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FINANCIAL ACCOUNTING FOR PETROLEUM RETAINED PRODUCTION
PAYMENTS BY THE WORKING-INTEREST PURCHASER
by
JERRY LANE PITTMAN, B.B.A.
A THESIS
IN
ACCOUNTING
Submitted to the Graduate Faculty of Texas Technological College
in Partial Fulfillment of the Requirements for
the Degree of
MASTER OF SCIENCE IN ACCOUNTING
Approved
August, 1969
ire
- n !r
Cr
ACKNOWLEDGMENTS
I am deeply indebted to my friend cind
professor. Dr. Kenneth L. FoX/ who directed
this thesis. Without his continued support
and guidance, completion of this thesis would
have been impossible.
ii
TABLE OF CONTENTS
ACKNOWLEDGMENTS ii
LIST OF TABLES V
LIST OP FIGURES vi
I. THE NATURE OF PRODUCTION PAYI-IENTS—
AN INTRODUCTORY DISCUSSION 1
II. FEDERAL INCOME TAX INFLUENCES 8
Introduction 8
Illustrative Case Study 9
A* s Tax Consequences 11
B's Tax Consequences 15
C*s Tax Consequences 18
Influence of Proposed Legislation . . . 21
Suinmary 22
III. FINANCIAL REPORTING UNDER THE
EQUITABLE-LIEN METHOD 25
Introduction 25
Oilola Case Study 26
Annual Report Excerpts 36
Surtunary' 38
IV. FINANCIAL REPORTING UNDER THE NET
AND ECONOMIC-INTEREST METHODS 40
Introduction 40
Oilola Case Study 42
Annual Report Excerpts 55
Summary 58 iii
iv
V. COMPARISON AND CRITIQUE OF THE THREE DIVERSE METHODS 60
Introduction 60
General Critiques and Comparison . . . . 61
Specific Critique and
Recommendation 68
Sumnary 73
VI. SUMMARY - . 75
BIBLIOGRAPHY 79
LIST OF TABLES
Table Page
1. Oilola Production Payment
Application 12
2. Computation of A's Taxable Income 14
3. Computation of B's Taxable Income 18
4. Computation of C's Taxable Income 20
5. Purchaser B's Income Statement Under the Equitable-Lien Method 30
6. Excerpts of Purchaser B's Balance Sheet Under the Equitable-Lien Method 33
7. Purchaser B's Income Statement Under the Net Method 47
8. purchaser B's Income Statement Under the Economic-Interest Method 48
9. Excerpts of Purchaser B's Balance Sheet Under Net and Economic-Interest Methods 52
10. Per Share Analysis of Earnings and Book Values for the Oilola Case 62
LIST OP FIGURES
Figure Page
1. Earnings Per Share for the Three Methods 64
vi
CHAPTER I
THE NATURE OF PRODUCTION PAYMENTS—
AN INTRODUCTORY DISCUSSION
In the past fifty years increasing importance has
been placed on the financing arrangement utilized by the
oil and gas industry called the production payment. This
production payment is a means to borrow money or to trade
oil and gas properties with minimal initial cash outlay
by the purchaser yet sufficient consideration to effect
the transfer of property. As described by Breeding and
Burton in their Income Taxation of Oil and Gas Production,
a production payment, more commonly known as an oil pay
ment or gas payment, is an interest in oil and gas in the
ground that entitles its owner to a specified fraction of
production for a limited time or until a specified sum of
money or a specified number of units of oil and gas has
been produced and received.
There are two types of production payments currently
used by the oil and gas industry—the carved-out and the
retained production payment. The carved-out production
payment is used at the time the holder of a working interest
Clark W. Breeding and A. Gordon Burton, Income Taxation of Oil and Gas Production (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1961), p. 205.
2
may sell or "carve-out" an overriding royalty of a short
duration (more commonly called a production payment) to
be paid back as production ensues. Once payout status
has been reached, the working interest that was carved out
reverts to the original holder.
The retained production payment, on the other hand,
is used to effect a transfer or sale of property permanently
to the purchaser. The owner of the working interest of a
producing property sells his interest in the property for
a relatively small initial cash payment plus a designated
amount payable, retained out of future oil and gas pro
duction, if and when, produced from the property.
The carved-out production payment is simply a loan
with a temporary pledge of oil or gas reserves attached
as security. While the carved-out payment has not been
subjected to the controversy that the retained payment has,
the retained production payment has been given the most
diverse treatment for accounting purposes and is, by far,
the most popular type of production payment. For such
reason this thesis deals solely with the retained pro
duction payment and its ramifications on accounting treat
ment and thought. To further limit this thesis the author
restricts his discussions to producing properties only and
to the accounting treatment as recorded by the purchaser
of the working interest.
Before getting to the essence of the current
accounting controversy, it is necessary to identify the
parties in the retained production payment and to intro
duce their functions applicable thereto. In the retained
production payment transactions, B, an oil and gas operator,
desires to buy a certain hydrocarbon lease or leases owned
by A. B will only advance a nominal portion of the sales
price for the initial cash consideration, and A will assign
the working interest in the property to B, subject to a
sizable retained production payment expressed in terms of
a fixed principal plus interest on the remaining balance
of the purchase price. The production payment will be paid
out of a certain percentage of first production until the
principal plus interest thereon has been licjuidated.
Arthur Andersen & Co. stated this procedure quite well.
The retained production payment is payable only out of the proceeds from the sale of a specified portion of the minerals, if, as/ and when produced; and B bears the cost of lifting all of the oil and gas produced/ including that applied to liquidation of the retained production payment.2
At the same time/ A sells the production payment to C/ an
investor/ banker/ or separate corporation/ for payment of
the production payment/ generally on a discounted basis
2 Arthur Andersen & Co., Accounting and Reporting
Problems of the Accounting Profession (Chicago, 111.: Arthur Andersen & Co., 1962), p. 113.
4
plus interest. The parties. A, B, and C, constitute what
is commonly known as the ABC arrangement by Federal income
tax authorities.
party B is not directly nor indirectly liable for
payment of the production payment since he has not acquired
and will not acquire the portion of the property retained
for the payment out of oil; he is, therefore, not liable
for the amounts of the lien on the total properties. B is
only liable, effectively, to operate the property. Any
liability attaches between Parties A and C since A has
borrowed the principal from C with a guaranty that it will
be repaid by A, only if the leases prove to be worthless
before liquidation of the payment occurs.
The existing problem in accounting, for the retained
production payment, is that it provides the working interest
(purchaser B) a fraction of production during the payout
period and a significantly larger fraction of production
after payout status is reached. This situation results in
an extreme variation in operating results for B between the
payout period and the period after payout. The cash income
to the working interest, B, may be so small during payout
that out-of-pocket production expenses are not covered,
purchaser B possibly will make an accounting in his financial
3 A. W. Walker, JT., "Oil Payments," Texas Law Review,
XX (January, 1942), 268-270.
statements for only his net investment (the initial small
cash outlay) in the property and the applicable propor
tional income; or he may present in his statements the
total value of the entire invested property subject to a
liability against the property which he did not assume and
the total gross income produced from the leases. Thus, a
problem has evolved due to the lack of uniformity and
comparability among companies in reference to appropriate
accounting treatment of the retained production payment.
Stanley Porter, partner with Arthur Young & Co./ commented
that.
The evolution of accounting thought on this problem, from both the financial and tax accounting viewpoints, constitutes one of the most fascinating stories in the history of accounting. Nor has this story ended, for the problem remains challenging and unresolved, today. 4
Three different methods have been used by the
petroleum industry accounting for the retained production
payment by the purchaser of a working interest—the
ecjuitable-lien method, the net method, and the economic-
interest method. Chapter III discusses the equitable-lien
method, while Chapter IV discusses the net and economic-
interest methods.
^Stanley P. Porter, Petroleum Accounting Practices (New York, N.Y.: McGraw-Hill Book Comtpany/ 1965)/ p. 189,
In Chapter II an examination is made of oil and
gas Federal income tax law and cases involving the purchaser
of a working interest. A major emphasis in Chapter II is
to present how Federal income tax laws influence the
accounting treatment of the retained production payment.
A discussion of the retained production payment without
defining or setting forth these tax laws would constitute
a wholly inadequate discourse. Chapter II also makes an
investigation into the future outlook of the ABC transaction
in relation to the Internal Revenue Service and possible
future Congressional legislation.
Chapter III describes the equitable-lien theory of
accounting for the purchaser's working interest. The
equitable-lien method presents the arrangement as though
the purchaser B had acquired the entire interest that was
owned by the seller A, with the production payment consti
tuting a liability in the nature of an equitable lien to
be satisfied only from the proceeds of the sale of oil or
gas if, and when, produced.
Chapter IV presents the net and the economic-
interest methods. The two methods are closely related to
each other since they are derivaties of income tax law.
Under the net method no liability is recognized; only the
initial cash consideration for the residual interest
acquired is capitalized; depletion is based on such cash
contribution; and the purchaser excludes from his income
that portion of the oil or gas sales proceeds applied to
reduce the production payment which the purchaser did not
assume. The purchaser, under the net method, includes in
his own expenses the total lifting costs for producing the
oil or gas. The economic-interest theory, also presented
in Chapter T7, requires that the proceeds from production
of the retained production payment be excluded from the
purchaser's gross income. The estimated total lifting
costs applicable to the production payment are capitalized
€Uid amortized over the production attributable to the
purchaser's interest.
