Tax Accounting for Oil & Gas. Tax Executives Institute

Transcription

1 Tax Accounting for Oil & Gas Tax Executives Institute December 6, 2016

2 Agenda ASC 740 Concepts Full Cost vs. Successful Efforts Cost Recovery Asset Retirement Obligations Case Study Other Considerations Wrap-Up 2

3 Learning Objectives Upon completion of this program, participants will be able to: Analyze ASC 740 general concepts Examine realistic examples of ASC 470 applications to balance sheets and income statements related to income taxes Discuss the difference between full cost and successful efforts accounting Examine cost recovery applications to various O&G properties Analyze asset retirement obligation calculations 3

4 ASC 740 Concepts

5 What is ASC 740 About? Defined: Accounting rules that companies must follow when accounting for income taxes pursuant to US GAAP, including how to measure and record the income tax accounts in the balance sheet, income statement and related disclosures 5

6 Balance Sheet Big Rig Oil & Gas Company Balance Sheet For the Years ended December 31, 20X9 and 20X8 (In Thousands) 12/31/20X9 Assets Cash $40,000 $11,500 Accounts receivable, net of allowance for bad debts 4,500 1,800 Current deferred tax assets Current Assets $44,695 $13,378 Fixed assets 15,000 15,000 Less: Accumulated Depreciation -6,000-3,000 Oil and Gas Property 61,000 0 Less: Accumulated DD&A -6, Long-term assets $64,000 $12,000 Total assets $108,695 $25,378 Liabilities Current taxes payable 1,044 - Current Liabilities $1,044 $0 ARO Liability 1,200 0 Notes Payable 60,000 Noncurrent deferred tax liabilities 8, Total liabilities $69,710 $778 Common stock 2,000 2,000 Additional paid in capital 20,000 20,000 Retained earnings 15,941 2,600 Stockholders' equity $37,941 $24,600 Total liabilities and stockholders' equity $108,695 $25,378 2/31/20X8 6

7 Income Statement Big Rig Oil & Gas Company Income Statement For the Years ended December 31, 20X9 and 20X8 (In Thousands) 12/31/20X9 Net sales $35,600 $8,800 Less: Salaries $3,100 $2,100 Payroll taxes Depreciation expense 3,000 3,000 Oil & Gas Property DD&A 6,000 Asset retirement obligation expense 200 Bad debt expense Meals & entertainment Fines & penalties Income before taxes 22,000 3,300 Tax expense 8, Net income 13,341 2,600 12/31/20X8 7

8 Cash Flow Statement Big Rig Oil & Gas Company Statement of Cash Flow For the years ended December 31, 20X9 and 20X8 (In Thousands) Operating Activities: 12/31/20X9* 12/31/20X8 Net Income 13,341 2,600 Change in deferred taxes 7, Change in bad debt Change in accounts receivable -3,000-2,000 Change in income tax payable 1,044 - Depreciation 3,000 3,000 Oil & Gas Property DD&A 6,000 0 ARO accretion Net cash provided by operating activities 28,500 4,500 Investing Activities: Capital expenditures (60,000) -15,000 Net cash provided by (used in) investing activities (60,000) -15,000 Financing Activities: Proceeds from common stock - 22,000 LT Loans 60,000 Net cash provided by (used in) financing activities 60,000 22,000 Beginning cash 11,500 - Ending cash 40,000 11,500 Supplemental cash flow information: Cash paid during the year for income taxes * Before tax provision calculations 8

9 ASC 740 General Concepts Accounting for the tax consequences of a transaction or event in the same period that it is recognized in the enterprise s financial statements ASC 740 provides: Taxes currently payable computed pursuant to applicable tax laws Guidance regarding the recognition and measurement of the future tax consequences recovering and settling the financial reporting carrying value of assets and liabilities, respectively Certain exceptions to the general rules Rules regarding disclosures Rules regarding accounting for uncertain tax positions 9

10 ASC 740 Terminology: Current Taxes Current tax payable/receivable ASC 740 does not define Tax liability or refund expected to be paid or realized during the normal operating cycle of the business (generally 12 months) Current tax provision (current expense or benefit) The amount of income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year 10

