Evolving Trends in COPAS Accounting Procedures Favor Operators in JOAs
by Al E. McClellan

About the Author
A certified public accountant, Al E. McClellan is a past president of COPAS, and he serves on the national panel of arbitrators for the American Arbitration Association. He also serves as president of a contract compliance firm (Petroleum Revenue Services), established in 1984, after having served as chief financial officer for independent oil and gas companies in Houston.  

When two or more parties enter into a joint venture arrangement for the exploration or acquisition of oil and gas properties they normally execute a joint operating agreement (JOA). A typical choice would be an American Association of Petroleum Landmen (AAPL) form, the 610 Model Form Operating Agreement, which designates one party as the operator and the other working interest party or parties as non-operators. From the first JOA published by the AAPL in 1956 (revised in 1977 and 1982) to the latest revision published in 1989, impartial treatment of operator and non-operator has been the prime consideration.  The joint venture arrangement is in reality a cost-sharing agreement between the parties with the costs of the venture apportioned on the basis of the ownership percentages set forth in the JOA (usually Exhibit A).

Under the provisions of the JOA, the designated operator is responsible for the costs incurred, paid, and proportionately billed and collected, from the non-operators.  The operator is, therefore, accountable to the non-operators for all expenditures associated with the joint venture and is responsible for keeping accurate accounting records.  To assure that costs are shared equitably, the non-operators are given the right to inspect the operator’s books and records relating to the joint venture.  This article will focus on the accountability of the operator to the non-operators for expenditures; the responsibilities of all parties in verifying the appropriateness of shared costs and in some cases revenuesthrough the audit process; and recently published accounting procedures which deviate from the cost sharing concept of joint ventures and further restrict and compromise the right to audit.

*Author‘s Note: Throughout this document certain beliefs and conclusions of the author may appear to be of a legal nature when, in fact, the author is not of the legal profession.  Many beliefs and comments come from 28 years of active participation in COPAS (President 1979-80) and from over 32 years of hands-on experience in the industry (the last 15 years spent specifically in contract compliance and litigation support).

Accounting Procedures:

Joint Operating Agreement Provisions
All JOA’s from 1956 through the 1989 operating agreement require the operator to promptly pay and discharge all costs and expenses incurred in the development of the contract area, pursuant to the agreement. Further, the operator must charge each of the parties with their proportionate shares upon the expense basis provided in the accounting procedure attached to the agreement and marked Exhibit C.  JOA’s written after 1977 impose an additional obligation upon the operator to keep an accurate record of the joint account showing expenses incurred and charges and credits made and received. By virtue of the foregoing provisions, the operator must account for the joint venture costs (net of credits received) through a joint account established and maintained in accordance with an accounting procedure attached to and incorporated into the JOA.

The Development of Accounting Procedures

Local Petroleum Accountants Societies
As accountants began encountering common problems inherent in the accounting function for oil and gas joint ventures, they started meeting to establish acceptable provisions to address the problems peculiar to JOA’s. In 1926, the first professional society of accountants dedicated exclusively to accounting within the oil and gas industry was formed in Los Angeles, California.  The second society of petroleum accountants was formed three years later in Tulsa, Oklahoma (Dallas and Houston were formed in 1944 and 1952 , respectively). Local accounting societies tended to develop accounting procedures applicable to their geographic area.  Consequently, in the 1950’s there were three accounting procedures in general use: the PAS #1 form, developed by the Los Angeles society and utilized in the west coast region of the United States; the PASO-1949 form, developed by the Tulsa society (revised to become the PASO-T-1955 form pursuant to some Texas societies becoming involved) and utilized in the mid-continent and gulf coast regions; and the PASWC form developed by the Western Canada society.

Council of Petroleum Accountants Societies
As the petroleum industry grew and expanded and joint venture parties from different geographical operating areas began coming together, commonly accepted accounting standards for this industry became vital.  In 1961, the 11 existing petroleum accounting societies across the country formed the Council of Petroleum Accountants Societies (COPAS).  In an effort to bring unity to solving common accounting problems throughout the industry, COPAS published its first accounting procedure, COPAS-1962, which in reality was a revision of the PASO forms.*

^* Editor‘s Note: Readers interested in acquiring the COPAS accounting procedures discussed in this article may contact the COPAS National Office, Jon Gear, Executive Director, P.O. Box 1190, Denison, Texas 75021-1190. Phone: (903) 463-5463. Fax: (903) 463-5473.

Provisions of COPAS-1962 Accounting Procedure
Throughout many revisions the format of the COPAS accounting procedure has basically remained the same, although specific provisions and procedures therein have changed.  In addition to the definitions of terms used throughout the accounting procedures, the general provisions concerning advances, payments, and approvals by non-operators will not be explored herein as this paper’s primary focus is on accountability through the joint account and audits.

Statements and Billings
Under this general provision of the accounting procedure, the operator bills the non-operators on or before the last day of each month for their proportionate share of costs and expenses (i.e., the joint account) for the preceding month. Such bills are accompanied by statements, or  joint interest billings (JIB’s), reflecting the total charges and credits to the joint account either in detail or summarized by appropriate classifications.

Adjustments
Probably one of the most significant provisions of the whole accounting procedure is found in this section. This provision is so strong and succinct that it has remained virtually unchanged throughout all revisions made by COPAS. It states in part:

Payment of any such bills shall not prejudice the right of any non-operators to protest or question the correctness thereof; provided, however, all bills and statements rendered to non-operators by operator during any calendar year shall conclusively be presumed to be true and correct after twenty-four (24) months following the end of any such calendar year, unless within the said twenty-four (24) month period a non-operator takes written exceptions thereto and makes claim on operator for adjustment.

Under this provision of the COPAS accounting procedure as incorporated into the JOA and executed by the operator and non-operators the parties agree, in effect, to a binding contractual provision that establishes a specific statute of limitation relating to charges and credits made to the joint account and reflected on the operator’s bills and statements. As an example, unless the non-operators take written exceptions to any charges or credits appearing on the operator’s bills and statements received in the calendar year of 1997 prior to December 31, 1999, such charges and credits are deemed correct and after December 31, 1999, cannot be challenged except  upon a finding of fraud or bad faith breach of contract by the operator.

Audits
With the contractual statute of limitation established, there is an implied need for the non-operators to audit the charges and credits made to the joint account as evidenced by the JIB’s.  Like the foregoing adjustments provision, the procedure for audits has remained virtually unchanged throughout various revisions of COPAS procedures, and the period for conducting such audits corresponds to the twenty-four (24) month period set forth in the adjustments provision. (See section on audits, below.)

Direct Charges
Operating costs and expenses incurred in the development and operation of joint venture property in the contract area are proportionately chargeable to all parties through the joint accounts as either direct charges or indirect charges.  Direct charges are normally for materials or services received on the property in the contract area.  However, some costs and expenses incurred for the direct benefit of the property may be billable as a direct charge even when incurred off the property if described and set forth as such in the COPAS accounting procedure.  Descriptions of direct charges set forth in COPAS-1962 and subsequent COPAS revisions include:

1. Rentals and royalties,
2. Labor,
3. Employee benefits,
4. Material,
5. Transportation,
6. Services,
7. Damages and losses to joint property,
8. Legal expense,
9. Taxes,
10. Insurance premiums, and
11. Other expenditures.

COPAS-1974 added a provision for equipment and facilities furnished by operator, andCOPAS-1984 added provisions for ecological and environmental charges, abandonment and reclamation charges, and communications.

If a cost or expense incurred qualifies as a direct charge based on the criteria set forth in the COPAS accounting procedure, as determined by the operator, it is charged to the joint account as a direct charge.  If such cost or expense is not directly chargeable, by default it is deemed an indirect charge.

Indirect Charges
Costs and expenses incurred in the development and operation of property in the contract area which benefit the property but are not identifiable as direct charges are deemed indirect charges and are generally recoverable through either an allocation or a fixed rate charge to the joint account.  In the COPAS-1962 accounting procedure, these indirect costs and expenses were set apart from direct charges and included district expense, administrative overhead, warehousing costs, and construction overhead.

Direct Expense
The costs and expenses of the operator in maintaining and operating a district office to supervise the drilling and producing operations in a specified district, or a field production office serving several properties, would qualify as a direct charge. In such cases, the costs and expenses readily identified as direct charges would be apportioned to all properties being served on an equitable basis.

Administrative Overhead
As compensation to the operator to cover expenses for administrative, supervisory, and office services including services from outside sources in connection with matters of taxation, traffic, accounting, and governmental agencies a fixed dollar rate per well per month is chargeable to the joint account.  Different rates apply for a drilling well and a producing well, with the drilling well rate being much higher (often ten times higher) than the producing well rate. The drilling and completion of a well require increased time and effort on the part of administrative, supervisory, and related office personnel which justifies the different rates.

Warehouse Costs
Where it is not practical to make direct purchase charges for the properties served, the operator may charge for the expense of maintaining and operating a warehouse for the storage and handling of materials for use on multiple properties on a predefined, equitable basis.

Combined Fixed Rate Per Well
With the 1962 accounting procedure, COPAS devised a method combining district expense, administrative overhead, and warehousing costs under a fixed dollar rate per well per month.  As with the administrative overhead rate, this combined fixed rate per well was different for a well being drilled and completed and a producing well. The use of a combined fixed rate per well for indirect charges became so widespread in the industry that, subsequent to 1968, COPAS accounting procedures eliminated the option to charge district expense, administrative overhead, and warehousing costs separately.  It should also be noted that with COPAS-1962 and all subsequently issued accounting procedures, provision was made whereby the fixed rate per well was to be adjusted on the first day of April of each year following the effective date of the JOA based on the percentage increase or decrease in the average weekly earnings as published annually in the  Crude Petroleum and Gas Production Workers by the United States Department of Labor.

Construction Overhead
In addition to the administrative overhead or combined fixed rates chargeable by the operator to the joint account, COPAS-1962 set forth a means of distinguishing an overhead charge for the construction of compressor plants, water stations, secondary recovery systems, salt water disposal facilities, and other projects from the more usual drilling and producing operations.

Material and Equipment Purchases, Transfer, and Disposition
Tangible material and equipment purchased for the joint account or furnished from the operator’s warehouse or other properties are charged based on certain conditions which are set forth in Section IV of the COPAS-1962 accounting procedure.  Section V covers the disposal of this material, and Section VI covers the basis of credits to the joint account for material and equipment being transferred from the property as determined by how it was originally charged and its condition when removed.  Subsequent to 1968, COPAS accounting procedures combined these three sections into one section.

Inventories
The last section of the COPAS-1962 accounting procedure and all subsequent revisions deal with the operator’s accountability for controllable material (tangible material or equipment) charged to the joint account and proportionately owned by all parties.  The operator is obligated to maintain detailed inventory records of such material and to verify the existence of such material at reasonable intervals of time.