Chapter V consolidates all three of these accounting
methods for comparative purposes. The diversity and lack
of comparability among the three methods under identical
assumptions are clearly displayed in this chapter. Each
method is critiqued for fair reporting and accounting
requirements, and a recommendation is made to solve this
accounting dilemma.
In the last chapter. Chapter VI, a summary of all
chapters of this thesis is made.
CHAPTER II
FEDERAL INCOME TAX INFLUENCES
Introduction
Tax authorities have termed the retained production
payment, more popularly known as the ABC transaction, as a
child of our tax law which allows the purchaser of an oil
property, subject to a retained oil payment, to exclude
from his income the revenue used to satisfy the oil payment
plus applicable interest. This "child" is partially the
reason for the widespread diversity in uniformity and
comparability as pointed out previously in Chapter I,
This chapter discusses these tax laws and their
influences on accounting treatment. Tax and Supreme Court
cases are surveyed, and an illustrative case applied to
the ABC arrangement is introduced to present the tax con
sequences of the parties involved. Furthermore, proposed
legislation in Congress which will materially affect the
production payment is investigated together with its
possible influence on accounting thought.
A. G. Schlossstein, Jr., "Financial Accounting for Oil payment Transactions," The Texas Certified Public Accountant, XXXI, No, 6 (1959), 13,
8
Illustrative Case Study
Party A wishes to sell his Oilola lease properties
for $16,000,000. Under conventional selling arrangements
Party B would purchase the Oilola leases by either paying
total cash or by borrowing the sum of $16,000,000. B,
thereby, would differentiate the initial cash outlay between
lease and well equipment of $2,500,000 (the fair market
value) and leasehold cost of $13,500,000 (the balance).
For tax purposes B could only recover these investment
costs through depreciation and depletion charges against
oil income as produced or through abandonment losses if 2
the leases proved to be worthless. Percentage depletion
would be allowed to B rather than cost depletion only if
it should be larger.
Since the $16,000,000 is such a large cash outlay
for B, and since the total is recoverable fully only if
four of the total ten million reserve barrels are produced
(see assumption below), this conventional method is not
too appealing to him, B, still desiring to purchase the
property, looks for a better financing arrangement—one
in which the initial cash payment is not as crippling to
him financially. Thus, the ABC production payment arrange
ment has been devised.
2 Kenneth G. Miller, Oil and Gas Federal Income
Taxation (New York, N,Y,: Commerce Clearing House, Inc, 1967)/ p, 185.
10 I
For explanatory purposes the ABC sale of oil and
gas is set forth below in a hypothetical case study
(hereinafter called the Oilola Case). The Oilola Case is
utilized in this chapter to explore current tax laws and
cases which serve for the appropriate tax treatment of the
transaction. The Oilola Case is carried throughout
Chapters III/ IV, and V to illustrate financial accounting
for the retained production payment. Listed below is a
summary of the major assumptions and other information
inherent in understanding the Oilola Case.
Oilola Case Major Assumptions 1. Party A: the seller or assignor 2. Party B: the purchaser of the working
interest 3. Party C: the payment lender or corporation 4. Initial cash payment: $4,000,000 5. Retained production payment: $12,000,000 6. Interest on unliquidated payment balance: S^o 7. Principal and interest payable out of 75%
of production 8. Total reserves: 10,000,000 barrels of oil 9. Barrel production per year: 2,000/000/
constant 10. Sales price per barrel: $3.00/ constant 11. Lifting costs per barrel: $.40, constant 12. Fair market value of lease and well
equipment: $2,500,000
13. Royalties and production taxes: disregarded
Party A will sell his working interest leases for
an initial cash consideration of $4,000,000 and retain an
oil payment of $12,000/000 plus interest of 5i^ to be paid
solely out of 75% of oil production if/ and when, produced.
A will then assign the retained production payment to a
third party/ C, for $12,000,000 plus interest.
11
As can easily be seen, a major advantage to B is
the relatively small amount of cash needed.to acquire the
properties coupled with the favorable contingency since
the production payment is not a direct or an indirect 3
liability. Another advantage to B is that income taxes
are saved since/ as explained later in this chapter,
gross income applied to the production payment is excluded
from B's taxable income under current tax regulations.
Application of the production payment for the
Oilola leases is illustrated in Table 1, This table presents
the requirement in barrels (75% of total yearly production)
necessary to liquidate the $12,000,000 production payment
plus the 5 1% interest on the outstanding principal amounts.
Note that the production payment is fully liquidated during
the third year, and observe that the fourth and fifth year
are free from the encumbrance; that is, all barrels pro
duced belong to B, the working-interest party.
A' s Tax Conseguences
A, the seller of the property/ realizes a capital
gain on the sale of the lease provided the tax holding
period requirement has been met. The production payment
must be assigned to C at the same time as, or subsequent
C. Aubrey Smith and Horace R. Brock, Accounting for Oil and Gas Producers (Englewood Cliffs, N.J.: Prentice-Hall/ 1959), p. 132,
12
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13
to, the assignment of the working interest to B for A to
be entitled to capital gain treatment on the entire con
sideration. To determine gain or loss on sale, A must
allocate his original cost basis between the interest sold
and the interest retained in the proportion of their
respective fair market values, and A must compute the gain
or loss on the difference between the cash received and
the basis of the interest sold. A then sells the retained
oil payment to another party/ C, and derives gain or loss 4
from such sale. According to Ernest L. Minyard,
If A assigns the reproduction payment interest to C prior to the assignment of the working interest to B, the proceeds from assignment of the production payment will be treated as an anticipatory assignment of income from the property and will be subject to taxation as ordinary depletable income. In other words, such proceeds would be added to proceeds from regular oil and gas sales from the property ^ prior to sale and would be taxed accordingly.
Oilola Case Application
In applying the above principles of income tax
regulations and cases to the illustrative case study.
^Commissioner v, Fleming, 82 F, 2d, 324 (C,A, 5th, 1936).
^Ernest L, Minyard, "How To Determine the Tax Saving that Makes an ABC Deal Worthwhile," The Journal of Taxation, XXIII (May, 1960), 291.
14
A's income on the sale of the Oilola leases would be
computed as shown in Table 2.
TABLE 2
COMPUTATION OF A'S TAXABLE INCOME
Fair Market Value
Total Properties
Properties Sold
Cash received Production payment
Less: Fair market value of lease and well ec[uipment
Value of leasehold rights
$ 4,000/000 12,000,000 $16,000,000
2,500,000 $13,500,000
$4,000,000
$4,000,000
2,500,000 $1,500,000
$13:500:000 $1-000'000 (1) = nilrlll =
Basis attributable to leasehold rights sold
A's Taxable Income Cash proceeds Less: Lease and well equipment Leasehold costs Selling and legal expenses
Taxable gain to A
$ 1,800,000* 111,111 18,889
$4,000,000
1,930,000
$2,070,000
*A's adjusted tax basis, prior to sale.
A, therefore, will report a capital gain of
$2,070,000 and will allocate a tax basis of $888,889
($1,000,000 less $111,111) to the production payment retained
15
by him. A then sells the retained oil payment to C for
$12,000,000 and will recognize a capital gain or loss,
if applicable, on such assignment.
B's Tax Conseguences
The ABC financing arrangement, under current tax
regulations, has direct tax benefits for B, the purchaser
of the oil and gas leases. B's tax benefits have evolved
primarily from one well-known Supreme Court Case entitled
Thomas v. Perkins established in 1937. The Supreme Court
held that a production payment constituted an economic
Interest in the oil and gas in place. Due to this economic
interest factor, the oil and gas income received by C, in
liquidation of his production payment, is considered to
be taxable and depletable income to him as though that
share of the hydrocarbon was produced and sold by him.
Therefore, the only taxable income to be reported by B
during the payout period of the payment is the remaining
working interest not retained, thus constituting the major
tax benefit attributable to B.
In an ABC transaction the production payment must
qualify as a depletable economic interest requiring the
liquidation of the payment to be paid solely out of oil
^Thomas v. Perkins, 301 U,S. 655 (1937),
16
or gas produced.*^ if the production payment is, or might
be, liquidated in any part from proceeds not derived from
a sale of the oil or gas produced from the property, it
is not a depletable economic interest in the property, in
such cases B will be taxed on income liquidating the pro-
duction payment.
B must allocate the initial cash outlay between
lease and well equipment and leasehold cost for income
tax purposes. Lease and well equipment is a depreciable
asset while leasehold cost is a depletable asset. Such
allocation of the initial cash outlay is determined by the
ratio of the asset's respective fair market values, if
known. Tax allocation of these two assets by B frequently
differs from the tax allocation previously recorded by A, 9
the seller.
All operating costs for the producing leases are
fully deductable by B for tax purposes provided that, at
the time of acquisition of lease, it is anticipated that
the income accruing to B during payout of the production
payment will be adeq[uate to pay these operating expenditures
7 Anderson v, Helvering, 310 U.S, 404 (1940). g Minyard, The Journal of Taxation, XXIII, p. 291. 9 Arthur Andersen & Co,, Oil and Gas Federal Income
Tax Manual (Chicago, 111,: Arthur Andersen & Co,, 1966)/ p. 248.
