Accounting for Administrative Overhead In oil and Gas Upstream Industry

Accounting for Administrative Overhead In oil and Gas Upstream Industry Hamdy Rashed, CMA; CAPM Bsc of Accounting and Auditing,, E-mail: hamdyrashed1@yahoo.com, Website: http://www.accountingsoul.com/ Dated on March 09, 2012 Abstract We suggest in this paper a framework to improve some accounting practices for how recognizing administrative overhead that is allowed by Production Sharing Contract (PSC) and Joint Operating Contract (JOC). Also, in our below discussion, we don t say which practice is correct or incorrect because the practices are depend on two factors such as legal contractual terms, and criteria of revenue recognition, we provide a guidance for how to recognize the administrative overhead that is allowed by PSC and JOC in oil and gas exploration and production industry. We start referring to the some terms of IASs, PSC, and JOC that can help us in the below suggestion. Keywords: Administrative overhead, PSA Overhead, JOA overhead, and Operator Overhead. The overhead is an axis of accountants or auditors attention in oil and gas industry which can be a disputed item between government and contractors and even between operators and nonoperators. Therefore, we need to know how the overhead is accounted for in joint accounts and in corporate accounts. First we need to define some common words are used in PSC and JOC. Contractor is stated in PSC and referred to the foreign investor that sign on PSC or is jointly and collectively foreign investors that sign on PSC. Operator is more common stated in JOC and referred to one of the jointly foreign investors that is responsible for operating the lease/acreage based on signed JOC. Non-Operator is a party other than operator. Affiliated Company is any company constitute a contractor or operator which may meet one of the following criteria based on the PSC or JOC; a. controls contractor or operator, or b. is controlled by contractor or operator, or c. controls or is controlled by a company which controls a contractor or operator, or d. in which the majority of voting rights is owned directly or indirectly by Contractor or operator or e. which is Contractor or operator directly or indirectly own a majority of righting votes at meetings. f. which is Contractor or operator directly or indirectly own a majority of righting votes of equity. Some PSC and JOC define the majority of voting rights or controls as the right to exercise 50% of voting rights. Many of us may have questions about 1

a- Is the Operator s overhead that is allowed by JOC recordable? b- Is the administrative overhead that is allowed to be recovered per JOC is recordable? c- How to record the allowable overhead based on JOC? d- How to record the allowable overhead based on PSC? As we know that operator s indirect costs are not allowed to be charged to joint accounts, but most of international joint operation (JOCs) indicate that operators are allowed to recover part of their indirect charges that is incurred in return of operator s headquarters or affiliated companies contribution services for the lease/acreage but in condition that the reimbursed operator overhead should not be used for creating profit for operator which is required in some JOCs, therefore, the excess should be returned back to non-operators. How the operator s overhead is accounted for based on most of international JOC and IFRS? The accounting for operator overhead varies based on different accounting procedures and text in the JOCs. Most of JOCs may be stated either as follow 1) "a) An Indirect Charge is to compensate Operator's home office, for its administrative contributions of performing services that is not to be considered as direct charge for the benefit of Joint lease/acreage b) shall be charged to the Joint Account. The Indirect Charge is calculated by following percentages...c) If the allowed minimum overhead exceeds the actual operator overhead, the excess should be refunded to nonoperating parties or applied as credit against indirect charges. d) The portion of all joint account costs or credits shall be charged to each party. Each party s paying interest share of cost paid shall be debited or credited to its accounts in the joint account records... " 2) "a)the operator is allowed to recover its indirect charges of its parent or affiliates for the administrative contributions for supporting joint venture by charging the non-operator by the allowed overhead which is calculated as follow...b) and exclude the allowed overhead for measuring net income or loss or b) All liabilities and costs or income incurred by operator in connection with joint operations should be charged to or credit to joint accounts shall be shared by parties based on paying interests except for operator overhead shall be 100% payable to non-operator to compensate the operator by the fully allowed overhead amount and non-operator pay it proportionately based on their paying interest" 3) a) Operator shall be compensated for cost not chargeable as direct charges that are incurred in connection with and in support of Joint Operations... b) Operator shall charge the Joint Account at the following rates 4) a) Operator shall charge the joint account periodically for the cost of indirect services and related office cost s of operator and its affiliates...indirect costs chargeable represent the cost of general counselling and support services provided by operator and its affiliate which are not practical to trace them to or associate them with specific projects but they provide benefit to joint operation... b) All liabilities and expenses or income incurred by operator in connection with Joint Operations should be charged to or credited to joint accounts shall be shared by parties based on participating interests unless the contract state different share for specific items Operator s Overhead is like management fees that allow the operator to reimburse other general expenses incurred by its parent or affiliates in carrying out some activities on 2

