The PASC 2011 Accounting Procedure – The First Look (Part 3, Overhead and Administration)

The challenge of preparing an overhead discussion isn’t just to describe the process of how to charge it. That’s pretty easy; most companies’ systems already have built in processes that do it for you. The challenge comes with deciding what constitutes “administration”, and therefore determining what overhead does or does not cover.

This third blog in my series on the PASC 2011 Accounting Procedure first tries to address some of the discussion around administration costs and fees, and then reviews some of the changes to Article III on Overhead.

What is Overhead?

For all intents and purposes, overhead is supposed to cover everything that is not directly chargeable in Article II. Sounds simple, but quite often it isn’t. PASC 2011 has provided significantly more guidance on what should be considered administration than its predecessors by adding a greatly expanded definition of “Administration” and through some more specific phrasing in Article II, but there is still likely going to be some gray areas here and there. PASC 2011 doesn’t have anything like “The Grid” that was attached to the PASC 1996 Accounting Procedure (the PASC 2011 pre-amble discusses why the grid was removed), so it was of course necessary to expand on what is covered by overhead in the text of PASC 2011.

While we have more direction on which of the Operator-provided functions are to be considered overhead, we can still anticipate more discussion around the chargeability of contracted administrative services or third party administration fees.

Third Party Administration

Third party administration costs can take many different forms and might imply different things to different people. For example, they may be established in a custom processing or contract operating arrangement as a fixed fee, they may arise on vendors’ invoices as a surcharge, or there might be specific administrative activities identifiable on something like an engineering firm’s invoice. What I can say in general about PASC 2011 is that a third party’s administrative costs that support an allowable contracted service are chargeable to the Joint Account. However, if the contracted service itself is an administrative activity, it remains not chargeable.

I recently attended a PJVA early morning session titled “We Only Want Custom Processing!” In essence, the peer discussion was on whether Non-Operators should accept the third party administration/production accounting fees that often accompany contract operating or custom processing agreements. The only general consensus that I saw there was “Do unto others as you would have them do unto you,” but otherwise there was no unanimous opinion on whether these charges should be universally accepted or not.

Auditors like to use a certain phrase from Clause 207(a) of the PASC 1996 Accounting Procedure Explanatory Text (and similar phrasing also exists in PASC 1988): “Contracted services normally considered overhead shall not be charged to the Joint Account.” It is often the case that an auditor will use this clause to raise an exception if they see something that looks to be administrative in nature or would be something normally done by the Operator in-house, even if it is from a contract operating or custom processing scenario.

PASC 2011 added some more clarification in Clause 207 by indicating that the Operator may charge for the “…cost of associated reporting performed by the contract operator if required under a contract operating arrangement.” In other words, involuntary production accounting fees would be chargeable to the Joint Account, which is in line with suggestions offered by some of the members of the audit community at the PJVA early morning session. Some custom processing arrangements require that a producer hand production accounting over to the custom processor and a fee must be charged for this service if the processor wants to go through that facility. This is one example of a situation where I would suggest that the production accounting fee would be chargeable to the Joint Account.

I’d like to offer one more point with respect to the administration/production accounting fees that are charged on contract operating agreements, and I’m certain that this has already been contemplated by a number of readers of this blog. Is there anything preventing a company from agreeing to a $1,000 all-in contract operating fee, rather than a $750 contract operating fee plus a $250 administration fee? If this is the case, it becomes very difficult for an auditor to scrutinize and challenge any administrative component of an all-in contract operating fee.

A Note on Workovers

Determining whether a workover should be considered as capital or as an operating expense for the purpose of overhead calculation has been a regular challenge for joint venture accountants and auditors. There has never been specific guidance on how to treat a workover, so accountants would look at criteria like whether material has just been replaced in kind, whether the useful life of the asset has been extended, and how much money was expended on the project. This isn’t exactly an IFRS-approved guideline to make an opex versus capex decision, but a decision had to be made somewhere.

PASC 2011 now indicates that a well workover that involves up to fifteen days of rig time per well should be considered Operations and Maintenance, and workovers involving more than fifteen days of rig time should be considered as a Completion. Whether you agree or disagree with this treatment, at least the joint venture accountants now have clear documentation on how overhead should be charged on workover projects.

The Details – A Synopsis of the Article III Terms

PASC 2011 has afforded companies with a new level of flexibility by presenting two different alternatives for charging overhead to the Joint Account.