17
If it is predicted that the operating costs will be in
excess of B's gross income while the retained production
payment is being liquidated/ this excess must be capitalized
as additional leasehold cost each year as costs are
incurred.10
Oilola Case Application
Application of the above principles of income tax
regulations to the Oilola Case would recjuire B to record
$2/500/000 of the initial cash paid ($4/000,000) as lease
and well equipment with the balance of $1,500/000 allocated
to leasehold cost. B will depreciate his lease and well
equipment over the remaining productive life of the Oilola
leases and will deplete his leasehold cost under maximum
allowable laws also during the productive life of the
leases.
B has no direct or indirect tax consequences until
production of the oil begins, computation of B's taxable
income from his 25% working interest of the Oilola leases
during the first year of production is illustrated in
Table 3, assuming 2,000,000 barrels or 20% of total reserve
barrels of oil are produced by the leases.
Lifting costs are deducted in full as incurred
for the entire property. Depreciation is based on the
Breeding and Burton, p. 501,
18
TABLE 3
COMPUTATION OF B'S TAXABLE INCOME
Revenue
Oil sales (2,000,000 barrels x
25% working interest x $3.00) $1,500,000
Expenses
Lifting costs (2,000,000 x $.40) $800,000
Depreciation (500,000 x $.45) 225,000
Depletion (20% x $1,500,000) 300,000 1,325/000
Taxable income to B $ 175,000
unit-of-production method by dividing the total leasehold
cost by B's total working-interest reserve ($2/500/000 *
5/555/000 = $.45). The per barrel provision is then
amortized over B's working-interest barrels. Cost depletion
is used in computing B's taxable income or loss because
of his high leasehold costs and because percentage depletion
would be less than cost, considering the applicable 50%
limitation of taxable income before the depletion provision.
C ' s Tax Consecfuences
C, an investor or corporation, will record the
production payment as a receivable asset and will reduce
this asset each year by the 75% working-interest revenue
applicable to the principal.received from B's Oilola lease
19
and will recognize income as the contra, c will also
record the interest on the unliquidated production payment
as income to him. Therefore, the entire amount received
by C, as consideration for the assignment of the production
payment, will be ordinary income to him in the year of
production, and it will be subject to an allowance for
depletion which is generally computed on the sum-of-the-
dollars method.
Oilola Case Application
In applying these tax principles to the Oilola
Production Payment, C will receive $4,500,000 in the first
year of production of which $3,840,000 will be applied to
the principal and $660,000 will be interest income, as
noted in Table 1. The total amount is ordinary income
subject to depletion. Depletion computed by C will, of
course, be the maximum under tax laws. Table 4 illustrates
C's tax position under current income tax regulations.
As can be noted in Table 4, C's taxable income of
$450,000 is essentially the 5J$% interest received on the
production payment. All of the principal and part of the
interest has been eliminated by the maximum allowable
depletion taken.
Commissioner v, P, G. Lake, Inc., 356 U,S, 260 (1958); and Arthur Andersen & Co., Oil and Gas « , , , p. 173.
20
TABLE 4
COMPUTATION OF C'S TAXABLE INCOME
Revenue
Oil sales (2,000,000 barrels x 75% working interest x $3.00)
Composed of: Principal $3,840,000 Interest 660,000 $4,500,000
Expenses
Depletion 4,050,000*
Taxable income to C $ 450,000
*Sura-of-dollars method: 12
Receipts for year ^ principal Total Expected Receipts ^
°^ lit:33°:000 $12,000,000 = $4,050,000
Frequently, C will borrow part or all of the
principal from another party, D, at a slightly lower percent
interest of/ for example, 5%. This procedure gives C a
^ interest spread (5 1% less 5%) as his ultimate tax
profit.
^^Ibid. 13 Arthur Andersen & Co., Oil and Gas . . . /
p. 174.
21
Influence of Proposed Legislation
An interview with Mr. E. L. Wehner/ partner in
charge of Arthur Andersen & Co.'s Houston office, disclosed
proposed legislation before The United States House of
Representatives' Ways and Means Committee which will
affect materially the ABC transaction and the respective
14 parties involved. As support for this interview, a
copy of the proposal prepared by the Treasury Department
has been secured by this author.
The Treasury Department's proposal, in effect,
would treat production payments as non-recourse loan trans
actions. As a result, the owner of the oil and gas lease
subject to the production payment would take into account
income and expenses with respect to the production payment
in the same taxable year. When an oil and gas property,
subject to a production payment, is transferred, it is
proposed that the transferee of the mineral property be
treated as if he had accjuired the lease subject to a
mortgage. The income derived from the property used to
satisfy the production payment would be taxable to the
owner of the property and would be subject to the allowance
for depletion. In the case of a working interest burdened
by a retained production payment, the production costs
14 E. L. Wehner/ private interview, June, 1969.
22
attributable to oil or gas applied to satisfy the pro
duction payment would be deductible in the year incurred. ^
Oilola Case Application
The proposed tax reforms would materially affect
Parties B and C in the Oilola Case, but would have no
effect on Party A. A will treat the gain on the sale of
his interest as a capital gain in the same manner as shown
in Table 2. B, however, will include the production pay
ment revenue in his gross income, subject to depletion,
during the payout period and will deduct as current expenses
the lifting costs incurred with respect to the oil used to
satisfy the production payment. C will treat the
$12,000,000 production payment as a nontaxable return of
capital and will record the interest as ordinary income.
Summary
The ABC transaction is, without a doubt, a "child"
of our Federal tax law. To discuss the transaction without
defining or setting forth these tax laws (both current and
proposed) would constitute a wholly inadequate discourse.
For that matter, it is extremely difficult to discuss any
Treasury Department, "Summary of The President's Tax Reform Proposals for The Revenue Act of 1969," Washington, D.C, April, 1969, (Xeroxed,)
23
major topic dealing with oil or gas accounting without
including income tax aspects and influences.
Current tax laws surrounding the purchaser of a
working interest subject to a retained production payment
have established the foundation for two of the three
variations in financial accounting treatment—the net
method and the economic-interest method. The net method
follows tax laws with few exceptions. Purchaser B
excludes from his income the proceeds from production
applicable to the retained production payment and includes
in his expenses all costs required to produce the total
hydrocarbon from the lease. The economic-interest method
follows income tcix laws and the net method with primarily
one major exception; that iS/ estimated lifting costS/
applicable to the production payment are capitalized and
amortized over the production attributable to B's interest.
The net cind economic-interest methods will be discussed
in Chapter IV.
The ecjuitable-lien method of financial accounting
treatment, however, does not follow current income tax
laws with respect to income to be recognized by B, This
method treats the ABC transaction as though B accjuires the
entire interest that was owned by A, the seller, with the
production payment assigned to B, The payment constitutes a
liability in the nature of an ecjuitable lien to be satisfied
24
only from the proceeds of the sale of oil and gas if,
and when, produced. The equitable-lien method of financial
accounting is supported by the proposed tax law changes
being considered currently by the House Ways and Means
Conmittee. . Foundations and possible consequences of the
equitable-lien method are discussed in chapter III.
CHAPTER III
FINANCIAL REPORTING UNDER THE
EQUITABLE-LIEN METHOD
Introduction
The equitable-lien concept of accounting for retained
production payments treats the transaction as though B, the
purchaser of the working-interest, acquired from A, the
seller, the entire or total property. This method, effec
tively, is contrary to the current legal view of the
"economic-interest" theory of law established previously in
Chapter II. The production payment is treated as a liability
of B in the nature of an ecjuitable lien to be satisfied only
from the proceeds of the sale of oil and gas as, and when,
produced. According to Arthur Andersen & Co., this method
regards the retained production payment as a method of
financing. Accordingly, the purchaser looks through the
legal form of the transaction and regards the substance
of the transaction as the acquisition of the entire property
subject to an unassumed lien thereagainst.
In substance, the equitable-lien method can be
inferred as being a lease which gives rise to property
^Arthur Andersen & Co., Accounting and Reporting . , p. 115.
25
26
rights since the purchaser of the working interest considers
himself the "owner" of the entire property. To the extent
that the leases acquired give rise to property rights for
the purchaser, then those rights and related liabilities
should be measured and incorporated in the balance sheet.
This chapter presents the equitable-lien method
of financial accounting and reporting by illustration of
the Oilola Case study and by examination of petroleum
company annual reports. These annual reports ser-ve this
chapter as support for the equitable-lien's use in practice.
Oilola Case Study
Assumptions
The Oilola Case study was introduced in chapter II
as the illustrative case for presentation purposes of this
thesis. For the sake of clarity and understanding in this
chapter, details of and assumptions to the case study are
reproduced in the following paragraphs.
A, the owner of the Oilola leases desires to sell
his leases to B, an oil operator, for $16,000,000. A,
utilizing the ABC tax arrangement for the transaction,
requires B to pay $4,000,000 in cash and retains an oil
John H. Myers, "Reporting of Leases In Financial Statements," Accounting Research Study No, 4 (New York, N.Y.: American Institute of Certified Public Accountants, 1962), p. 4.
