February 11, 2005
Chief Financial Officer
Dear Chief Financial Officer,
We have recently addressed several accounting and disclosure issues that may apply to your oil and gas or other operations. To the extent applicable, please consider these issues when preparing your next financial report covering periods ending on or after December 15, 2004.
We understand that some companies in the petroleum industry are reporting activity related to buy/sell arrangements for oil and gas commodities at fair value on a gross basis in their statements of operations. These transactions typically involve contractual arrangements that establish the terms of the buy and sell agreements either jointly, in a single contract, or separately, in individual contracts that are entered into concurrently or in contemplation of one another with a single counterparty. There may be provisions accommodating differences in quantities or grades, receipt and delivery locations, and stipulating that monetary consideration accompany the exchange. Such arrangements may be employed to facilitate the procurement of feedstock for refinery operations, or to otherwise manage the supply chain or inventory generally. Some companies may find it necessary to enter into a series of these transactions with different counterparties in an effort to obtain a given quantity of feedstock or inventory for a single location. We understand that these arrangements are undertaken due to market forces of supply and demand, and may serve to increase the efficiency with which transportation assets are utilized, or to reduce the overall cost of acquiring inventory.
The Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) is currently considering the issue as to whether some or all of these buy/sell arrangements should be accounted for at historical cost pursuant to the guidance in paragraph 21(a) of APB Opinion No. 29, Accounting for Nonmonetary Transactions. Additionally, we have questions regarding the appropriateness of reporting the proceeds and costs of buy/sell arrangements on a gross basis in the statement of operations. Although consideration of these issues is not yet complete, it is apparent that proceeds and costs associated with such transactions are fundamentally different in character than those of a company's primary operations.
Accordingly, in filings that include financial reports covering periods ending on or after December 15, 2004, you should separately identify on the face of the statements of operations the proceeds and costs associated with buy/sell and comparable arrangements reported on a gross basis for all periods presented. You may accomplish this by either presenting the amounts as separate line items, or within parenthetical notations next to the captions that include these amounts. If the amounts are not material enough for disclosure on the face of the statements of operations, you should disclose the amounts in a footnote. We ask you to fully disclose in the accounting policy notes the characteristics of material arrangements of this type, the circumstances under which they are used, and the accounting literature relied upon in determining whether gross or net reporting would apply. You should also explain in your policy notes that the EITF is considering related matters in Issue 04-13, and describe how the financial statement presentation might change should a single method of reporting be required. Where reported volumes and revenues reflect material activity arising from these transactions, you should include quantification of the effects and address any related material trends and uncertainties in your Management's Discussion and Analysis (MD&A).
Our observations, and the disclosure guidance provided herein, are based on experience with transactions utilized in the petroleum industry; however they may have application to non-petroleum products and other industries. If you report proceeds and related costs from buy-sell or comparable transactions on a gross basis and you file a registration statement under the Securities Act of 1933 prior to including disclosure in your annual report, then you should disclose the issue as a recent development in your registration statement.
Exploratory Drilling Costs
In the course of reviewing filings made by companies in the petroleum industry, we have observed instances where the accounting for exploratory drilling costs has not corresponded to the explicit requirements in paragraphs 31-34 of FASB Statement No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies (SFAS 19). We are aware that the FASB has posted for comment a proposed FASB Staff Position (FSP) to revise SFAS 19.1 In the meantime clearly describe your policies and practices, contrasted with the explicit requirements set forth in paragraphs 31 and 34 prohibiting continued capitalization more than one year following completion of drilling unless certain criteria are met.
In those situations where drilling has been completed for more than one year and notwithstanding the proposed FSP, we believe you should be able to demonstrate currently that you have been actively and continuously pursuing those activities necessary to classify reserves as proved, and that any extended delay has been beyond your control. For example, we generally would not view conducting environmental or engineering design studies, or searching for partners in development or production, as providing reasonable support for the deferral of exploratory drilling costs beyond one year after drilling is complete. In those cases where justification of continued deferral is linked to your pursuit of required permits, you should be able to demonstrate that you have taken reasonable steps to secure all required permits on a timely basis.
