Fuelling speculation on oil and gas reserves?

The valuation and stakeholder focus in an exploration and production company (EPC) is completely on its oil and gas reserves. These are measured either on a participating interest basis or an entitlement interest basis. Different enterprises follow different practices, which have a significant impact on financial statements.

EPCs usually form joint ventures with other players in the industry. The partners enter into a production sharing contract with the Government that specifies their rights and obligations with respect to the exploration/ development/ production activities at the hydrocarbon block.

After profit petroleum

The contract also spells out the interest that each of the venture partners would have in the block, which is generally referred to as the Participating Interest or Working Interest. The venture partners generally share all expenditure and revenues from the block in the ratio of their respective PIs. The Government is entitled to a share of revenue (in the case of a producing block), which is referred to as profit petroleum.

Profit petroleum is often paid as a percentage of profits, and the percentage is usually a progressive one — that is, it increases with increasing profit according to the terms of the contract. Consequently, the venture partners' revenues are reduced.

The share of revenue accruing to the venture partners after payment of profit petroleum and adjustments to cost recovery is referred to as the Entitlement Interest. The Government's share in revenues from oil and gas activities is usually large, sometimes as high as 70 per cent. Understandably, the impact of EI and WI on financial statements can be significant.

Basis of disclosure

The Guidance Note on Accounting for Oil and Gas Producing Activities requires enterprises to disclose their interests in proved reserves and proved developed reserves of oil and gas. However, the note doesn't state explicitly whether such an interest should be disclosed on WI or EI basis. Consequently, the quantum of reserves disclosed by an enterprise, which is an important piece of information in a financial statement, may not be comparable between entities.

A similar dichotomy exists in the accounting of revenue, inventory and depletion cost. The cost of depletion, which is significant in an EPC, is dependent on the reserves under consideration and the use of different basis may yield significantly different results. A related issue is whether an enterprise should present its revenues on WI or EI basis.

Under WI, a company will present gross revenue, including the profit petroleum share of Government and present profit petroleum payable, as expense. Under EI, a company will only recognise net revenue. While this may not impact profits, it will impact the top-line.

The calculation of EI would entail significant assumptions, the most important being the price of crude, which is very subjective. But with adequate disclosure of the assumptions, it will make greater sense to those reading the financial statement.

The Institute of Chartered Accountants of India may consider clarifying this aspect in the revised Guidance Note on Accounting for Oil and Gas Producing Activities.

(Naman Agarwal is a senior professional in a member firm of Ernst & Young Global. )