behalf of non-operating partners and that is not covered by direct costs. The management fees are included in joint accounts as an expense and included in Operator s Corporate account as revenue that are presented in the income statement that is required by par 52 & 53 of IAS 31. However, the management fees (allowed operator s overhead) that compensate operator is considered as reduction of general and administrative costs Some companies prefer to offset operator overhead that is compensated from other partners per JOC with the actual administrative overhead but if it is practical to determine the type of expenses that needs to be reduced, otherwise, it needs to be recorded as Other income in Corporate account. Allowable fixed and even the closed sliding scale with decreasing percentage will lead operator to charge onsite (direct charges). Means, increase direct charges more than indirect charges. But the open sliding scale and variable rate will lead Contractor or Operator to increase the actual headquarters administrative overhead to compensate their overhead as much as they can. In our example, Suppose that Company X is an operator and Corporate and affiliated companies should charge Joint accounts for actual G&A cost for overhead by amount of $1,000,000, but this amount is exceed the overhead that is allowed by JOCs that by amount of $600,000. Therefore, Company X would charge joint accounts by amount of $400,000 by joint interest billing as allowed overhead (management fees) per JOCs. JOCs shows the working interest of each partners as follow; Company X's share is 60%, Company Y's share is 25% and Company Z's share is 15%, and the total direct costs that are charged to joint account $1,000,000. how much non-operators (Companies Y and Z) should pay Company X for allowed overhead? To answer the question, we need to understand how the accounting procedures in JOC treat such overhead. The above JOC s provision that are provided as example lead to different accounting practices for overhead as follow. Case 1: For the above examples no. 1, 3 & 4 of JOC provisions show that the operator share with non-operators for the allowable overhead ($400,000) and ask the non-operators to pay the allowed overhead fees based on their working interests only Joint Venture Accounts (Joint Account) Direct exploration Cost 1,000,000 Allowed Overhead 400,000 Total Cost 1,400,000 Joint Interest Billing Code Description Sub amount Total Amount 001-1 Tangible Development Cost 001-2 Intangible Development cost 100,000 300,000 001-3 Operating Expenses 600,000 002-01 Operator Overhead 400,000 Total Cost 1,400,000 Code Description Participating Interest Total Amount 100 Company X 60% 840,000 201 Company Y 25% 350,000 202 Company Z 15% 210,000 100% 1,400,000 3

Corporate accounts of operator As per IFRS Other Income (400,000) 201 Company Y 25% 500,000 202 Company Z 15% 300,000 100% 1,400,000 Total cutback exploration cost (excl overhead) 600,000 Cutback allowed overhead 240,000 Net (Income)/loaa 440,000 Corporate accounts of operator As per IFRS Other Income (400,000) Case 2: For the above example no. 2 of JOC provisions show indicate that the non-operators should 100% pay operator the amount of $400,000 to recover the allowed operator's overhead fees Joint Venture Accounts (Joint Account) Direct exploration Cost 1,000,000 Allowed Overhead - Total Cost 1,000,000 Joint Interest Billing Code Description Sub amount Total Amount 001-1 Tangible Development Cost 001-2 Intangible Development cost 100,000 300,000 001-3 Operating Expenses 600,000 Total Direct Cost 1,000,000 002-01 Operator Overhead 400,000 Total Cost 1,400,000 Code Description Participating Interest Total Amount 100 Company X 60% 600,000 Total cutback direct cost (excl overhead) 600,000 Net (Income)/loss 200,000 If the allowed overhead (management fee) is not clearly stated to include or exclude as expense in joint account, heated discussion will probably be happened because one interpretation will change the fully meanings and to be on favor of another partner. Many operators and petroleum accountants prefer to record the operator overhead as expenses in joint account and other income in Corporate account, and it is proper to record the expense in joint account and credit in contra account such as overhead expense control, and doing the accounting entries a) When the allowed overhead is billed and charged to the participants on the periodically basis, the accounting entry for allowed overhead is as follow Dr. License A - Overhead Expense Joint account Cr. License A Overhead Exp Control Contra account (Corporate Acc) or Cr. License A - Other Income (Corporate acc) b) When the operator cuts back the joint accounts to record its share of joint costs to corporate accounts, the following entry will be as follow: 4

