with internally generated funds Increased competitionamong entities for exploration rights to undeveloped properties, increased risksrelated to exploration and development of oil and gas properties, as well asrising acquisition and development costs, have resulted in entities turning morefrequently to external sources of funds

1.59 Oil and gas entities use a variety of ownership arrangements for

shar-ing risks These arrangements may be in the form of undivided interests, incorporated entities (joint ventures), corporations, limited liability companies,partnerships, and others The oil and gas entity determines the appropriate

un-method to account for these varied ownership arrangements This involves termining whether consolidation, equity method accounting, cost basis account-ing, or proportional consolidation are applicable, based on the specific facts andcircumstances See chapter 3, "Accounting for Common Oil and Gas OwnershipArrangements," of this guide for a discussion of accounting for common oil andgas arrangements.

de-Joint Interest Arrangements

1.60 Entities often enter into arrangements with others as a means of

raising or sharing capital This can be done by creating joint operations, ten in the form of joint ventures or partnerships, and is often accomplished

of-by transferring a portion of the working interest to other parties Depending

on the attractiveness of the property and the owner's willingness to dilute itsinterest, a portion of the costs of a property may be financed in this manner

An example is a carried interest arrangement, in which one party agrees toincur all the costs to develop and operate a property but maintains the right

to recapture its costs or a defined greater amount from the proceeds of tion Such arrangements in which parties bear disproportionate costs are often

produc-referred to as promotes See chapter 2 of this guide for information regarding

joint interest arrangements

Limited Partnerships1

1.61 Oil and gas operators may organize limited partnerships or limited

liability companies taxed as limited partnerships These legal entity

partner-ships are commonly called oil and gas funds, oil and gas program funds, or oil

and gas drilling funds Limited partnerships may be organized by a sponsor,

who sells interests in the partnership to private investors and then acts as thegeneral partner when the partnership has been organized Limited partner-ships are often structured to maximize the tax deductions passed through tothe limited partners or provide current yield for larger institutional investors.The limited partners are usually liable only for the amount of their contribu-tion to the partnership The general partner normally has unlimited liabilityfor the debts and obligations above the limited partners' capital; however, thegeneral partner has full control over the partnership's operations and receives

a management fee for their services

1.62 The limited partnership is governed by the partnership agreement,

which explains the rights and obligations of the partners The partnershipagreement specifies the method of allocating revenues and expenses betweenthe general and limited partner interests The basic allocation methods arefunctional allocation, reversionary interest, promoted interest, and carried in-terest The entity analyzes the substance of the transaction and the details

of the partnership agreement to determine the proper accounting treatment.Methods for special allocation of profits and costs for tax purposes may be in-appropriate for financial reporting purposes

1.63 Aside from the differences in the equity section of the financial

state-ments and the allocation of revenues and costs between the general and limitedpartners, the accounting for, and the auditing of, an oil and gas limited part-nership are basically the same as for any other oil and gas producer However,

1 For guidance on earnings per unit calculations for master limited partnerships with

incen-tive distribution rights, refer to the "Master Limited Partnerships" subsections of FASB Accounting

Standards Codification 260-10.

financial statements are often prepared on either the income tax or cash basis,except for those limited partnerships that are issuers, which are required to beprepared on the basis of GAAP.

Royalty Trusts

1.64 SEC Codification of Staff Accounting Bulletins Topic 12(E),

"Finan-cial Statements of Royalty Trusts," addresses the reporting requirements forroyalty trusts, which file financial statements with the SEC A royalty trust istypically created by a company conveying a net profits interest in certain ofits oil and gas properties to the newly created trust The trust then distributestrust units to its unitholders The trust is a passive entity, usually with a de-fined term of existence, which is prohibited from entering into or engaging inany business or commercial activity of any kind and from acquiring any oil andgas lease, royalty, or other mineral interest The function of the trust is to serve

as an agent to distribute the income from the net profits interest The amount

to be periodically distributed to the unitholders is defined in the trust ment and is typically determined based on the cash received from the net profitsinterest less expenses of the trustee Royalty trusts typically report their earn-ings on the basis of cash distributions to unitholders The net profits interestpaid to the trust for any month is based on production from a preceding month;therefore, the method of accounting followed by the trust is different fromthe accrual accounting method that would have been followed by the creatingcompany

