JV accounting needs grow as oil and gas deals proliferate

Rod Radojevic, Infor, Detroit

Joint ventures (JVs) have long been a staple of doing business in the upstream oil and gas industry. Oil and gas companies typically use JVs as a means to share risk or to bring special skills to an exploration and production project on an equity basis.

Whether the JV is mandated because of the often massive capital requirements of oil and gas projects or because of local-source requirements in many countries, its use has only grown in recent years. The proliferation of mega-projects (especially in the light of expanding deepwater exploration and development) and the acceleration of resource nationalism trends have put JV transactions atop many E&P companies' priority lists.

Unconventional resources spawn more JVs

The upstream oil and natural gas industry is in fact seeing a new uptick in JVs to accommodate the meteoric growth of activity in North America's unconventional gas and oil plays, notably the shale plays. Major international oil companies are increasingly entering into JVs with independent producers in US and Canadian shale plays not only to participate in prolific, long-lived resource plays as stand-alone investments but also to glean know-how and technology applicable to shale deposits in their own countries. And independents benefit from the infusion of capital to carry out ambitious oil and gas shale development plans.

The unconventional oil and gas boom will also create JV opportunities in countries outside North America. China, expected to account for about 65% of the world's oil demand growth and about 30% of its natural gas demand growth, is heavily emphasizing domestic as well as foreign investment in unconventional oil and gas. While its conventional oil and gas resources alone won't fill China's voracious energy appetite, the world's largest energy consumer has significant shale gas and coalbed methane resources.

According to Ernst & Young, non-Chinese upstream companies will find their partnership opportunities somewhat limited in China, as they are typically only available to the larger, integrated, and/or specialized international oil companies.

"However, unconventional gas development in China, both in terms of shale and coal seam gas, could become open to partnership opportunities for smaller, but…specialized IOCs," Ernst & Young said. "Notably with unconventional gas development in China, oil field services (OFS) companies should see a substantial increase in demand for their services. The current Chinese OFS industry will likely need outside help. Service requirements…are sharply higher for unconventional oil and gas developments, with specialized equipment, supplies, and technical expertise needed (e.g., higher-horsepower rigs drilling long horizontal wells, using multi-stage hydraulic fracturing)."

Among the many challenges presented by this increase in the use of JVs is the ability of the finance department to manage effectively manage them. The complexity and sensitive nature of JV transactions requires a financial management solution that can meet the unique needs of upstream oil and gas operations. Further complicating this challenge is the transition to a single, unified global accounting standard with the implementation of the International Financial Reporting Standards (IFRS). Oil and natural gas E&P companies in particular face daunting challenges with the transition. Even in countries that have already adopted or set out a path for adoption of the new standard, many questions still linger about how to interpret what amounts to largely broad statements of accounting principles under IFRS.

And in those countries where IFRS implementation has yet to occur, the questions loom even larger. Of particular concern is reconciling with and switching over from US Generally Accepted Accounting Principles (GAAP), the standards that have underpinned the vast majority of upstream oil and gas financial reports worldwide for more than a generation. As a result, oil and gas E&P companies need finance solutions that are above all, adaptable.

Defining oil and gas JVs

The presence of contractually-agreed joint control is what distinguishes a JV from other kinds of cooperation between entities. Without that joint control—entailing unanimity of agreement and individual veto rights—it is not a joint venture.

According to PricewaterhouseCoopers, IFRS distinguishes three JV classes: jointly controlled operations, jointly controlled assets, and jointly controlled entities.

"Joint operations are often found where one party controls hydrocarbon rights and has production facilities and another party has transport facilities and/or processing capacity," PWC stated. "The parties to the joint operation will share the revenue and expenses of the jointly produced end product. Each will retain title and control of its own assets. The venturer should recognize 100% of the assets it controls and the liabilities it incurs, as well as its own expenses and its share of income from the sale of goods or services from the JV."

Jointly controlled assets, however, typically reflect the sharing of risk and costs instead of profit-sharing. For example, a JV entailing ownership in an oil field might entitle a venturer to obtain a share of the produced oil after recognizing the venturer's share of liabilities, expenses, and income from operations.

Jointly controlled entities can be accounted for via either proportionate consolidation or equity accounting, according to PWC: "The choice between these two methods is a policy choice and must be applied consistently to all jointly controlled entities."

A key practical issue that sometimes arises is ensuring that JV results are incorporated by the venturer on the same basis as the venturer's own results—i.e., using the same generally accepted standards (IFRS) and the same accounting policy choices.

"The growing use of IFRS is helping to reduce the adjustments required but doesn't eliminate them," PWC notes. "Companies should be aware, however, that the IASB [International Accounting Standards Board] is proposing to eliminate the choice of proportionate consolidation in certain circumstances."

