Entities With Oil and Gas Producing Activities — AICPA Audit and Accounting Guide

This Audit and Accounting Guide provides the latest information on accounting and auditing issues affecting the oil and gas producing industry. Updated with conforming changes as of May 1, 2008, it includes guidance in planning and performing audits under the risk assessment standards (SAS Nos. 104-111). This edition of the guide has also been conformed to reflect the Defining Professional Requirements standard (SAS No. 102). Furthermore, it provides additional guidance on the auditor's responsibilities as set forth in SAS Nos. 112-114, including identifying and reporting internal control deficiencies, understanding the link between the auditor's consideration of fraud and the auditor's assessment of risk, dating of the management representation letter, and the auditor's communications with those charged with governance.

The guide summarizes applicable requirements and practices, and delivers "how-to" advice for handling audit and accounting issues common to the oil and gas producing industry. It includes accounting requirements for oil and gas producing activities and a discussion of the relevant financial statement considerations for the oil and gas producing industry. The guide covers the following new accounting pronouncements:

• FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115
• FASB Statement No. 157, Fair Value Measurements, and related FASB Staff Positions

For a topical listing of subject matter by chapter, click on the Table of Contents tab.

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Preface
Purpose and Applicability

Scope
This guide describes relevant matters unique to the oil and gas producing industry in order to assist the independent auditor in auditing and reporting on financial statements of entities performing these activities. Generally accepted auditing standards (GAAS) and generally accepted accounting principles (GAAP) are applicable in general to the oil and gas producing industry. The general application of those standards and principles is not discussed herein; rather, this guide focuses on the special problems inherent in auditing and reporting on the financial statements of an entity with oil and gas producing activities.

Limitations
This guide concentrates on the domestic exploration and production activities of oil and gas companies and generally does not address the special problems related to other activities of integrated oil and gas companies or foreign activities. This guide also does not differentiate between onshore and offshore activities, because their financial accounting considerations are similar.

This guide provides information regarding statutory rules and regulations applicable to the industry. Also included are illustrations of the form and content of financial statements for entities with oil and gas producing activities. Rules and regulations, as well as applicable authoritative accounting and auditing pronouncements, are subject to change and revision. Therefore, the auditor should keep abreast of developments affecting these items.

This guide contains certain suggested auditing procedures, but detailed internal control questionnaires and audit programs are not included. The nature, timing, and extent of auditing procedures are a matter of professional judgment and will vary depending on the size, organizational structure, existing internal control, and other factors in a particular engagement.

The accounting principles described in this guide are limited to the successful efforts method specified by Financial Accounting Standards Board (FASB) Statement No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies, and the full cost method specified by the Securities and Exchange Commission (SEC) in Regulation S-X.

FASB Statement No. 25, Suspension of Certain Accounting Requirements for Oil and Gas Producing Companies — an amendment of FASB Statement No. 19, suspended the effective date specified by FASB Statement No. 19 for requiring the successful efforts method of accounting. However, the FASB statement maintains that for purposes of applying paragraph 13 of FASB Statement No. 154, Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3, the successful efforts method is preferable for accounting for oil and gas producing activities. As a consequence, no justification for a change to the successful efforts method is necessary nor is a preferability letter for such a change required by the SEC for its registrants. Any change to the full cost method must be justified as being preferable in the circumstances, and a preferability letter describing those circumstances must be filed with the SEC by registrants. This guide is intended only to provide an overview of the accounting principles and the current SEC regulations, but the bibliography contains extensive references that include more in-depth discussions of accounting principles and SEC regulations. It should be recognized that hybrids of both of these methods are referred to by those names and are often considered to be within the framework of GAAP for nonissuers. This guide has not been expanded to include other practices followed by some nonissuers.

Effective Date
The provisions of this guide shall be effective for audits of financial statements for periods ending on or after December 31, 1986.

Public Accounting Firms Registered With the Public Company Accounting Oversight Board
Subject to the SEC oversight, Section 103 of the Sarbanes-Oxley Act of 2002 (act) authorizes the Public Company Accounting Oversight Board (PCAOB) to establish auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms in the preparation and issuance of audit reports as required by the act or the rules of the SEC. Accordingly, public accounting firms registered with the PCAOB are required to adhere to all PCAOB standards in the audits of issuers, as defined by the act, and other entities when prescribed by the rules of the SEC.

References to Professional Standards
In citing the professional standards, references are made to the AICPA Professional Standards publication. In those sections of the guide where specific PCAOB Auditing Standards are referred to, references are made to the AICPA's PCAOB Standards and Related Rules publication. Please refer to appendix D of this guide for a summary of major existing differences between AICPA standards and PCAOB standards. Additionally, when referencing professional standards, this guide cites section numbers and not the original statement number, as appropriate. For example, SAS No. 54 is referred to as AU section 317.

Applicability of Requirements of the Sarbanes-Oxley Act of 2002
Publicly held companies and other issuers (definition to follow) are subject to the provisions of the act and related SEC regulations implementing the act. Their outside auditors are also subject to the provisions of the act and to the rules and standards issued by the PCAOB.

Presented is a summary of certain key areas addressed by the act, the SEC, and the PCAOB that are particularly relevant to the preparation and issuance of an issuer's financial statements and the preparation and issuance of an audit report on those financial statements. However, the provisions of the act, the regulations of the SEC, and the rules and standards of the PCAOB are numerous and are not all addressed in this section or in this guide.

Definition of an Issuer
The act states that the term issuer means an issuer (as defined in Section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)), the securities of which to file reports under Section 15(d) (15 U.S.C. 78o(d)), or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 (15 U.S.C. 77a et seq.), and that it has not withdrawn.