27
production payment of $12,000,000 payable out of 75% of
future production. Upon completion of the transfer, A will
assign the production payment to C, a banker or separate
corporation, for immediate access of the principal cash.
Listed below is a summary of the major assumptions and
other information inherent in understanding the Oilola Case.
Oilola Case Major Assumptions 1. Party A 2. Party B 3. Party C
the seller or assignor the purchaser of the working interest the payment lender or corporation
4. Initial cash payment: $4,000,000 5. Retained production payment: $12,000,000 6. Interest on unliquidated payment balance: 5 ^ 7. Principal and interest payable out of 75%
of production 8. Total reserves: 10,000,000 barrels of oil 9. Barrel production per year: 2,000,000,
constant 10. Sales price per barrel: $3.00, constant 11. Lifting costs per barrel: $.40, constant 12. Fair market value of lease and well
equipment: $2,500,000
13. Royalties and production taxes: disregarded
Assume, additionally, that B is a recently formed corpora
tion with 40,000 shares of $100 par value capital stock
and no other assets or accounts than those recjuired for
the purchase transaction.
Purchase Transaction
The acquisition of the Oilola leases by B is
generally accounted for by recording the cash paid plus
the production payment's principal as productive assets
with the principal as a liability at the date of such
purchase, shown in the following entry:
J*!'*"''"
Lease and well equipment
Leasehold cost Production payment payable
Cash
Debit
2,500,000 13,500,000
28
Credit
12,000,000 4/000,000
Observe that the fair market value ($2,500/000) is used
for the recording value of lease and well equipment in
accord with income tax purposes. The leasehold cost is
the difference between the total sales price and the lease
and well fair market value ($16,000,000 less $2,500,000),
a treatment contrary to income tax regulations. Occasionally,
only the initial cash payment is charged to the leasehold
account at the date of accjuisition, and the additional
payments in liquidation of the production payment are
debited to the property account as they are subsecjuently
made. Let it be assumed, however, for the purpose of this
thesis, that the initial cash paid, net of the fair market
value of equipment, plus the production payment are
capitalized as leasehold cost as shown in the above entry.
The production payment payable account is more
frequently treated as a contra to the leasehold cost account
on the asset side of the balance sheet, in lieu of a debt
Leo C, Haynes, "Accounting for Leasehold Costs in the Petroleum Industry," The Journal of Accountancy (April, 1942), p, 336.
29 4
on the liability side. The theory behind this treatment
is founded on the fact that the payment is a contingent
liability to be paid only if the applicable hydrocarbon is
produced. As the production payment is liquidated, the
book value of the leasehold cost increases.
Income Statement Presentation
B's equitable-lien income statement for the five
productive years of the Oilola leases is shown in Table 5.
Oil sales revenue in Table 5 is the total gross production
from the leases. Gross income for the entire lease is
used under the equitable-lien method because B has acquired
A's entire interest subject to the lien on production.
This procedxire is contrary to the income tax accoiinting
discussed in chapter II where only oil sales applicable to
B's working interest are included in his gross income in
determination of taxable income.
According to Table 1, the first three years include
both the amounts applied to the liquidation of the produc
tion payment (75%) and the amounts applicable to B's
working interest (25%) or 2,000,000 barrels times $3.00
per barrel. Payout of the payment occurs at the end of
the third year, thereby boosting B's cash position
^Porter, p, 498.
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31
substantially for the fourth and fifth years. The income
statement, which, of course, continues to report total
property gross income after payout, does not indicate the
change in B's cash flow. More comments concerning proper
disclosure under these circumstances are discussed later
in this chapter.
Lease operating expenses and other lifting costs
are deducted in full from gross income as incurred, thereby
fairly matching costs given up with the applicable income
reported.
Lease and well equipment is depreciated over the
leases' productive life of five years on the unit-of-
production basis. Computation of depreciation per barrel
is determined by dividing the cost by the total reserves
($2,500,000 * 10,000,000 = $.25).
The leasehold cost is depleted over the productive
life of the leases also on the unit-of-production basis.
Computation of depletion per barrel is determined by
dividing the cost by the total reserves ($13,500,000 *
10,000,000 = $1.35).
Under the ecjuitable-lien method the oil production
applied to interest expense on the unlicjuidated principal
is deducted in the income statement along with operating
expenditures. Since the total interest on the unlic[uidated
payment is not capitalized with the leasehold cost and
32
since gross income includes the application of the payment's
principal and interest, this expenditure must be deducted
on the income statement.
Balance Sheet Presentation
The only significant items on B's balance sheet
under the equitable-lien method are the leasehold cost
section with its applicable amortization and the equity
section. Table 6 presents these two items as though they
were extracted from B's balance sheet.
The cash allocated to leasehold cost, as shown in
Table 6, is capitalized together with the production pay
ment principal, and the unlicjuidated principal is deducted
as a contra to the gross leasehold. As B produces the oil
subject to the production payment, he makes the entry
below to record the payment to the holder (see application
of production payment in Table 1 for determination of
amounts) . These proceeds paid to the holder are treated
partly as a reduction of the contingent liability account
operating to increase B's ecjuity in the leasehold account 6
and partly as a discount or interest expense.
^Smith and Brock, p. 350.
Sorter, p. 189.
33
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34
Debit Credit
Interest expense 660,000 Production payment payable
(leasehold cost) 3,840,000 ^^^^ 4,500,000
Net income and retained earnings are substantially
high under the equitable-lien theory on a per year analysis
and on a cumulative years' analysis since revenue is
reported at gross including both production payment
application and remaining working interest income. The
application of the production payment of $4,500,000 out of
$6,000,000 gross income in the first year's production /
presents an interpretative problem for financial reporting.
As to the solution to this matter, Stanley Porter commented,
"It is apparent that, in those instances where the gross
method" (equitable-lien) "of accounting is followed, it
is necessary to supplement the basic financial statements
of cash flow or working capital provided if they are to be 7
meaningful to the ordinary reader." The cash flow or
working capital analysis serves to reconcile the reported
income with the production payment applications until
payout status is reached.
" Ibid., p. 517.
35 Income Tax Allocation
income tax allocation under the equitable-lien
method Imposes, primarily, two problem areas determining
tax expenses in the statement of income and the amount of
Income tax for the Federal return. These areas are gross
income and depletion expense.
The gross income problem is centered around the
"total-property concept," characteristic of the equitable-
lien method of accounting, versus the "separate-property
concept," characteristic of Federal income tax regulations.
In the Oilola Case Purchaser B accounts for total property
gross income for financial purposes ($6,000,000)7 whereas,
under income tax laws, B must account for his separate
property gross income ($1,500,000).
The depletion expense problem is also founded on
the total property concept of the equitable-lien method.
Capitalization of $13,500,000 of leasehold costs for
equitable-lien purposes, as opposed to $1,500,000 for
income tax purposes, creates substantial differences in
the two methods' depletion expense.
These two differences are considered to be permanent
differences according to APB Opinion No. _11 since they
" . . . arise from statutory provisions under which
specified revenues are exempt from taxation and specified
expenses are not allowable as deductions in determining
36 8
taxable income." Only a footnote informing the statement
reader of the nature and amounts, if material, of these
permanent differences would be required for fair financial
disclosure.
Annual Report Excerpts
Coastal States Gas Producing Company utilized the
equitable-lien method in reporting its purchase of pro
ductive leases subject to retained production payments
for the fiscal year 1968. In their annual report, certified
by the accounting firm of Touche, Ross, Bailey & Smart,
Coastal included $443,561 pre-tax income applicable to the
production payment in the total pre-tax income of
$24,382,085. A cash flow or working capital statement was
not included with the financial statements or appended 9
notes. The auditors issued an unqualified audit report.
In a more vivid and more material example. General
American Oil Company of Texas also used the equitable-lien
method in their 1968 annual report. General American's
total pre-tax income for the comparative years reported
was $23,322,405 for 1968 and $12,829,943 for 1967 of which
^Accounting Principles Board, "Accounting for Income Taxes," Opinion No. U (New York, N.Y.: American Institute of Certified Public Accountants, 1967), p. 168.
^Coastal States Gas Producing Company, Annual Report (1968), pp. 12-16.
37
$14,448,770 in 1968 and $11,028,504 in 1967 amounted to
income applied to liquidation of the retained production
payment's principal and interest.
The Company's balance sheet for both years included
in the gross cost of producing properties approximately
$170,000,000 applicable to leases subject to the produc
tion payment. In a footnote to the financial statements,
disclosure was made of such amounts together with a state
ment that since no direct liability attached to these
payments, the unpaid balances were shown as a deduction
from the property accounts.
General American included a statement of source
and application of funds with its financial statements
which presented the amounts applied to liquidation of the
retained payments; and the Company disclosed, in the foot
note, the accounting method employed and the retained
amounts involved—gross income from crude oil and gas sales,
taxes and interest expense, and net proceeds. General
American also provided another footnote on income taxes
stating that the recognized production payment amounts
were excluded in determination of the income tax liability
for financial reporting purposes. Ernst and Ernst,
^^General American Oil Company of Texas, Annual Report (1968), pp. 15-21.