JV consolidation guidance under IFRS

The primary guidance for consolidating financial statements, including variable-interest entities, under US GAAP, is ASC 810 Consolidations. Under IFRS, the guidance for consolidating financial statements is contained within IAS 27 (Amended) Consolidated and Separate Financial Statements and SIC 12 Consolidation—Special Purpose Entities.

"Under both US GAAP and IFRS, the determination of whether or not entities are consolidated by a reporting enterprise is based on control, although differences exist in the definition of control," contends Ernst & Young. "Generally, under both [standards], all entities subject to the control of the reporting enterprise must be consolidated (note that there are limited exceptions in U.S. GAAP in certain specialized industries). Further, uniform accounting policies are used for all of the entities within a consolidated group, with certain exceptions under U.S. GAAP (for example, a subsidiary within a specialized industry may retain the specialized accounting policies in consolidation)."

Under both GAAP and IFRS, according to Ernst & Young, the consolidated financial statements of the parent and its subsidiaries may be based on different reporting dates as long as the difference is not greater than three months. However, under IFRS, a subsidiary's financial statements should be dated the same as the financial statements of the parent unless impracticable.

"An equity investment that gives an investor significant influence over an investee (referred to as ‘an associate' in IFRS) is considered an equity-method investment under both US GAAP (ASC 323 Investments—Equity Method and Joint Ventures, formerly APB 18) and IFRS (IAS 28 Investments in Associates) if the investee is not consolidated," Ernst & Young notes. "Further, the equity method of accounting for such investments, if applicable, generally is consistent under both US GAAP and IFRS."

Under US GAAP, JVs are generally accounted for using the equity method of accounting, with the limited exception of unincorporated entities operating in certain industries that may follow proportionate consolidation.

ASC 825-10 Financial Instruments (formerly FAS 159) gives entities the option to account for equity-method investments at fair value. For those equity-method investments for which management does not elect to use the fair value option, the equity method of accounting is required, according to Ernst & Young. Uniform accounting policies between investor and investee are not required.

Under IFRS, IAS 31 Investments in Joint Ventures permits either the proportionate consolidation method or the equity method of accounting. If the latter, IAS 28 generally requires investors (other than venture capital organizations, mutual funds, unit trusts, and similar entities) to use the equity-method of accounting for their investments in associates in consolidated financial statements. If separate financial statements are presented—that is, those presented by a parent or investor—subsidiaries and associates can be accounted for at either cost or fair value. Uniform accounting policies between investor and investee are required.

JV contributions

Venturers often contribute assets to JV upon its creation—either in cash or assets. Asset contributions entail a disposal by a venturer in exchange for a share of assets contributed by other venturers. Thus, says PWC, the contributor must recognize a gain or loss on the disposal, measured as the difference between its share of the asset's fair value and the other venturers' share of the book value of the contributed asset.

"This is classified in the balance sheet according to the nature of the asset—in the case of jointly controlled assets—or when proportionate consolidation is applied to a jointly controlled entity," PWC contends. "The equivalent measurement basis is achieved when equity accounting is applied; however, the interest in the asset forms part of the equity accounted investment balance.

"The same principles apply when one of the other venturers contributes a business to a joint venture. However, in this case, one of the assets recognized will be goodwill, calculated in the same way as in a business combination."

The tools for effective JV management

Given these challenges, CFOs for upstream oil and gas E&Ps need software that can support the growing use of JVs, as well as other strategies that will undoubtedly evolve in the future. Often, however, finance departments are forced to rely on either aging software solutions that struggle to keep up with new demands, or inflexible finance systems that were implemented on the coat tails of larger ERP implementations. In either case, these systems result in inefficiency and reduced financial controls, ultimately limiting the finance department's ability to play a strategic role in the organization.

To keep up with increasingly complex demands, CFOs at oil and gas E&Ps need financial management software that is both industry-driven and flexible. Some key features required for effective JV management include flexibility in ascertaining procurement processes and powerful cost allocation capabilities, as well as robust inventory analysis and costing features to precisely track all expenses related to a JV exploration and development project.

The ability to manage financial processes for disparate business units – no matter how varied the function or geography – is a major asset in such a global industry. Some additional core capabilities that will aid in JV management include the flexibility to manage JV projects as they change; the ability to keep parallel books for reporting purposes, and real-time reporting capabilities.

The upstream oil and gas market is a dynamic industry that will continue to grow, and effective JV management is becoming a staple of every CFO's role. Add to that IFRS, increasingly stringent reporting requirements and the near-certainty of additional regulations, and you've got finance departments that must manage a dramatically increased level of complexity. Having the right people, processes, and technology in place will form the foundation of successfully navigating whatever may lie ahead.

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