Determining whether an oil and gas entity should be treated as an oil and gas fund under Accounting Standards Codification (ASC) 946, Financial Services—Investment Companies, or an oil and gas operating entity can be a challenging endeavor—even for the most sophisticated accounting professional. In this article, we’ll explore the requirements of an oil and gas entity to qualify as an investment company and use fair value reporting.
Qualifying as a Private Investment Company
The initial determination of whether an upstream oil and gas entity is an investment company should be completed upon the entity’s formation. An investment company must possess the following fundamental characteristics:
- Provides investors with investment management services – As a practical consideration, this generally is done through a management company structure.
- Commits to its investors that its business purpose is investing for investment income and/or capital appreciation – As a practical consideration, this generally is stated within the oil and gas entity’s private placement memorandum, limited partner agreement or member agreement.
- Doesn’t obtain benefits from an investee that aren’t normally attributable to ownership interests or that are other than capital appreciation or investment income – As a practical consideration, this generally is viewed as the income generated by the oil and gas entity in the form of current yield (flow-through distributions) and realized gains when an oil and gas property is exited.
In addition to the fundamental characteristics, an investment company also should adhere to the following typical characteristics:
- Has more than one investment – As a practical consideration, it’s very common for oil and gas entities to only have one investment but still be considered an investment entity. This is because the use of special-purpose vehicles and alternative investment vehicles is a very common structure for oil and gas entities.
- Has more than one investor – As a practical consideration, it’s very common for upstream oil and gas entities to establish sidecar investment vehicles that contain a single investor. These entities usually do meet the requirements of an investment entity if the entity attached to the sidecar also meets the requirements of being an investment entity.
- Has investors that aren’t related parties of the parent or investment manager.
- Has ownership interests in the form of equity – As a practical consideration, this would include partnerships and limited liability companies. C corporations wouldn’t be allowed to use ASC 946.
- Manages substantially all of its investments on a fair value basis – As a practical consideration, this assessment should be done from the viewpoint of the investor, not management. Management may not wish to measure the oil and gas investment at fair value, but if this level of reporting generally is required by the entity’s investors, then this criterion would be met.
An investment company generally will meet all of these typical characteristics; however, the absence of one or more of those typical characteristics doesn’t necessarily preclude an entity from being an investment company. If an entity doesn’t possess one or more of the typical characteristics, it should apply judgment and determine if its activities are consistent with those of an investment company. In addition, an entity should reassess whether it correctly determined its investment company status only if the entity is no longer regulated under the Investment Company Act of 1940 or there’s a subsequent change in the entity’s purpose and design.
Measurement of Investments Under the Fair Value Model
If it’s been determined that an entity qualifies as an investment company, the investment company must report all of its oil and gas investments on a fair value basis.
Fair value is defined by ASC 820, Fair Value Measurement, as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value is a market-based measurement and not an entity-specific measurement. A fair value measurement requires assumptions (including assumptions about risk) that market participants would use. The objective of a fair value measurement is to determine the price that would be received to sell an asset or paid to transfer a liability at the measurement date.
Remember, it’s important for any oil and gas fund to understand the reporting requirements and assess the qualifications to report at fair value. For more information or assistance with assessing the requirement for your oil and gas fund, contact Brian Matlock, Paul Russell, Howard Hong or your trusted BKD advisor.