^^Ibid.
38
General American's auditors, issued an unqualified audit 1 o
report for the reported year.
Summary
The equitable-lien method treats the retained
production payment as an acquisition by the working-interest
party of the entire leases subject to an unassumed lien.
This view looks through the legal concept (Federal income
tax law) which requires separate reporting of income as
between the purchaser and the holder of the production
payment for their appropriate interests. The production
payment principal and initial cash paid are capitalized in
full as property accounts. The unpaid payment is pre
sented as a liability, either contra to the property or
as a debt on the right side of a balance sheet.
Net income, total and per share, includes all
amounts of income and expense applicable to the total
property, even though a certain percent of gross income,
retained by the payment holder, is paid to him during
payout status of the production payment.
Fair and informative disclosure under the equitable-
lien concept has required practitioners to include either
in the footnotes or in the funds statement sufficient
information for the reader to ascertain the accounting
•"•^Ibid.
39
and reporting nature of retained payments and amounts «
involved, if material. A footnote, regarding income tax
expense allocation has also been regarded as necessary
for informative disclosure.
CHAPTER IV
FINANCIAL REPORTING UNDER THE NET
AND ECONOMIC-INTEREST METHODS
Introduction
Current tax laws and legal framework of the ABC
transaction have established two related methods of
financial reporting and accounting for retained production
payments—the net and the economic-interest methods.
The net method follows Federal income-tax reporting
with one minor exception. The purchaser of the working-
interest, B, under this method, records his initial cash
outlay as property,* he includes in his gross income only
that which is applicable to his working interest, and he
deducts all costs and expenses incurred in operation of
the total properties. The primary exception between this
financial method and income tax reporting lies in the area
of cost depletion for book purposes versus percentage
depletion for tax purposes.
The economic-interest method follows Federal income
tax reporting and the net method with one major exception.
Similar to the net method of financial reporting, this
method requires the purchaser to include in his gross
income only that which is attributable to his working
40
41
interest, not that retained by the production payment
holder; and it requires the purchaser to record his initial
cash outlay as property. The major exception to the
economic-interest method, when compared to Federal income
tax reporting, is that lifting costs applicable to the
retained production percentage are capitalized as additional
leasehold cost for the payout period of the production
payment and are amortized over the productive life of the
property. This procedure, of course, creates a difference
between cost depletion expense for book purposes and
percentage or cost depletion, whichever is applicable,
for income tax purposes.
Basic reasoning that supports the accounting
treatment of these two related methods is that retainment
of the oil payment has resulted in the creation of two
complete and separate properties. This concept is the
legal view established by the Thomas v. Perkins Supreme
Court case. The purchaser is considered to be the owner
of a future or residual interest, and the production
payment holder is considered to be the owner of a right
to substantially all the oil produced from the property 2
until his interest has been liquidated.
^Thomas v. Perkins, 301 U.S. 655 (1937); and A. W. Walker Jt., Texas Law Review, XX, No. 3, 268-270.
^Ibid.
42
This chapter discusses these accounting and
reporting aspects of the two related methods. Like
Chapter III, emphasis on presentation in this chapter is
placed on the Oilola Case study and on appropriate petroleum
company annual reports. These annual reports serve this
chapter, like Chapter III, as support for the methods'
use in practice.
Oilola Case Study
The Oilola Case study, previously introduced in
Chapters II and III, is the illustrative case for presen
tation purposes of this thesis. For the sake of clarity
and understcinding in this chapter, details and assimiption
to the case study are reproduced in the following
paragraphs.
A, the owner of the Oilola leases, desires to
sell his leases to B, an oil operator, for $16,000,000.
A, utilizing the ABC tax arrangement for the transaction,
requires B to pay $4,000,000 in cash and retains an oil
production payment of $12,000,000 payable out of 75% of
future production. Upon completion of the transfer A will
assign the production payment to C, a banker or separate
corporation, for immediate access of the principal cash.
Listed below is a summary of the major assumptions and
other information inherent in understanding the Oilola
Case.
43
Oilola Case Ma lor Assumptions 1. Party A: the seller or assignor 2. Party B: the purchaser of the working
interest 3. Party C: the payment lender or corporation 4. Initial cash payment: $4,000,000 5. Retained production payment: $12,000,000 6. Interest on unliquidated payment balance: 5^. 7. Principal and interest payable out of 75%
of production 8. Total reserves: 10,000,000 barrels of oil 9. Barrel production per year: 2,000,000,
constfioit 10. Sales price per barrel: $3.00, constant 11. Lifting costs per barrel: $.40, constant 12. Fair market value of lease and well
equipment: $2,500,000
13. Royalties and production taxes: disregarded
Assume, additionally, that B is a recently formed corpor
ation with 40,000 shares of $100 par value capital stock
and no other assets or accounts than those required for
the purchase transaction.
Purchase Transaction
The net method records the acquisition of the
productive leases on the basis of fair market values. The
initial cash payment of $4,000,000 by B is allocated to
lease and well equipment ($2,500,000, the fair market
value) and leasehold cost ($1,500,000, the balance). This
proportioning is in full compliance with Federal income
tax reporting discussed in Chapter 11.^ The entry below
^Arthur Andersen & Co., Oil and Gas . . • / p. 248.
44
reflects the accounting mechanics of the purchase trans
action under the net method.
Debit Credit
Lease and well equipment 2,500,000
Leasehold cost 1,500,000 Cash 4,000,000
Similar to the net method, the economic-interest
accounting requires the fair market value to be used in
allocating a value to the lease and well equipment account.
The leasehold cost account, however, includes not only
the balance between the equipment' s fair market value and
the initial cash outlay, but also the capitalized lifting
costs to the extent of the interest retained by the pro
duction payment. Determination of these lifting costs is
made by estimation both of the lifting cost per barrel
and of the barrel reserves needed to liquidate the pro
duction payment. These estimations, based on engineering
and costs analyses, are usually realistic and have general 4
acceptance among accountants in the petroleum industry.
The Oilola Case purchase transaction under
economic-interest accounting would be recorded as shown
on the following page.
^porter, p. 499.
45
Debit Credit
Lease and well equipment 2,500,000
Leasehold cost 3,278,000 Cash 4,000,000 Accrued lifting costs 1,778,000
The capitalized lifting costs in the above entry are
computed by multiplying the barrel reserves applicable
to the retained interest (see Table 1) times the lifting
cost per barrel (4,445,000 x $.40 = $1,778,000). These
costs are credited to an accrued liability account since
they are an estimate of future amounts payable which are
attributable to C's share of future production. The
accrued account, sometimes termed a reserve or a deferred
liability, is amortized only by payments of these lifting
costs when incurred or by revised engineering or cost 5
estimations.
Occasionally, lifting costs are capitalized each
year as incurred, thereby eliminating the need for a
reserve for lifting costs. Under this procedure the
leasehold cost account increases annually, requiring
separate computations of per-barrel depletion cost for
each year during payout. Results of annual lifting cost
capitalization are lower per-barrel amounts in earlier
^Robert M. Pitcher, Practical Accounting for O U Producers (Tulsa, Okla.: Robert M. Pitcher, 1957), p. 116.
46
years and higher amounts in later years. For illustration
purposes, however, this thesis utilizes the reserve or
accrual method of capitalizing lifting cost.^
In both the net and the economic-interest methods,
a memorandum entry of the production payment principal
($12,000,000) is made, but no actual recording or reflec
tion is made on B's books or financial statements, except,
perhaps, in footnote form. This procedure characterizes
the separate property concept, discussed previously.
Income Statement Presentation
B's income statements, under the net and the
economic-interest methods, for Oilola's five productive
years, are presented in Tables 7 and 8, respectively.
Reference should be made, at this point, that payout of
the production payment occurs at the end of the third
year, converting B's percentage of gross income from
25% to 100%. At the bottom of these tables, a reproduc
tion from Table 1 is made of barrels attributable to
B and C's interests in regard to pre-payout and post-
payout status of the production payment.
Oil sales revenue in Tables 7 and 8 represent
solely B's working interest for each year, computed by
^porter, p. 501.
47
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49
multiplying his yearly working-interest barrels times
$3.00 per barrel. When payout status of the production
payment is reached, B's gross income is increased sub-
stantially^ reflecting the conversion from separate
properties into total properties.
Lease and well equipment is depreciated in the
same manner under the net and the economic-interest
methods (also in full accord with Federal income tax law).
Computation of the per-barrel provision is based on the
unit-of-production method by dividing the total leasehold
cost by B's total working-interest reserve ($2,500,000 ^
5,555,000 = $.45). Observe that B's working-interest
reserve is used as the denominator in this computation in
lieu of the total-barrel reserve of the property, a method
utilized by the equitable-lien method (Chapter III).
Under the net method lifting costs in full are
deducted from revenue as the expense is incurred each
year (2,000,000 barrels x $.40 per barrel). Leasehold
cost of $1,500,000 is amortized as depletion expense by
the unit-of-production method, utilizing B's working-
interest reserve in the same manner depreciation expense
is computed for both methods ($1,500,000 t- 5,555,000 =
$.27).