agree-1.65 SEC Codification of Staff Accounting Bulletins Topic 12(E) states that

the SEC staff will accept a statement of distributable income, which reflectsthe amounts to be distributed for the period under the terms of the trust agree-

ment in lieu of a statement of income prepared under GAAP SEC Codification

of Staff Accounting Bulletins Topic 12(E) further states that this position is due

to the SEC staff 's belief that the item of primary importance to the reader ofthe financial statements of the royalty trust is the amount of the cash distri-butions to the unitholders for the period reported Should there be any change

in the nature of the trust's operations due to revisions in the tax laws or otherfactors, the SEC staff 's interpretation would be reexamined In cases in whichthis presentation is used, a note to the financial statements should disclose themethod used in determining distributable income and should also describe howdistributable income, as reported, differs from income determined on the basis

of GAAP

Other Sources of Capital

1.66 Quite common are various forms of production payment and net profit

interest transactions, whereby an investor advances funds to be repaid fromfuture production See the "Frequently Encountered Transactions for Trans-ferring Mineral Interests" section in chapter 2 for further discussion of thesetypes of arrangements

History of Accounting for Oil and Gas Producing Activities

1.67 Two accounting methods are acceptable for use by oil and gas

pro-ducers: the successful efforts method and the full cost method The accountingrequirements for these two methods are discussed in separate chapters of thisguide In addition, appendix A, "Summary of the Successful Efforts and FullCost Methods of Accounting," of this guide provides a high level comparison

of the two methods The following discussion summarizes the development ofGAAP for oil and gas entities.

1.68 Prior to the mid-1950s, most oil and gas entities used the successful

efforts accounting method or some variation thereof In the mid-1950s, a form

of the full cost method of accounting was introduced that became popular withsmall, newly formed entities because it allowed for the deferral of costs untilsuccessful exploration produced offsetting revenue By 1970, almost half of thepublic oil and gas producing entities were using a form of the full cost method

1.69 In 1969, the AICPA called for the elimination of the full cost method

and recommended that the successful efforts method be the only acceptablemethod The Accounting Principles Board (APB) appointed a committee to de-velop an authoritative opinion on financial accounting and reporting for the oiland gas industry; however, the APB was disbanded in 1973 before the commit-tee completed its charge

1.70 In December 1977, FASB issued guidance that required a form of

successful efforts accounting as the uniform method for all enterprises engaged

in oil and gas producing activities

1.71 The SEC called for public hearings in August 1978 before adopting

FASB Statement No 19, Financial Accounting and Reporting by Oil and Gas

Producing Companies, as the authoritative standard of accounting and

report-ing for oil and gas producreport-ing entities filreport-ing reports with the SEC Because of thestrong opposition voiced at those hearings, the SEC issued Accounting Series

Release (ASR) No 253, Adoption of Requirements for Financial Accounting and

Reporting Practices for Oil and Gas Producing Activities ASR No 253

r adopted the form of successful efforts accounting and the sures prescribed by FASB

disclo-r indicated the SEC's intention to develop a form of the full costaccounting method as an acceptable alternative for SEC report-

ing purposes (ASR No 258, Oil and Gas Producers—Full Cost

Ac-counting Practices).

r concluded that both the full cost and successful efforts methods

of accounting, based on historical costs, fail to provide sufficientinformation on the financial position and operating results of oiland gas producing entities and, accordingly, that steps should betaken to develop an accounting method based on a valuation ofproved oil and gas reserves (The SEC later decided that the valu-ation accounting it proposed — reserve recognition accounting —was no longer considered to be a potential method of accounting

in the primary financial statements of oil and gas producers.)

r adopted rules that require financial statement disclosure of tain financial and operating data, regardless of the method of ac-counting followed

cer-1.72 In ASR No 257, Requirements for Financial Accounting and

Re-porting Practices for Oil and Gas Producing Activities, and ASR No 258, the

SEC released its final rules for successful efforts and full cost accounting

As a result, entities under SEC jurisdiction could follow either the full costmethod prescribed in Section 406.01.c of ASR No 258 or the successful effortsmethod prescribed in Section 406.01.b of ASR No 253, as modified by Section