Issuers, as defined by the act, and other entities when prescribed by the rules of the SEC (collectively referred to in this guide as issuers or issuer) and their public accounting firms (who must be registered with the PCAOB) are subject to the provisions of the act, implementing SEC regulations, and the rules and standards of the PCAOB, as appropriate.

Nonissuers are those entities not subject to the act or the rules of the SEC.

Guidance for Issuers
Management Assessment of Internal Control
As directed by Section 404 of the act, the SEC adopted final rules requiring companies subject to the reporting requirements of the Securities Exchange Act of 1934, other than registered investment companies and certain other entities, to include in their annual reports a report of management on the company's internal control over financial reporting.

Companies that are large accelerated filers or accelerated filers, as defined in Exchange Act Rule 12b-2, are required to comply with these rules for fiscal years ending on or after November 15, 2004. Foreign private issuers that are large accelerated filers or accelerated filers and that file their annual reports on Form 20-F or 40-F must begin to comply with rules for the first fiscal year ending on or after July 15, 2006. Nonaccelerated filers including foreign private issuers that are not accelerated filers are required to comply with the rules for the first fiscal year ending on or after December 15, 2007. See the SECWeb site at www.sec.gov for further information.

The SEC rules clarify that management's assessment and report is limited to internal control over financial reporting. The SEC's definition of internal control encompasses the Committee of Sponsoring Organizations of the Treadway Commission (COSO) definition but the SEC does not mandate that the entity use COSO as its criteria for judging effectiveness.

The auditor's attestation on the effectiveness of the internal control over financial reporting is currently required for large accelerated filers and accelerated filers. For nonaccelerated filers, the auditor's attestation is required for annual reports for fiscal years ending on or after December 15, 2009.

Select SEC Developments
The SEC posted an interpretive release, Commission Guidance Regarding Management's Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, on June 20, 2007, to provide guidance for management regarding its evaluation and assessment of internal control over financial reporting. This guidance is organized around two broad principles. The first principle is that management should evaluate whether it has implemented controls that adequately address the risk that a material misstatement of the financial statements would not be prevented or detected in a timely manner. This guidance describes a top-down, risk-based approach to this principle. The second principle is that management's evaluation of evidence about the operation of its controls should be based on its assessment of risk. This guidance provides an approach for making risk-based judgments about the evidence needed for the evaluation.

The SEC also posted a final rule, Amendments to Rules Regarding Management's Report on Internal Control Over Financial Reporting, on June 20, 2007, that provides, among other significant provisions, that a company performing an evaluation in accordance with the aforementioned interpretive guidance also satisfies the annual evaluation required by Exchange Act Rules 13a-15 and 15d-15. Among other rule changes, the SEC defined the term material weakness and revised the requirements regarding the auditor's attestation report on the effectiveness of internal control over financial reporting to require the auditor to express an opinion directly on the effectiveness of internal control over financial reporting and not on management's evaluation process.

In a subsequent final rule, Definition of the Term Significant Deficiency, posted August 3, 2007, the SEC defined the term significant deficiency for the purpose of implementing Section 302 and Section 404 of the act. By including a definition of significant deficiency in SEC rules, in addition to the definition of material weakness, the SEC has enabled management to refer to its rules and guidance for information on the meaning of these terms rather than referring to the auditing standards. Readers should refer to the SEC Web site at www.sec.gov for more information.

Guidance for Auditors
The act mandates a number of requirements concerning auditors of issuers, including mandatory registration with the PCAOB, the setting of auditing standards, inspections, investigations, disciplinary proceedings, prohibited activities, partner rotation, and reports to audit committees, among others. The PCAOB continues to establish rules and standards implementing provisions of the act concerning the auditors of issuers.

Applicability of GAAS and PCAOB Standards
The act authorizes the PCAOB to establish auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms in the preparation and issuance of audit reports for entities subject to the act or the rules of the SEC. Accordingly, public accounting firms registered with the PCAOB are required to adhere to all PCAOB standards in the audits of issuers, as defined by the act, and other entities when prescribed by the rules of the SEC.

For those entities not subject to the act or the rules of the SEC, the preparation and issuance of audit reports remain governed by GAAS as issued by the Auditing Standards Board.

Select PCAOB Developments
On May 24, 2007, the PCAOB adopted Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements (AICPA, PCAOB Standards and Related Rules, Rules of the Board, "Standards"), and an independence rule relating to the auditor's provision of internal control-related nonaudit services. Auditing Standard No. 5 supersedes PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in ConjunctionWith anAudit of Financial Statements. The SEC approved the standard on July 25, 2007, and it is effective for audits of internal control over financial reporting required by the act for fiscal years ending on or after November 15, 2007. Earlier adoption is permitted at any point after SEC approval.

Auditing Standard No. 5 is principles-based and is designed to increase the likelihood that material weaknesses in internal control will be found before they result in material misstatement of a company's financial statements and, at the same time, eliminate procedures that are unnecessary. It focuses the auditor on the procedures necessary to perform a high quality audit and makes the audit scalable so it can change to fit the size and complexity of any company. Readers should refer to the PCAOB Web site at www.pcaob.org for more information.

Major Existing Differences Between GAAS and PCAOB Standards
The major differences between GAAS and PCAOB standards are described in both part I of volume one of the AICPA Professional Standards and in part I of the AICPA publication titled PCAOB Standards and Related Rules. Please refer to appendix D of this guide for a summary of major existing differences between AICPA standards and PCAOB standards.

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