If you report capitalized exploratory drilling costs on your balance sheets, disclose the following in your financial statements:
- The accounting policy regarding capitalization of exploratory drilling costs, including the criteria management applies in evaluating whether costs incurred meet the criteria for initial and continued capitalization and the frequency with which such evaluations are made;
- Total capitalized exploratory drilling costs, as of each balance sheet date, pending the determination of proved reserves;
- As of the most recent balance sheet date, the number of wells and amount of such capitalized costs that are associated with:
Further sub-divisions in amounts based on any additional criteria (such as, particular projects or phases in the exploration programs) that would be meaningful in conveying information about the uncertainty and risk profile of these cost pools;
- wells in areas requiring a major capital expenditure before production could begin, where additional drilling efforts are not underway or firmly planned for the near future, and
- wells in areas not requiring a major capital expenditure before production could begin, where more than one year has elapsed since the completion of drilling;
For exploratory drilling costs that continue to be capitalized as such after the completion of drilling, an explanation of the delay in characterizing reserves as proved reserves, including the activities undertaken to evaluate the reserves and the wells, additional information needed before the associated reserves may be classified as proved, and the estimated timing of when the evaluation of the reserves will be completed;
An estimate of the effects on your financial statements as of the beginning of the earliest year and for each year of operations presented that would have resulted from your application of the proposed FSP;
A tabular disaggregation of exploratory drilling costs deferred by year, or using several ranges of years, sufficient to convey the length of time that has elapsed since the incurrence of costs for completed individual wells that do not require a major capital expenditure before production could begin, along with an indication of the number of wells to which those costs relate; and
For each period in which a statement of operations is presented, the net changes from period to period in capitalized exploratory drilling costs, including separate disclosure of:
- additions to capitalized exploratory drilling costs that are pending the determination of proved reserves,
- capitalized exploratory drilling costs that were reclassified to wells, equipment and facilities based on the determination of proved reserves, and
- capitalized exploratory drilling costs that were charged to expense.
Finally, MD&A disclosures should address the trends and uncertainties related to exploration expenses, and the extent to which they were affected by the deferral of exploratory drilling costs. We will not object to a discussion of any diversity in practice that may have existed previously with respect to the capitalization of exploratory drilling costs, or changes in the industry affecting your operations that have occurred since SFAS 19 was issued that are the basis for the proposed FSP.
Disposition of Oil and Gas Properties under Rule 4-10(c) of Regulation S-X
Pursuant to FASB Statement No. 141, Business Combinations (SFAS 141, and its predecessor, APB Opinion No. 16 (APB 16)), goodwill may be recognized in connection with the acquisition of oil and gas exploration and production properties that constitute a business. Rule 4-10(c)(6)(i) of Regulation S-X, applicable to the full cost accounting method, specifies that "sales of oil and gas properties, whether or not being amortized currently, shall be accounted for as adjustments of capitalized costs, with no gain or loss recognized, unless such adjustments would significantly alter the relationship between capitalized costs and proved reserves of oil and gas attributable to a cost center." It goes on to indicate that "a significant alteration would not ordinarily be expected to occur for sales involving less than 25% of the reserve quantities of a given cost center."
The staff considered the specific circumstance of a property disposition that resulted in a less than 25% alteration of the proved oil and gas reserve quantities within a full cost center. In connection with that disposition, the staff considered if goodwill should be allocated to the property disposed, and, if so, whether that allocated goodwill should remain as a component of the capitalized full cost center or be reflected in the statement of operations. The staff notes that Rule 4-10(c) of Regulation S-X only addresses the accounting for exploration and production costs and expenses and does not contemplate the recognition of goodwill. Conversely, in connection with the acquisition of oil and gas properties that constitute a business, SFAS 141 (APB 16) requires that fair value be allocated to those properties and other identifiable assets with only the excess purchase price recognized as goodwill.
The staff concluded that Rule 4-10(c) of Regulation S-X should be applied literally and, as a consequence, only the fair value allocated to the oil and gas properties in a business acquisition should be included in the costs accounted for under that Rule. Goodwill associated with acquisitions of oil and gas properties that constitute a business is recognized in accordance with SFAS 141 but accounted for outside of the full cost rules. Therefore, when dispositions of these properties occur, the goodwill previously recognized does not affect the associated adjustments contemplated under Rule 4-10(c)(6)(i). Rather, the accounting for the goodwill and any potential impairment should follow the provisions of FASB Statement No. 142, Goodwill and Other Intangible Assets (SFAS 142). You should consider whether a property disposition that results in a less than 25% alteration of the proved oil and gas reserve quantities within a given cost center is a trigger that requires goodwill be evaluated for impairment under SFAS 142. Note that the staff has not yet addressed whether any portion of goodwill should be allocated to a disposition of greater than 25%, but less than 100%, of the oil and gas reserves in a given cost center, and companies in this circumstance should consult with the staff.
If you have any questions regarding this letter, please call Leslie Overton at (202) 942-2960 or Barry Stem at (202) 942-1870.
Carol A. Stacey
1 Proposed FSP FAS 19-a was posted for comment on the FASB's web site on February 4, 2005.