11 ASC 740 Terminology: Deferred Taxes Deferred tax asset (DTA) Generally represents a future reduction in taxes payable Tax effect of deductible temporary differences Tax effect of loss carryforwards and credit carryforwards Valuation Allowance (VA) Portion of DTA for which it is not MLTN that a tax benefit will be realized Deferred tax provision (deferred expense or benefit) Generally, change in net deferred tax asset or liability including changes in valuation allowance Deferred tax liability (DTL) Generally represents a future increase in taxes payable Tax effect of taxable temporary differences 11

12 ASC 740: Income Taxes Balance Sheet Approach Compute the income tax provision (tax provision) for each taxpaying component of an entity and by jurisdiction Current taxes payable or refund receivable Follows the same calculation process as preparing the tax return Deferred tax assets or liabilities recorded for the tax effects of the differences between the book and tax bases of assets and liabilities and tax attribute CF determined based upon the recognition and measurement requirements for tax positions Expected future tax effect of temporary differences and CFs Unrecognized tax benefits Measure based upon enacted tax laws and rates Reconcile and adjust GL accounts to computed balances 12

13 Balance Sheet Presentation DTAs and DTLs Deferred tax assets and liabilities are classified as current or noncurrent based on the classification of the related asset or liability that gives rise to a temporary difference or carryforward for financial reporting purposes A deferred tax asset or liability that is not related to an asset or liability for financial reporting purposes is classified based on the expected reversal For a particular tax-paying component of an entity and within a particular tax jurisdiction, all current deferred tax liabilities and assets shall be offset and presented as a single amount and all noncurrent deferred tax liabilities and assets shall be offset and presented as a single amount (ASC ) An entity shall not offset deferred tax liabilities and assets attributable Note: On October 5, 2015, the FASB finalized its ASU No which requires companies to different to classify tax-paying all deferred components taxes as noncurrent. of the For entity public or companies, to different the new tax provisions jurisdictions will be (ASC effective ) for annual periods beginning after Dec. 15, However, early adoption will be allowed for all companies. 13

14 Summary of E&P (Upstream) Business Processes Acquisition Exploration Development Production Plugging and Abandonment Activities Acquire rights to minerals Obtain lease(s) Geological and geophysical work Drilling exploration well(s) Evaluate formation Drill development wells Well completion, casing, and cementing, Christmas tree Treatment, processing, and transporting to market Removal of equipment and casings, sealing and capping well, site restoration 14

15 Full Cost vs. Successful Efforts

16 Full Cost vs. Successful Efforts Primary difference in the two accounting methods is the manner in which costs are capitalized and the methods of impairment of such costs; this difference in turn creates a significantly different balance sheet Pros and cons of the two approaches are hard to define as the application of such accounting would be different for various companies depending on their overall success in the drilling program Perceived notion would be that successful efforts portrays a reflection of truly productive assets on the balance sheet by not allowing for the capitalization of cost associated with exploratory dry holes In contrast, full cost would look to the balance sheet and conclude that the productive asset is the total oil and gas reserves and reflects all costs incurred to obtain such reserves 16

17 Acquisition: The Lease Land Department acquires the rights to develop properties from the mineral owners, usually via a lease GAAP Treatment: Acquisition Cost of Land/Lease Bonus Successful efforts Full cost Tax Accounting Capitalize Capitalize Capitalize Delay rentals (deferral payment) Expense Capitalize Capitalize Cost Recovery - Depletion Expense Expense Expense Leasehold Cost Impairment Expense Expense Depends * Impairment valuation allowances for unproved properties Expense Capitalize to full cost pool, assess for impairment Lease bonus is paid to the lessor in return for rights to explore; drill wells Primary lease term: Time allowed to commence drilling (usually negotiable 2, 5 or 7 year terms are common) Royalty provisions: Lessors retain a royalty interest in the minerals (negotiable) Delay rentals: Payment to defer commencement of drilling Held by production * Taxpayers are generally allowed to deduct, as an ordinary loss, under Code Section 165, the adjusted basis of those interests in oil and gas properties that have been proven to be totally worthless during the tax year, subject to unit of property determinations. NA 17

18 Exploration GAAP Treatment: Geological and Geophysical Costs: Study and testing of surface rocks Seismic survey (2D, 3D, and 4D) Drilling test wells Testing core samples from non-producing strata in existing wells Magnetic surveys Infrared detection Successful efforts Computer aided geological modeling and reservoir simulation Full cost Tax Accounting Geological and geophysical costs Expense Capitalize Capitalize Proved reserves found (exploratory wells) Proved reserves not found (exploratory wells) Capitalize Expense Capitalize Capitalize Expense/ Capitalize Expense/ Capitalize Exploration Well: After determining a drilling location based on the G&G data, a well is drilled to analyze various rock layers to determine which layers potentially contain oil and natural gas Formation Evaluation: Logging the well to confirm or disprove the decision to drill based on seismic data 18