Dr. License A Overhead Exp Control (Corporate Acc), or Dr. License A Overhead Exp (Corporate Acc) Accounts Receivables Joint Interest Billing (Corporate acc) Cr. License A - Overhead Expense Joint account (JV acc) c) When the actual administrative Corporate and affiliates overhead is allocated based on appropriate allocation method to other licenses, the accounting entry will be as follow Dr. License A Overhead Exp Control (Corporate Acc) or Dr. License A Overhead Exp (Corporate Acc) Cr. Corporate Cost Allocation Clearance (Corporate acc) Affiliates Cost Allocation Clearance (Corporate acc) d) The variance between the allowed overhead and the actual overhead is charged to License A overhead exp in Corporate accounts and could not be charged to joint account because the joint account reflect the minimum or allowed overhead that operator should charge Joint accounts. e) In the consolidated financial statements, the intercompany transactions need to be eliminated, therefore, the impact of entries in point (c) and (d) need to be eliminated, and either the overhead fees presented in revenue or to be presented in offset expenses. How the Contractor overhead is accounted for based on most of international PSCs? The administrative overhead that is stated in many international Production Sharing Contracts (PSCs), the PSCs varies from country to another, but there are many similarities in administrative overhead among those PSCs. Some PSCs allow Contractor to recover for reimbursing certain defined general and administrative expenses in respect of services rendered outside of the host state by affiliated entities and in variable amounts based on opened sliding scale percentage that has not limit or ceiling for recoverability that could be vary over the life of the operations. The recoverability of contractor cost overhead is split between the operator and non-operators based on their participating interests (paying interests). How the contractor overhead that is allowed by PSCs is presented in the operator s financial statements and Should such overhead fees be recorded in the operator s corporate accounts or even joint account? In fact, Most of oil companies do not record such overhead because it is already reported revenue which included in cost oil that is itself included in revenue when it is sold. It is not preferred to record such overhead either during exploration phase or production phase because under exploration phase there is no adequate certainty for economic benefit associated with recovering such cost will flow to the company which the main criteria of revenue recognition is probable economic benefit will flow to entity is not met in this stage because the probable of recovering overhead per PSC is adherent to probability of oil discovery and entering production stage, and many of lease/acreage has less 40% probability of oil discovery and production entrance, and this degree of uncertainty is very high that make revenue recognition is not probable and it is between reasonable possible and remote. Therefore, it is not appropriate to recognize the revenue in this stage, even though it is totally offset with the cutback expenses because even the recording its expense is not appropriate. Expense or loss is recognized when a) it is probable economic benefits will outflow from entity, b) it is probable for depleting assets or c) incurrence of liabilities, therefore, overhead exp that is allowed by PSC to compensate Contractor does neither caused by incurrence of liabilities, depleting of assets and outflow of economic benefit. In author s opinion, it is not appropriate to record revenue and expenses for recovery overhead allowed by PSC, and the criteria of 5

recognizing those items have not been met. And recording them in the records even though it has nil effect in the financial statements will lead to complicated intercompany transactions and provide irrelevant financial information by showing that entity s generating unreal income, even if it is offset with unreal expenses. JOC between four parties operated block in Yemen JOC between two parties operated block in Yemen Under production stage, The Contractor recover their cost including their overhead but within the limit that is allowed by PSC via cost oil that is measured in quantity of barrels which is sold along with profit oil share and recorded in the revenue, therefore, no need to record the Contractor overhead allowed by PSC in the accounting books of either operator s book or non-operator s because if we did so, it will overstate the income by unreal revenue and overstate the expense by unreal expense, and complicate the intercompany transactions that may lead the affiliated Companies to make payments on behalf of each other for unreal transactions as discussed above. Some companies prefer to record the PSC allowed overhead in JV account but credit another account categorized under the same ledger and head account to clear or offset the PSC overhead expense for managerial purposes. This practice is more better than crediting other income in Corporate account. References IAS Framework IAS 18 IAS 31 Yemen PSC Kurdistan PSC Tunisian PSC 6