  • Alternative A:   Perhaps the easiest overhead method to administer (and the default overhead method if the election in Clause 302 isn’t filled out), Alternative A quite simply suggests a 2% overhead rate on all capital (except for Exploration, which is suggested at a 5%). On the operating side, a 10% rate is suggested on all operating costs except for property taxes, processing/transportation fees, utilities, and environmental fees, on which 2% is recommended.
  • Alternative B:    This overhead alternative offers the sliding scale overhead calculation on capital that most of us are familiar with, but with some significant changes. Across any separate type of capital project (Abandonment and Reclamation, Catastrophe, Exploration, Drilling, Completion, Construction and Equipping), the sliding scale overhead has been suggested as 5% of the first $250,000, 3% of the next $250,000, and 1% of the remainder. Whereas earlier versions of PASC required that Drilling and Completion be combined for the purpose of overhead calculation, PASC 2011 allows the Operator to reset the sliding scale for Completion projects. Notwithstanding the above, Alternative B also offers an opportunity to set your own percentage overhead rate for any particular capital project. For Operations and Maintenance, there are a variety of elections to populate that force the Parties to separately contemplate overhead rates for property taxes, processing/transportation fees, utilities, and environmental fees.

Before forming an opinion on how you feel about these Alternatives, please keep in mind that our current drilling/completion “standard industry practice” (sliding scale 3% on the first $50,000, 2% on the next $100,000 and 1% on the remainder) has been common at least since the Petroleum Accountants Society of Western Canada (PASWC) released its 1969 model accounting procedure. A lot has changed since then. It is rare that a well can be drilled for under $1MM, and with the advent of multi-stage fracs, some well completions are costing millions of dollars. Wells are being drilled faster, and even though the industry standard overhead thresholds have never really been increased, it becomes easy to see how the administrative burden that the Operator carries has increased since 1969.

Accounting System and Land System Changes

I can sum this point up quite succinctly: There isn’t a single one of your accounting or land system’s current overhead methods that will be valid with any alternative offered in PASC 2011. Being careful to not over-dramatize, adopting the overhead changes suggested in your PASC 2011 Accounting Procedure and making it work in your accounting system is likely just a very simple matter of having your company’s masterfile maintenance representative add some new overhead validation codes – this is fairly easy to do in most accounting systems. However, because of added definitions and additional flexibility to establish different overhead rates for any given activity, I would encourage land system administrators to review the terms of Article III closely to ensure that your land system itself is structured to accommodate that flexibility. Many of the land systems that I’m familiar with are not yet able to do this and may require some patches from the programmers.

Closing

With some more specific phrasing in Article II, additional and expanded definitions, increased recommended overhead rates and the elimination of “The Grid” that we saw in PASC 1996, even the accounting for overhead in PASC 2011 has seen an overhaul. The PASC pre-amble indicates that they are still contemplating releasing an “information only” overhead grid, but it will no doubt require further deliberation. The added flexibility of the Overhead provision is a great addition and provides companies with a better framework for negotiation at the beginning of a joint venture. I often wince when I see a Non-Operator being charged 10% overhead on millions of dollars of just power, so I would encourage negotiators and JV Representatives or take advantage of this added flexibility. It is impossible to address the eligibility of every type of administrative expenditure (contracted or not), but PASC 2011 has certainly moved us forward by providing clarification on the bigger issues.

Please be sure to look for the fourth and final article on the Integrity blog site which will discuss what the PASC 2011 Accounting Procedure means to the oil and gas industry in general and will provide some commentary on opinion of the changes.

If you have any questions on the subject matter contained within this blog or are interested in a custom training program for your company on joint venture issues, please feel free contact us through our website at www.integrity-audit.com.

All content provided on this blog is for informational purposes only. The content contained herein does not represent the official or unofficial opinion of PASC, CAPL or any other industry association and is based solely on the opinion of the author. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site. The owner will not be liable for any errors or omissions in this information nor for the availability of this information. The owner will not be liable for any losses, injuries, or damages from the display or use of this information.

Posted by: Kody Carroll

The PASC 2011 Accounting Procedure – The First Look (Part 2, Direct Charges)

My first blog in this series on the Board-approved PASC 2011 Accounting Procedure took a look at what was new and interesting in Article I of the Accounting Procedure. Whereas Article I deals more with the guidance of joint venture accounting practices and agreement administration, Article II of the PASC Accounting Procedures has always been to indicate what is and is not to be considered direct charges to the Joint Account and sets out the foundation of our joint venture accounting practices. Article II will be the focus of this blog where we’ll work to address some of the notable additions or changes in the PASC 2011 Accounting Procedure, without getting lost in some of the details.