The economic-interest method, however, has an
interrelationship between lifting cost and depletion
50
expense. Estimated lifting costs attributable to C's
working interest during payout are capitalized as additional
leasehold cost at the date of acquisition. This capitalized
lifting cost is added to the allocated amount from the
initial cash payment, as demonstrated in the purchase
transaction. The total leasehold cost of $3,278,000 is
then amortized as depletion expense by the unit-of-
production method, also using B's working-interest barrels
($3,278,000 • 5,555,000 = $.59).
Interest expense which is incurred on the un
liquidated payment principal before payout status has
been reached is not deducted on the income statements
following net or economic-interest accounting methods.
Reasoning supporting this treatment follows the separate
property concept. Since the production payment is con
sidered to be a separate economic interest (under these
related methods) and since the gross income applicable
thereto is excluded from B's gross income for the two
methods' statement purposes, this expenditure must be 7
deducted on the income statement.
Balance Sheet Presentation
Leasehold cost and stockholder equity accounts
are presented as though they were extracted from B's
" Ibid., p. 189
>.0t*^
51
balance sheet in Table 9 for both the net and the economic-
interest methods. These two accounts are considered the
most significant items on B's balance sheet for comparative
purposes.
Observe, in Table 9, the significant variances
between leasehold cost for the net method and the leasehold
cost for the economic-interest method. The amount for the
net method runs about half that of the same amount for the
economic-interest method until the Oilola leases have
been fully depleted of all reserves (end of fifth year),
at which time the two accounts are equal. This difference,
of course, is the result of the capitalized lifting costs
under the economic-interest method.
B does not account for the production payment in
his balance sheet as a direct or an indirect liability
since he has not acquired and will not acquire the portion
of the property retained for the payment out of oil; he
is, therefore, not liable for the amounts of the lien on
the total properties. B is only liable, effectively, to
operate the property. Any liability, as previously stated
in Chapter II, attaches between parties A and C since A
has borrowed the principal from C with a guaranty that it
will be repaid by A, only if the leases prove to be 8
worthless before liquidation of the payment occurs.
^A. W. walker, Jr., Texas Law Review, XX, No. 3, 268-270.
HHBBkrr-
52
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53
Retained earnings and total stockholder.equity
for the two methods in Table 9 are. equal at the end of the
leases* productive life; however, substantial differences
occur in the between years before the leases' expiration.
These differences are due to the deduction of lifting
costs in total as incurred under the net method while
these same lifting costs are capitalized under the economic-
interest method.
In a final comparison of the two methods the 9
economic-interest method more nearly approaches the cost
and the matching principles established by the accounting
profession as having substantial authoritative support
for fair and informative accounting and reporting. The
cost principle is important under economic-interest
accounting since the amount of lifting cost is relatively
material to the transaction as a whole, and, without
disclosure of such amounts, a misstatement of fact occurs.
The net method disregards the capitalized lifting cost
approach and deducts these costs currently as incurred^
a procedure which leads to the matching principle. The
matching principle is violated under the net method by
^Paul Grady, "Inventory of Generally Accepted Accounting Principles for Business Enterprises," Accounting Research study No. 7 (New York, N.Y.: American Institute of Certified Public Accountants, 1965), p. 228.
^^Ibid., p. 74.
54
failure to give effect to the lifting cost since the costs
to produce the production payment oil is as much a cost
of the last barrel produced as of the first barrel. Loading
the entire lifting cost against B»s working interest only
during the first three years' production results in a
non-matched relationship between gross income and expense.
The economic-interest method more fairly matches these
lifting costs with the applicable gross income received.^^
Income Tax Allocation
Income tax expense allocation for the net method
is not deemed necessary since reported income can be
reconciled to taxable income simply by accounting for the
difference between cost depletion used for book purposes
and percentage depletion, if used, for tax return purposes.
According to APB Opinion No. 11 this type of difference
amounts to a "permanent difference" and requires no
12 allocation of interperiod tax expense.
Income tax expense allocation under the economic-
interest method, however, is required. Treatment of the
lifting costs, as part of B's additional leasehold cost,
requires such tax allocation since these costs are
•'•Smith and Brock, pp. 350-352.
•^^Accounting principles Board, p. 168
55
customarily deducted in full for tax purposes. APB
opinion NO. 11 states that this type of timing difference
is one in which/ "Expenses or losses are deducted in
determining taxable income earlier than they are deducted
in determining pre-tax accounting income." The Board
concluded that this type of timing difference should be
accounted for by tax expense allocation in the year(s)
in which the differences arise and in the year(s) in
which the differences reverse.
Annual Report Excerpts
Net Method
Atlantic Refining Company, in 1957, utilized the
net method in reporting their purchase of the productive
leases of Houston Oil Company of Texas subject to two
retained production payments. Atlantic advanced $75,000,000
cash for the initial payment for the properties with the
14 production payments amounting to $125,000,000.
In a footnote in their annual report, Atlantic
stated that the production payments were not considered/
" . . . indebtedness, direct or indirect, contingent or
^^Ibid., p. 165.
^^Schlosss te in , Tl e Texas C e r t i f i e d Public Accountant, XXXI, No. 6, 16 .
56
otherwise of the company. . . . " and were not reflected
in any manner in the balance sheet of the Company. The
Company also informed its stockholders that the remaining
15% of production, not retained by the payment holder^
was estimated to yield enough to pay for operating expenses
of the total properties.
In this author's review of more than twenty
different annual reports and his study of several texts
and articles, the above example of Atlantic's acquisition
was the only practice found utilizing the net method.
Certain accounting authorities, however, have commented
that this method is the "forerunner" of all methods used
in practice because it is used more widely than the other
methods. This author submits that the net method may be
used more widely than the other methods but only in
smaller unpublished company reports or when immaterial
amounts are involved. In the twenty-plus annual reports
reviewed, all petroleum companies exercised either the
economic-interest or the equitable-lien method in accounting
for acquisition of properties subject to retained produc
tion payments. Reasons for these choices are presented
in Chapter V.
^^Ibid., p. 17.
57
Economic-Interest Method
Continental Oil Company utilized the economic-
interest method in accounting for its acquisition of the
coal properties of Consolidated Coal Company in 1966,
subject to a reserved production payment of $450,000,000.
in their annual report, certified by Arthur Young and
Company/ Continental summarized that the costs of producing
coal (mining costs) applicable to the production payment
are capitalized and cimortized using per-ton rates designed
to write off the capitalized mining costs over the Company's
share of the estimated tonnage. Capitalized amounts were
disclosed. Amounts were also disclosed in Continental's
statement footnotes of the revenues excluded from income
and applied against the production payment, including
principal, interest, and closing costs. The auditors
16 issued an unqualified audit report.
In their 1968 annual report Ashland Oil and
Refining Company also utilized the economic-interest method
of accounting for purchase of properties subject to
retained production payments. In a footnote to the finan
cial statements the Company disclosed that it is a practice
to capitalize lifting costs attributable to the production
payment holder's interest and amortize these amounts over
••• Continental Oil Company, Annual Report (1968), pp. 33-37.
58
the productive life of the leases based on the working-
interest reserves not retained. Amounts capitalized as
property costs and amounts excluded from income applicable
to the production payments were disclosed in the footnotes.
Ashland's auditors, Ernst and Ernst, issued an unqualified
17 audit report. '
Summary
The net and economic-interest methods are related
methods; they both treat the retained production payment
as an acquisition by the working-interest party of only
that psurt of the lease not retained by the payment holder.
This theory is conceived as a separate-property concept
which requires the purchaser to account for his working
interest only. The production payment debt is not accounted
for (except by memorandum entry) by the working-interest
party since he is not directly, indirectly, or contingently
liable for its liquidation.
The net method deducts lifting costs in full,
while at the same time the method includes in income only
the interest attributable to the purchaser's share until
payout. Under this procedure lifting costs are not
equitably matched with gross income recognized. The
" Ashland Oil & Refining, Annual Report (1968), pp. 22-27.
59
economic-interest method, however, capitalizes as addi
tional leasehold cost those excess lifting costs over
the purchaser»s working-interest and amortizes the
leasehold cost over the life of the property. This
principle fairly matches lifting costs with applicable
gross income recognized by the purchaser.
These two methods follow the legal and Federal
income tax foundations of the ABC transaction, and they
elude the financing arrangement concept which is recognized
by the equitable-lien method. Both methods are used by
petroleum companies and both methods currently are con
sidered "generally accepted" by the accounting profession.
CHAPTER V
COMPARISON AND CRITIQUE OF THE
THREE DIVERSE METHODS
Introduction
Three diverse methods of accounting for retained
production payments by the working-interest purchaser
have been surveyed in Chapters III and IV. An illustrative
case study (the Oilola case) has been carried throughout
these chapters to present the accounting and reporting for
each of the three methods. The equitable-lien, the net,
and the economic-interest methods all have supportive
arguments which can be asserted to defend or condemn each
method's use for proper accounting recognition, a fact
that is obvious since all methods are utilized in practice.
The three methods are considered to have general
acceptance among practitioners in the accounting profession.
