Oil and Gas Audit: ARO, Reserves, Full Cost Ceiling Test

An oil and gas producer carries two balances that move a small company from profit to loss with one change in an input: the capitalized cost of its properties, and the liability to plug wells and restore sites. Both rest on estimates that come from engineers, not from the ledger. A firm that audits a producer is auditing the reserve report as much as the trial balance.

This guide covers the accounting model, the ceiling test, the ARO roll-forward, and the procedures and requests that make up the file.

Pick the method first: full cost or successful efforts

A producer uses one of two methods for exploration and development costs. Under successful efforts, costs of unsuccessful exploration are expensed and productive costs are capitalized. Under full cost, all costs in a cost center are capitalized. The disclosure requirements of ASC 932 apply to both. Regulation S-X Rule 4-10 states that entities using successful efforts comply with ASC 932, and it prescribes the full cost rules, including the ceiling test.

The method drives the impairment model, so document it in the planning memo before anything else. See the audit planning memo guide.

Reserves: the input behind depletion and impairment

Depletion, the full cost ceiling and the supplemental disclosures all start from proved reserves. Rule 4-10 defines proved reserves as quantities estimated with reasonable certainty to be economically producible under existing economic conditions, operating methods and government regulations. For deterministic methods, reasonable certainty means a high degree of confidence that the quantities will be recovered. The price used is the unweighted arithmetic average of the first-day-of-the-month price for each of the 12 months before period end, unless contracts fix the price.

Auditors do not re-estimate reserves. They evaluate the work of the client's reserve engineer under AU-C 620: competence and objectivity, the data given to the engineer, and whether the price deck, cost deck and development plan match the audited records and the board-approved budget. Compare the volumes in the report to the production volumes in the ledger. If proved undeveloped locations in the report have no funded drilling plan, the booked volumes are in doubt.

The full cost ceiling test

Under Rule 4-10(c)(4), capitalized costs net of accumulated amortization and related deferred taxes cannot exceed the cost center ceiling. The ceiling is the present value of estimated future net revenues from proved reserves discounted at ten percent, plus the cost of properties not being amortized, plus the lower of cost or estimated fair value of unproven properties in the amortization base, less the related income tax effects. Any excess is charged to expense and disclosed separately in the period it arises.

The SEC staff's guidance in SAB Topic 12 adds details that matter in fieldwork:

Cash flow hedges under ASC 815 count in the ceiling computation for the hedged production, with disclosure of the share hedged.
Post-year-end acquisitions and hedges entered into after year-end cannot be used to avoid a year-end write-down. Reserves proved up after year-end on properties owned at year-end can show costs were not impaired, but the excess must still be disclosed.
Future outflows for AROs already accrued are excluded from the present value of future net revenues. Counting them twice understates the ceiling.

Worked example (illustrative numbers). A full cost company has net capitalized costs of $48.0 million. Present value of future net revenues at ten percent is $41.5 million. Unevaluated property costs are $3.0 million, and the related tax effect is $0.5 million. The ceiling is 41.5 + 3.0 - 0.5 = $44.0 million. The excess of $4.0 million is a write-down. The audit steps: recompute the ceiling from the reserve report, agree the price deck to the 12-month average, check that the ARO cash flows are not in both the asset base and the net revenue stream, and test that unevaluated costs were assessed at least annually for impairment, as Rule 4-10 requires.

Under successful efforts, impairment of proved properties follows the long-lived asset model, tested at a level with identifiable cash flows. The same reserve and price inputs feed that test, so the same engineer-review procedures apply.

Asset retirement obligations

ASC 410-20 requires a liability at fair value when the obligation to plug and abandon a well is incurred, with an equal amount added to the carrying cost of the asset. The liability accretes each period, and the capitalized cost is depleted with the property. Revisions to the estimated cash flows adjust both the liability and the asset. Filers report the roll-forward as liabilities incurred, settlements, accretion and revisions, and the auditor should expect the same four lines. The firm's ASC 410-20 standard page covers layering and the credit-adjusted risk-free rate in detail.

Worked example (illustrative numbers). A company owns 40 wells. The plugging estimate is $60,000 per well, or $2.4 million undiscounted, to be settled in 12 years. At a 7 percent credit-adjusted rate, the present value is 2,400,000 / 1.07^12, about $1.066 million. Year-one accretion is about $74,600. One year later, the cost estimate rises to $75,000 per well, adding $600,000 undiscounted. If the credit-adjusted rate at that date is 8 percent and 11 years remain, the new layer is 600,000 / 1.08^11, about $257,000, added to the liability and to the asset.

The test points: well count in the ARO schedule against the well master list and state regulator records, the cost per well against recent invoices from plugging contractors, the discount rate against the company's borrowing, and timing assumptions against the reserve report's end-of-life dates. A well count lower than the field list is the error to look for, especially after property acquisitions. For judgment calls, apply AU-C 540 and document how management's bias was assessed.

Revenue, joint interest billing and other risks

Revenue from oil and gas sales falls under ASC 606, recognized when control of production transfers at the delivery point stated in the purchase contract. Risks to cover:

Revenue cutoff and accruals. Operators report production to purchasers a month or two later. The year-end accrual for unreported sales is an estimate to test against subsequent receipts.
Joint interest billings. Where the company is a non-operator, test billings for authorization (AFE) and compare to operating agreements. Where it is the operator, test the receivable from partners and the cash call balances.
Royalty and revenue suspense. Unclaimed or disputed royalty owners create liabilities that need a completeness test.
Gas imbalances and take-or-pay positions under marketing contracts.
Going concern. Borrowing base redeterminations tie to reserves, so a lower reserve report can trigger a repayment demand. Apply AU-C 570.

PBC list

Reserve report, engineer's engagement letter and qualifications, and the price and cost assumptions
Lease and well master list, with working interests and net revenue interests
ARO roll-forward with the cost estimates and discount rates
Ceiling test computation (full cost) or impairment analysis (successful efforts)
Purchaser statements, division orders and the accrual workpaper for unreported sales
Joint interest billing detail, AFEs and operating agreements
Credit agreement, borrowing base notices and covenant calculations
Hedge confirmations and effectiveness documentation
State regulator bonding and plugging notices

Red flags

A reserve report that was not updated after a significant price move or a change in drilling plans
ARO per well that is flat for several years while contractor costs rise
Wells in the field with no ARO line, or plugged wells still in the schedule
Capitalized overhead that grows faster than drilling activity
Unevaluated costs that never move to the amortization base
Borrowing base shortfalls that appear in the first lender report after year-end

Sources

CORAA prepares ready-to-review audit files for US CPA firms; see /us.

Part of CORAA University · Specialized engagements: related guides, calculators and templates.

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error

Oil and Gas Audits: Asset Retirement Obligations, Reserve Estimates and Impairment