MODULE 3 HISTORICAL EVOLUTION OF ACCOUNTING PRINCIPLES AND PRACTICES

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1 MODULE 3 HISTORICAL EVOLUTION OF ACCOUNTING PRINCIPLES AND PRACTICES

2 OUTLINES Unique features of Oil and Gas Accounting Accounting Concepts, Principles and Standards in Petroleum Accounting Classification of Costs Methods of Accounting Chart of Account

3 Unique Features of Oil and Gas Accounting The major characteristics of oil and gas are as follows: 1. High Exploration Risk and Uncertainty: The risk associated with oil and gas production are: a. Risk in locating new oil well site and exploration which involves drilling to confirm oil presence in commercial quantity, since oil is not a surface affair but hidden underground. b. Geological risk or recoverable reserves risk which is the risk of not finding oil in a large commercial quantity. c. Market risk: this includes risk of market acceptability due to quality of product and unfavoured dwindling oil prices. Crude oil is of different quality and could be rejected in the world market if it falls short of the required quality. d. Political Sovereign Risk: This is the risk of exploring oil in a calm political atmosphere. Where oil is discovered and exploration is going on but unfavourable politics emanated, it may lead to loss of investment. e. Economic Risks: These types of risks are economic related risks like inflation, unexpected changes in tax policies, monetary policies, currency devaluation, fluctuation in exchange rate e.t.c

4 Unique Features of Oil and Gas Accounting cont. 2. World Economic Dominance of Oil and Gas: The high return in this industry is what informs the dominance in the world economy. it is dominance in terms of; a. Financial figure or returns: Government earns huge sums of money from oil and gas business, hence, it attracts great interest in almost all the countries in the world as there are a lot of bye product from its production apart from the oil and gas such as jelly, pesticides and insecticides. Influences in global economy: Where the best quality and accepted oil economy tends to dictate policies in the world oil markets and other policies and decisions. A country with oil reserves in commercial quantity is highly respected in the country of nations.

5 Unique Features of Oil and Gas Accounting cont. c. Politics: In West Africa for instance, Nigeria dominated the political discussion in forming a West African Monitoring Group (Ecomog - an Intervention force), which led to the hard earned peace in Liberia today to give an example, where Leaf- Johnson is currently the head of government. Also, the discovery of oil in large quantity in Nigeria gives her a prominence in Economic Community of West African State (ECOWAS). Nigeria is the major financier of ECOWAS today and this is not unconnected with the huge revenue Nigeria generates from oil. d. Social: Oil and gas industry is an industry that has specially created great wealth for and a large employer of labour in the whole world as it has an unlimited potential as raw materials are in abundance hence, it has great impacts on people which tends to attract people into the business.

6 Accounting Concepts, Principles and Standards and Standards in Petroleum Accounting Financial accounting is not an end in itself. It provides information to the various users of financial statements. Many of these users have conflicting information needs. Over the centuries, during which the financial accounting profession has developed, a body of principles has evolved to regulate the practice of the profession so that the preparation of financial statement is guided by consistent and acceptable principles. These principles known as concepts are so fundamental that their application has come to be taken for granted. They have been accepted and issued in the form of accounting standards by such bodies as the International Accounting Standards Committee (IASC) and Nigeria Accounting Standards Board (NASB). The basic concepts are: 1. Going Concern Concept; the assumption is that the business unit will operate in perpetuity that is; the business is not expected to be liquidated in the foreseeable future. A business is considered a going concern if it is capable of earning a reasonable net income and there is no intention or threat from any source to curtail significantly its line of business in the foreseeable future. Without this assumption, application of the historical cost concept would not make sense at all.

7 Accounting Concepts, Principles and Standards and Standards in Petroleum Accounting..cont. For example, if there is evidence suggesting that the firm is about to be liquidated, the assets would no longer be carried at cost. Rather, the assets would be restated to their realizable values. 2. Periodicity: Although the results of a business unit cannot be determined with precision until its final liquidation, the business community and users of financial statements require that the business be divided into accounting periods (usually one year) and that changes in position are measured over these periods. In compliance with this concept, the trading and profit or loss of a business organization, which is now referred to as statement of comprehensive incomes, is prepared for the year ended, i.e. every 12 months, except in the following instances i. The first final accounts after commencement of business ii. The last final accounts up to cessation of business, and iii. When there is a change to a new accounting period

8 Accounting Concepts, Principles and Standards and Standards in Petroleum Accounting..cont. Also, the statement of financial position is prepared to show the financial position of the firm at the end of every year. 3. Entity Concept; every economic unit, regardless of its legal form of existence, is treated as a separate entity (in accounting) from parties having proprietary or economic interest in it. 4. Realization Concept; the concept establishes the rule for the periodic recognition of revenue as soon as i. It is capable of objective measurement and ii. The value of assets received or receivable in exchange is reasonably certain. iii. It is possible to recognize revenue at a variety of points. 5. Matching; the concept holds that for any accounting period, the earned revenue and all the incurred costs that generated that revenue must be matched and reported for the period. If revenue is carried over from a prior period or deferred as the case may be.

9 Accounting Concepts, Principles and Standards and Standards in Petroleum Accounting..cont. 6. Consistency; usually there is more than one way in which an item may be treated in the accounts without violating accounting principles. The concept of consistency holds that when a company selects a method, it should continue (unless conditions warrant a change) to use that method in subsequent periods so that a comparison of accounting figures over time is meaningful. The concept ensures that the accounting treatment of like items is consistent taking one accounting period with another. 7. Historical cost; this concept holds that cost is the appropriate basis for initial accounting recognition of all the assets acquisitions, services rendered/received, expenses incurred, creditor s and owners interest; and it also holds that subsequent to acquisition, cost values are retained throughout the accounting process. 8. Substance over form; although business transactions are usually governed by legal principles, they are nevertheless accounted for and presented in accordance with their legal form. The aim of this convention is to prevent firms from distorting their results by dogmatically following the letters of the law instead of showing the substance of the enterprise s transactions.

