February 16, 2012 Leave a comment
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.
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.
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Posted by: Kody Carroll