Ebook Petroleum accounting: Principles, procedures & issues: Part 2

C H A P T E R Glossary Terms carried interests arrangement carried party carrying party equalizations free well agreement participation factors reversionary interest FARMOUTS, CARRIED INTERESTS, AND UNITIZATIONS Key Concepts: • Definition of the term farmout • Carried interests • Accounting for unitization • Tax accounting for farmouts, carried interests, and unitizations Chapter 23 Farmouts, Carried Interests, and Unitizations 388 The pooling of capital concept has long been a part of accounting theory as well as an essential element in the federal taxation of extractive industries. It is common for an entity to acquire an interest in a mineral property through the contribution of money, property, or services, and assume all or part of the risk and burden of developing and operating it. One party may contribute a leasehold to the venture, another may provide equipment or services, such as drilling, and still another entity may contribute money. Members of the venture agree that they are contributing to a common pool of capital. Thus, each is viewed as making an investment in a venture or adding to the venture’s reservoir of capital in return for ownership interest in the venture as a whole. Many transactions of this type are also considered as exchanges of productive assets in return for similar productive assets, especially if mineral interests, intangible drilling costs, and equipment are viewed as similar. FASB Current Text Oi5.135 states no gain or loss is recognized at the time of conveyance in a pooling of capital or an exchange of similar productive assets. Commonly encountered applications of these concepts are examined in this chapter. Generally, it is assumed that the successful efforts method is being followed. Although many of the same rules apply, special considerations for full cost companies are examined at the end of this chapter. FARMOUTS When the owner of a working interest transfers all or part of the operating rights to another party in exchange for the transferee assuming some portion of the cost of exploring or developing the property, the transaction is referred to as a farmout. One type of farmout is essentially a sublease without cash consideration. The original lessee assigns the working interest, but retains an overriding royalty or a net profits interest in return for the assignee’s agreement to perform and pay for specified drilling and development activities. For example, assume ABC Oil Company (ABC) assigns the working interest in Nellie Bell lease No. 26710 to Big Time Company, subject to a retained overriding royalty of one-eighth of total production from the property. As consideration, Big Time agrees to drill a well to a depth of 5,000 feet or to a specific sand formation, if shallower. Big Time is to complete the well and bear all equipment installation costs. It spends $340,000 for intangible drilling and development costs and $80,000 for lease and well equipment. ABC’s original lease cost was $75,000 and it had a fair value of $400,000 at the time of the farmout agreement. Oi5.138(b), specifies how this transaction should be accounted for by the two parties: An assignment of the operating interest in an unproved property with retention of a nonoperating interest in return for drilling, development, and operation by the assignee is a pooling of assets in a joint undertaking for which the assignor shall not recognize gain or loss. The assignor’s cost of the original interest shall become the cost of the interest retained. The assignee shall account for all costs incurred as specified by paragraphs .106 through .132 and shall allocate none of those costs to the mineral interest acquired. If oil or gas is discovered, each party shall report its share of reserves and production (refer to paragraphs .160 through .167). In this instance, both entities have contributed to the pool of capital. Each has benefited, yet no gain or loss is recognized by either party. ABC’s leasehold cost of $75,000 becomes its cost for the overriding royalty retained and is recorded as follows: 389 Farmouts, Carried Interests, and Unitizations Chapter 23 223 Proved Royalties and Overriding Royalties 75,000 211 Unproved Property Acquisition Costs 75,000 To record farmout of Nellie Bell lease and retention of one-eighth override. The entry assumes that no impairment of this property has been recorded on an individual lease basis. If such an impairment occurs, the net book value of the lease is assigned to the overriding royalty. For example, assume that individual impairment of $30,000 has been recorded on the lease in the preceding example. The entry to record the farmout is: 223 ProvedRoyaltiesandOverridingRoyalties 45,000 219 AllowanceforImpairmentandAmortizationofUnprovedProperties 30,000 211 Unproved Property Acquisition Costs 75,000 To record farmout of Nellie Bell lease and retention of one-eighth override. Big Time classifies its investment in the property based on the type of expenditures made. No part of the costs incurred is allocated to the mineral rights obtained, and no gain or loss is recorded. The entry made by Big Time is summarized as follows: 231 IntangibleCostsofWellsandDevelopment 233 TangibleCostsofWellsandDevelopment 340,000 80,000 301 Vouchers Payable 420,000 TorecordthecostsofdrillingandequippingwellonNellieBelllease underafarmoutagreement. Ifthewellisdry,thecostsincurred(lessnetsalvage)arechargedtoUnsuccessfulExploratory Wells by Big Time. ABC would have recorded impairment of the overriding royalty. FREE WELLS When the owner of a working interest assigns a fractional share of the interest in return for another operator’s drilling and equipping one or more wells without cost to the assignor, a free well has resulted. The term free well is used because the assignor retains a portion of the working interest and receives an interest in the well and equipment without bearing any part of the cost. The assignor also shares in the first production from the well. Afreewellisconsideredasharingarrangementunderthepoolingofcapitalconcept,andno gain or loss is recognized by either party to the transaction. Oi5.138(c) addresses this issue: An assignment of a part of an operating interest in an unproved property in exchange for a “free well” with provision for joint ownership and operation is a pooling of assets in a joint undertaking by the parties. The assignor shall record no cost for the obligatory well; the assignee shall record no cost for the mineral interest acquired. All drilling, development, and operating costs incurred by either party shall be accounted for as provided in paragraphs .106 through .132. If