This thesis has demonstrated that all three methods have
been used by prominent petroleum companies in current and
prior years. As of the date of this writing, the American
Institute of Certified Public Accountants has not issued
Schlossstein, The Texas Certified Public Accountant, XXXI, No. 61, 14-17; Porter, 498-508; and Smith and Brock, 346-352.
60
61
any opinion or any research bulletin of what it considers
proper accounting for production payments. The American
Institute has, however, engaged a research study on extrac
tive industries and plans to issue the study sometime in
the future. The study, which began in 1964, is being
conducted by Robert E. Field, a partner with Price Water-
house and Company. The problem of production payments will 2
be surveyed thoroughly by this research project.
This chapter brings these three methods together
in comparative form, displaying the diversity created in
earnings and book values per share under the same assumptions
of the Oilola case. General critiques of each method are
presented with the comparisons, and a specific critique is
pointed out as being the essence or deciding factor that
should determine proper accounting treatment.
General Critiques and Comparison
Summarizing the three methods in illustrative form.
Table 10 reproduces from previous tables per share earnings
and book values for the productive life of the Oilola
leases. An examination of Table 10 reveals significant
differences in earnings and book values per share utilizing
identical assumptions of the Oilola case for the three
^American Institute of Certified Public Accountants, Newsletter, Jan. 17, 1969.
62
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63
methods. These differences occur only between years before
e qpiration of the leases' useful life, and .the cummulative
or total effect after expiration is identical for the three
methods. Thus, the problem of accounting and reporting
the three methods is between years before e:q>iration of
the leases' life and not the total overview of the financial
data. It is difficult to conceive of this diversity (many
times with immense magnitude and materiality) which has
created a lack of financial comparability and uniformity
among petroleum companies but which has received acceptance
from members of the accounting profession.
The most significant diversity between years for
the methods is earnings per share. Figure 1 reproduces
in graphic form the variances between the methods' yearly
earnings per share.
The Equitable-Lien Method
The equitable-lien method maintains a higher and
more level earnings per share during pre-payout status
than the other two methods as noted in Figure 1. Higher
income occurs because the method reports total income and
expenses from the entire property with the upward move
ment being caused by decreased interest expense paid to
the production payment holder during the payout period.
The leveling effect in earnings is created since no change
64
$100.00 ^
$ 75.00
Earnings Per Share
$ 33.50
$ 25.00
$ 19.50
$ 8.50
$ 0.00
Average
End of Year
Fig. 1.—Earnings Per Share for the Tliree Methods
65
in gross income occurs after payout and since the production
payment is capitalized as leasehold cost and depleted
evenly over the life of the entire property.
Equitable-lien accounting recognizes income evenly
over the life of the total property, and it matches income
with expenses in an equitable manner. The method makes an
appropriate recognition of the build up in the purchaser*s
equity of the property as can be noted by examination of
book values per share (see Table 10) . The legal view is
disregarded under this method in favor of the business
intent of the arrangement, a matter discussed as the
"specific critique" later in this chapter.
The equitable-lien method requires that full
disclosure be made of the fact that certain earnings have
been set aside for liquidation of the production payment;
and, therefore, earnings may not necessarily provide a
source for dividends until the payment has been liquidated.
This requirement is satisfied by providing a funds statement
or footnote disclosing amounts applied to the production
payment. The method recjuires a footnote informing readers
the reason for relatively small income tax expense in
relation to the large net income and the reason that
allocation of such tax expense is not necessary.
66
The Economic-Interest Method
The economic-interest method maintains, in Figure 1,
a lower earnings per share than the equitable-lien method
before payout of the production payment, and its earnings
jump well above the equitable-lien's earnings after payout.
This trend occurs since the economic-interest method re
ports only the purchaser's working-interest income and
expenses before payout and reports total property income
and expense after payout. This method, similar to the
net method, depletes the cash allocated leasehold cost
plus capitalized lifting costs as opposed to the cash
allocated amount plus the large production payment char
acteristic of equitable-lien accounting.
The economic-interest method yields to estimations
and human judgment since the number of barrels to be
applied to the production payment must be pre-determined
together with the future lifting cost per barrel for
capitalization of such as leasehold costs. This method
defers recognition of income from the total property until
payout of the production payment occurs, thereby causing
an erratic jump in net income. Such an earnings' jump
may tend to create an unwarranted rise in the company's
market price per share of trading stock. Income is fairly
matched with expenses under this method since all lifting
costs are not deducted as incurred. Economic-interest
67
accounting does not recognize the build-up in the lease
hold equity since it substantially conforms to the separate
property idea of income-tax law and accounts for the pro
duction payment principal only in memorandum form. The
income tax and legal views are discussed in the "specific
critique" later in this chapter.
The Net Method
The third accounting treatment, the net method,
has lower earnings per share before payout than the other
two methods (see Figure 1), yet it exceeds the other two
methods during the post-payout period. Reporting the
purchaser's gross income only and deducting total expenses
applicable to the entire property causes the lower earnings.
Since this method capitalizes only the allocated cash as
leasehold cost, depletion expense is less than the other
methods, thus causing net income to be higher after payout
of the production payment.
The net method has one basic fault, one that, in
this writer's opinion, negates altogether the use of the
method for any type of financial reporting. The fault is
that income is not fairly matched with expenses. Only the
p\irchaser's fractional income is reported on his income
statement, while all of the lifting costs for the entire
properties are deducted from this income before payout of
the payment.
68
Interperiod tax allocation is not necessary under
the net method since taxable income and accounting income
are reconciled with each other simply by discounting
percentage depletion taken for tax purposes. A funds
statement or an applicable footnote thereto is not necessary
because the income statement reflects the actual flow of
funds.
Like the economic-interest method, the net method
creates a drastic jump in earnings when payout of the
payment is reached. Too, this method follows the income
tax and legal views of separate properties, a problem
discussed immediately below under "specific critique."
Specific Criticfue and Recommendation
The above general critiques and comments (especially
those for the equitable-lien and economic-interest methods)
can be argued favorably or unfavorably by almost any party
without determining a sound guideline for appropriate
accounting treatment. A more specific critique of the
three methods^ the legal versus the economic viev/point, is,
in this writer's opinion, the sole determinant in selecting
the proper method for fair accounting and reporting purposes.
The retained production payment, or ABC transaction,
was determined to be a "child" of our income tax law in
Chapter II. If purchaser B desires to buy the leases from
69
seller A, then he has two choices in selecting the means
to finance the purchase. First, he could pay cash for the
entire sales price amounting to an ordinary sale transaction.
The accounting treatment for this oil lease purchase trans
action is the same as that for the common purchase of
buildings or equipment. Mechanics of recording this type
of transaction require a debit to property for the cost and
a credit to cash or some sort of liability. Secondly,
purchaser B could negotiate with seller A to utilize the
ABC transaction (an income-tax arrangement) for the purchase
of the leases. Under this treatment A receives from B
only a minimal initial cash outlay and retains a certain
amount of future production from the property for the
balance of the sales price. The accounting treatment for
this arrangement has led to the three diverse methods
discussed previously.
The result or final outcome of both of these
choices (cash purchase or ABC arrangement) is essentially
Identical. B acquires the property with a duty to operate
it; A receives cash and a lien on future production as
consideration for his property given up.
TOie problem of accounting for the ABC purchase of
oil leases is reduced to a legal versus an economic or
business viewpoint. Should B record the transaction as
though he acquired only that which has not been retained
70
as a lien by A, a concept conforming to the legal view
of the purchase? Or should B treat the transaction as
though he has acquired the entire property subject to a
non-recourse loan conforming to the economics and the
business intent of the purchase? Whether the cash purchase
or the ABC arrangement is used, the economics or business
intent is the same—the transfer of property from seller
to purchaser. The ABC method is merely a financing
agreement similar to an installment loan, B pays a small
down payment and, subsequently, makes installments on the
remaining purchase price. The only reasons the ABC trans
action is utilized in lieu of an installment loan are due
to the income tax and payment licjuidation advantages
acquired by B. The income tax advantage permits B to
exclude from his taxable income the proceeds applied to
the production payment liquidation—the separate property
foundation of income tax and legal views. The liquidation
advantage reqires that B is not directly, indirectly, or
contingently liable for the liquidation of the production
payment if the leases prove to be worthless. Both of these
advantages do not alter the business or economic intent
of the transaction—the purchase and sale of property.
Of the three accounting methods for the ABC
arrangement, the equitable-lien treatment is the only means
that fully satisfies the business intent of the parties
71
in the financing transaction. The method assumes that
the purchase of the oil leases is like the purchase of
any other property, it records the full sales price as
the cost of the asset acquired, and the liability is recog
nized in the debt section of a balance sheet or is shown
as a contra to the property during payout.
The other two methods, net and economic-interest,
disregard the financing agreement and treat the ABC
transaction in conformity with strict or modified income-
tax and legal arrangements. They record only gross income
applicable to the purchaser and deduct expenses either
applicable to the entire property or applicable to the
working-interest percentage, within these methods, the
financing agreement is completely eluded since the sales
price of acquiring the property is not capitalized as cost
of the property and an obligation to pay a certain per
centage of oil as, and when, produced in the future is
neither reported nor disclosed.
