OIL & NATURAL GAS CORPORATION LIMITED2 Oil&Natural Gas Corporation Limited (ONGC) is the premium organization in India

responsible for exploration and production of petroleum and natural gas set up by the Government of India. Information regarding ONGCs reported profit for four financial years is as follows:
Net Profit (Rs. Crores) 1984-85 882 1985-86 1,302 1986-87 1,484 1987-88 1,508

An article published in The Economic Times in August 1988 stated that ONGCs net profit of Rs.1,508 crore for the year ended March 31, 1988 was only marginally higher than that of the previous year which was reported at Rs. 1,484 crore and asked whether ONGCs profits had reached a plateau or even begun to decline3. The article argued that the improved performance should been in the context of accounting changes in 1985-86. ONGCs accounting policies up to the year ender March 31, 1985 was as follows: 1. Expense all geological and geophysical survey cost in the year in which incurred. 2. Capitalize exploratory drilling cost and a. expense 1/5 of the expenditure in respect of areas for which the success or failure of the exploratory effort has not been determined; b. expense 1/3 of the exploratory drilling expenditure net of amortization as stated in (a) above in respect of areas in which the exploratory was determined to have failed from the year in which it was decided to surrender the area; c. transfer to Producing property account all exploratory drilling cost net of amortization as stated in (a) above in respect of areas declared as commercial producers. 3. Capitalise all development drilling expenditure as part of Producing Property along with the exploratory drilling expenditure as stated in 2(c) above and deplete in 10 equal instalments beginning the year when the area was declared a commercial producer regardless of the level of production. Subsequent development drilling costs were capitalized and expensed in equal instalments in the balance years remaining to complete 10 years from the year of commercial production. 4. Capitalise all costs incurred on erection/installation of production facilities like flow lines, group gathering stations, production platforms and other facilities up to the delivery point. These costs are depreciated as per the rates provided in the Income Tax Act and Rules following the diminishing balance method. Depreciation on the facilities up to the date of commercial production was capitalized as part of the development cost of the field and ultimately as part of Producing Property and expensed as indicated under (3) above. Depreciation from the year of commercial production was expensed in the year in which it was charged.

2 3

This case has been prepared by Prof. R. Narayana Swamy, Indian Institute of Management Bangalore. ONGCs Performance: Review of Some Aspects, The Economic Times, August 1988.

5. Capitalize at cost plant and equipment like trunklines rigs, transport, survey equipment, support facilities, etc., and depreciate at the rates provided in the Income Tax Act and Rules, following the diminishing balance method. Depreciation on transportation activity of crude or gas was expensed in the year in which it was charged while depreciation on other plant and equipment was allocated to exploratory or development activity and capitalized. This depreciation was expensed as part of the exploration/development cost as indicated under 1-3 above. 6. Expense all replacement cost of plant and equipment in the year in which these were incurred. It was felt that the above policies (2-4) resulted in understatement of fixed assets and did not take into account the need to spread the costs over the projected total production from the field. Also, the policies did not accord with international oil industry practices for charging such costs. Consequently, ONGC decided to adopt the successful efforts method and changed its accounting policies as follows: 1. Geological and geophysical survey costs will be expensed in the year in which they were incurred, as per the existing policy. 2. Exploratory drilling costs in areas declared unsuccessful and surrendered as on March 31, 1986 will be expensed net of amortization till last year. 3. Exploratory drilling costs net of amortization till last year in respect of areas yet to be determined as unsuccessful or abortive (as on March 31, 1986) will be capitalized as Wellsin-progress. 4. All accumulated exploratory drilling cost and development drilling cost in successful fields including related facilities like follow lines, production installations, offshore platforms, etc. already commissioned (as on March 31,1986) will be capitalized. 5. The above costs have been taken net of amortization, depletion and depreciation already charged till last year. After considering the additions during the year, the costs have been expensed following the unit-of-production method by individual field/basin. The recoverable reserves have been taken as per the estimates by the Reserve Estimation Committee as on January 1, 1986. These reserves are limited to A, B, and C-1 category reserves. The audit report of the Comptroller and Auditor General of India (CAG) presented the following information regarding the effect of the companys accounting policy changes (amount in crore):
Nature of Expenditure Depletion Depreciation Amortization Charged to Profit and Loss Account Rs 417.48 Rs 146.65 474.40 217.76 253.92 271.73 1,145.80 636.14 Increase(+)/Reduction(-) Rs (-) 270.83 (-) 256.64 (+) 17.81 (-) 509.66

The CAG report observed: The successful efforts method . Requires appropriate administrative practices under which abandoned areas are declared as such without any delay and even in areas under exploration the expenditure incurred on dry wells is immediately expensed. The present head of account wells-in-progress includes the cost of many dry wells. Non-expensing of the cost of dry wells has thus resulted in understatement of expenditure and overstatement of profits (extent not ascertainable). Under the new policy the depletion has been computed by multiplying the total production by the unit rate of production which is arrived by working out the ratio of total investment in producing properties and production facilities over the total estimated recoverable reserves. The manner of computing the unit rate or production as adopted by the Commission has the effect of depressing the total amount of depletion due to the following: (i) The total recoverable reserves included the reserves of C-1 category (which are only probable reserves). (ii) The total recoverable reserves are correlated with the investment actually required to extract the same. (iii) Cost of production has been considered to be an investment without correlating the useful life of such facilities to the productive life of the reserves. Required 1. Examine the impact of the accounting changes effected by ONGC in 1985-86. 2. Who are the potential users of ONGCs financial statements? How might they react to the change? 3. Identify the possible managerial motives for making accounting changes. How far are they relevant in ONGCs case? 4. Draft a note on the accounting changes for inclusion in ONGCs report. 5. From the standpoint of users of financial statements, what safeguards are available against attempts by corporate management to make arbitrary accounting changes?