406 of ASR No 257, which is a method identical to that contained in FASB'sguidance

1.73 In response to the SEC's issuance of ASR No 253, FASB issued

ad-ditional guidance that suspended most of the provisions of its successful forts accounting guidance for an indefinite period However, some provisions

ef-of the successful efforts accounting guidance, including the accounting for ferred income taxes and some aspects of property conveyances and disclosurerequirements, were retained and became effective Thus, entities that report tothe SEC may follow either accounting method Nonpublic entities have no pre-scribed method of accounting for oil and gas producing entities However, theFinancial Reporting Executive Committee (FinREC) believes that nonpublicentities engaged in oil and gas producing activities should apply either the suc-cessful efforts method established by FASB or the full cost method established

de-by the SEC because these are the only comprehensive methods of accountingdeveloped for oil and gas producing entities FinREC also recommends that anynonpublic entity that chooses to follow a method that varies from one of thesemethods should disclose in the notes to its financial statements any differencesbetween the accounting policies it follows and those established by FASB or theSEC relating to oil and gas producing activities

1.74 In November 1982, FASB issued guidance establishing disclosures

to be made about oil and gas producing activities for publicly traded prises when presenting a complete set of annual financial statements The SECgenerally adopted these disclosure standards in Section 406.02 of Financial

enter-Reporting Release No 9, Supplemental Disclosures in Oil and Gas Producing

Activities.

1.75 The SEC reporting requirements contained in Final Rule No

33-8995 revised the disclosure requirements for oil and gas reserves, in addition tochanging the definition and requirements related to the determination of thequantities of oil and gas reserves The SEC reporting requirements contained

in Final Rule No 33-8995 also changed certain accounting requirements der the full cost method of accounting for oil and gas activities On January 6,

un-2010, FASB issued ASU No 2010-03 ASU No 2010-03 includes changes to counting and disclosure requirements that are consistent with SEC Final Rule33-8995

ac-1.76 For purposes of this guide, successful efforts refers to the accounting

method specified in FASB ASC 932-360, and full cost refers to the accounting

method specified in Rule 4-10(c) of Regulation S-X

International Standards of Accounting for Oil and Gas

1.77 The International Accounting Standards Board (IASB) has

estab-lished an accounting framework alternative that includes International counting Standards, International Financial Reporting Standards (IFRSs), andinterpretations The accounting framework established by the IASB does nothave comprehensive accounting standards that would specifically address ac-

Ac-counting for extractive industries, including oil and gas activities IFRS 6,

Ex-ploration for and Evaluation of Mineral Resources, addresses accounting for

the exploration stage of oil and gas and mining activities Other operations andtransactions related to oil and gas activities should follow the overall account-ing framework established by the IASB Further development of accountingstandards under IFRSs is in progress The IASB has initiated an extractiveactivities research project, which is expected to address the matters related to

accounting and financial reporting of reserves and resources in the extractiveindustries, as well as other extractive industry accounting issues.

1.78 Currently, oil and gas companies preparing financial statements

un-der IFRSs as issued by the IASB may adopt accounting policies different fromthose under GAAP as long as the accounting policies follow the overall account-ing framework of the IFRSs.2However, entities that file reports with the SECcontinue to provide disclosures required by FASB ASC 932-235-50 For furtherinformation, refer to the IASB website at www.ifrs.org

2 The SEC reporting requirements contained in Final Rule No 33-8995, Modernization of Oil

and Gas Reporting, revised Form 20-F to incorporate Subpart 1200 of Regulation S-K, with respect

to oil and gas disclosures, and delete appendix A of item 4.D in Form 20-F (which previously required significantly less oil and gas reserves disclosure for foreign private issuers versus domestic filers).