Subsequent COPAS Accounting Procedures
The first COPAS accounting procedure, COPAS-1962, was basically a revision of the PASO forms which were utilized in the mid-continent and gulf coast regions of North America. Western Canada and the west coast regions did not embrace the recommendations of COPAS-1962 and continued to utilize their own forms for their geographical region.  In its efforts to unitize, consolidate, and address the ever changing nature of the oil and gas industry, COPAS has revised its recommended accounting procedures form several times over the years.

COPAS-1968 Accounting Procedures
In order to accommodate the west coast region, the COPAS-1968 accounting procedure provided for the billing of administrative overhead or combined rates as either a fixed amount per well per month (utilized in COPAS-1962) or as a percentage of monthly expenditures (utilized in the PAS #1 forms).  Other changes required the user to fill in multiple blanks and to select from multiple options, including whether or not to charge the operator’s first-level supervisors in the field (or technical employees either on or off the property) as a direct labor or include them in the overhead rates.  Thus, COPAS-1968 was not one of the more widely accepted accounting procedures recommended by COPAS.  It should be noted that with the recommendation of this new accounting procedure, COPAS discontinued publication of COPAS-1962.

COPAS-1974 Accounting Procedures
COPAS-1974 was an attempt to simplify the accounting procedure and address changing operations within the industry.  The revised procedure eliminated many options, including that of charging district expense, administrative overhead, and warehousing costs.  Direct charges, for the most part, included costs and expenses either incurred on the property or directly relatable to the property. Indirect charges were included in the rates set forth in the section on overhead. Notably, the option of whether or not to include technical employees, consultants, or contractors when not directly employed on the property was eliminated.

COPAS-1976 Accounting Procedure
The COPAS-1976 offshore accounting procedure was basically COPAS-1974 with additional provisions in the direct charges section to cover costs and expenses associated with offshore operations. Included in the equipment and facilities furnished by operator provision were shorebase and offshore facilities. Direct charge provisions were added for communications and ecological and environmental costs.

COPAS-1984 Accounting Procedure
The major change made in the COPAS-1984 accounting procedure from COPAS-1974 was the reinstatement of the COPAS-1968 option of having  off-property personnel (including consultants and contractors) chargeable to the joint account as a direct charge or being included in the overhead rates. Also, direct charge provisions were made for ecological and environmental costs, abandonment and reclamation costs, and communications.

COPAS-1986 Accounting Procedure
As with the COPAS-1976 offshore accounting procedure, COPAS-1986 is basically COPAS-1984 with additional provisions in the direct charges section to cover costs and expenses associated with offshore operations. Included in the provision for equipment and facilities furnished by the operator are shorebase and offshore facilities.

COPAS-1995 Accounting Procedure
The COPAS-1995 is a somewhat radical accounting procedure developed and approved by COPAS as an “alternative” procedure to accommodate the recommendation of an energy task force (comprised of mostly majors and large independents) to develop a method for charging a monthly lease operating amount.  This new procedure provides for a monthly fixed amount per active well to compensate the operator for all costs applicable to joint property operations except for royalties, ad valorem and production/severance taxes, downhole well work, controllable material, and projects that qualify for drilling, construction and/or catastrophe overhead.  Thus, lease operating expenses (both direct and indirect) can be charged either as a monthly fixed amount per well or in the more traditional ways.

In another radical departure from COPAS-1984 and its predecessors, the direct charges section was split into two sections, one for costs incurred on the joint property and one for costs incurred off the joint property.  Direct charges for costs incurred off the property included facilities which could be charged on an allocated or fixed rate per unit (well, Mcf, BOE, etc.) basis; ecological and environmental costs; legal expenses; training; and engineering, design, and drafting costs associated with major construction or catastrophes.  It should be noted that the fixed rates charged for facilities by the operator or its affiliates can equal the average commercial rates prevailing in the area.

The fact that the operator or its affiliates could now charge the joint account average commercial rates for services or materials constituted a radical and controversial change from previously recommended COPAS accounting practices.  Many people viewed this with alarm and saw it as a departure from the underlying fundamental concept of cost-sharing and the basic tenet that one party should not profit at the expense of the other through the joint account.  In prior recommended procedures, the operator was allowed to use average commercial rates prevailing in the immediate area of the joint property less twenty percent (20%).  This 20% reduction to commercial rates was intended to offset a profit margin inherent in commercial rates.  Consequently, if the operator wanted to furnish operator-owned equipment and facilities, the rates to be charged were to be commensurate with costs of ownership and operation and were not to provide the operator with a profit.

Under the COPAS-1995 accounting procedure, the operator is allowed to make a profit not only on operator-owned equipment and facilities, but also on any services or material provided by an affiliate.  Unlike previous accounting procedures, wherein nothing was said about affiliates, COPAS-1995 defines an affiliate as any party directly or indirectly controlling, controlled by, or under common control with the operator. A paragraph in the general provision section for affiliates states that charges to the joint account for any services or material provided by an affiliate shall not exceed average commercial rates for such services or material.  It further provides an option whereby the affiliate’s records relating to the work performed would or would not be made available to the non-operators for audit.  Conceivably, all services and materials charged to the joint account could come through affiliates of the operator, and the operator would, in effect, make a profit (possibly offsetting the operator’s entire proportionate share of the joint venture costs). Furthermore, the only auditable documents could be billings from the affiliates to the operator.

COPAS-1998 Project Team Accounting Procedure
COPAS developed and approved the 1998 accounting procedure specifically to address the issues that arise when large or major companies join together and form a project team for a major undertaking, such as the development of a deepwater project.  COPAS-1998 was designed to be used on any project where the parties established a team to perform work and/or studies pursuant to the JOA.

As with COPAS-1995, affiliates of the operator working at the request of a project team can (under the cost basis method) charge the joint account for any materials, facilities, or services which do not exceed average commercial rates, when such rates are available. Otherwise, affiliate services can be charged to the joint account as charged by the affiliate (to the operator) and include any services or materials procured for joint operations (Paragraph 7.C. of Section II).  Thus, with COPAS-1998, all services and materials charged to the joint account could come through affiliates of the operator, and the operator would, in effect, make a profit. The only auditable documents could be billings from the affiliates to the operator.  As with COPAS-1995, the affiliates’ records relating to the work performed or services provided may not be available for audit, depending on which election box has been checked.

When COPAS approves and publishes a new revision, publication of the preceding COPAS recommended accounting procedure usually ceases. Publication of COPAS-1962 ceased when COPAS-1968 was approved, and so on until the approval of COPAS-1995. However, COPAS-1995 was developed and approved as an “alternative” accounting procedure; therefore COPAS continues to publish the COPAS-1984 Onshore and COPAS-1986 Offshoreaccounting procedures, which remain the accounting procedures of choice for most of the JOA’s being negotiated within the industry today. Contrary to the assumption that the most recently published accounting procedure supercedes its predecessors, COPAS-1995and COPAS-1998 do not necessarily reflect the “current thinking” of COPAS relating to accounting for the costs and expenses of normal joint venture operations.

COPAS Published Guidelines
Unlike the COPAS accounting procedures which become legally binding when incorporated as an exhibit to the JOA, COPAS publishes other documents which are meant to explain, interpret, and guide the accounting and auditing functions being performed in the industry. Unless these other documents are specifically incorporated by reference into the JOA or attached accounting procedure, they have no legal standing. However, these documents are often used to provide evidence of custom or industry practice when a contract provision is determined to be ambiguous.

COPAS Bulletins
COPAS publishes a companion explanatory bulletin for all the aforementioned COPAS accounting procedures to interpret and elaborate on the provisions of the particular accounting procedure to which it relates. Explanatory bulletins published by COPAS include the following:

	Bulletin No. 5	COPAS-1962	Accounting Procedure
	Bulletin No. 8	COPAS-1968	Accounting Procedure
	Bulletin No. 13	COPAS-1974	Accounting Procedure
	Bulletin No. 15	COPAS-1976	Offshore Accounting Procedure
	Bulletin No. 22	COPAS-1984	Onshore Accounting Procedure
	Bulletin No. 25	COPAS-1986	Offshore Accounting Procedure
	Bulletin No. 33	COPAS-1995	Accounting Procedure
	Bulletin No. 34	COPAS-1998	Project Team Accounting Procedure

In addition, COPAS publishes other bulletins covering a variety of accounting and auditing issues that provide guidelines and recommended courses of actions for common problems facing accountants and auditors within the industry.  Developed with the participation of twenty-three (23) active societies representing nearly three thousand (3,000) members, COPAS bulletins provide broad industry representation.

COPAS Interpretations
The revision of an existing accounting procedure involves a tremendous amount of time and effort to reach a consensus on all of the issues under consideration.  Normally, the revision process takes around two years, and, consequently, the task is not undertaken until it is perceived that a number of additions, deletions, or changes are warranted.  In 1980, in order to solve problems as they arose and to serve its members and the industry in a more timely fashion, COPAS began publishing COPAS interpretations.  An interpretation offers guidance on a specific issue or problem which is currently causing confusion or controversy.

As originally conceived, the next revision of the COPAS accounting procedure would incorporate the interpretations that had been issued in the intervening period of time. This has been done in many instances, but unlike the COPAS accounting procedures COPAS continued to publish all interpretations.  COPAS has invited further confusion by not only continuing to publish the interpretations, but by revising them to reflect on a current controversy or problem.

As stated earlier, COPAS interpretations (and bulletins) have no legal standing unless specifically incorporated by reference into the JOA or COPAS accounting procedure.  Prior to COPAS-1995, none of the COPAS accounting procedures provided for incorporation of interpretations or bulletins. However, COPAS-1995 refers to COPAS Interpretation No. 11 to describe the operator’s cost of established plans for employee’s benefits and to COPAS Bulletin No. 21 for examples of accessorial charges relating to actual trucking costs. In addition to these references, COPAS-1998 incorporates by reference COPAS Interpretation No. 27 which specifies that training costs are chargeable as a direct charge to the joint account and COPAS Interpretation No. 30 which recommends including incentive compensation programs in the salaries and wages chargeable to the joint account as direct labor.  Because COPAS has a practice of revising interpretations and bulletins (e.g., a revised COPAS Bulletin No. 21 was approved in the 1998 fall meeting of COPAS), the question arises: What effect do the revisions have on a JOA previously executed under a COPAS-1995 accounting procedure?

Audits:

Joint Operating Agreement Provisions
Between 1956 and 1982 JOA’s made provisions for each party to have access at all reasonable times to information concerning the development or operation of the contract area, including the operator’s relevant books and records. The 1989 JOA gave each non-operator or duly authorized representative full and free access at all reasonable times to all operations of every kind and character conducted for the joint account in the contract area and to the records of operation conducted thereon or production therefrom, including the operator’s relevant books and records relating thereto.  The language of the 1989 JOA regarding access to records additionally provides that any audit of operator’s records relating to amounts expended and the appropriateness of such expenditures shall be conducted in accordance with the audit protocol specified in Exhibit ‘C’ (emphasis added).

Under the foregoing provisions, the non-operating parties have the right to review and indeed audit the books and records of the operator which relate to the development and operations of the contract area.  However, as regards costs and expenses (expenditures) incurred by the operator, and subject to the accounting procedure attached and incorporated into the JOA, the non-operators’ right to audit has been restricted and compromised.