19 Development Hole is lined with casing pipe to provide a conduit from the surface to the producing formation GAAP Treatment: Successful efforts Full cost Tax Accounting Proved reserves, successful (development wells) Capitalize Capitalize Expense/ Capitalize* Proved reserves, dry hole (development wells) Capitalize Capitalize Expense/ Capitalize* Development: If the reservoir looks promising based on the exploratory well, additional production wells will be drilled; an exploratory well may also become a production well Completion: Once casing is set in the hole, it is cemented in place; a Christmas tree is added, along with equipment necessary to produce the well * An analysis of costs should be performed to determine the amount of IDC and LWE. IDC is generally expensed and LW&E is capitalized. Even if a taxpayer elects to capitalize IDC, tax rules allow dryhole IDC to be expensed. 19

20 Development: Cost Recovery Hole is lined with casing pipe to provide a conduit from the surface to the producing formation GAAP Treatment: Intangible Drilling Costs Cost Recovery Lease and Well Equipment Cost Recovery Successful efforts Full cost Tax Accounting Capitalize Capitalize Expense* Expense Expense Expense * IDC costs that a taxpayer has elected to capitalize should be amortized over 60 months (120 months for foreign IDC) beginning with the month the costs are incurred. Intangible Drilling Costs: Costs that have no salvage value and that are incidental to and necessary for the drilling of wells or the preparation of wells for oil and gas production Typically representative of the single largest category of expenditures Include amounts paid for labor, fuel, hauling, rents and supplies used in drilling a well, preparing a well location, and assembling various equipment components until the Christmas tree is added and production is ready to begin Tangible Equipment Costs: Costs incurred to purchase equipment that normally has salvage value Cost include surface and production casing, wellhead equipment, tanks, pumps, separators and other machinery 20

21 Production GAAP Treatment: Lease Operating Expenses: Successful efforts Activities involved in lifting oil and gas to the surface and gathering, treating and storing them in the field These costs include in pumper cost, labor to operate the well, repair and maintenance, materials and supplies consumed, taxes and insurance These cost are typically expensed when incurred Full cost Tax Accounting Lease operating expenses Expense Expense Expense Lease operating expenses (results in additional reserves) Capitalize Capitalize Expense LOE may also include costs associated with repairing, restoring, or increasing production flow; these are referred to as workover costs Workover costs that result in drilling to new depth or increase in reserves will generally be capitalized as intangible drilling costs 21

22 Plugging and Abandonment GAAP Treatment: Successful efforts Full cost Tax Accounting Asset Retirement Obligation - creation Record Asset & Liability Record Asset & Liability NA Asset Retirement Obligation - Revisions Adjust Asset & Liability Adjust Asset & Liability NA Asset Retirement Obligation life of well Accretion Expense Accretion Expense NA Plugging and Abandonment well plugged Reduce Liability Reduce Liability Expense All properties must eventually be plugged and abandoned Companies are required to record the estimated costs associated with retiring their oil and gas producing properties (i.e., plugging and abandonment) as a present value of the future liability at the time of installation 22

23 Comparison of Methods: Example Incurred $500K of G&G costs locating prospect Acquired 500 acre lease for $100/acre Drilled exploratory dry hole for $500K Drilled successful exploratory well $800K ($200K is L&WE; $600K is IDC) Drilled development well that was dry hole for $700K ($200K is LW&E; $500K is IDC) Incurred one year of lease operating expenses of $300K 23

24 Comparison of Methods: Example (cont.) Successful efforts solution: Capitalize Expense G&G Costs $500K Acquire leasehold $50K Drill well #1 500K Drill well #2 800K Drill well #3 700K Production expense 300K $1.55 M $1.3M 24