Chapter 2

Primary Business Activities of the Industry

Acquisition of Mineral Interests

2.01 In the United States, the rights to minerals underlying private lands

were initially held by the land surface owners Ownership of both the surface

and mineral rights in a tract is called a fee interest in the property The federal

government and state governments almost always possess title to all mineralsunderlying the surface acreages they own Similarly, Indian tribes generallyown the minerals underlying their lands States bordering on the oceans andgulfs own mineral rights within specified distances from the shore, and thosedistances vary by state The federal government owns the mineral rights be-yond the offshore areas owned by the state governments and up to the interna-tional waters line

2.02 An owner of the fee interest in a tract of land may sell all or part of the

mineral rights but retain ownership of the surface More commonly, the fee terest owner will sell the surface rights but retain ownership of the underlyingminerals

in-2.03 Most commonly, an oil and gas entity does not acquire a fee interest

but acquires rights to drill wells and produce minerals through oil and gas leasecontracts or lease agreements

2.04 It is common in oil and gas operations to have multiple and varying

types of ownerships of individual properties This variety of ownership interestshas developed in response to the need to share risks, take advantage of taxopportunities, and raise the large amounts of necessary capital

2.05 A lease contract typically grants a working interest in the property to

the lessee The lessee's rights and obligations include bearing most of the costsassociated with drilling and equipping wells and producing the oil and gas that

is found

2.06 The working interest owner usually obtains a lease from a mineral

rights owner(s), either through an in-house landman or an independent leasebroker The landman or broker researches public records to verify the legal own-ers of the mineral interest in the property and may obtain legal title opinions,although in some instances, the title work will not be performed until shortlybefore drilling commences The landman or broker then finds the mineral own-ers and negotiates the lease terms on an individual basis with them An upfront

payment to the mineral owner made to obtain the lease is called a lease bonus

and is discussed subsequently

2.07 In some situations, the owner of the property will have sold the

sur-face rights but retained ownership of the mineral rights In these cases, thelessee initially negotiates with the mineral rights owner(s) and, at some point,also negotiates with the surface owner(s) Generally, the surface owner cannotprevent drilling and producing operations from being carried out on the prop-erty, although negotiations for drill sites, surface damages, and rights-of-waymay be necessary This may involve payments to the landowner for damages toproperty, use of areas needed for drilling and producing operations, and othernegotiated issues

By AICPA Copyright © 2018 by American Institute of Certif

2.08 Oil and gas leases on state owned properties are normally awarded

through a bidding process, with leases granted to the highest bidder Leases

on federally owned properties located offshore or on known geological tures, as well as certain other properties, also are awarded by bidding Leases

struc-on federally owned properties located struc-onshore may be awarded through leaseapplication systems with a standard fee

2.09 As discussed in the subsequent section "Basic Concepts of

Prospect-ing and Exploration Activities," some exploration activities may precede theacquisition of mineral rights

Important Provisions in Lease Contracts

2.10 Lease contracts The most important provisions commonly found in

oil and gas leases are explained briefly in the following paragraphs A standardlease agreement, prepared by the American Association of Professional Land-men, is often adapted to fit particular circumstances The provisions of oil andgas leases include important information relevant to the accounting for thesearrangements

2.11 Lease provisions The basic provisions in leases are generally similar,

but each lease may contain unique provisions because the parties may add,delete, or modify provisions These nonstandard provisions can have significantimplications, particularly with respect to the payment of lease royalties to thelessor Also, the parties may pool adjacent leases to form a tract large enough

to cover a field or reservoir In those cases, production from a single well may

be subject to multiple leases with different terms

2.12 Lease bonus The lease bonus is the cash or other consideration paid

to the lessor by the lessee in return for the lessor granting the lessee rights toexplore for minerals, drill wells, and extract any minerals found The bonus isnormally computed on a per acre basis and may range from a few dollars per

acre in wildcat locations (locations not near formations known to contain oil or

gas deposits) to several thousand dollars per acre for locations near producingwells

2.13 Primary term and drilling obligation The maximum period of time

allowed for the lessee to commence drilling a well on the property covered in the

lease contract is referred to as the primary term, which is usually 2–5 years The

primary term of properties located in close proximity to producing wells may

be as short as 1 year; however, the primary term of properties located in remoteareas far from producing wells may be as long as 10 years If drilling has notbegun within the primary term, the lease contract automatically terminatesunless the parties agree on an extension The lessee usually has to make aspecified payment to the lessor to keep the lease in force beyond the primaryterm