COPAS Accounting Procedure Provision
Prior to COPAS-1984, the general provision section of the COPAS accounting procedures contained the following basic language:

A non-operator, upon notice in writing to operator and all other non-operators, shall have the right to audit operator’s accounts and records relating to the accounting hereunder (joint account)* for any calendar year within the twenty-four (24) month period following the end of such calendar year; provided, however, the making of an audit shall not extend the time for the taking of written exception to and the adjustments of accounts as provided for in the previous paragraph on adjustments.  Where there are two or more non-operators, the non-operator shall make every reasonable effort to conduct joint or simultaneous audits in a manner which will result in a minimum of inconvenience to the operator.  (Operator shall bear no portion of the non-operators’ audit cost incurred under this paragraph unless agreed to by the operator.)**

*   Substituted for “accounting hereunder” after COPAS-1968.
** Sentence added to provision in COPAS-1968 and thereafter.

In the COPAS-1984 accounting procedure, another sentence was added to the foregoing provision which placed further restrictions on the non-operators’ right to audit and a new paragraph was added obligating the operator to reply to an audit as follows.

Added to Paragraph A:

The audits shall not be conducted more than once each year without prior approval of operator, except upon the resignation or removal of the operator and shall be made at the expense of those non-operators approving such audit.

Added to Paragraph B:

The operator shall reply in writing to an audit report within 180 days after receipt of such report.

In an attempt to further define the operator and non-operator’s roles in conducting, responding to, and resolving claims arising from an audit, COPAS-1995 significantly expanded the provisions for expenditure audits by incorporating many of the protocol guidelines previously published in COPAS Bulletin No. 3, Expenditure Audits in the Petroleum Industry.

The audit provisions of COPAS-1998 are basically the same as those of COPAS-1995except that the audit report is to be issued within 90 days (instead of 180 days) after completion of the audit field work, and an audit resolution meeting (conference) may be called to resolve outstanding audit issues/exceptions within 15 months (instead of 18 months) after the date of the audit report. A notable addition to COPAS-1998 is a provision which requires the non-operator to maintain auditable records supporting any expenditures chargeable to the joint account through the operator and subjects the non-operator to the same audit rights and obligations as those between the operator and other non-operators.

Expenditure Audits COPAS Bulletin No. 3
In 1965 COPAS published Bulletin No. 3 on expenditure audit protocol (revised in 1986) to establish guidelines for both the operator and non-operators when the non-operator exercises the right to audit the operator’s accounts and records as provided for in the COPAS accounting procedure. In 1988, the publication of COPAS Bulletin No. 26, Guidelines for Expenditure Audits in the Petroleum Industry, provided guidance for the performance of the audit. Not intended to be a complete audit program, this bulletin and its exhibits serve as a guide from which a program might be developed to fit the specific audit situation facing the non-operator. In 1993, COPAS revised Bulletin No. 3 and incorporated it along with Bulletin No. 26 into one comprehensive bulletin in two sections, audit protocol and procedure guidelines. COPAS again revised Bulletin No. 3 in the spring of 1998.

Protocol Roles and Responsibilities
The protocol section of this bulletin covers items the operator and non-operator must consider in initiating and preparing for the audit, conducting the audit, and resolving claims arising from the audit.

Initiating and Preparing for the Audit
Although each non-operator has the right to audit the operator’s books and records, the initiation of an audit often comes from the non-operator having the largest working interest in the property to be audited. If the non-operator wanting to conduct the audit does not have the largest interest, all non-operators with larger interests should be contacted before any audit arrangements are made and an agreement reached as to who will lead the audit.  Once this decision is made, the non-operator leading the audit is to contact the operator and schedule time in the operator’s offices to conduct the audit, confirm the scheduled time with a confirmation letter to the operator requesting the documentation be made available prior to or upon arrival at the operator’s offices, and send a ballot letter to the other non-operators soliciting their participation.

Conducting the Audit
This section of the protocol guidelines sets forth the responsibilities of the lead auditor: (1) to the audit team members participating on behalf of other non-operators (including the proration of audit costs); (2) to the operator, from the opening conference to the exit conference; (3) for the issuance of the final audit report to the operator; and (4) for the response, rebuttal, and resolution of audit claims. Guidelines also delineate the responsibilities of the audit team members to the lead auditor.

The operator’s role and responsibilities in the audit include: (1) providing functional accommodations; (2) establishing a means for answering inquiries and/or requests for documents; (3) responding to exceptions set forth in the audit report (crediting or charging the joint account where appropriate); and (4) cooperating with the non-operators toward resolution of all claims raised by the audit.

Resolution of Audit Exceptions
COPAS Bulletin No. 3 states that the non-operators should issue a final audit report to the operator within 90 days of completion of the audit field work (usually considered to be the date of the exit conference).  The COPAS-1995 accounting procedure provides that the lead audit company’s audit report shall be issued within 180 days after completion of the audit field work and that failure to issue the report within the prescribed time will preclude the non-operator from taking exception to any charge billed within the time period audited.  COPAS-1998 requires the report to be issued within 90 days.  As stated earlier, COPAS-1984 and all subsequently issued accounting procedures obligate the operator to respond in writing within 180 days after receiving an audit report.  COPAS-1995 and COPAS-1998 expand on this provision and set forth other obligations for both the operator and non-operators.

The guidelines established in COPAS Bulletin No. 3, as well as the provisions added to the COPAS accounting procedures, address the industry’s  objective of resolving audit exceptions and closing outstanding audits expeditiously.  Accordingly, COPAS Bulletin No. 3 provides that non-action by the lead audit company in excess of one year of an operator’s most recent substantive response should be viewed as acceptance of same and the audit considered closed.  Likewise, non-action by the operator in excess of one year of the lead audit company’s final report or most recent substantive response should be viewed as acceptance of the non-operators’ position and appropriate adjustments and/or payments would be expected by the non-operators.  (The COPAS-1995 and COPAS-1998 accounting procedures include a 90-day failure to respond resolution for both the operator and lead audit company.)

Procedure Guidelines
The procedure guidelines section of COPAS Bulletin No. 3 provides guidance for the performance of the audit by the auditors.  It is not intended to set forth a complete audit program but includes items which should be considered by the auditor in determining the scope of the audit: the preliminary work to be done prior to conducting the audit in the operator’s office or field; the audit steps utilized in examining the records and documents provided by the operator; the verification of equipment in the field; and the preparation of a final audit report (a sample audit report is included in Bulletin No. 3 as an exhibit).

Revenue Audits COPAS Bulletin No. 23
Unlike audits of expenditures, revenue audits are not addressed by any of the COPAS accounting procedures.  The only mention of revenues in most joint venture contracts is in the provision of the JOA relating to the working interest owners’ right to take production in kind.  However, since the operator is responsible for the production from the contract area and the books and records relating thereto, and since the non-operators have a vested interest in gaining access to those books at all reasonable times, COPAS developed and approved Bulletin No. 23, Guidelines for Revenue Audits in the Petroleum Industry in 1985. This bulletin provides recommendations to parties auditing production and revenue records and to parties being audited.  Bulletin No. 23 aims to give the auditor the basics to be considered for a revenue audit but does not provide a detailed audit program.  In 1992, COPAS added a protocol section to Bulletin No. 23 utilizing the format familiar to the industry from the expenditures audit bulletin.

The protocol and procedure guidelines in Bulletin No. 23 rest on the following assumptions:

• Auditor (non-operator) is auditing auditee (operator).
• Auditor (non-operator) has the right to audit auditee (operator) based on applicable contracts/agreements.
• Adjustment period is based on applicable state statutes or contractual agreements.

The guidelines address revenue audits between the auditor, who might be (1) a working interest owner who is not the operator of a producing property; (2) a producer who is a party to a gas purchase contract with a gas plant; (3) a producer who is a party to a gas processing (or other service for a fee) agreement with the plant owner; (4) a plant owner who is not the plant operator; (5) a producer/seller of production sold to a purchaser; or (6) a party having the right to audit production/revenue proceeds, and the auditee, who might be either the party designated as operator by an operating agreement or JOA, the party designated as agent under applicable contracts/agreements,  the purchaser of production, or the party being audited, regardless of the actual function of the audited party.

Protocol Roles and Responsibilities
Rather than limit the application of protocol to revenue audits of operators by non-operators, COPAS recognized that purchase/sales contracts or agreements and operating agreements for large production units, secondary recovery units, and plants might contain audit right provisions.  Therefore, the protocol section was written to provide guidance to both the auditor (non-operator or the party having the right to audit) and the auditee (operator or party being audited, regardless of the actual function of the audited party). Guidelines are provided in initiating and arranging the audit, conducting the audit, setting forth the auditee’s (operator’s) role in the audit, preparing the audit report, and in the bearing of audit costs.

Procedure Guidelines
The procedure guidelines in Bulletin No. 23 cover three basic categories of production: oil and condensate, gas and casinghead gas, and plant products or natural gas liquids.  The guidelines were developed and are presented from a producer’s point of view instead of an operator of a lease or owner of a gas plant.  Each of the aforementioned categories is divided into three areas of concern: preparatory work, field work (verification of volumes) and field work (verification of values).  This approach was taken because the party responsible for volumes may not always be the party responsible for determining values and/or making payments.

Oil and Condensate
In many cases, an oil and condensate contract will not exist between the buyer and seller, and a division order may be the only existing contract relating to oil or condensate revenues.  The operator may or may not distribute oil or condensate revenue to the other interest owners (sometimes disbursement is made to owners by the purchaser) with the respective owner’s interest in the property and the posted prices being the basis for such distributions.  However, other contracts or sales agreements can exist and should be the foundational basis for the audit where applicable.

Gas and Casinghead Gas
The procedure guidelines for gas and casinghead gas, first developed and published in 1985, rested on a historical background wherein (1) natural gas was produced by producers and sold to pipelines on the basis of ownership or entitlement to reserves; (2) sales contracts between producers and pipelines were generally long-term; (3) the pipeline aggregated supply quantities and resold the gas to consumers either directly or through local distribution companies; and (4) the transportation service of getting the gas from the wellhead to the burnertip was a cost recovered in the pipeline sales price. However, recent regulatory initiatives, including Federal Energy Regulatory Commission Orders 436, 500, and 636 have transformed the natural gas industry and fundamentally changed the traditional roles of producers, operators, and pipelines. Producers, often through the operator, now enter into short-term transactions with the consumer, either directly or through brokers or marketers on the spot market.

Pipelines now function as transporters, rather than aggregators and merchants.  As a result of the increased number of players involved to move virtually the same quantity of gas produced and sold as in the past, there are more transactions taking place.  These changes demand faster and more efficient nomination, confirmation, and allocation processes to account for the ownership of gas in an expeditious manner and to provide timely information on such matters as quantities produced, purchased, sold, received, and delivered, plus gas imbalances, invoices, and payments.  These changes and the resulting need for accurate information are compounded by the imprecise measurement associated with the physical characteristics of natural gas and the change in value determinations on the basis of the heating value of gas (BTU) rather than cubic feet (Mcf).