25 Comparison of Methods: Example (cont.) Full cost solution: Capitalize all costs of $2.55M, except for LOE of $300K 25

26 Cost Recovery

27 Cost Recovery O&G Property Successful Efforts Full Cost Tax Accounting LHC Capitalize to depletable base UOP Depletion Expense Delay Rentals Capitalize to depletable base UOP Depletion Capitalize to depletable base UOP Depletion G&G Expense Capitalize to depletable base UOP Depletion Domestic: Capitalize, amortize over 24 months Foreign: Capitalize to depletable base, UOP depletion IDC Capitalize to depletable base UOP Depletion Capitalize to depletable base UOP Depletion Domestic: Expense/Elect to Capitalize and amortize over 60 months beginning in the month paid or incurred Foreign: Capitalize and amortize over 120 months beginning in the month paid or incurred Well Equipment Capitalize to depletable base UOP Depletion Capitalize to depletable base UOP Depletion Capitalize MACRS depreciation 7yr life Elect UOP depreciation 27

28 GAAP DD&A: Full Cost Amortization of capitalized costs is generally calculated based upon the unit of production methodology Full Cost: Amortization base includes the sum of capitalized costs net of accumulated DD&A, estimated future development costs applicable to proved undeveloped reserves, estimated dismantlement, restoration, and abandonment costs Amortize over proved developed and undeveloped reserves (total proved)* Formula: Amortization Base Accum Amortization times the ratio: Current Production Volume (Current Production Volume + Ending Reserves*) *proved developed and undeveloped reserves 28

29 GAAP DD&A: Successful Efforts Successful Efforts: Assets are grouped by field or reservoir or individual property Acquisition (mineral property) costs are amortized over total proved (proved developed + proved undeveloped) reserves Proved property well and development costs plus estimated future costs of site restoration (net of salvage) are amortized over proved developed reserves Okay to exclude costs of projects in progress Unacceptable to include future development costs Formula: Amortization base Accum Amortization times the ratio: Current Production Volume (Current Production Volume + Ending Proved Developed Reserves) 29

30 Asset Retirement Obligations

31 Asset Retirement Obligations GAAP Properties must eventually be plugged and abandoned Companies are required to record the estimated costs associated with retiring their O&G producing properties as a liability at the time of installation ARO Liability is offset by an equal ARO Asset, recorded to fixed assets ARO Accretion: Liability is accreted over the expected life of the property Tax ARO accretion is disallowed for tax purposes A deduction is allowed in the year cash payments are made to plug and abandon wells 31

32 Asset Retirement Obligations (cont.) ARO Cash Flow Analysis Estimated cash outflow $(100,000) Discount factor using 5% discount rate ARO at December 31, 2010 $ (78,353) 230 Capitalized Asset Retirement Cost (ARC) 78, Asset Retirement Obligation (ARO) 78,353 Source: Brady, Chang, Jennings and Shappard. (2011). Petroleum Accounting Principles, Procedures, & Issues. Denton, TX: Professional Development Institute. 32

33 Asset Retirement Obligations (cont.) Calculation of Incremental ARO Upward revision of cash outflow $ (20,000) Discount factor using 6% discount rate Incremental ARO at December 31, 2011 $ (16,792) Calculation of Accretion Expense 2011 ARO at December 31, 2010 (Figure 20-1) $ 78,353 Discount rate when ARO incurred x 5% 2011 accretion expense $ 3, Accretion Cost on ARO 3, Asset Retirement Obligation (ARO) 3,918 To record accretion expense for 2011 Source: Brady, Chang, Jennings and Shappard. (2011). Petroleum Accounting Principles, Procedures, & Issues. Denton, TX: Professional Development Institute. 33

34 Asset Retirement Obligations (cont.) Calculation of ARO due to Timing Change in Cash Outflows Undiscounted future cash outflows $ 100,000 Discount factor using the same credit-adjusted risk-free rate used in the establishment of the original ARO (5%) reflecting the revised three-year expected accretion period Revised ARO balance to be recognized as of December 31, ,384 Current ARO balance after recognizing 2011 accretion expense ($78,353 + $3.918) (82,271) Additional ARO to be recognized as of December 31, 2011 $ 4, Capitalized Asset Retirement Cost (ARC) 20, Asset Retirement Obligation (ARO) 20,905 To record additional asset retirement costs associated with the change in the estimated timing ($4,113) calculated in Figure 20-4 and the estimated ARO cash outflows ($16,792) calculated in Figure Calculation of ARO at Year-End ARO recognized at inception $ 78, accretion recognized 3,918 Additional ARO recognized in ,905 Carrying value of ARO at December 31, 2011 $103,176 Source: Brady, Chang, Jennings and Shappard. (2011). Petroleum Accounting Principles, Procedures, & Issues. Denton, TX: Professional Development Institute. 34