Labour and Contracted Services

The labour and contracted services clauses in our PASC Accounting Procedures have grown and expanded over time in the face of changing operating and competitive environments. Industry’s compensation programs have become more complex to attract and retain talented and experienced personnel. Technology and communication systems have blurred what used to be a definitive line between what is on-site versus off-site for the purposes of establishing what activities are chargeable to the Joint Account. Naturally, you could expect the Labour and Contracted Services clauses in PASC 2011 to evolve just as our labour needs and compensation programs have and so some discussion on just the personnel component of Joint Operations is warranted.

  • Alignment by Function

Previous versions of PASC had a significant distinction between how to treat employee labour (i.e. salaried individuals) and contracted services, even though a contractor might very well provide the same service that an employee would. For example, the “Services” clause of PASC 1996 never contemplated that something like supervision might be outsourced, but we regularly see it in industry practice. With PASC 2011, we have more of an alignment by using similar phrasing through Clauses 201 and 207 that places less emphasis on whether an individual is an employee or a contractor, and chargeability therefore becomes more dependent on the services provided by an individual. Further, separating on-site/off-site functions into their own sub clauses provides us with a more simplified approach to determine the chargeability of individuals.

  • A Note on Supervision

When auditing supervision, auditors have to constantly be aware of which accounting procedure they are working with because each version modified the chargeability of the different layers of supervision. For comparison, PASWC 1976 and PASC 1983 indicated that only first level field supervision was chargeable. PASC 1988 then came and allowed us to elect whether second level supervision was allowable or not. PASC 1996 later established that any supervision, regardless of whether it was first level or second level, was allowable as long as it was “On-site” (meaning it could also be in the field or production office servicing the Joint Property). Now we come full circle with PASC 2011, which defines Supervision as only being first level and it must be “On-site”, with any other supervision chargeable only with approval of the Parties.

Will this change be enough to make companies revaluate their organization charts that auditors review payroll against? Maybe not. At the very least, though, I’d suggest that this is still worth bringing to the attention of companies’ managers who determine the field organizational structure, and the analysts who do the budgets.

  • ICPs – Incentive Compensation Programs

ICPs are a new definition for PASC 2011, but not a new concept. Variable pay and pay for performance were discussed in passing in PASC 1996, but increasingly sophisticated compensation plans meant that separate guidance on just ICPs was warranted. What is new for PASC 2011 is a limit of 25% of base salary for ICPs, and an election to either include or exclude company stock options from being chargeable to the Joint Account.

(For those with the burning questions on administration labour, I can say for now that administrative labour continues to not be chargeable to the Joint Account, but I’ll address this in more detail in Part 3 of this blog series.)

Engineering and Technical Services

There has always been a fine line between Engineering and Technical Services. PASC 2011 makes the two even more related. Engineering and Technical Services are addressed under both the Labour and Contracted Services clauses (with reasonably similar phrasing), and it’s interesting to note that PASC 2011 allows Technical Services to be charged on a “percentage of cost” basis provided it’s clearly disclosed, much like Engineering and Design has been in previous versions of PASC. The biggest modification to Engineering that we see with the PASC 2011 Accounting Procedure is that we have an entire Accounting Procedure Interpretation (API) document dedicated to the chargeability of Engineering functions.

The audit community has wrestled for some time with what do with certain items that had been outsourced to third party engineering firms. For example, project management, bid review and selection, AFE management, and project budgeting were all items that would be commonly queried as potentially “administrative” in nature. API-15 provides some relief to those that would have to respond to such queries by explicitly listing an array of chargeable engineering activities, including those above.

Please don’t take this as a blank cheque for charging “engineering” time, however. The word “procurement” is notably absent from the list of chargeable activities in API-15, and administrative activities like invoice coding and invoice routing remain administrative in nature.

Computerized Systems and Communication

I have a friend who is an engineer. I joined his family at his house for dinner one evening and walking past his den, I noticed his computer running with a variety of changing graphs, charts and indicators. He explained that he was monitoring a well that was being drilled in real time. He was able to review the rate of penetration, pressures, pump rates, string torque, gas at mud tanks, and any comments entered by field personnel, amongst a variety of other things. He grabbed his Blackberry and shot off a quick email, and promptly received a phone call from someone on the rig site. They only needed to chat for a few minutes since my friend could already see what was going on down the hole just as well as the field personnel.

