To place revenue recognition in the natural resources industry in perspective, a review of the applicable generally accepted accounting principles is necessary. The main focus in all wasting asset or natural resource companies is on their cost structure, not revenue. Since much of the revenue — the price of the commodity — is beyond the control of the average integrated resource company, it is not a price maker but a price taker. So profits in this industry depend on controlling and reporting of costs.
A resource company first establishes a depletion base and then the question arises as to how the given depletion base is to be written off.
In establishing a depletion base, a resource company must consider its acquisition, exploration, development, and restoration costs. Because the current expensing versus deferral of these costs is crucial, the manner of establishing reserves for a resource company (particularly in the non-timber segments) is the heart of generally accepted “reserve accounting.”
For oil and natural gas companies the depletion base is determined according to proved reserves — reserves that are in actual production or are supported by formation tests. Proved reserves may be developed, meaning that they are recoverable using existing facilities, or undeveloped, meaning that they are recoverable but the facilities for processing and transporting the reserves to market are not in place and greater investments are required. Proved reserves are the principal asset of any resource company and the basis for much of its value.
The critical issue in these companies is one of reserve costing not revenue recognition. How the exploration costs to obtain these reserves are treated is of vital concern; moreover, even the FASB and the SEC have had difficulty in this area. This is one of the few areas where the FASB pronouncements were opposed to the SEC directives, as follows.
FASB Statement No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies, (1977) was developed at the behest of Congress and resulted in the “successful efforts” method being the only acceptable method of treating exploration and development costs; that is, only exploration costs associated with proved reserves are capitalized and amortized over the life of these reserves. Exploration costs that result in no reserves are expensed.
The difficulty with Statement 19 is that it clearly favored the large integrated oil and gas companies over the small independent companies. In response, the SEC decided that neither the successful efforts method nor the full costing method (capitalization and amortization of all exploration and development costs when the cost center [for example, U.S. operations] reserves are produced) accurately identified the underlying value of the reserves.
Born in 1978 was the SEC method known as “reserve recognition accounting,” which required natural resource companies to estimate the reserves, costs, distribution, discount rate, and the future selling price. Predictably, this chimerical method never got off the drawing board. In 1978, the SEC relented and allowed resource companies the option of using either the successful efforts or the full cost method.
FASB Statement No. 25, Suspension of Certain Accounting Requirements for Oil and Gas Producing Companies, (1979) which suspended SFAS No. 19 as to its effective date, resulting in conformity with the SEC directive discussed above.
FASB Statement No. 69, Disclosures about Oil and Gas Producing Activities, (1982) responded to the SEC concern about the current value of reserves. It requires natural resource companies to disclose their method of accounting (successful efforts or full cost). In addition, publicly traded natural resource companies must disclose, as supplemental information, the current value of their reserves measured by discounted future net cash flows. Nonpublic natural resource companies can continue to follow Statement 25.
To determine what measure of supplemental information is sufficient for Statement 69 purposes, see AICPA Statement on Auditing Standards (SAS) No. 43, Omnibus Statement on Auditing Standards, and AICPA SAS No. 52, Omnibus Statement on Auditing Standards —1987.
Mining companies adopt the same general accounting scheme as oil and gas companies but have significant concerns about impairment and restoration costs. For example, restoration costs related to environmental concerns are addressed in AICPA Statement of Position (SOP) No. 96-1, Environmental Remediation Liabilities.
Timber companies adopt a range of industry methods that are unlike those of the “below-ground” natural resource companies. Little FASB or SEC guidance is available, allowing timber companies this flexibility in choosing their accounting method. Valuing forests at discounted future cash flows, historical cost with reforestation costs immediately expensed, or capitalizing and amortizing these costs on a units-of-production basis are therefore all acceptable methods.
There are special tax rules in the natural resources industry, the most common of which is the deduction allowed for the greater of cost depletion or percentage depletion for non-timber companies. The percentage depletion allows a deduction from 5% to 22%. See Internal Revenue Code (IRC) sections 611, 612, 613, and 613A. Timber tax rules entail special elections for capital gains trtreatment at IRC section 631.
As indicated above, the major focus for natural resource companies is not revenue recognition but cost allocation and reserve accounting.
Oil and natural gas companies receive revenue from their properties. Here FASB Concepts Statement (CON) No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, dictates that revenue be recognized when realized or realizable and earned. Royalty payments, settlement amounts, and other such revenue sources will therefore be reflected on a current basis. No revenue is recognized on non-produced (reserves) or distributed product.
Revenue for natural resource companies (oil and gas, mining and timber) is recognized on actual sales, management fees, sale of leases, and gains or actual sales of properties. Because CON 5 controls revenue recognition, if proven reserves have not been purchased, distributed, and sold, revenue is not realized and therefore not recognized. Similarly uncut timber reserves do not trigger revenue recognition.
Excerpted by permission. Copyright 2007, Specialty Technical Publishers.