In 1992, COPAS revised Bulletin No. 23 and addressed some of the aforementioned transitional changes, but the process of moving the gas from the wellhead to the burnertip has become even more complex and confusing to track and verify through audit as more and more entities are carving out for themselves a piece of the revenue attributable to production.  Although the guidelines provided can help the auditor develop a revenue audit program for gas and casinghead gas, COPAS should consider revising this section of the bulletin to assist the auditor in the environment of today.

Plant Products Natural Gas Liquids
The guidelines in this section of the bulletin presume that the auditor is conducting the audit of settlements under a gas processing agreement with the gas plant operator.  While recognizing that the plant operator may not make settlements to the producers but rather furnish the data to the lease operator or final producer for payments the guidelines assume that the plant operator and the settlement entity are the same.  Minor changes were made in this section when the bulletin was revised in 1992.

Summary:

The ever evolving nature of the oil and gas industry and the proliferation of JOA’s have exacerbated the difficulty of providing accurate accounting that properly reflects equality among all parties in a joint venture.  COPAS has endeavored to ease the burden by developing and publishing standardized accounting procedures whereby fair and equitable costs would be shared by the parties to a joint operating agreement.  However, in trying to equate the needs and desires for accounting in a major or large independent oil and gas company to those of a small producer and vice versa, COPAS, despite its good intentions, may have increased the difficulty rather than minimized it.

Accounting Procedures
Upon the publication of the COPAS-1995 accounting procedure which was, in effect, a new, revised COPAS accounting procedure publication of the older COPAS accounting procedure ceased (although use of the older form may have continued by the parties executing a new JOA).  For example, COPAS ceased publishing the 1962 form when the 1968 form was approved; publication of the 1968 form ceased upon publication of the 1974 form; and publication of the 1974 form ceased upon publication of the 1984 form.  As each new form recommended by COPAS was published, it replaced its immediate predecessor.  The new form, however, did not replace the older accounting procedure attached to an existing, properly executed JOA.  The legality of the provisions in the older accounting procedure was not affected, irrespective of any changes in the newly revised form, unless the JOA to which it was attached was amended accordingly and the new COPAS accounting procedure attached.

Even though the format of the COPAS accounting procedure remained fairly stable in the twenty-two years between 1962 and 1984 (COPAS-1995 will be addressed separately), there have been a number of dramatic changes within the provisions.  This creates a problem in accounting when an entity has been the designated operator of JOA’s throughout the period.  Conceivably, the operator could be accountable to non-operators under four different COPAS accounting procedures.  Since most accounting systems within an entity are geared toward uniformity and consistency, the methods and procedures developed to account for joint operations are generally built around the COPAS accounting procedure predominant within the company.  Consequently, charges billable to the joint account under another COPAS accounting procedure may be billed incorrectly.  In most cases, the appropriateness of the charge only comes to light when audited against the specific, applicable accounting procedure.

With the replacement of the old COPAS form by publication of the newly recommended COPAS accounting procedure, the natural tendency within the industry is to regard the new accounting procedure as the current thinking of COPAS and until the publication of COPAS-1995, there may have been some validity to this way of thinking.  However, COPAS-1995 did not necessarily reflect the current thinking of COPAS.  Even though some provisions therein did represent the current thinking of some of the approximately 2,700 members of the 24 societies representing approximately 1,200 entities, the document was developed and narrowly approved as an alternative COPAS accounting procedure. 

COPAS-1998 likewise may not generally reflect the current thinking of COPAS since it was developed for a specific application and does not replace any previously approved accounting procedures.  When compared to all preceding COPAS accounting procedures, the radical changes made within these two documents both as to concept and procedureclearly calls for careful evaluation and discernment by all parties before incorporating either document into a JOA.  To have a document whereby the operator is allowed to make a profit on any service or material provided through an affiliate, and for the non-operator not to have the right to audit the books and records of that affiliate, defies both logic and the spirit of a joint venture arrangement.

Audits
All JOA’s provide the non-operating parties with access to the operator’s books and records relating to the development or operation of the contract area at all reasonable times.  The 1989 JOA extends this access to the non-operator’s duly authorized representative and specifically includes the operator’s books and records relating to production from the contract area.  Therefore, non-operators have the right to conduct both revenue and expenditures audits of the operator’s books and records relating to the contract area set forth in the JOA.

In regard to audits of joint venture expenditures, the aforementioned right to audit has been restricted and compromised.  In the 1989 JOA access to records provision, additional language provided that any audit of operator’s records relating to amounts expended and the appropriateness of such expenditures shall be conducted in accordance with the audit protocol specified in Exhibit C (emphasis added).  Exhibit C to the JOA is the COPAS accounting procedure, all versions of which set forth limitations and procedures for conducting an audit of expenditures.  All expenditures audits are to be conducted within the twenty-four (24) month period following the calendar year in which expenditures were billed to the non-operators, and every reasonable effort is to be made for the non-operators to conduct joint or simultaneous audits.  The non-operators participating in the audit normally bear the non-operator’s audit cost, and, effective with COPAS-1984, audits cannot be conducted more than once a year without the operator’s approval except upon resignation or removal of the operator.

Also effective with COPAS-1984, the operator is obligated to provide a written reply to an audit within 180 days after receiving the audit report on expenditures.  The COPAS-1995alternative accounting procedure and the COPAS-1998 project team accounting procedure expand on and add to the aforementioned audit limitations and procedures for both the operator and the non-operators.  In fact, the COPAS-1995 and COPAS-1998 accounting procedures could even preclude the non-operator from auditing the records of affiliates for any work performed by an affiliate and charged through the joint account to the non-operators.  Consequently, all parties to a JOA should pay close attention to and understand the audit provisions set forth in the specific accounting procedure attached to the JOA currently, whether the JOA exists or is being proposed.

Whenever a non-operator decides to audit revenues under provisions of the JOA and/or expenditures under provisions of the COPAS accounting procedures, guidance can be found as to protocol and procedures in COPAS Bulletin No. 23, Guidelines for Revenue Audits in the Petroleum Industry and Bulletin No. 3, Expenditure Audits in the Petroleum Industry: Protocol and Procedures Guidelines. The non-operator or its duly authorized representative should be thoroughly familiar with these two bulletins as most audits conducted in the industry today follow the protocol and procedures set forth therein.

Additionally, COPAS has published two interpretations to provide guidance for problems encountered in expenditure audits, COPAS Interpretation No. 21, Documentation Supporting Joint Interest Expenditures and Interpretation No. 23, Twenty-Four Month Audit Period Audit and Accounting Adjustments.  While neither of these interpretations nor the aforementioned bulletins have legal standing since they are not incorporated into the JOA or COPAS accounting procedure attached thereto most accountants in the oil and gas industry believe that anything COPAS publishes, without consideration of form or the approval process within COPAS, establishes acceptable industry accounting practices and procedures.  Therefore, to facilitate expeditious, efficient, and beneficial results from an audit, the non-operator should select an auditor knowledgeable in COPAS accounting procedures and guidelines, in addition to being experienced in all phases of operations relating to exploration and production within the industry.

Audit Resolution
After an audit by a non-operator which results in claims for additional revenues or if exceptions have been taken to charges and/or credits made by the operator to the joint account, the operator either grants or denies one or more of the claims or exceptions.  For those claims or exceptions denied (or not granted to the satisfaction of the non-operator) a dispute often arises.  In most instances, the non-operators who participated in the audit will furnish a rebuttal to the operator’s written response to the audit report wherein claims or exceptions were denied.  This response and rebuttal process may be repeated until either one of the parties gives in or a settlement is negotiated.

Audit Resolution Conference
When the response and rebuttal process reaches an impasse, often the non-operator who led the audit will request a conference meeting between the operator and all audit participants for the purpose of resolving all outstanding audit items still in dispute. (COPAS-1995 and COPAS-1998 accounting procedures specifically provide for the audit resolution conference.)  If all those in attendance have the authority to resolve the dispute issues on behalf of their company and have the inclination to make a good faith effort to resolve the outstanding issues, the audit resolution conference can accomplish its purpose and close the audit.  However, if the operator does not want to grant the claim or exception or propose a settlement agreeable to the non-operators, it often seems the only recourse to non-operators is a lawsuit against the operator and, indeed, it may be.

Litigation or Arbitration
Litigation is time-consuming, expensive, and can virtually destroy the business relationship between the parties.  Often these reasons alone will discourage the non-operators from pursuing litigation, in which case the claim or exception in dispute is automatically resolved in favor of the operator.  However, if the stakes are high enough, litigation becomes more likely.  More times than not, the issues disputed in litigation between the parties are settled often at the eleventh hour before trial and the settlement agreement is sealed.  If such is the case, both operator and non-operators would benefit from a private and confidential settlement reached through arbitration.

To the operator, arbitration will require less out-of-pocket costs than the defense of a lawsuit.  Due to the private and confidential nature of arbitration, awards which have a negative impact on the operator are limited to those properties and those parties involved in the arbitration process. Arbitration allows closure of outstanding claims or exceptions in a more expedient fashion and can produce a more acceptable resolution for both parties as the arbitrator(s) are selected based on their experience and knowledge relative to the issues at hand rather than relying upon an uninformed judge and/or jury.  Lastly, because the parties agree in writing to be bound by the decision of their arbitrator(s), once an award is rendered, it is usually binding, enforceable, and seldom reviewed by the courts.

All parties entering into a joint venture arrangement should modify the JOA or the accounting procedure to provide for binding arbitration as the means to settle unresolved claims or exceptions resulting from an audit.  Operators and non-operators currently disputing unresolved audit claims or exceptions should strongly consider an agreement to submit existing disputes to binding arbitration.  An audit can be closed within ninety (90) days of the filing of the dispute with the American Arbitration Association [See McClellan, Arbitration: A Means of Settling Oil and Gas Disputes, Petroleum Accounting and Financial Management Journal, Vol. 16, No. 2 (Fall, 1997) and Landman, Vol. 43, No. 1, (January/February, 1998)].

 

Arbitration: A Means of Settling Oil and Gas Audit Disputes
by Al E. McClellan

When two or more parties enter into a joint venture arrangement for the exploration or acquisition of oil and gas properties, they normally execute a joint operating agreement, typically an AAPL 610 Model Form Operating Agreement (JOA), designating one party as the operator and other working interest parties as non-operators. In the various revisions of this JOA, the non-operators� right to audit the operator�s books and records relating to joint venture operations is established. This right to audit is further established in the accounting procedure normally attached to the JOA as Exhibit �C.� The most common form attached is an accounting procedure recommended by the Council of Petroleum Accountants Societies (COPAS). Most, if not all, joint interest audits are conducted via the provisions of the JOA and COPAS accounting procedure.

Once an audit has been conducted and exceptions have been taken to charges and/or credits made by the operator to the joint account, the operator either grants one or more of the exceptions and makes an adjustment to the joint account (often resulting in a credit) or denies one or more of the exceptions and a dispute arises.