2.14 Lease termination Customarily, leases terminate at the end of the

primary terms The lessee may also avoid all obligations and give up all rightsand responsibilities by simply failing to pay rentals when due, or the lessee mayterminate the contract at any other time by executing a formal lease surrender

or a quit claim deed

2.15 Lease extension If the lessee wishes to retain a property for which

the primary term is about to expire but on which drilling has not begun, anextension of the original lease may be agreed to by all parties upon an additional

payment by the lessee, or a top lease (a new lease contract on the same property)

may be executed, usually involving an additional bonus payment by the lessee.

A top lease also may be taken by a third party in expectation of the expiration

of the existing lease

2.16 Delay rentals The payment made to defer drilling activities for an

additional period of time at the end of the primary term is commonly called a

delay rental The amount of the annual delay rental is negotiated, and if the

delay rentals are not paid on or before the due date, the lease contract lapses

2.17 Fixed or mandatory rentals In addition to the usual delay rentals

typically included in contracts, some contracts may include additional fixed

or mandatory rental payments that are payable without regard to whetherdrilling has begun or production has been established In effect, these paymentsare deferred bonuses paid on an installment basis

2.18 Lessor's royalty interest Typically, the lessor retains a royalty

inter-est in the properties being leased This entitles the lessor to receive, free andclear of all exploration, development, and production costs, a specified portion ofthe oil and gas produced (or, now more commonly, a specified portion of the value

of such production) less (a) the related state severance or production taxes and (b) certain costs necessary to get the product into a marketable condition Occa-

sionally, the royalty interest may bear certain other specific costs The royalty

interest created by the lease contract is referred to as the basic royalty

inter-est Historically, the basic royalty interest has been one-eighth of the value of

the mineral produced and sold, but it may vary Many lease contracts on erties near producing areas now call for up to a one-fourth or greater basicroyalty

prop-2.19 Compensatory royalties The payment made by the lessees to royalty

owners as compensation for lost income during periods when the entity has notfulfilled its drilling and production obligations (for example, failure to follow anagreed-upon development plan for the property or failure to drill an offset wellwithin a specified time if a productive well is drilled within a specified distance

on an adjoining property)

2.20 Other costs related to development delays After mineral rights have

been acquired through a lease, several years may elapse before drilling begins.Economic or market conditions may delay development During that period, thelessee may have to pay specified expenses related to the property

2.21 Shut-in royalties Most lease contracts provide for shut-in royalties,

which are payments by the operator to the royalty owner if a successful wellhas been drilled but production has not begun within a specified time aftercompletion of the well The lease contract also may call for shut-in royalties

to be paid on producing wells from which production has been temporarilysuspended Shut-ins frequently occur on properties containing gas and may

be caused by reduced prices, the absence of a market, working over the well,

a lack of transportation, or the necessity to obtain permission from a mental unit Shut-in payments may or may not be recoverable by the operatorout of royalties accruing to the royalty owner from production subsequent tothe shut-in period, and they may also not be applicable in the event of a forcemajeure related event, such as, a pipeline explosion

govern-2.22 Guaranteed or minimum royalties For properties with a high

prob-ability of being productive, the mineral owner may be able to negotiate a ified minimum royalty payment each month or year for a specified period

spec-Guaranteed payments may or may not be subject to offset against future alties payable to the royalty owner.

roy-2.23 Production holds lease Once a successful well has been drilled and

commercial production has begun, the lease remains in effect for as long asthere is production without extended and indefinite interruption The lease is

then classified as held by production In some cases, the lease specifies that

the production be commercial (profitable), but other leases are silent regardingcommercial production If production ceases, the operator acts in good faith toresume the extraction of oil or gas within a reasonable time, or the contractterminates (Reasonable time may be specified in the lease contract.)

