Oil & Gas Accounting 101 – Accounting Methods
Most small independent producers, who are not required to use a GAAP method of accounting, use a tax method of accounting or a hybrid of successful efforts and tax.
The rules for tax accounting are set forth in the Internal Revenue Code and the corresponding Treasury Regulations.
The general rule for accounting methods in the Internal Revenue Code states:
Taxable income shall be computed under the method of accounting on the
basis of which the taxpayer regularly computes his income in keeping his books. (IRC Sec. 466(a))
This means that your taxable income is calculated using the same method you use doing your monthly accounting. That’s what “keeping your books” means.
This code section goes on to define the permissible methods. The permissible accounting methods under IRC Sec. 466(c) are:
- Cash receipts and disbursement method (cash method)
- Accrual method
- Any other method permitted under the law, and
- Any combination of the methods permitted under the regulations
The accounting method used must clearly reflect income and be consistently applied. Treas. Reg. Sec. 1.446-1 states:
It is recognized that no uniform method of accounting can be prescribed for all taxpayers.Each taxpayer shall adopt such forms and systems as are in his judgment best suited to his needs. However, no method of accounting is acceptable unless it clearly reflects income…provided all items are treated consistently from year to year.
The cash method means that you recognize income when you receive payment, either for the oil & gas produced or for services performed. It also means that you recognize expense when you pay the bill for the expense.
The accrual method means that you recognize income when the oil or gas is produced and expenses when the expense is incurred. So gas produced in March would be March revenue even though you might not receive the payment from the first purchaser until May. Expenses are incurred when you receive the bill for the expense instead of when you pay the bill.
Other Methods Permitted
This generally doesn’t apply to oil & gas accounting. It deals with methods such as the “crop method of accounting” and the “long-term contract method”
A Combination of Methods
You can combine methods such as using the cash method for receivables (revenue), and the accrual method for payables (expenses).
Notice that the accounting method can be the cash method, the accrual method or a hybrid method of cash and accrual as long as you stay consistent.
Source: SherWare Blog