The subject of retained production payments is
currently being investigated by The United States House
of Representatives' Ways and Means Committee, a topic
which was discussed in Chapter II. The House Committee is
considering a proposal submitted by The Treasury Department
which will treat production payments as non-recourse loan
transactions. This proposal requires the purchaser to
72
take into account income and expenses for the entire property
and to treat the transaction as though he acquired the
entire lease subject to a mortgage. The Congressional
proposal is in exact alignment with the equitable-lien
method of accounting and with the business intent of the
financing arrangement.^
If the proposal is passed by Congress, accounting
practitioners have no choice but to utilize the equitable-
lien method since the other two methods will only be
derivatives of old tax laws. If the proposal is not
passed by Congress, the underlying concept of the ABC
transaction still exists as a means of financing and the
arrangement should be treated as such rather than some
legal hybrid that avoids the essence of the purchase.
In line with the business intent, the economics
of the transaction, and the inherent financing character
istics, only one method exists to present fairly the
financial position and results of operations of a company—
the equitable-lien method. There is no difference,
financially speaking, between an ABC transaction and the
pledging of oil reserves for a loan, similarly, there is
no difference between the ABC transaction and the purchase
^Treasury Department, "Summary of The President's Tax Reform Proposals for The Revenue Act of 1969," Washington, D.C, April, 1969. (Xeroxed.)
73
of a building with a pledge of a certain amount of income
for payment thereof, if the accounting profession is to
continue to report to interested parties this financial
status of companies, it must not alter its course by
treating the same financing transaction in one manner at
one time and in an alternate manner at another time.
Summary
The three methods of accounting for retained pro
duction payments, when placed in comparative form under
identical assumptions, clearly reveal the diversity and
lack of uniformity that is prevalent within the petroleum
industry and the accounting profession. Accounting
practitioners and petroleum companies alike are detouring
in varied ways, trying to accomplish their reporting goal,
fair presentation, without establishing a method which
has general acceptance and substantial authoritative
support.
The equitable-lien and the economic-interest methods
have general supportive arguments which can lead to justi
fication for both when considering solely these general
critiques. Some of the general critiques included in this
chapter are the matching principal, interperiod tax
allocation, funds flow disclosure, and leasehold cost
accounting. The net method, however, has little or no
74
support among these general critiques for appropriate
accounting treatment since the method materially violates
the matching principle. The net method should be excluded
from financial reporting altogether because of this factor
alone.
A specific critique, when comparing the ecjuitable-
lien and the economic-interest methods, is centered around
the business intent and the applicable tax law of the
production payment transaction. The economic-interest
method looks through the business intent of the trans
action, which is a financing arrangement, in favor of
income-tax accounting or separate property treatment.
The equitable-lien method follows the intent of the pro
perty exchange as a financing agreement and wholly disre
gards the separate property of Federal income-tax concept.
The equitable-lien method of accounting for the
retained production payment should be the only generally
accepted method because its characteristics are in perfect
harmony with the economics and business purpose of the
transaction. Fair and informative financial reporting
requires this type of accounting treatment rather than some
sort of hybrid method that does not meet the business
intent objective.
y
CHAPTER VI
SUMMARY
Three methods of accounting for retained production
payments by the purchaser of a working interest have been
developed in the past fifty years—equitable-lien, net,
and economic-interest methods. These methods' financial
results are quite diverse, and for this reason, they lead
to lack of comparability and uniformity among petroleum
company annual reports utilizing the retained production
payment. An illustrative case study, carried throughout
this thesis, cleeirly reveals this diversity and lack of
comparabi1ity.
A retained production payment is a financing
arrangement. The owner of a working interest sells his
oil or gas properties to a purchaser for a small down pay
ment and retains a certain percentage of future production
for the balance of the sales price. The seller, in turn,
assigns the retained production payment to a lender for
an advance of cash.
Current income tax laws have established the
accounting characteristics of the net and economic-interest
methods. The tax law states that the retained production
payment creates two economic interests in the property
transferred—that retained by the holder of the payment
75
76
and that remaining with the purchaser of the working
interest. The net and the economic-interest methods are
related since they both account for these separate interests
of the property until payout of the production payment
occurs. Once liquidation of the production payment is
reached/ then these two methods begin accounting for the
total property interests. The purchaser reports, before
payout, gross income attributable to his remaining working
interest only. The purchaser also reports costs and
e3q>enses attributable solely to his remaining working
interest with the exception of lifting costs.
The net method deducts lifting costs in full for
the total property each year. This procedure causes
expenses to be matched fairly with applicable income during
the payout period. For this reason alone, the net method
has little or no accounting validity in accomplishing the
objective of fair presentation.
The economic-interest method, on the other hand,
capitalizes lifting costs attributable to the production
payment and only deducts those lifting costs belonging
to the purchaser's remaining interest during the payout
period. This procedure results with income being fairly
matched with expenses.
The equitable-lien method follows the business
intent rather than the current tax law in accounting for
77
retained production payments. This method treats the
retained production payment as an acquisition by the
purchaser of the entire leases subject to an unassumed
lien. Gross income and expenses from the entire property
are fairly matched and reported by the purchaser of the
property. The production payment principal and initial
cash paid are capitalized in full as cost of the total
property acquired. The unpaid payment is recognized as
a liability by the purchaser during the liquidation period.
A specific critique, when comparing all three
methods for fair reporting purposes, is centered around
the business intent and the applicable tax law of production
payment transactions. The net and economic-interest methods
look through the business intent of the transaction, which
is a financing arrangement, in favor of income tax account
ing. The equitable-lien method follows the intent of the
property exchange as a financing agreement and wholly
disregards current income-tax accounting.
This author believes there is no difference between
the production payment transaction and the pledging of oil
reserves for a loan. The retained production payment is
merely a non-recourse loan transaction with inherent tax
benefits belonging to the parties involved. Accounting
treatment should follow the business intent and the
economics of the financing agreement like that of any sale
78
of property, by establishing the equitable-lien method
as the only acceptable means to present fairly the
financial characteristics of the transaction.
BIBLIOGRAPHY
Books
Arthur Andersen & Co. Accounting and Reporting Problems. Chicago, 111.: Arthur Andersen & Co., 1962.
• Q J- and Gas Federal Income Tax Manual. Chicago, 111.: Arthur Andersen & Co., 1966.
Breeding, Clark W., and Burton, Gordon A. Income Taxation of Oil and Gas Production. Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1961.
Irving, Robert H., and Draper, Verden R. Accounting Practices in the Petroleum Industry. New York, N.Y.: Ronald Press, 1958.
Miller, Kenneth G. Oil and Gas Federal Income Taxation. New York, N.Y.: Commerce Clearing House, Inc., 1967.
Pitcher, Robert M. Practical Accounting for Oil Producers. Tulsa, Okla.: Robert M. Pitcher, 1957.
Porter, Stanley P. Petroleum Accounting Practices. New York, N.Y.: McGraw-Iiill Book Company, 1965.
Smith, Aubrey C , and Brock, Horace R. Accounting for Oil and Gas Producers. Englewood Cliffs, N.J.: prentice-Hall, Inc., 1959.
Periodicals
Accounting principles Board. "Accounting for Income Taxes," Opinion No. Ij . New York, N.Y.: American Institute of Certified Public Accountants, 1967.
Bullion, J. Waddy. "Tax Aspects of Production Payment Transactions," Journal of Petroleum Technology,. July, 1962.
79
80
Dodson, Charles R., and McGee, John S. "Economic Factors in Bank Loans on oil and Gas Production," Journal of Petroleum Technology. October, 1958.
Florence, Fred F. "Financing oil Properties," World Oil. February, 1950.
Grady, Paul. "Inventory of Generally Accepted Accounting Principles for Business Enterprises," Accounting Research Study No. 2- New York, N.Y.: American Institute of Certified Public Accountants, 1965.
Haynes, Leo, C. "Accounting for Leasehold Costs in the Petroleum Industry," The Journal of Accountancy. April, 1942.
Meyers, John H. "Reporting of Leases in Financial Statements," Accounting Research Study No. £. New York, N.Y.: American Institute of Certified Public Accountants, 1962.
Minyard, Ernest L. "How to Determine the Tax Savings That Makes an ABC Deal Worthwhile, " The Journal of Taxation. XXIII, May, 1960.
Schlossstein, Adolph G., Jr. "Financial Accounting for Oil Payment Transactions," The Texas Certified Public Accountant. XXXI, May, 1959.
Stewart, Charles A. "Oil Industry Accounting Practices," The Price Waterhouse Review. Spring, 1963.
Terry, Lyon F., and Hill, Kenneth H. "How Bankers Evaluate Oil-Producing properties," World Oil. December, 1958.
Walker, A. W., Jr. "Oil Payments," Texas Law Review. XX, January, 1942.
Other
Anderson y. Helvering. 310 U.S. 404, 1940.
Coimiissioner y. Fleming. 82 F. 2d, 324, C.A. 5th, 1936
Coimissioner y. P^G. Lake, Inc. 356 U.S. 260, 1958.
81
Thomas y. Perkins. 301 U.S. 655, 1937.
Treasury Department. "Summary of The President's Tax Reform Proposals for The Revenue Act of 1969." Washington, D.C, April, 1969. (Xeroxed.)
E. L. Wehner. private interview, June, 1969.