2.24 Offset clause A common provision, called an offset or drainage clause,

specifies that the lessee drill leaseline offset wells to prevent drainage of oil orgas to a nearby tract (usually adjoining) if a well is drilled within a specifieddistance of the boundary of the property involved in the lease Often, the con-tract states that the offset well is necessary when a prudent operator woulddrill the offset well under similar circumstances

2.25 Surface damages Provisions are frequently incorporated in a mineral

lease to define what damages to the surface overlying the minerals, resultingfrom drilling and production activities, are paid by the lessee and which dam-ages are not reimbursable

2.26 Continuous drilling clause Once production has been established,

some leases specify that additional wells be drilled within a certain time tocontinue to hold the remaining acreage under the lease that is not associatedwith a producing well A continuous drilling clause may provide additional time

to develop the leasehold beyond the primary term

2.27 Right to assign interest The lease contract grants each party the right

to assign, without approval of the other party, all or any part of its rights andobligations created under the contract

2.28 The typical lease contract is likely to contain a variety of other

provi-sions designed to identify the rights and obligations of the parties, based on thenature and peculiarities of the individual operating environment, such as lim-itations on drill site locations and the location of pipelines to remove producedoil and gas from the property

Frequently Encountered Transactions for Transferring

Mineral Interests

2.29 Purchase or sale of working interest Oil and gas producers frequently

purchase from other producers working interests in leases that may or may nothave been developed The acquisition may involve the sale and transfer to thepurchaser of all rights and obligations of the original working interest owner for

cash consideration This transaction would be referred to simply as a purchase

and sale of the working interest The transaction would not affect the interests

of the royalty holder

2.30 Carve outs In addition to outright sales or purchases of working

in-terests, oil and gas producing entities frequently engage in transactions thatinvolve all or part of the working interest in a property and also create non-operating interests that may be retained by the entity or "carved out" of theworking interest and transferred to the other party Transactions of this type

may be entered into as a means of financing drilling and development by theworking interest owner.

2.31 Overriding royalty interest A working interest in a property also may

be purchased, subject to retention of an overriding royalty interest (ORRI) bythe transferor An ORRI is almost identical to a basic royalty interest, except

it is "carved out" of the working interest created by the original lease Thistransaction has no effect on the original lessor's royalty interest Like a royaltyinterest, an ORRI bears little or no costs

2.32 A net revenue interest (NRI) or net profit interest (NPI) is an

inter-est in production created from the working interinter-est and measured by a certainpercentage of revenues or net profits (as defined in the contract) from the oper-ations of the property

2.33 Net revenue interest An NRI is the total revenue interest that a party

owns in an oil and gas lease, well or drilling unit, normally the party's workinginterest less lease burdens

2.34 Net profit interest An NPI owner is entitled to a specific share of

profits from the property It is particularly important that net profit and thecosts used to calculate it are carefully defined in the contract The costs mayinclude both capital and operating costs As in the case of overriding royalties,the NPI may be "carved out" of the working interest and transferred to anotherparty or may result from the transfer of the working interest to a new owner,with the NPI being retained by the former working interest owner

2.35 Lease burdens The sum of the interests in both revenue and costs

will obviously total 100 percent However, because the various royalty ownerswill often not share in the costs consistent with their share of revenues, theworking interest owners will generally incur a greater share of the costs than

revenue interests This difference is often called the lease burden.

2.36 Production payments A production payment entitles its owner to

re-ceive a specified fractional share of the working interest's share of gross

pro-duction until a specified amount of propro-duction (called a volumetric propro-duction

payment [VPP]) or a specified amount of cash has been recovered Less

fre-quently, the life of the production payment may be expressed in terms of aspecified period of time The production payment may be "carved out" of theworking interest and "sold" separately, or it may be retained by the seller whenthe working interest is transferred to a new owner

2.37 The terms NRI, NPI, and VPP are widely used by industry

partic-ipants; however, they may have different meanings when applied to differentcontracts The form and substance of these transactions are important to thedetermination of the proper accounting treatment Depending on the contrac-tual terms and related production and pricing risk retained or conveyed, thesetransactions can be accounted for as loans, prepaid commodity sales, the sale

of a mineral interest with revenue deferred, or an outright sale No specificaccounting guidance related to many of these types of agreements exists How-ever, the accounting for certain forms of these agreements is described in the

"Conveyances" section of chapter 4, "Successful Efforts Method and GeneralAccounting for Oil and Gas Activities."