In most instances, the non-operators who participated in the audit will furnish a rebuttal to the operator�s written response to an audit wherein credits for exceptions have been denied. This response and rebuttal process may be repeated until either party gives in or a settlement is negotiated. However, if the operator does not want to grant the exception or propose a settlement agreeable to the non-operators, it may seem that the only recourse to the non-operators is a lawsuit against the operator. This course of action can be time consuming, expensive and virtually destroy the business relationship between the parties.

Arbitration provides a viable means of settling disputes arising between the operator and the non-operator. It is a private, informal process by which all parties agree in writing to submit their disputes to one or more impartial persons authorized to resolve the disputed and sometimes controversial exceptions by rendering a final and binding award.

Major Features of Arbitration

A written agreement between the parties to resolve disputes by the use of impartial arbitration – Such a provision may be inserted in or added to a contract for the resolution of future disputes, or it may be an agreement between the parties to submit an existing dispute to arbitration.

Informal procedures
Under the American Arbitration Association (AAA) rules, the arbitration procedure is relatively simple. Strict rules of evidence are not applicable. There are no motions or formal discovery practices. There are no requirements for transcripts of the proceedings or for written opinions of the arbitrator(s). Though there is no formal discovery, the AAA�s various commercial rules allow the arbitrator(s) to require the production of relevant documents. The AAA�s rules are flexible and can be varied by mutual agreement of the parties. Thus, the parties control the range of issues to be resolved by arbitration, the scope of the relief to be awarded, and many of the procedural aspects of the process. Therefore, arbitration is less formal than a court trial, and the hearings are private and confidential.

Impartial and knowledgeable neutrals serve as arbitrators
The arbitrators may be business persons or attorneys with expertise in a particular area. Arbitrators are selected for specific cases because of their knowledge of the subject matter. Consequently, based on their experience, arbitrators can render an award grounded on thoughtful, thorough and pertinent analysis.

Final and binding awards which are enforceable in a court
Few awards are reviewed by the courts because the parties have agreed to be bound by the decision of their arbitrator(s). Court intervention and review is limited by applicable state or federal arbitration laws and award enforcement is facilitated by these same laws.

Advantages of Arbitration Over Litigation
To the operator, arbitration will require less out-of-pocket costs than those normally incurred in the defense of a lawsuit (which is often settled on the eve of going into the courtroom for a trial). This lower cost is brought about by the discovery process being limited to production of documents with fewer depositions and expert witness testimonies, by a somewhat concise definition of the disputed items, and by an informal hearing on the facts rather than a prolonged court trial.

Due to the private and confidential nature of arbitration, awards which have a negative impact on the operator will be limited to those properties involved in the arbitration and only to the extent of those parties involved in the arbitration process. The operator would not be required or necessarily expected to make similar adjustments to other operated properties, as the case might be should the operator�s contention be negated in a public trial. In the case of arbitration, the issues are decided only between the parties involved in the arbitration and no one outside of the arbitration process has access to how the issues between the parties were decided. Consequently, no one outside of the arbitration process has enhanced their position for settlement of pending disputes.

Another advantage to the operator, as well as the non-operator(s), is the closure of outstanding audit exceptions in a more expedient fashion. There is no reason why an audit could not be settled within a year from when the written exception is presented by a non-operator to an operator. Under more recent COPAS recommended accounting procedures, the operator has 180 days in which to respond to an audit. Then, under COPAS protocol and procedures guidelines established in Bulletin No. 3 (revised April, 1993), the lead auditor is to furnish a written response (normally referred to as a rebuttal) to the operator�s response within 90 days. When this rebuttal is received by the operator, either an adjustment is forthcoming or the ongoing dispute has been well defined and the position of the parties are known to each other. At this point, an audit resolution conference should be held between the authorized decision makers of the parties, and if settlement of the disputed items is not reached, the matter could be decided between the parties by an arbitrator or arbitration panel, and each company could then go on about its business (without the animosities often encountered in a lawsuit).

It should be noted that when, at the option of either party, the operator and non-operators have agreed to arbitrate any unresolved audit exceptions which might arise in the future, the audit resolution conference (if the exceptions actually get this far) take on a whole new spirit for settlement. All parties would be more inclined to settle the unresolved issues rather than bear the additional expenses of arbitration. Consequently, with an agreement to arbitrate being made when the parties enter into a joint venture, very few audit exceptions should actually go to arbitration. (See Appendix A for a proposed modification to the COPAS accounting procedure or Appendix B for a proposed Exhibit to the JOA.)

Where there is no arbitration agreement in place between the parties and audit exceptions remain unresolved, it is recommended that all parties move toward closure and settlement of the issues by now agreeing to arbitrate such issues. (See Appendix C for possible language for an agreement to arbitrate existing disputes.)

If the parties involved in disputed audit issues are seeking resolution from a knowledgeable, informed source, the arbitration process is often preferred over a trial decision. One of the reasons is because the parties have the opportunity to select the arbitrator(s) based on their experience and knowledge relative to the subject matter rather than trusting to �the luck of the draw� for the judge and/or jury to decide the issues. The arbitrators may be business persons or attorneys experienced in the oil and gas industry with expertise in the particular area of joint venture operations and accounting. If the issues in dispute are complex, it would be advantageous for the operator and the non-operator (as a group if more than one) to each appoint an arbitrator and then the two arbitrators select a third neutral arbitrator to serve on an arbitration panel. Although all three arbitrators are to be neutral to the parties and in their decision, the fact that each side to the dispute appointed a panel member, the perception is that the arbitrator would not have been appointed unless he or she was in agreement with the position of the appointing party in the dispute. However, even if this perception is true and each party-appointed arbitrator is a champion on each side of the issue, the third arbitrator exists to settle the disputed issues. One way to avoid �hired gun� arbitrators is for the parties to agree to select the panel through the AAA and its National Panel of Arbitrators who serve under the AAA�s commercial arbitration rules and whose conduct is guided by a specific Code of Ethics. If the issues in dispute are not complex and/or not material in amount, the operator and non-operator may want to select only one impartial and neutral, but knowledgeable, arbitrator and forego the expenses of the party-appointed arbitrators. In either case, arbitration panel or single arbitrator, the primary goal of settling the dispute in a competent, efficient manner is usually achieved.

Once an award is rendered by the arbitrator(s), it is usually binding and enforceable as few awards are ever reviewed by the courts because the parties agreed in written to be bound by the decision of their arbitrator(s). Court intervention and review is limited by applicable state or federal arbitration laws and award enforcement is facilitated by these same laws. Consequently, binding arbitration negates, except in rare instances, the lengthy and costly appeal process associated with the courts.

Summary

Arbitration is a private, informal process by which disagreeing parties agree in writing to submit their disputes to one or more impartial persons authorized to resolve the controversies by rendering a final and binding award. It is a valid, non-threatening procedure whereby unresolved audit exceptions can be settled in an expeditious and efficient manner.

All parties entering into a joint venture arrangement should modify the operating agreement or accounting procedure to provide for binding arbitration as the means to settle unresolved exceptions resulting from an audit of charges and credits made by the operator to the joint account of the parties.

Operators and non-operators currently disputing unresolved audit exceptions should strongly consider an agreement to submit these existing disputes to binding arbitration. As a result of agreeing to arbitrate the exceptions, the audit could be closed within 90 days of the filing of the dispute with the American Arbitration Association.

Conclusion

Most persons do not want to be involved in lawsuits. Litigation can entail lengthy delays, high costs, unwanted publicity and ill will. Appeals might be filed after a decision has been rendered causing further delay and costs. On the other hand, the process of binding arbitration is usually faster and less expensive, and the conclusive resolution to the disputed issues may be more equitable to the parties, having been rendered by neutral arbitrators having specialized experience and knowledge in the subject matter of the dispute. Therefore, binding arbitration is indeed a viable means of settling exceptions and claims arising from a non-operators� audit of an operator�s accounts and records.

 

APPENDIX A

Arbitration Clause Addition to Audit Section of COPAS Account Procedures (Section I, Paragraph 5)

In order to resolve disputed audit exceptions after one year from the date the operator receives the non-operator(s) audit report, if operator and non-operator cannot agree on items disclosed in such report, upon the request of either party, any dispute or controversy between the parties concerning items arising out of the audit conducted by non-operator(s) pursuant to the terms of this accounting procedure shall be resolved by binding arbitration administered by the American Arbitration Association (AAA) in accordance with the Commercial Arbitration Rules of the AAA, and, to the maximum extent applicable, Title 9 of the U.S. Code (United States Arbitration Act). Three arbitrators, each being knowledgeable in the subject matter of the dispute, shall be chosen and shall resolve all disputes in accordance with the substantive law. Within 15 days after the commencement of arbitration, the operator and non-operator group shall each select one arbitrator and the two party-appointed arbitrators shall select a third neutral arbitrator within 10 days of their appointment.

If the party-appointed arbitrators are unable or fail to agree upon the third arbitrator, the third arbitrator may be selected by the AAA. Prior to the commencement of hearings, each of the arbitrators shall take an oath of impartiality. Limited civil discovery shall be permitted for the production of documents and the taking of depositions. A preliminary hearing with the parties and/or their representatives and the arbitrators shall be held to specify the issues to be resolved, to stipulate uncontested facts, and to consider any other matter that will expedite the arbitration proceedings. All issues regarding conformation with discovery requests shall be decided by the arbitrators. Unless determined otherwise by the arbitrators, each party shall bear the expenses of its party-appointed arbitrator, its own counsel, experts, witnesses, preparation and presentation of proofs and an equal share of the fees and expenses of arbitration. However, the arbitrators shall have the power to award to the prevailing party, if any, as determined by the arbitrators, all of its costs and fees, grant injunctive relief, and impose liens on real property to the extent necessary to enforce any awards. Each party agrees to keep all disputes and arbitration proceedings strictly confidential, except for disclosures of information required in the ordinary course of business of the parties or by applicable law or regulation. Each party further agrees to abide by and perform any award rendered by the arbitrators and that a judgment of the court having jurisdiction may be entered upon the award.

APPENDIX B

EXHIBIT_____

Attached to and made a part of that certain AAPL Model Form Operating Agreement dated __________ by and between ______________ as operator, and _____________________ as non-operator(s).