To the engineering readers of this blog, this is just another regular day in the office (wherever that office happens to be at the moment) and this is nothing new. To the accountants and auditors, it might be an interesting perspective of why we need API-16 on Chargeable Communication Systems and API-17 on Chargeable Field Computer Systems.

Thanks to the computerized systems and communication tools available, my friend was able monitor the well in real time saving him a trip to the rig site; he was also able to provide instantaneous instruction to the on-site workers and received immediate updates back. Plus I got a free dinner. It’s a win-win-win situation. The third win is for the Non-Operators in the well. The computerized tools that are on-site allow head office technical staff responsible for the design and execution of a drilling program to monitor rig parameters during the actual drilling process with the ultimate goal of improving drilling efficiency for the benefit of the Joint Account.

API-16 and API-17 have been written keeping in mind that technology changes, practices evolve, and new tools are constantly popping up to service this industry. It stands to reason that if new technology and communication tools are making Joint Operations more effective and efficient while simultaneously reducing travel and personnel costs, the Non-Operators should share in the costs of maintaining any system that directly benefits the Joint Property.

Did We Really Need the Allocation Options Clause in PASC 1996?

PASC 1996 had Clause 221 – Allocation Options, which laid out some options (fixed rate, percentage of cost or some other basis such as well count) for charging various activities to the Joint Account. Really, you could have taken any activity listed in Article II in PASC 1996 and assigned an allocation option to it. I don’t think I’ve seen an Accounting Procedure that actually utilizes this option recently, so it was no surprise to see this clause removed from PASC 2011 altogether.

Personally, I really liked the Allocation Options clause. While some of the larger companies already have the sophisticated allocation procedures and accounting systems in place for administration of operating cost recoveries, the smaller operators wrestle with ways to administer their chargeable activities since they might not have or be able to afford the expensive licenses just for the allocation modules. The small operators are the ones that would really benefit from Clause 221, so it surprises me why more small operators don’t use it with PASC 1996. Going forward with PASC 2011, the options for charging the various activities are often contained within the clause governing that activity, but without some of the more flexible options that were afforded by Clause 221.

Closing

In this blog, we’ve only scratched the surface of the new, changed or interesting items in Article II of PASC 2011. Having reviewed some of the things you can and can’t do, I’d like to close by referring to my discussion on approval in my previous Part 1 blog. Please keep in mind that you can charge anything you want under PASC 2011, even if it contradicts the terms of Article II of the Accounting Procedure, as long as you get approval. Make it easy on an auditor to look at an AFE or other approval document and recognize that there is appropriate disclosure of typically non-chargeable or gray-area items that can be accepted as chargeable to the Joint Account.

Please check back on the Integrity blog site for the next article in this series, which will focus on Article III – Overhead and will discuss other administration activities.

If you have any questions on the subject matter contained within this blog or are interested in a custom training program for your company joint venture issues, please feel free contact us through our website at http://www.integrity-audit.com/.

All content provided on this blog is for informational purposes only. The content contained herein does not represent the official or unofficial opinion of PASC, CAPL or any other industry association and is based solely on the opinion of the author. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site. The owner will not be liable for any errors or omissions in this information nor for the availability of this information. The owner will not be liable for any losses, injuries, or damages from the display or use of this information.

Posted by: Kody Carroll

Welcome to Integrity Audit and Accounting Ltd.

Welcome to the Integrity Audit and Accounting Ltd. blog. The purpose of this blog site is to address common issues and questions surrounding joint venture audits, joint venture accounting issues, PASC agreement clarification, and anything else related to the management of joint ventures in the Canadian oil and gas industry.

We’ll be adding new topics and new discussions from time to time, so please check back regularly for any new updates.

To suggest a topic for discussion, please feel free to email us at info@integrity-audit.com.

For additional information on Integrity and the services we offer, please check us out at http://www.integrity-audit.com.

All content provided on this blog is for informational purposes only. The content contained herein does not represent the official or unofficial opinion of PASC, CAPL or any other industry association and is based solely on the opinion of the author. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site. The owner will not be liable for any errors or omissions in this information nor for the availability of this information. The owner will not be liable for any losses, injuries, or damages from the display or use of this information.

Posted by: Kody Carroll

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