2.38 A number of other contracts and special interests in the production

from an oil and gas lease may be created, often as part of a plan to finance

development activities Some of the other contracts creating mineral interestsare described throughout this guide.

2.39 Nonmonetary exchanges Oil and gas entities frequently enter into

agreements to transfer an interest in oil and gas properties in exchange for aninterest in other properties owned by another company Entities generally en-ter into this type of arrangement to "core up" existing acreage positions withoutthe need to expend additional capital Careful evaluation of the scope consider-

ations outlined in FASB Accounting Standards Codification (ASC) 845-10-25-1

is required to determine if the transaction is within the scope of the etary exchange guidance Transactions are deemed to be exchanges only if thetransferor has no substantial continuing involvement in the transferred assets(for example, risks and rewards of ownership have transferred) If a transactionmeets the definition of a nonmonetary exchange, then the guidance in FASBASC 845-10-30-3 requires valuation of nonmonetary assets acquired and sur-rendered at fair value

nonmon-Documents and Files Relating to Mineral Interests

2.40 Administration The lessee usually maintains a prospect file or a

lease (land) file, or both, for each property These files include a copy of thelease contract, the survey or other legal description of the property, and thetitle opinions As the prospect is developed, additional documents, such as au-thorizations for expenditures (AFEs), division orders to allocate revenue to thedifferent interest owners, purchase contracts (if applicable), operating agree-ments, regulatory permits, and producer status certifications, are added to thelease file This file is an important source of information for accountants andauditors

2.41 Operating agreements Joint interest (also referred to as joint

ven-ture) operations result from an agreement among two or more working interest

owners whereby one party is designated as the operator for the developmentand operation of the jointly owned property In joint interest operations, eachworking interest owner retains an undivided interest in the jointly operatedproperty This direct ownership is usually included in the financial statements

of the investor through direct inclusion of its proportional share of the expenses,revenues, assets, and liabilities Liabilities are only several in nature Jointinterest operations are designed to accomplish the objectives of sharing risk,obtaining capital, maximizing efficiency of development and operations, andenhancing the recovery of reserves

2.42 Joint operating agreements Joint interest operations are governed

by complex operating agreements that set forth the rights, duties, and tions of each party A significant part of the agreement is the accounting proce-dure section, which establishes the basis for charges and credits to the operatorand nonoperating parties and provides for billings, advance of funds, paymentschedules, audits, and other matters The accounting provisions in joint oper-ating agreements usually follow a model provision devised by the Council ofPetroleum Accountants Societies (COPAS) Although the lease is usually con-sidered the accounting unit, many costs cannot be directly identified with aparticular lease Such costs are usually categorized as indirect expenses andare recovered by allocating overhead to leases on some reasonable basis Thesecosts include service unit costs and certain types of overhead

obliga-2.43 Joint interest billings The operator bills the nonoperators (usually

by the 15th of the month following the accounting month) for their shares of

the month's expenditures The billing is referred to as a joint interest billing.

The operator also may make a cash call at the beginning of each month for thenonoperators' shares of anticipated capital expenditures that will be incurredduring the month

2.44 Most large oil and gas entities, as well as many smaller entities, act

as operators on a number of the oil and gas properties in which they have aninterest It is important to note, however, that nearly all entities will be non-operators, with respect to a portion of their properties In addition, the extent

to which nonoperators take an active role in the operation of properties varies

in practice In many instances, the nonoperator maintains full accountabilityfor activities on the properties, including advance authorization of capital ex-penditures through the AFE process and review and approval of revenue andexpense transactions In other instances, nonoperators may rely almost entirely

on the operator for recording transactions and maintaining accountability andmay receive only a summary report of activity

2.45 Joint interest audits The accounting procedure section of the

operat-ing agreement usually contains a provision that establishes the timoperat-ing of theauditing of the operator's records by the nonoperating parties Under some ofthe accounting procedures, the nonoperators may audit the operator's expendi-tures within two years after the end of the period to be audited If such an option

is not exercised or if an exception is not granted in advance, the nonoperatorswould be precluded from conducting a subsequent audit, and all transactionsbilled would be considered correct