35 Case Study

36 Big Rig Oil & Gas Company Case Study Facts and Assumptions: Big Rig Oil & Gas Co. is a US public company that began business in 20X8 Assume US tax rate of 35% and ignore any graduated tax rate Big Rig operates in one state that has a statutory tax rate of 6% Refer to Big Rig s trial balance Tax>book depreciation is $2,000 and $2,000 in 20X8 and 20X9, respectively Tax basis in Oil & Gas Property is provided Tax depletion in excess of basis is $100 Pre-tax book income in 20X9 is $22,000 Objective: Calculate all 20X9 income tax accounts (20X8 amounts are provided): Income taxes payable/receivable Deferred tax assets/liabilities 36

37 Trial Balance Big Rig Oil & Gas Company Trial Balance For the Years ended December 31, 20X9 and 20X8 (In Thousands) 12/31/20X9* 12/31/20X8 Cash 40,000 11,500 Accounts receivable 5,000 2,000 Bad debt allowance Fixed assets 15,000 15,000 Accumulated depreciation -6,000-3,000 Oil & Gas Property 61,000 0 Accumulated DD&A on Oil & Gas Property -6,000 0 Deferred Tax Assets Current tax payable - - Deferred tax Liabilities Asset Retirement Obligation Accrual -1,200 - LT Notes Payable -60,000 - Common stock -2,000-2,000 Additional paid in capital -20,000-20,000 Retained earnings Beginning of year -2,600 - Revenue -35,600-8,800 Salaries 3,100 2,100 Payroll Taxes Bad Debt Expense Depreciation 3,000 3,000 Oil & Gas Property DD&A 6,000 - Meals & entertainment (50% deductible) Accretion Fines & penalties (non-deductible) Income Taxes * Before tax provision calculations 37

38 Big Rig Oil & Gas Company Case Study Tax Oil & Gas Property Basis at 12/31/2009 O&G Property Gross Tax Basis Accum DD&A Net Tax Basis Assumptions LHC 18, ,100 Tax Depletion Rate of 5% G&G - US 6,000 1,500 4,500 IDC - US Expensed/Incurred in Jan Well Equipment 6, ,143 Total O&G Property 30,000 3,257 26,743 38

39 Prepare Current Tax Payable/Expense Step 1: Prepare current tax payable/expense Federal 12/31/20X9 State Pre-tax income 22,000 22,000 State tax - current 0 Permanent differences Meals & entertainment Fines & penalties Percentage depletion in excess of basis Temporary differences Depreciation - book 3,000 3,000 Depreciation - tax -5,000-5,000 O&G Property DD&A - book 6,000 6,000 O&G Property DD&A - tax -3,257-3,257 Intangible Drilling Costs -30,000-30,000 ARO Accretion Bad Debt Allowance - prior year Bad Debt Allowance - current year Taxable income -6,507-6,407 Tax rate 35% 6% Current tax payable/expense (2,277) (384) 39

40 Prepare Current Tax Payable/Expense (cont.) In the previous slide, there was a loss of ($6,507) in 20X9; resulting in the following: Expense/(benefit) (2,277) (384) However, we have to ask ourselves: May the current period loss be carried back? Were taxes paid in the carryback period that may be refunded? May the loss be carried forward to reduce taxes payable in future years? If there are no prior taxes to refund and the losses carry forward, the benefit is recorded as a deferred tax benefit, assuming it is expected that the related deferred tax asset will be realized. 40

41 But What about AMT? Alternative Minimum Tax paid results in a credit available for future years Thus, a common Temporary Difference that also exists for O&G companies is AMT Big Rig Oil & Gas expensed IDC of $30,000 and calculated the following AMT: Regular Taxable Income/Loss (6,507) AMT Depreciation Adjustments 1,000 IDC Preference 10,726 Alternative Minimum Taxable Income 5,219 AMT 1,044 What is the result? 41

42 Prepare Deferred Taxes: State Step 2: Prepare deferred taxes Temporary Differences State 12/31/20X8 CY Change 12/31/20X9 Fixed assets (2,000) (2,000) (4,000) Oil & Gas Property - (27,257) (27,257) ARO Bad debt allowance Net Operating Loss 6,407 6,407 (1,800) (22,350) (24,150) DTA/(DTL) - State 12/31/20X8 CY Change 12/31/20X9 Classification Fixed assets (120) (120) (240) Non-current Oil & Gas Property - (1,635) (1,635) Non-current ARO Non-current Bad debt allowance Current Net Operating Loss Non-current (108) (1,341) (1,449) 42