ARBITRATION

1. Binding Arbitration � In order to resolve any dispute or controversy arising out of a joint interest audit conducted by non-operator(s) pursuant to the terms of the operating agreement and/or accounting procedure which remains open and unresolved after one year from the date the operator receives the non-operator�s audit report, will be submitted to binding arbitration, upon the request of either party, in accordance with the terms hereof. The unresolved audit exceptions shall be referred to collectively as a �dispute� and either party may, by summary proceedings (e.g., a plea in abatement or motion to stay further proceedings), bring an action in court to compel arbitration of the disputes.
2. Governing Rules � All disputes between the parties shall be resolved by binding arbitration administered by the American Arbitration Association (AAA) in accordance with the terms hereof, the Commercial Arbitration Rules of the AAA, and, to the maximum extent applicable, the United States Arbitration Act (Title 9 of the U. S. Code). In the event of any inconsistency between this agreement and such statute and rules, this agreement shall control. Judgment upon the award rendered by the arbitrators may be entered in any court having jurisdiction.
3. Statute of Limitations � All statutes of limitation that would otherwise be applicable shall apply to any arbitration proceeding.
4. Qualifications of Arbitrators and Scope of Award � The arbitrators shall resolve all disputes in accordance with the applicable substantive law. Three arbitrators shall be chosen to decide the dispute, and each arbitrator shall be knowledgeable in the subject matter of the dispute. The operator and the non-operator (as a group, if more than one) shall each have the right to select one arbitrator for the panel and the two arbitrators thereby selected will select the third arbitrator for the panel. If the party-appointed arbitrators are unable or fail to agree upon the third arbitrator, the third arbitrator shall be selected by the AAA. Prior to the commencement of hearings, each of the arbitrators shall take an oath of impartiality. Unless determined otherwise by the arbitrators, each party shall bear the expenses of its party- appointed arbitrator, its own counsel, experts, witnesses, preparation and presentation of proofs and an equal share of the fees and expenses of arbitration (which includes the expenses of the third arbitrator). However, the arbitrators shall have the power to award to the prevailing party, if any, as determined by the arbitrators, all of its costs and fees, grant injunctive relief, and impose liens on real property to the extent necessary to enforce any awards.
5. Other Matters � To the maximum extent practicable, an arbitration proceeding hereunder shall be concluded within 90 days of the filing of the dispute with the AAA. Arbitration proceedings shall be conducted in ______(city), ______(state), unless otherwise agreed in writing by all parties to such arbitration. Limited civil discovery shall be permitted for the production of documents and the taking of depositions with all issues regarding conformation with discovery requests being decided by the arbitrators. A preliminary hearing with the parties and/or their representatives and the arbitrators may be held to specify the issues to be resolved, to stipulate uncontested facts and to consider any other matter that will expedite the arbitration proceedings. Each party agrees to keep all disputes and arbitration proceedings strictly confidential, except for disclosures of information required in the ordinary course of business of the parties or by applicable law or regulation.

APPENDIX C

Agreement to Arbitrate
Unresolved Audit Exceptions

WHEREAS, _________________ the designated operator and ___________ as designated non-operator(s) entered into an operating agreement dated ______ to explore and develop certain leases, and

WHEREAS, audit exceptions taken by the non-operator(s) in an audit report to the operator dated ________ remain open and unresolved,

NOW, THEREFORE, we, the undersigned parties, hereby agree to submit these open and unresolved exceptions to binding arbitration under the Commercial Arbitration Rules of the American Arbitration Association (AAA) and to the maximum extent applicable, Title 9 of the U. S. Code (United States Arbitration Act) We further agree that three arbitrators, each being knowledgeable in the subject matter of the dispute, shall be chosen and shall resolve all dispute in accordance with the substantive law. Within 15 days after the commencement of arbitration, the operator and non-operator group shall each select one arbitrator and the two party-appointed arbitrators shall select a third neutral arbitrator within 10 days of their appointment. If the party-appointed arbitrators are unable or fail to agree upon the third arbitrator, the third arbitrator shall be selected by the AAA. Prior to the commencement of hearings, each of the arbitrators shall take an oath of impartiality. Limited civil discovery shall be permitted for the production of documents and the taking of depositions. A preliminary hearing with the parties and/or their representatives and the arbitrators may be held to specify the issues to be resolved, to stipulate uncontested facts, and to consider any other matter that will expedite the arbitration proceedings. All issues regarding conformation with discovery requests shall be decided by the arbitrators.

Unless determined otherwise by the arbitrators, each party shall bear the expenses of its party-appointed arbitrator, its own counsel, experts, witnesses, preparation and presentation of proofs and an equal share of the fees and expenses of arbitration. However, the arbitrators shall have the power to award to the prevailing party, if any, as determined by the arbitrators, all of its costs and fees, grant injunctive relief, and impose liens on real property to the extent necessary to enforce any awards.

Each party agrees to keep all disputes and arbitration proceedings strictly confidential, except for disclosures of information required in the ordinary course of business of the parties or by applicable law or regulation.

Each party further agrees to abide by and perform any award rendered by the arbitrators and that a judgment of the court having jurisdiction may be entered upon the award.

IN WITNESS WHEREOF, this agreement for arbitration is entered into on the ______ day of __________, ______ OPERATOR __________________ ATTEST OR WITNESS: _____________  By: _____________  __________________ Type or print name

NON-OPERATOR (Lead Company) __________________ ATTEST OR WITNESS: _____________  By: _______________  __________________ Type or print name

 

Searching for Dollars-Revenue Analysis (Audit)
by Al E. McClellan, President of Petroleum Revenue Services

With the downturn in the oil and gas industry, most companies have found that having an adequate cash flow is an illusive goal.  The need for additional dollars has caused many of these companies to consider the question, are we really receiving all of the revenue from our producing oil and gas properties?@

The complexity of revenue accounting creates confusion, and confusion causes errors.  Since purchasers do not have the incentive to correct errors which are not in their favor, sellers will not receive the revenue to which they are entitled unless they can make certain that these errors are identified and corrected.  Unless the accounting for the product and the revenue from its sale is analyzed by experienced analysts, most of these errors will go undetected and revenues will not be realized.

AUDIT OF COSTS

In the past many oil and gas companies, as well as investors in oil and gas operations, have concentrated on questions relating to the cost of their investments.  Since most of us have control of the money we pay out, we often question, are we getting that for which we pay and are we paying more than we should?  In joint operations we have relied on the audit of billings from the operator in accordance with accounting procedures recommended by the Council of Petroleum Accountants Societies (COPAS) to answer these questions.  In fact, the provisions of these accounting procedures specifically give the non-operators the right to audit the expenditures charged to the joint account by the operator.

Since the COPAS accounting procedures are usually attached to, and made a part of, the operating agreement between the operator and non-operators, the operator becomes contractually obligated to follow the procedures set forth therein.  Consequently, most exceptions taken in an audit of joint interest billings result in claims against the operator.  Since the downturn in the oil and gas industry has caused some operators to become more innovative and aggressive in their billing procedures, non-operating investors should continue to search for dollars through the audit of joint interest billings.  In addition, non-operators should make greater use of audits of joint interest revenues.

ANALYSIS OF REVENUES

For a variety of reasons, searching for dollars through an analysis of revenues has not been a high-priority concern for many participants in the oil and gas industry.  In exploring the need for revenue analysis, most of these reasons fall into four general categories:

• Trust between parties within the industry,
• Complexity of the product (especially gas),
• Complexity of accounting,
• Expertise and personnel.

Trust Within the Industry

From its beginning, the oil and gas industry has been and (although somewhat tested in the last few years) is still known as the ‘good old boy’ industry.  Billions of dollars have changed hands on a hand shake and/or a man’s word because there has been the element of trust.  This trust is exemplified by the reliance of the non-operating owners (both working interest and royalty) upon the operator to monitor the revenues generated from the sale of their products.  Logically, the non-operators conclude that since the operator usually has an interest in these revenues (often the largest interest), the operator will effectively monitor the revenues attributable to his interest.  Therefore, the non-operating owners trust the operator to monitor their revenues as he monitors his own revenues.  No matter how sound this logic may be or how much trust is placed in the operator, many operators do not have the time, expertise, or personnel to adequately analyze revenues being received and disbursed.

If the operator is not effectively monitoring oil and gas revenues, the operator then relies on and trusts the purchaser to honor the provisions of the sales contract.  Up to this point, all parties in a trusting relationship (operator and non-operators) have had the same incentive – to receive the highest price possible for the product being produced.  They know that once the product is produced and sold, it is gone and whatever they receive for its sale is final.  Thus, their incentive is to get the highest price possible.  But, what is the incentive of the purchaser in the sale transaction?  The purchaser’s incentive is to purchase the product at the lowest possible price.  Therefore, if there are any provisions in a sales contract that would cause the purchaser to pay a higher price for the product, he may have a great incentive to ignore the implementation of any such provisions.  How often do purchasers notify the owners that, because of an oversight, a clerical error, or due to the implementation of some contract provision, they will be getting more for the sale of their product?  Are these adjustments in revenues retroactive, prospective or both?  What happens if oversights, clerical errors or misinterpreted provisions are not identified and brought to the attention of the purchaser by those who have an incentive to receive a higher price?  When the well is either sold or is depleted and abandoned, then the owners of the product have realized less revenues than they were entitled to receive.  Conversely, the purchaser has paid less for the product than he contracted for an should have paid.

Although sales contracts may contain similar provisions, there is no standard sales contract within the industry.  Therefore, the provisions of contracts are unique and any one contract cannot be accounted for or replied upon in the exact manner as other sales contracts.  However, this assumption of standardization of sales contract is prevalent with both the purchasers and the sellers.  Thus, many sellers are mistakenly trusting the parties to the sales transaction without realizing the uniqueness of each sales contract. This trust has resulted in owners being deprived of the revenue to which they entitled.

Complexity of the Product

The complexity of products within the oil and gas industry creates many problems in determining the appropriate amount of revenue to be received for the products being produced.  Whether the product is oil, gas or liquid products, measurement becomes the essential basis for determining the amount of revenue to be received.  The form and characteristics of the product determine the methods and procedures used to measure production, and the form and characteristics of each product produced within the industry are different.  Oil is different from liquid products and gas, liquid products are different from oil and gas, and gas is different from oil and liquid products.  Although there are problems associated with the measurement of oil and liquid products, gas is by far the most complex to measure.

Almost every person in the industry knows that an MCF is the basic unit of measurement for gas and is 1000 cubic feet of gas.  Likewise, they know a cubic foot of gas in the amount of gas contained within a 1 ft. x 1 ft. x 1 ft. cube.  What many fail to consider is that gas is compressible and expandable.  Therefore, the amount of gas contained within a measure cubic foot depends on the pressure being applied on the gas within the cubic foot.  Thus, it becomes important to know the pressure base used to measure the gas, especially when the sales contract may provide that the price is to be determined on a different pressure base.

Another aspect of gas measurement which causes problems within the industry and consequently results in revenues going unrealized concerns the heating value of the gas being measured.  Most people in the industry know that BTU stands for British Thermal Unit or the amount of heat necessary to raise the temperature of a pound of water 1 degree Fahrenheit.  What many fail to realize is that the heating value of gas is determined by the physical properties within the gas.  The gas can be rich with heavier hydrocarbons such as propane, or lean with very few of these components.  The rich gas generates greater heating value (BTUs) because of these components and therefore is deemed to have greater value than lean gas.  With the price to be paid for gas being determined by the heating value, the measurement of the heating value of the gas within the cubic foot becomes essential.  Another point to consider when measuring the BTU content of a cubic foot of gas is that this BTU content usually changes with production.  As a well is produced, the gas can either become richer or leaner.  Often the gas becomes richer and therefore increases in value, but if not measured (tested), the owners will not receive the full amount of revenues to which they are entitled.

