For the Texas franchise tax, may an oil and gas company exclude estimated well-abandonment costs from surplus by carrying them as accumulated depletion/depreciation - and can it amend to do so?

Plain-English summary

An oil and gas company asked whether it could keep estimated costs of abandoning producing wells out of surplus for the (pre-2008) Texas franchise tax by carrying them in a contra-asset account - specifically, in accumulated depletion, depreciation and amortization (DD&A) - relying on FAS No. 19, paragraph 37, Tax Code Sec. 171.109(i)(2), and Comptroller's Decision No. 30,897 (1997). The Comptroller answered with a timing-based, method-specific rule that turns on the arrival of FAS No. 143.

• The accounting change. In June 2001, FAS No. 143 (Accounting for Asset Retirement Obligations) amended FAS No. 19 and requires abandonment costs to be recognized as an estimated liability. It is effective for financial statements for fiscal years beginning after June 15, 2002, so the taxpayer's DD&A theory is only relevant for report periods before FAS 143 takes effect.
• Before FAS 143 - a choice of methods. For those earlier periods, oil and gas companies could treat estimated abandonment costs as either an estimated liability account or an allowance for DD&A. The Comptroller allows a corporation to use one of these alternative methods on its original reports, provided it has not already changed methods on a franchise tax report in the last four years (Sec. 171.109(e)).
• What that meant for this taxpayer. The client may treat abandonment costs as DD&A and exclude the account from surplus on its original 2002 report (to the extent not yet filed under an extension) and its original 2003 report.
• No amending to switch methods. The Comptroller will not let a corporation amend its franchise tax report to adopt an alternative acceptable method. FAS 19 did not preclude recognizing future abandonment as a liability, and the agency never required oil and gas companies to recognize an estimated liability - so there was no accounting error, mistake, or invalidation of existing policy as Rule 3.547(c)(5) requires for an amended report.
• After FAS 143. Effective with reports originally due on or after January 1, 2004, FAS 143 controls; it requires recognizing future abandonment costs as an estimated liability for fiscal years beginning after June 15, 2002, and based on FAS 143 and Sec. 171.109(a)(1) the account must be included in surplus on those reports.

Currency note: This applies the pre-2008 franchise tax's surplus rules, replaced by the current margin tax (House Bills 3 and 3928) effective January 1, 2008. Treat as historical.

What this means for you

Oil and gas producers

For the short pre-FAS-143 window, you had a genuine choice: carry estimated abandonment costs as an allowance for DD&A (and keep them out of surplus) or as an estimated liability. But the choice had to be made on an original report, could not be exercised more than once every four years, and could not be captured retroactively by amending. Once FAS 143 applied (reports due on or after January 1, 2004), the liability had to be included in surplus.

Accountants and tax professionals

Two levers matter here: the once-every-four-years limit on changing accounting methods (Sec. 171.109(e)) and the narrow grounds for an amended report (Rule 3.547(c)(5) - only an accounting error/mistake or invalidated policy). A method preference is neither, so plan the election on the original filing.

Common questions

Q: Could an oil and gas company exclude estimated abandonment costs from Texas franchise surplus?
A: Before FAS 143, yes - by treating them as an allowance for DD&A on an original report, if it had not changed methods in the last four years (Sec. 171.109(e)).

Q: Could it amend a prior report to make that change?
A: No. There was no accounting error, mistake, or invalidated policy, so Rule 3.547(c)(5) did not permit an amended report.

Q: What happens after FAS 143?
A: For reports originally due on or after January 1, 2004, FAS 143 controls and the abandonment account must be included in surplus (Sec. 171.109(a)(1)).

Citations and references

Statutes, rules, and authorities:

• Texas Tax Code Sec. 171.109(i)(2) - certain reserve/contra-asset accounts excluded from surplus
• Texas Tax Code Sec. 171.109(e) - change of accounting method allowed on an original report, not more often than once every four years
• Texas Tax Code Sec. 171.109(a)(1) - definition of surplus
• 34 Tex. Admin. Code Sec. 3.547(c)(5) - amended report allowed only to correct an accounting error/mistake or on invalidation of existing policy
• Comptroller's Decision No. 30,897 (1997)
• Financial Accounting Standards No. 19 (para. 37) and No. 143 (Accounting for Asset Retirement Obligations)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200209495L

Original ruling text

September 26, 2002

Dear **:

This letter is in response to your ruling request as to whether oil and gas
companies may use a contra-asset account for the estimated cost of abandoning
producing wells.

You rely on Statement of Financial Accounting Standards (FAS) No. 19, paragraph
37 as supporting your assertion that estimated abandonment costs can be
included in the accumulated Depletion, Depreciation & Amortization (DD&A)
account. To the extent generally accepted accounting principles (GAAP) allows
estimated abandonment costs to be included as accumulated DD&A, you believe
that the amount should be excluded from surplus based on Tax Code 171.109(i)(2)
and Comptroller's Decision No. 30,897(1997).

In June 2001, FAS No. 143, Accounting for Asset Retirement Obligations, was
issued and is effective for financial statements for fiscal years beginning
after June 15, 2002. FAS No. 143 amended FAS No. 19 with respect to
dismantlement, restoration, and abandonment costs, and the new standard
requires that the costs in question be recognized as an estimated liability.
Because these costs can no longer be included in DD&A after the effective date
of FAS 143, your ruling request is relevant only for report periods prior to
the effective date of FAS No. 143.

Prior to the effective date of FAS No. 143, there is indication that oil and
gas companies may treat estimated abandonment costs as either an estimated
liability account or an allowance for DD&A. We would allow corporations to use
one of these alternative methods in their original reports provided those
corporations have not already made such a change on their franchise tax reports
in the last four years. See Tax Code 171.109(e).

This means that your client may treat the abandonment costs as DD&A and exclude
the account from surplus on its original 2002 (to the extent report has not yet
been filed as a result of an extension) and original 2003 reports. However, we
do not allow corporations to amend their franchise tax report to use an
alternative acceptable method to calculate franchise tax. FAS 19 does not
preclude the recognition of future abandonment costs as a liability account and
the agency has never required oil and gas companies to recognize an estimated
liability; thus, there was no accounting error, mistake or invalidation of
existing policy as required by Comptroller Rule 3.547(c)(5).

Effective with reports due on or after January 1, 2004, FAS No. 143 controls.
It requires oil and gas corporations to recognize future abandonment costs as
an estimated liability for fiscal years beginning after June 15, 2002. Based
on FAS 143 and Tax Code Sec. 171.109(a)(1), the account must be included in
surplus on reports originally due on or after January 1, 2004.

Should you have any questions, you may contact me at 512/463-4496.

Sincerely,

Jerry Bobbitt
Tax Policy Division

cc: Eleanor Kim
Mike Reissig