10 Accounting Concepts, Principles and Standards and Standards in Petroleum Accounting..cont. 9. Objectivity: This principle connotes independence of judgment on the part of the accountant preparing the financial statements. Objectivity requires supports by verifiable evidence in constract to subjectivity or dependence on the unverifiable opinion of the accountant preparing the financial statement. 10. Fairness; this is the extension of the objectivity principle. In view of the fact that there are many users of accounting information, all having differing needs, the fairness principle requires that accounting reports should be prepared not to favour any group or segment of society. 11. Materiality; The principle holds that only items of material values are accorded their strict accounting treatment. An item will be considered material if its omission or misstatement could distort the financial statement such that it influences the economic decisions of users taken on the basis of the financial statements. 12. Prudence; This principle demands exercising great care in the recognition of profit whilst all known losses are adequately provided for. This is however not a justification for the creation of secret or hidden reserves

11 Classification of Cost In the oil and gas industry, costs are classified either by nature and function of the costs namely Prospecting costs Acquisition costs Exploration and appraisal costs Development costs Production costs and Supporting facilities and equipment costs Or by the physical characteristics of the assets acquired namely; Tangible costs, and Intangible cost Classification by Nature and Function of the Costs Prospecting costs; these are costs incurred when the real searching for oil are carried out. This is done by the specialists who know things about oil and gas matters Acquisition costs; these are incurred to purchase lease or otherwise

12 Classification of Cost.cont. acquire a property (whether proved or unproved). Example includes the cost of signature or lease bonuses, options to purchase or lease properties, brokerages, legal fees e.t.c. Exploration and Appraisal cost; these are costs incurred to explore (discover) oil before oil reservoir is developed. Examples include costs associated with geological, geophysical, and other pre-drilling costs including remuneration of personnel involved. It also include costs of drilling, dry holes and bottom hole pressure enhancement. It also includes depreciation, amortization and allocated operating costs of support equipment facilities Development costs; these are costs incurred to gain access to proved reserves and provide facilities for drilling, lifting, treating, gathering and storing of oil and gas. They include depreciation and allocated operating costs of support equipment facilities. Production cost; these are costs incurred in lifting, treating, gathering and storing oil and gas. They include costs of personnel engaged in operation of wells and related equipment facilities, repairs and maintenance of production facilities materials, supplies, insurance, services and fuel consumed in such operations. They also include allocated operating costs of support equipment facilities but do not include DD & A of license acquisition, exploration and development costs and costs of decommissioning.

13 Classification of Cost.cont. Supporting facilities and equipment costs; these are costs relating to trucks, drilling equipments, workshops, warehouses, camps division and field offices. Usually, these facilities and equipment serve one or more activities relating to acquisition, exploration, development and production. These costs are therefore capitalized and apportioned to the different activities. Tangible and Intangible Cost Tangible costs are costs of assets, like machinery, equipment, vehicles, which have physical properties (including the costs of labour to install them even though those costs do not result in a physical assets). On the other hand, intangible costs are costs that result in assets that have no physical properties, or assets that have physical properties but cannot be salvaged at the end of an operation e.g costs of drilling paid to contractor, labour for clearing services such as acidizing, fracturing and thermal processes.

14 Method of Accounting In oil and gas accounting, there are three methods namely; 1. Successful Effort Method (SEM) 2. Full Cost Method (FCM) 3. Reserves Recognition Accounting Method (RRAM) Out of the three methods listed above, only two (i.e. SEM and FCM) are frequently used for preparing and accounting for oil and gas operation 1. Successful Effort Method; as the name implies, successful effort method is a method that capitalizes costs that are successful in the statement of financial position of the oil and gas industry. All other effort (costs) that are not successful is expensed into the statement of comprehensive income of the firm. 2. Full Cost Method; this method capitalizes all costs whether successful or not. As a result of this, FCM over capitalizes costs over and above the reserves that will be utilized to recoup the costs. This is the reason why oil companies making use of FCM calculates ceiling test on capitalized costs.

15 Method of Accounting.Cont Reserves Recognition Accounting Method; RRAM is a proposition of Security and Exchange Commission (SEC) in United State of America (USA) due to the claim that none of either successful or full cost methods gives meaningful result of operation of oil and gas company. In this method, SEC proposition on RRAM is that an enterprise would be allowed to recognize the value of proved oil and gas reserves as assets and changes in such reserves values as earning in the financial statements.

16 Chart of Accounts There exists typical chart of accounts for a successful efforts company and a full cost company. The differences between the two charts highlight the differences between the methods of accounting for oil and gas. The chart of account for a successful efforts company shows some of the following accounts: A/C 8000 Exploration expenses 8002 Cost of carrying and retaining undeveloped properties 8003 Test well contributions 8004 Unsuccessful exploratory wells 8005 Unsuccessful exploratory stratigraphic wells These accounts do not appear in the chart of accounts of a full cost company since all exploratory costs, whether they result in reserves or not are usually capitalized by a full cost company. The chart of account for a full cost company shows some of the following accounts:

17 Chart of Accounts.Cont. A/C 8000 Administrative and general expenses 8001 Office Salaries 8002 Other Salaries 8003 Rent 8004 Office Supplies; etc.