Complexity of Accounting

Once the product has been defined and its contents measure, the volume attributable to an owner’s interest must be considered.  The first task is to determine the ownership percentage of each owner and seller of the product.  This ownership percentage is determined by the title to the property’s mineral interest and the various conveyances and assignments of mineral interests and portions thereof.  This process of determining ownership is often a difficult one entrusted to the operator’s land department, legal staff and/or outside attorneys.  It should be noted also that although the ownership percentages have been determined, They are constantly subject to change through such transfers as gifts, sales and/or death.  Each subsequent change in ownership must be accounted for  and this process can be further complicated if there is more than one purchaser of a product from the well or property.

Because each working interest generally has the right to take production in kind, there may be more than one sales contract applicable to any given property.  This often creates a problem in that one party may produce a disproportionate amount of product in relation to its ownership interest.  As a result, one party may become over-produced while other parties become under-produced.  This imbalance must be accounted for since the terms and prices under the various sales contracts are often not the same.

Accounting for the revenues produced from sale of the products is further complicated by government regulations.  The relevant regulations affecting revenues generally fall into two categories – price controls and taxes.  The complexity of price controls is exemplified by the Natural Gas Policy Act (NGPA), whereby the sale of gas was subjected to approximately 27 pricing categories.  The rules and procedures to be followed once it had been determined under which category the sale qualified were also complex, and resulted in timing differences which placed additional demands on revenue accounting.

In the area of taxes, sales of products within the oil and gas industry have always been burdened by some type of severance (production) tax.  However, the method of calculation and application of a severance tax usually varies from product to product, as well as between taxing authorities from state to state.  Another tax which affects revenue accounting came into existence with the implementation of a windfall profit tax (WPT).  Throughout the oil industry there has been much confusion in accounting for and remitting this tax.  Much of this confusion arose because the rules and regulations did not offer clear and concise guidance in an appropriate manner.

In summary, the complexity of accounting for revenue to be realized from the sale of products results from the complexity of the products, the complexity of ownership, the intervention of government rules and regulations, and the lack of standard sales contracts.  These complexities are compounded by the lack of standard sales contracts.  These complexities are compounded by the lack of guidance available to those entrusted to account for the revenue.

Expertise and Personnel

There is very little guidance for the revenue accountant since coverage of oil and gas revenues is extremely limited in the few accounting texts available and in the limited number of oil and gas accounting courses taught in colleges and universities.  Also unlike joint interest accounting, revenue accounting has not been “COPAS-ized”.  The standard accounting procedures developed and recommended by COPAS deal only with the costs associated with the exploration for the production of oil and gas revenues.  Standard accounting procedures for revenues have not been developed by COPAS, and therefore the guidance furnished by COPAS through its interpretations and bulletins is not as comprehensive for revenues as for expenditures.  Consequently, on-the-job training is the chief means of instruction and guidance to the revenue accountant.

Although on-the-job training can sometimes be a trial-and-error method, usually an experienced revenue manager or supervisor is available to furnish needed guidance and instruction.  However, personnel reductions resulting from the downturn in the industry have limited the availability of experienced revenue accountants.  Also, because experienced accountants were often given early retirement in the first wave of cost-cutting felt throughout the industry, today’s revenue accountants are less experienced than those of a few years ago and have fewer places to turn for answers to the many questions and problems inherent in a complex accounting area.

The lack of guidance and the “pressure-cooker” working conditions which constantly face the revenue accountant are the principle reasons why the average revenue accountant usually has fewer years of experience than other accountants within the industry.  Much of the pressure is further compounded by the cardinal rule to never lose a producing lease because of the non-payment of revenues.  Consequently, even though the revenue accountant might suspect (or know) that the funds received from a purchaser are incorrect, they are disbursed as received with the idea that appropriate corrections will be made at a later date.  However, if because of the workload or the lack of information, errors are not corrected, they compound with time and cause further grief to the conscientious revenue accountant.  Often this unrelenting pressure motivates the accountant to transfer to another area of accounting (or sometimes out of accounting altogether) at the first opportunity.

Summary of Need

The complexity of the products (especially gas) has been, and always will be, a major reason for analyzing revenues to determine if the appropriate revenues are being received.  The complexity of accounting for these revenues continues to increase with government rules and regulations, changes in taxes and the more frequent shifts in markets for oil and gas products (i.e., gas sales to transmission companies under long-term contracts versus short-term spot and direct sales to the end-users).  Adding to these complexities is the fact that although some wells have been shut-in because of economics, the accounting necessary for all producing properties has not diminished in proportion to the number of revenue accountants left within the industry to perform the task. Consequently, errors are being made and errors are going undetected.  Since purchasers do not have the incentive to correct errors which are not in their favor, the sellers will not receive the revenue to which they are entitled unless these errors are identified and corrected.  Most of these errors will go undetected unless the accounting for the product and its revenue is analyzed by experienced analysts.

ASPECTS OF REVENUE ANALYSIS

Before proceeding to analyze oil and gas revenues, one must address many unanswered questions.  One of the paramount questions to be answered is, do you have the right to analyze (audit) the operator’s and/or purchaser’s records?  Through the COPAS accounting procedures, the non-operating working interest owners have the right to audit the costs associated with the drilling, completion and operation of a well, but it is generally agreed that this audit right does not extend to production and the revenues generated from the sale of that production.  Thus, what gives an owner of the product (whether the owner is an operator, a non-operating working interest owner, or a royalty owner) the right to audit?  Further, do audit rights extend beyond the operator and/or to the purchaser?

Upon the determination that audit rights do exist, the other aspects of revenue analysis to be considered include the following:

• Initiating and conducting the analysis (audit),
• Time limitation on rights and/or period analyzed,
• Participation and roles of the parties involved,
• Access to production facilities and records to be provided,
• Action on exceptions and sharing of analysis costs.

Initiating and Conducting the Analysis (Audit)

The protocol for initiating and conducting revenue analysis or audit has not been established, although COPAS has taken the initial step to develop this protocol and will ultimately issue a bulletin, as was done with Bulletin No. 3 on joint interest expenditures. COPAS is currently developing a questionnaire that will be circulated throughout the industry to determine the contents of a revenue audit protocol bulletin that would provide guidance in such areas as scheduling, audit scope, time frame, documentation, and preliminary and final reports.

Time Limitations

Currently joint interest accounting procedures provide for a review of charges within the twenty-four (24) month period following the calendar year in which the charges are billed.  Most sellers and their accountants will agree that this two-year limitation does not apply to the review and analysis of revenues received.  Contrary to any specific audit limitation provisions within a sales contract, most of these parties will agree that revenue reviews are limited only by the statutory limitations of the state in which the production occurred.

Participation of the Parties

Non-operating owners (both working and royalty interest owners) generally receive only check-stub information from the operator (or sometimes from the purchaser) concerning the sale of their oil and gas products.  This information is usually limited to disclosure of the production month, the quantity of product sold, the gross value of the product sold, the applicable taxes deducted, and any adjustments being made to arrive at the net amount being paid to the recipient.  Since this check-stub information is wholly inadequate for a proper analysis of revenue, the non-operating owners usually call upon the operator to furnish the necessary information.  Therefore, the operator becomes involved in any revenue analysis being conducted on behalf of a non-operator.

Whether or not the operator becomes a participant in an analysis of the revenues from a specific operated property is another matter.  One would think that since the operator normally has an ownership position (often the largest working interest percentage) in the revenues from the property and since most errors result in additional revenues being due from the purchaser(s), the operator would be eager to participate in revenue analysis.  However, many operators are reluctant to initiate or participate in revenue analysis.  Some of the reasons for this reluctance may include the lack of time, expertise and/or personnel, a negative reflection on their fiduciary duty if deficiencies are found, and the realization that as an owner they could share in any additional revenues recovered from a purchaser without bearing any costs associated with conducting the review by another party.  It should be noted that because of the complexities of the products and the complexities associated with accounting for revenues, most operators cannot afford the personnel and expertise necessary to monitor all aspects with total assurance.  Since most revenue exceptions result in claims against the purchaser for additional revenues from production on the property, all owners are usually beneficiaries.  Consequently, should not all owners attempt to join together and share in the expense of analyzing revenues?  In the same way that non-operators are balloted for participation in an audit of the charges made to the joint account by the operator, should not all owners (operator, working interest, and royalty owners) be balloted for participating in an audit of the purchaser?

Although the operator is called upon to provide the information necessary to conduct revenue analysis, often a portion of this information is not available because it has never been received from the purchaser.  If the analyst does not have the cooperation of the operator, a question is raised as to whether non-operating owners have a right to the purchaser’s information and, if so, how is this information to be acquired.  A purchaser is generally not a party to COPAS guidelines, and contractual information between the seller and purchaser is often deemed confidential.  Operators are often looked upon as the seller and therefore the question arises as to whether purchasers are required to provide information or make it available to the revenue analyst.

Access to Facilities and Records

The accuracy of revenue is, in large part, dependent on the accuracy of production information, product measurement facilities and techniques.  For this reason, on-site reviews may be extremely beneficial in performing an analysis (audit) of the revenue derived from the sale of the product.  In tracing the products from the wellhead and the resultant sales proceeds to the check stub, a thorough understanding of the measurement and flow or transportation of the product is essential.

Revenue analysis requires flexibility since all the needed records are often not maintained in one location.  For example, often in large companies the revenue function is segregated from the production function.  Likewise, these two functions are often segregated from the marketing or contracts function.  The records associated with all of these functions are necessary for a proper analysis of revenue and the fact that they may be in different locations could impose deterrents and long delays to revenue analysis.  Some of the many types of records and documents utilized for production accounting and revenue calculations which are used frequently in an analysis (audit) of revenue include:

• Operating agreements BTU calculations
• Division orders GPM calculations
• Gas purchase contracts Gas charts
• Gas purchase statements Orifice meter calibrations
• State production reports Check meter volumes
• Allocation statements BS&W calculations
• Settlement statements LACT meter provings
• Storage reports Price postings
• Oil purchase contracts Tank strapping (tables)
• Run tickets Gas chromatograph analysis
• Gas plant statements NGPA filings
• Schematic diagrams Deferred production reports
• Gas balancing statements Take-or-pay statements

As stated earlier, some of the above records and/or information may not be available except from the purchaser.  Consequently, the analyst must be concerned with how to gain access to the needed information.  Again the question of whether the analyst has the right to receive the information from the purchaser arises.

Action on Claims and Costs

Without the formalities provided for revenue analysis or audit as provided by COPAS concerning joint interest audits, there is much confusion as to the procedures to be followed in reporting revenue exceptions and claims.  Neither a standard form of report nor standard contents of a report has been recommended within the industry.  The nature of the findings and the claims resulting from them should indicate to whom the report is to be directed.  Certainly, those bearing the costs associated with the analysis or audit should receive a copy of the report.