43 Why Are State Deferreds Calculated First? There is a federal benefit for state taxes paid because state taxes are deductible in calculating federal taxable income There is also a federal benefit or detriment related to future state taxes (Benefit) State DTA Federal DTL (Detriment) (Detriment) State DTL Federal DTA (Benefit) Notice the state DTAs/DTLs were calculated using the state statutory rate of 6% 43

44 Prepare Deferred Taxes: Federal Temporary Differences Federal 12/31/20X8 CY Change 12/31/20X9 Fixed assets (2,000) (2,000) (4,000) Oil & Gas property - (27,257) (27,257) ARO Bad debt allowance Net Operating Loss 6,507 6,507 AMT Credit 1,044 1,044 State net current DTA/DTL (12) (18) (30) State net noncurrent DTA/DTL 120 1,359 1,479 (1,692) (19,865) (21,557) DTA/(DTL) - Federal 12/31/20X8 CY Change 12/31/20X9 Classification Fixed assets (700) (700) (1,400) Non-current Oil & Gas property - (9,540) (9,540) Non-current ARO Non-current Bad debt allowance Current Net Operating Loss - 2,277 2,277 Non-current AMT Credit - 1,044 1,044 Non-current State net current DTA/DTL (4) (6) (11) Current State net noncurrent DTA/DTL Non-current (592) (6,274) (6,867) 44

45 Prepare Summary of Total Tax Expense Step 3: Summary of total tax expense Current tax expense Federal 1,044 State - Total current tax expense 1,044 Deferred tax expense Federal 6,274 State 1,341 Total deferred tax expense 7,615 Total tax expense 8,659 Total tax expense = CTE + DTE CTE = Current Taxes Payable DTE = Change in Deferred Tax Assets and Liabilities 45

46 Prepare Tax Accounting Lead Sheet Step 4: Prepare tax account lead sheet DR/(CR) Federal tax payable State tax payable DTA Current DTA Noncurrent DTL - Current DTL Non-current Current tax expense Deferred tax expense Check - entries balance if zero Beginning balance 20X9 Federal current tax 20X9 State current tax 20X9 Federal deferred tax 20X9 State deferred tax Ending balance (4) (820) - - (1,044) 1, ,867 (6) (10,240) 6, (1,755) - 1,341 0 (1,044) ,305 (11) (12,815) 1,044 7,615 get the balance sheet correct and the P&L falls out 46

47 Prepare Rate Reconciliation Step 5: Prepare rate reconciliation Pre-tax income 22,000 Federal tax 7, % State tax (net of federal benefit) % Meals & entertainment % Fines & penalties % Percentage depletion in excess of basis % Total tax expense 8, % Reconciliation between the tax provision computed by applying the statutory federal rate to pre-tax book income and actual expense 47

48 Balance Sheet Big Rig Oil & Gas Company Balance Sheet For the Years ended December 31, 20X9 and 20X8 (In Thousands) 12/31/20X9 2/31/20X8 Assets Cash $40,000 $11,500 Accounts receivable, net of allowance for bad debts 4,500 1,800 Current deferred tax assets Current Assets $44,695 $13,378 Fixed assets 15,000 15,000 Less: Accumulated Depreciation -6,000-3,000 Oil and Gas Property 61,000 0 Less: Accumulated DD&A -6,000 0 Long-term assets $64,000 $12,000 Total assets $108,695 $25,378 Liabilities Current taxes payable 1,044 - Current Liabilities $1,044 $0 ARO Liability 1,200 0 Notes Payable 60,000 Noncurrent deferred tax liabilities 8, Total liabilities $69,710 $778 Common stock 2,000 2,000 Additional paid in capital 20,000 20,000 Retained earnings 15,941 2,600 Stockholders' equity $37,941 $24,600 Total liabilities and stockholders' equity $108,695 $25,378 48

49 Income Statement Big Rig Oil & Gas Company Income Statement For the Years ended December 31, 20X9 and 20X8 (In Thousands) 12/31/20X9 12/31/20X8 Net sales $35,600 $8,800 Less: Salaries $3,100 $2,100 Payroll taxes Depreciation expense 3,000 3,000 Oil & Gas Property DD&A 6,000 Asset retirement obligation expense 200 Bad debt expense Meals & entertainment Fines & penalties Income before taxes 22,000 3,300 Tax expense 8, Net income 13,341 2,600 49

