Financial Reporting for Oil and Gas Private Equity Funds

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 professionals and private equity funds.

The initial determination of whether an oil and gas entity qualifies as an investment company should be completed upon the entity’s formation. An investment company must possess the following fundamental characteristics under ASC 946:

It provides investors with investment management services. This is done through a management company structure.

It commits to its investors that its business purpose is investing for investment income and/or capital appreciation. This is stated within the oil and gas entity’s private placement memorandum, limited partner agreement or member agreement.

It 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. This is viewed as realized gains versus sales of physical oil and natural gas.

In addition to the fundamental characteristics, an investment company generally has the following typical characteristics:

It has more than one investment. However, 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.

It has more than one investor. However, it’s quite 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.

It has investors that aren’t related parties of the parent or investment manager.

It has ownership interests in the form of equity. This would include partnerships and limited liability companies. C corporations wouldn’t be allowed to use ASC 946.

It manages substantially all of its investments on a fair value basis. This assessment should be done from the viewpoint of the investor, not management.

An investment company will generally 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 it has 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, which is generally desired for institutional investors.

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.”