2.46 Joint interest audits are normally conducted by the nonoperators'

in-ternal auditors or independent auditors hired by the nonoperators The purposeand, therefore, the scope of joint interest audits are significantly different fromthat of audits of financial statements in accordance with generally acceptedauditing standards Such audits are beyond the scope of this guide; however, it

is important to note that as of the date of this guide, no generally recognizedjoint interest audit standards are in existence However, COPAS has a standingcommittee that focuses on joint interest audits This committee investigates,analyzes and recommends solutions to issues relating to oil and gas industryaudits, with particular attention to concerns arising from the application andinterpretation of COPAS publications

2.47 Division orders Contractual agreements among the parties

deter-mine ownership interests, and rarely are two contracts exactly the same Inalmost every case, there will be at least two recipients of production proceeds:the working interest owner and the royalty owner Thus, a division of inter-

est order (or simply, division order) is prepared A regular division order is an

agreement among the purchaser of production and all the various owners of

in-terest in the property This agreement includes (a) the legal description of the property; (b) the owners of interest in the property; (c) the interest owned by each; and (d) the terms of purchase, including provisions dealing with passage

of title, price, measurement, production taxes, and related items The operator

of the property circulates the division order to the various owners of interest

By signing the division order, each owner represents ownership to be as statedand agrees to all other provisions of the division order Sometimes, the operatorreceives the full payment from the purchaser and makes the distribution to theother owners

2.48 In the event that an owner of an interest is unknown or cannot be

located and the signature cannot be secured on the division order, the revenue

applicable to that interest is held in suspense In a similar manner, revenue isheld in suspense pending receipt of proof of title or a title opinion, execution

of the division order, or litigation to resolve a dispute over ownership of aninterest Many states hold that as long as there is clear evidence of correctownership, operators cannot withhold revenues simply because a division order

is not signed

Basic Concepts of Prospecting and Exploration Activities

2.49 The purpose of geological and geophysical (G&G) exploration is to

obtain information about subsurface geological conditions that can be used inassessing the probability that oil or gas exists in commercial quantities; it isalso used to identify specific, optimum drilling locations Typically, this processinvolves first identifying large areas that have characteristics indicating thatunderground structures or stratigraphic variations that are conducive to thetrapping of oil and gas exist (This initial search for areas that warrant further

exploration is often referred to as prospecting.)

2.50 The second step is to carry out detailed tests on areas identified in

the broad survey as potentially containing mineral deposits to determine thelikelihood that minerals exist in sufficient quantities to justify drilling This

more detailed work is referred to as exploration For the sake of simplifying the

discussion, both of these activities are frequently grouped together and called

exploration activities.

2.51 Geological exploration involves scientific studies focused primarily on

the earth's crust and examines the materials and life forms in the crust sinceits origin Analysis of the chemical content of the earth's surface is a primeexample of geological studies

2.52 Geophysical exploration studies examine the earth's surface using

quantitative and physical methods, such as seismography (bouncing soundwaves off the surface and underlying strata and measuring the pattern andstrength of their reflections in order to get a "picture" of the underlying miner-als and formations)

Prospecting and Exploring for Potential

Hydrocarbon-Bearing Structures

2.53 At one time, prospecting principally involved visible sightings of

surface accumulations of oil that had seeped from the formations Later, theprimary technique used in locating potential petroleum-bearing structures inmany areas was surface geological mapping to define the structural featuresexpressed in the rock outcrops that indicated an oil and gas trap likely would

be present in the subsurface

2.54 Today, many methods are being used to carry out prospecting work

on projects covering thousands of square miles, including logs, cores, aerial tography, plane-based imaging radar, satellite imaging radar, and U.S govern-ment Landsat satellite infrared images In addition, as discussed subsequently,various seismic methods are now widely used in prospecting and explorationactivities

2.55 Aerial photographs can be taken of large areas; however, aerial

pho-tography is very expensive, and the photographs do not always provide highquality pictures of the surface