50 Other Considerations

51 Ceiling Test GAAP Full cost companies calculate a Ceiling by cost center and compare that ceiling to the net capitalized costs of oil and gas properties If the capitalized costs exceed the ceiling, a permanent write-down is taken Ceiling is comprised of several components but may generally be defined as the present value of future cash flows Use 12 month average price Use 10% discount rate Performed quarterly (for public companies) or annual (non-public companies) Tax Ceiling test impairment charge is disallowed for tax purposes 51

52 Unproved Property Impairment GAAP Assess for impairment periodically (evaluate at least annually) Valuation allowances are established to reflect the reduction in value Unproved properties with individually significant costs should be evaluated on an individual property basis Tax Taxpayers are generally allowed to deduct, as an ordinary loss, under Code Section 165, the adjusted basis of those interests in oil and gas properties that have been proven to be totally worthless during the tax year Unit of Property No rights retained (e.g., no delay rentals) 52

53 Dispositions of Assets: Full Cost Discontinued Operations Assets Held for Sale Full Cost typically requires the sale of the entire FCP to record a gain/loss S-X Rule 4-10 governs the accounting for gains/losses for full cost usually no gain or loss is recognized (adjust the full cost pool) Gain/loss is acceptable if disposition is so large that would significantly alter the relationship between capitalized costs and proved reserves (threshold 25% of the reserve quantities of a cost center) 53

54 Dispositions of Assets: Successful Efforts Successful Efforts looks to the sale of a field or lowest level of utilized cash flows: Unproved property: Individual impairment test for the property or group impairment (part of a pool) Non-monetary exchanges (ASC 845): Fair value the exchange with gain/loss recognized Part of a proved property: Gain or loss is recognized (or may be treated as a normal retirement with no gain or loss if doing so does not significantly impact the DDA rate) Retirements of proved property: No gain or loss on individual well or equipment abandonments until last well on the property is abandoned or ceases to produce and the entire property is abandoned 54

55 Interest Capitalization GAAP Interest capitalized on unproved leaseholds, if exploratory activity was in progress Interest capitalization normally occurs from the first expenditure to explore the lease and continues until the property is written off or produces Full cost companies: Interest may be capitalized only for costs excluded from the amortization pool Tax Interest capitalization follows rules under IRC Section 263A (Reg A-8) Rules specific to oil and gas activities exist under Reg A-13 55

56 Joint Activities Joint Activities (Joint Ventures of Undivided Interests) Not taxed as corporations or treated as partnerships owners net share determines owners taxable income Tax only partnerships may exist where sharing arrangements do not follow ownership in the interest Joint Ventures (Joint Operations) For GAAP, owner records are proportional share of assets, liabilities, revenues and expenses Separate financials are generally not prepared for a separate entity JOA: Defines key provisions of the joint venture interests, operator, relationship of the parties, allocation of production, requirements for abandonment, insurance, development and operating costs, liabilities/litigation JOA governs joint interest billings and the non-operators right to audit Will define if arrangement is electing to be treated as a partnership for tax purposes or not 56

57 Carried Interests Common scenario: Carried party assigns some or all interest to the carrying party Carrying party pays agreed upon amount of costs of drilling the well and operating the property and is allocated these costs in return GAAP Under US GAAP, generally: No gain or loss at time of conveyance Expenditures accounted for by the party making the expenditure No entries other than the reclass from unproved to proved property are necessary for the carried party prior to payout Tax Under US Tax it depends 57

58 Farm Outs Common scenario: Original lessee assigns WI but retains overriding royalty or net profits interest in return for the assignee s agreement to perform/pay for specified drilling and development activities WI owner transfers all or part of operating rights to another party in exchange for the transferee assuming some portion of the cost of exploring or developing property GAAP No gain or loss recognized on transfer Tax Under US Tax, generally, no gain or loss is recognized where an interest was retained; GET THE FACTS! 58

59 Wrap-Up

60 Key Takeaways A basic understanding of ASC 740 is critical to success when accounting for income taxes pursuant to US GAAP Deferred taxes represent the expected future tax effects of temporary differences and carryforwards 60

61 Key Takeaways It is important to understand the difference between full cost and successful efforts Cost recovery application varies depending on the O&G property 61

62 Questions? 62

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