the conveyance agreement requires the assignee to incur geological or geophysical expenditures instead of, or in addition to, a drilling obligation, those costs shall likewise be accounted for by the assignee as provided in paragraphs .106 through .132. If reserves are discovered, each party shall report its share of reserves and production (refer to paragraphs .160 through .167). Chapter 23 Farmouts, Carried Interests, and Unitizations 390 To illustrate a free well scenario, assume ABC owns several unproved leases in the Little River area. In January of the current year, it contracts with Freeco to drill and equip a well on the property—at Freeco’s cost. In return, ABC assigns an undivided one-half working interest in the Downy lease to Freeco. ABC’s original cost of the lease was $24,000. Freeco spends $125,000 on intangibles and $30,000 on equipment for the property, which is considered proved after the well is completed. Each party receives one-half of the production revenues, beginning with the first production, and each bears one-half of operating expenses and further developmental costs. Since the transaction comes under the pooling of capital concept, the accounting treatment for both parties is essentially the same as accounting for farmouts. Assuming group impairment method is used, the entry required by ABC is: 221 Proved Property Acquisition Costs 24,000 211 Unproved Property Acquisition Costs 24,000 TotransfercostofDownyleasetoprovedleaseholds. For Freeco, the transaction is expressed in the following summary journal entry: 231 IntangibleCostsofWellsandDevelopment 233 TangibleCostsofWellsandDevelopment 125,000 30,000 101 Cash 155,000 TorecordcostsofafreewelldrilledforafractionalinterestinDowny lease. Underthisprocedure,ABCassignsnocosttoIDCorequipment,andFreecoassignsnocost to the mineral interest. Each party reports only its share of production and proved reserves. Another type of free well agreement calls for the lessor to retain all of the working interest and assign the driller a nonoperating interest in the property in return for drilling and equipping the well. Using data from the preceding example, assume ABC retains the entire working interest in a lease and assigns Freeco an overriding royalty of one-fourth of total production from the property in return for Freeco’s drilling and equipping the well. This transaction represents a pooling of capital because each party contributes property, money, or services to a joint venture in return for some type of ownership interest. Thus, no gain or loss is recognized by either party. As the holder of a nonoperating interest, Freeco has no ownership in either the IDC or equipment. It might appear that the entire $155,000 spent by Freeco should be treated as the cost of the overriding royalty. However, since Oi5.138c specifically prohibits classifying a portion of well costs to an earned mineral interest, it is more consistent with Oi5 conveyance rules for Freeco to treat the entire $155,000 as well costs. CARRIED INTERESTS For many years, carried interests have been widely used in the oil and gas industry. While various forms exist, all achieve the same economic result. A Manahan contract is a commontypeofcarried interests arrangementand is illustrated in the following example. ABC, the carried party, owns the working interest in an unproved lease named A1. It assigns its entire interest to Developco, the carrying party. Developco agrees to pay all costs of drilling, equipping, and operating the property until the entire amount is recovered out of working interest revenue. This period is referred to as the time of payout. Developco 391 Farmouts, Carried Interests, and Unitizations Chapter 23 then reassigns one-half of the working interest to ABC (which has a 50% reversionary interest). At that time, ABC and Developco share equally in further revenues and production expenses and any additional expenditures for drilling or development. ABC’s cost of the lease is $20,000. Developco spends $100,000 for IDC and $32,000 for equipment placed on the lease. The well is completed and production begins on November 1, 2006. Working interest revenue is $30,000 per month (for 500 barrels) beginning with the first production and expenses are $8,000 per month. On December 31, 2006, proved reserves attributable to the working interest are 390,000 barrels. Based on these facts, Developco has $22,000 per month of net revenue ($30,000 revenue less $8,000 expenses) to apply toward recoupment of drilling and development costs. At the end of 2006, Developco has received $44,000 (two months at $22,000) and is entitled to recover an additional $88,000 ($132,000 - $44,000) out of revenue before ABC begins to share in production. The accounting treatment specified by Oi5.138(d) for carried interests is summarized as follows: 1. No gain or loss is recognized by either party at the time of conveyance. 2. The expenditures or contributions of each party are accounted for in a proper manner by the party making the expenditure or contribution. 3. All revenue and cash expenses belong or apply to the carrying party until payout; except for the entry to transfer the property’s cost to Proved Properties, no entries are necessary by the carried party until that time. Since neither party records gain or loss on the conveyance transaction, ABC transfers the leasehold cost of $20,000 (or net book value, if impairment has been recorded on an individual lease basis) to Proved Leaseholds when the property becomes proved. 221 Proved Property Acquisition Costs 20,000 211 Unproved Property Acquisition Costs 20,000 TorecordprovingoftheA1leasecarriedbyDevelopco. Since Developco is considered to own the full working interest until payout, its costs of drilling and equipping the well are recorded in the following journal entry: 231 IntangibleCostsofWellsandDevelopment 233 TangibleCostsofWellsandDevelopment 100,000 32,000 101 Cash 132,000 TorecorddrillingandequipmentcostsontheA1lease. As mentioned, Developco is entitled to recover its expenses related to the property until it receives the entire amount due. If cash proceeds from the property are inadequate, ABC has no liability for unrecovered amounts. Developco has $22,000 per month of net revenue ($30,000 revenue less $8,000 expenses), which is $44 for each working interest barrel ($22,000/500 barrels) to apply toward recoupment of drilling and equipment costs. Thus, in November and December of 2006, Developco includes all the revenue and expenses in its income statement as summarized (for the two months) in general journal form: 101 Cash 60,000 601 Crude Oil Revenues 60,000 TorecordproductionrevenuesfromtheA1lease. ... - tailieumienphi.vn