It should also be noted that although there should be a reasonable amount of time allowed for the operator and/or purchaser to research the findings and formulate a response, a set time frame has not been established.  However, it is certain that adjustments are more difficult to obtain with the passage of time and, unlike joint interest audit exceptions, adjustments in revenues are often retroactive and prospective.

How to Analyze Revenue

After deciding to analyze revenues from the production of oil and gas to determine if all that is due is being received, one must decide how to proceed.  To provide guidance within the industry, COPAS published Bulletin No. 23, “Guideline for Revenue Audits in the Petroleum Industry,” in April, 1985.  The forward to this bulletin succinctly covers the intent of the guidelines contained therein:

Since revenue auditing is a relatively new expertise in which some audit staffs have found themselves lacking, a need has arisen for guidelines the auditor can use in preparing and conducting this type of audit.  The following guidelines are only intended to give the auditor the basics for such an audit and not a detailed audit program.  The conditions under which volumes and revenues are dispersed are very different in many cases.  Therefore, the audit should expand and tailor the guidelines to fit each individual audit.

From the general guidelines provided in the Bulletin, an experienced analyst or auditor could develop a comprehensive, detailed program, but such a program would have to have a high degree of flexibility because of the varied revenue conditions.  These guidelines provide an excellent checklist as to what should be considered in developing the audit program.

In developing a detailed program, one needs to be keenly aware that product quantification and measurement techniques are essential to the determination and realization of revenue from the production and sale of the product.  Due to the complexities of the products and the difficulties often encountered in measurement, engineering knowledge and experience on the part of the analysts (auditors) can better assure that all revenues due are being received.

Whether an owner (seller) decides to commit the time, personnel, and resources to develop revenue analysts and a program for reviewing the revenue from producing properties, or contracts with one of the few firms capable of providing revenue analysis, there exists a tremendous need for analysis in the industry.  Due to the complexities of the products and the problems inherent in accounting for unique, non-standard sales contracts, owners are losing millions of dollars in revenue to which they are entitled.

Errors, which compound themselves with time, have been and are being made daily which favor the purchaser.  Analysis by competent, experienced analysts is a proven means of identifying these errors and quantifying results.  If these errors are not properly identified, any revenue due because of them will never be collected.

 

THE IMPACT OF COPAS 
by Al E. McClellan, Past President of COPAS

Although lacking statutory clout and muscle, it has been said that the Council of Petroleum Accountants Societies (COPAS) is to the oil and gas industry what the Financial Accounting Standards Board (FASB) is to public accounting and public corporations.  As the FASB virtually dictates how public corporations will account for and report financial position and results of operations, COPAS uses a consensus process to establish generally accepted accounting practices and procedures for oil and gas companies in presenting the results of their operations to their investors and joint venture participants.

In 1961, when twelve existing petroleum accounting societies joined together to form COPAS, they probably did not envision a Council (1) which would have delegates from 25 societies representing approximately 4,000 petroleum accountants, (2) which would furnish guidance in areas of petroleum accounting other than joint interest personnel, (3) which would have a national office and employ full-time personnel, (4) which would establish national oil and gas schools to provide specialized training for accountants new to the oil and gas industry and specialized training for accountants new to certain areas of petroleum accounting, and (5) which would publish documents defining what would be charged and how charges would be made by the operator to the non-operators in a particular joint venture.

In addition to an exchange of ideas between societies and a forum for the enhancement of standard practices within the industry, COPAS was established to furnish guidance and uniformity in accounting for a unique specialized industry.  Initially, COPAS members sought to standardize the myriad of joint venture accounting practices through the issuance of accounting procedures and bulletins.  With this in mind, COPAS issued and published its first standard accounting procedure form and related bulletin in 1962.  This accounting procedure, was readily adopted within the industry and became attached to and made a part of operating agreements.  The procedure was developed through a committee process which drew upon the practices and experiences of the membership within each individual accounting society.  The membership resource of COPAS has grown tremendously over the years.  By 1988, eight accounting procedures for exploration and production companies had been developed through this process.  Accounting guidelines for such diverse topics as joint ventures, oil and gas/revenues, audits and refinery accounting have been issued under the auspices of COPAS.

As the oil and gas industry has grown and changed, accounting likewise has changed.  To meet the changing accounting needs, COPAS has periodically revised its recommended accounting procedures.  Each revision was made after substantial discussion and input from each society representing a cross section of many different exploration and production companies.  Each revision was published only after approval of the Council through a vote from each participating society.  Revisions to the COPAS onshore accounting procedure were made in 1968, 1974 and 1984, and to the offshore accounting procedure in 1986.  With the issuance and publication of each standard accounting procedure, an interpretative bulletin was also issued and published to provide guidance and clarification.  Like the accounting procedures, these bulletins (as are all bulletins published by COPAS) represented input from all societies and were approved by the voting process of the Council.

Although accounting procedures and practices within the industry are constantly monitored by the various COPAS standing committees (particularly by the Audit Committee which deals with the application of these procedures), a revision to the COPAS accounting procedure is not usually undertaken until there are deemed a significant number of needed changes.

To address problems arising or occurring within the period between the time when a revision is needed and the time when these revisions are formally incorporated into the accounting procedure, and to provide guidance on a timely basis, COPAS in 1980 gave the COPAS Executive Committee (subsequently replaced by the COPAS Board of Directors) authority to issue and publish COPAS interpretations.

Interpretations provide recommendations to specific problems resulting from government intervention or fluctuations in the market for goods and services.  Interpretations were intended to utilize procedures whereby all petroleum accounting societies and their members had input to insure that issuance only takes place after general agreement of all societies.  It was recognized that although interpretations did not have the formal approval of the Council and were not, like accounting procedures, incorporated into operating agreements, since they were published by COPAS, they would have impact on the accounting practices within the industry.  It is doubtful that the Council really envisioned the significance of these interpretations on accounting in the oil and gas industry.

The impact of COPAS published interpretations can be seen with Interpretation #14 issued December 4, 1984, when COPAS recommended that published discounts on tubular goods be considered in establishing the current new price to be utilized on material transfers.  From that time forward, most oil and gas companies utilized published discounts in pricing material transfers of tubular goods even though published discounts had been in existence for several months.  The issuance of this interpretation did not change the fiduciary duty or obligation to operate in a prudent, efficient manner an operator has to the non-operators nor did it change the COPAS accounting procedure which requires the operator to charge material transfers to the joint account based on the current new price.  However, many companies chose not to honor their obligations until Interpretation #14 was issued because they felt they were allowed to charge undiscounted prices because of existing COPAS accounting procedures.  The interpretation clearly had a financial impact on parties to operating agreements.

Another example of the influence of COPAS can be seen through their development of the Computerized Equipment Pricing System (CEPS) utilized for the pricing of material transfers of controllable equipment.  CEPS was designed and implemented because of the large inventories maintained and the tremendous volumes of material transfers being processed during the late 1970’s and the early 1980’s.  Pricing of these materials transfers was a huge task because of the size of inventories and the variety of inventory items.  The constant changes (generally upward) in prices, and the accounting procedure requirement that material transfer prices be based on current new price at the date of movement required constant updating of inventory records to keep up with pricing requirements.

With the downturn in the oil and gas industry in the mid-1980’s, the intended use for CEPS changed.  COPAS certainly did not envision the discontinuance of price lists being published and the current practice of vendors offering large unpublished discounts from their published prices, and certainly did not intend to create an opportunity for operators to use CEPS (which incorporates published price lists) to profit at the expense of non-operators.  However, some companies appear to be processing their discounted purchases through an inventory account to create a gain when pricing the material transfers to the joint account by utilizing CEPS pricing.  These companies claim that CEPS is the recognized and accepted pricing system for controllable goods.  They further claim that use of CEPS does not result in unreasonable gains for operators, or it would not be indorsed by COPAS as the material transfer pricing system.

COPAS did indeed endorse CEPS as an (not the) acceptable method of pricing material transfers by the issuance of Interpretation #15 on May 20, 1986.  It recommends its use where needed to standardize and simplify material pricing but cautions that using this method may not always comply in total with certain provisions of the COPAS accounting procedures.  It further states, “In the event that pricing differences result from using CEPS and the accounting procedures, the accounting procedure shall prevail.”  Thus, since all charges for controllable material (either as a direct purchase  or as a material transfer) under the COPAS accounting procedure are based on current new price, utilization of CEPS for the purpose of achieving a gain on the transfer of materials to non-operators violates the provision of the accounting procedure.

The last example of impact or influence held by COPAS centers on the area of research papers which are disseminated through the COPAS national office.  As with COPAS interpretations, research papers are approved for publication by the COPAS Board of Directors rather than the Council.  In publishing these research or position papers, COPAS believed the topics covered therein had only limited interest and application within the industry.  This may or may not be the case but one thing is for sure, once something is published (in no matter what form), it is impossible to unpublish the document and sometimes such publication leads to Council approval.  An example of this is seen with the publication of a research paper on accounting for over and short gas deliveries.  A short time thereafter, this research paper was published virtually intact as Bulletin No. 24.

The fate of a recently approved research paper setting forth a standard accounting procedure for gas accounting is uncertain.  Although developed by the COPAS Revenue Committee and approved by the COPAS Board, this document was never circulated to the other COPAS standing committees and contains audit language which was unanimously voted against by the COPAS Audit Committee.  The provisions of this accounting procedure set forth a two-year limitation for claims against a purchaser of gas and was published despite the expressed concern that such a limitation was not in the best interests of the exploration and production companies (producers) without whom COPAS could not exist.

Perhaps the petroleum accountants associated with COPAS through their local accounting societies know the differing approval processes and consequently, the differing weight given COPAS accounting procedures, bulletins, interpretations, or research papers, but others do not know.  Most of those in the oil and gas industry believe that anything COPAS publishes, without consideration of form, establishes acceptable standard industry accounting practices and procedures.  Although this perception is factually in error, it is a perception that may well drive how other perceive COPAS’ activities and its works. Given this significant influence within the industry, COPAS may need to evaluate all of their publications to determine consistency, timeliness and general agreement from all parties involved.  Failure to do this could lead to a weakening of an original COPAS objective which was to develop industry accounting rules by consensus.

With the long-standing history and acceptance of COPAS accounting procedures and interpretations, COPAS has become the recognized authority for accounting within the oil and gas industry.  Their recommendations and guidelines have become the generally accepted accounting standards by which the various parties within the industry account for and are accountable to one another.  Definitions, terms, and phrases established by COPAS have become recognized in many legal concepts.  Contracts are negotiated and investment decisions are often made based in part on the accounting procedures recommended by COPAS.  COPAS standards are often looked to as clarifying intent or meaning of contracts in the industry even if the contract does not contain direct reference to COPAS.  As a result, COPAS is often viewed as reflecting the voice of the industry on accounting issues.  This makes COPAS a powerful organization.

Having risen from a group of industry accountants seeking to solve limited issues to an organization perceived as reflective of industry views and practices, it may be time for COPAS to re-evaluate its operations, publications, and activities to make certain that it continues to meet membership needs under its new, more powerful leadership mantle.