A key consideration for OIAC is the future impact of IFRS on the accounting for oil and gas exploration, development, production and decommissioning activities for UK companies.  OIAC members have met with members of the International Accounting Standards Board (IASB) to discuss the likely issues, and OIAC has formed an IFRS working party to monitor developments in IFRS.

Scope, Timing & Legislation

In June 2002, the EU adopted a regulation that requires listed EU companies to adopt International Financial Reporting Standards (IFRS) in their consolidated financial statements from 2005.  Countries outside the EU including Australia, Russia and several Middle Eastern and African countries have also agreed on mandatory compliance with IFRS.

The regulation does not prescribe the accounting standards which companies should follow in their standalone financial statements: the EU has left this to the discretion of individual member states, no doubt having regard to the close interrelationship between accounting policies and taxation in many jurisdictions.

The DTI decided earlier this year that UK companies would be allowed a choice in their standalone financial statements, subject to a requirement that companies within a UK group should all follow either IFRS or UK GAAP. UK companies will be required to follow IFRS in their consolidated financial statements from 2005, in accordance with the EU regulation. 

This represents fundamental change in the financial reporting framework for UK companies.  Time to prepare is limited.  The comparative period for 31 December 2005 financials begins with the 31 December 2003 balance sheet. 

Meanwhile, the International Accounting Standards Board (IASB) is currently updating many of its standards in advance of 2005, and the UK Accounting Standards Board has recently issued a number of new draft standards aimed at reducing differences between IFRS and UK accounting standards.

Upstream Oil & Gas Company Accounting under IFRS

There is currently no IFRS specific to upstream oil and gas activities, nor is there any equivalent of the SORP under IFRS.  The IASB’s predecessor issued a discussion paper on accounting in the extractive industries in November 2000, however, no final standard, or exposure draft, was ever issued.

In the absence of a specific IFRS applicable to oil and gas activities by 2005, the IASB concluded in principle in September 2003 that it would permit, on adoption of IFRS, the ‘grandfathering’ of certain accounting policies connected with exploration and evaluation activities.  Grandfathering would allow a company the option of continuing to follow its local accounting policies in certain areas, irrespective of whether those policies would otherwise be acceptable under IFRS.

Notwithstanding certain exemptions relevant to the oil and gas industry included in existing IFRS, in the absence of specific grandfathering arrangements, there has been much debate as to whether key elements of full cost accounting, or indeed successful efforts accounting, would survive beyond 2005 under IFRS.

A draft of the grandfathering rules, which are expected to be incorporated into the updated IFRS on property, plant and equipment, has yet to be exposed.  Whether UK companies moving to IFRS will be able to continue with their existing full cost or successful efforts accounting policies unchanged will depend upon the detail of the grandfathering rules, expected by the end of 2003.

However, OIAC believes that the IASB intends to allow full cost accounting and successful efforts accounting to continue, at least for the time being, pending fuller consideration by the IASB of the specific issues faced by the industry at some stage in the future.  The IASB’s published agenda provides no indication that, other than the grandfathering arrangements, the extractive industries feature as a high priority.

The grandfathering arrangements for IFRS adopters are expected to apply only in the specific areas of cost capitalisation and impairment tests.  In all other areas, existing UK accounting practices, under the SORP, may only continue where they comply with IFRS.

Areas of Potential Change

To date, OIAC has identified the following specific areas where recommended practice under the SORP may not be permitted under IFRS.  The comments below are tentative, and OIAC continues to evaluate these areas.

Decommissioning estimates

In many respects, accounting for decommissioning obligations under IFRS is similar to the accounting treatment required under the SORP. However, IFRS does not currently deal with accounting for changes in decommissioning estimates.

Under the SORP, changes in estimates of decommissioning costs and timing result in an adjustment to the provision and an equal adjustment to the cost of fixed assets.  Subject to any impairment, or creating a negative asset, the effect of the change in estimate is borne in the profit and loss account as the adjusted carrying value of the asset is depreciated.

Under IFRS, the IFRIC has recently issued an exposure draft, which, if approved as an IFRIC pronouncement, will require the effect of a change in estimate on a decommissioning provision to be apportioned between the part of the asset that has been depreciated and the part that has yet to be depreciated. The part attributed the depreciated element would be recognised as an immediate charge or credit in the period, and only the balance would be adjusted against the cost of the asset.

The exposure draft would create an additional difference between IFRS and established accounting practice in the UK and the United States.

Responses to the exposure draft were due by 3 November 2003.  OIAC has written to IFRIC to express a number of concerns in relation to the exposure draft. OIAC's letter is also available to read on this web page.

Asset exchanges

Under IFRS, asset swaps are generally accounted for at fair value under IAS 16 Property, plant and equipment (giving raise to a gain or loss) unless the assets exchanged are ‘similar’ where no gain is recognised, but a loss may be recognised.

Asset swaps are accounted for at historical cost under UK GAAP (i.e. at no gain or loss).

Under IFRS, straightforward exchanges of interests in fields or licences at a similar point in the exploitation life cycle might be viewed as ‘similar’.  The treatment of other exchanges, for example of proved properties for unproved properties, may be less clear and requires further consideration. 

Taking the concept further, a carried interest or a farm-in might also be argued to represent an asset swap, potentially to be accounted for at fair value and resulting in the recognition of a gain or loss.

OIAC believes there are important issues associated with measuring and recognising gains based on transfers of interests in unproved properties.

Derivatives and long term contracts

Many ‘typical’ UK gas sales contracts will meet the definition of a derivative in IAS 39 ‘Financial Instruments: Recognition and Disclosure’.  Unless the gas contracts qualify for the ‘own use’ exemption (IAS 39 para 6a), companies will be required to apply the mark-to-mark method of accounting and recognise the gas sales contracts as potentially very significant items in the balance sheet, with movements in the period recognised as income or expense in the profit and loss account.

Gas contracts which are not derivatives themselves often contain ‘embedded derivatives’ (e.g. optionality and indexation to oil or electricity prices), which will need to be assessed to determine whether they meet the criteria of being ‘closely related’.  Embedded derivatives that are not ‘closely’ related are also required to be marked-to-market and similarly recognised in the balance sheet.

Experience suggests that the particular treatment and measurement of each long term gas contract is dependent on the precise terms of that agreement, particularly in relation to price setting and offtake commitments, and the analysis is frequently complex.

The SORP, and UK GAAP, generally includes no such requirement to account for long term gas agreements on a mark-to-market basis.

Take or pay arrangements

Where take or pay payments are received which provide a right for the payer to take additional volumes at some point in the future, the SORP recommends that the receipt is accounted for as a liability rather than as revenue until such time as the delivery obligation is fulfilled, or lapses.

Whether a take or pay receipt should be recognised as a liability or as revenue under IFRS warrants consideration.

If a liability is recognised by the recipient under IFRS, there is a further question as to whether this amount should be equal to the amount received or measured on some other basis, such as the incremental cost of meeting any remaining obligation to deliver volumes in future.

Production imbalances between joint venturers

The SORP recommends that underlift, as well as overlift, should be recorded against cost of sales and included in the balance sheet, measured at market value.  Underlift and overlift balances are generally expected to unwind over a short period of time, and generally producers have ready access to the crude market.

The treatment of overlift differs from the guidance on banked gas in paragraph 131(e) of the SORP, which recommends that the liability is established initially at the current production cost and revised at least annually, to reflect any changes to production costs.  Such imbalances will not always reverse in the short term, and producers do not necessarily have access to ‘the market’ for gas.

The basis on which production imbalances should be recognised and measured under IFRS, in both the balance sheet and in revenue, warrants further consideration.

Exposure draft 4 - disposal of non-current assets and presentation of discontinued operations

OIAC has written to IFRIC to express a number of concerns in relation to the exposure draft. OIAC's letter is also available to read on this web page.

Information on the IASB is available on their website   www.iasb.org.uk .  The extractive industries exposure draft (due for issue in November 2003) will be made available on the IASB website.