International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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a share of any production to which it is entitled in the future in exchange for the
carrying party funding one or more phases of the project. In other words, the parties
create a new interest out of an existing working interest. If the project is unsuccessful
then the carrying party will not be reimbursed for the costs that it has incurred on
behalf of the carried party. If the project is successful then the carrying party will be
reimbursed either in cash out of proceeds of the share of production attributable to
the carried party, or by receiving a disproportionately high share of the production
until the carried costs have been recovered.100
6.1.1
Types of carried interest arrangements
Carried interest arrangements tend to fall into one of the following two categories:
• financing-type arrangements – the carrying party provides funding to the carried
party and receives a lender’s return on the funds provided, while the right to
additional production acts as a security that underpins the arrangement; or
• purchase/sale-type arrangement – the carried party effectively sells an interest or a
partial interest in a project to the carrying party. The carrying party will be required
to fund the project in exchange for an increased share of any proceeds if the project
succeeds, while the carried party retains a much reduced share of any proceeds.
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In practice, however, it is not always easy to determine in which category a particular
carried interest arrangement falls, as is illustrated in the example below.
Example 39.4: Carried interests (1)
Scenario 1
The carrying party has proposed a $10 million project, which has a very high chance of succeeding. The
carried party, which is unable to fund its share of the project, agrees that the carrying party is entitled to
recover its cost plus 7% interest by giving it a disproportionately high share of the production. If the
production from this project is insufficient to repay the initial investment, the carried party should reimburse
the carrying party out of its share of production from other fields within the same licence.
Scenario 2
The carrying party has proposed a project that may cost up to $6 million, the outcome of which is uncertain.
The carried party, which is unwilling to participate in the project, agrees that the carrying party is entitled to
all production from the project until it has recovered three times its initial investment.
Scenario 3
The carrying party has proposed a project that may cost up to $5 million, which has a good chance of
succeeding. The carrying party has a 60% interest in the licence and the carried party holds the
remaining 40%. The carried party, which is unable to fund its share of the project, agrees that the
carrying party is entitled to an additional 25% of the production until the carrying party has recovered
its costs plus a 20% return.
When entering into a carried interest arrangement, an entity must assess whether the
arrangement is a financing-type arrangement or purchase/sale-type arrangement. Some
of the indicators that a carried interest arrangement should be accounted for as a
financing-type arrangement are that:
• the carried party is unable to fund its share of the project;
• the risks associated with the development are not significant, i.e. financing-type
arrangements will be more common in the development stage; and
• the carrying party receives a return that is comparable to a lender’s rate of return.
Indicators that a carried interest arrangement should be treated as a purchase/sale-type
arrangement include:
• the carrying party and carried party have genuinely different opinions about the
chances of success of the project, and the carried party could fund its share of the
project if it wanted to;
• there are significant uncertainties about the outcome of the project. Purchase/
sale-type arrangements are therefore more common in the E&E phase;
• the arrangement gives the carrying party voting rights in the project;
• there are significant uncertainties about the costs of the project, perhaps because
it involves use of a new technology or approach;
• the carrying party could lose all of its investment or possibly earn a return
significantly in excess of a lender’s rate of return; and
• the carrying party can only recover its investment from the project that is subject to the
arrangement and there is no recourse to other assets or interests of the carried party.
In Example 39.4 above, scenario 1 has the characteristics of a financing-type arrangement,
while scenario 2 has those of a purchase/sale-type arrangement. However, when an
arrangement (such as scenario 3) has financing-type and purchase/sale-type characteristics
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(e.g. as a result of the relative bargaining strength of the parties), an entity will need to
analyse the arrangement carefully and exercise judgement in developing an appropriate
accounting policy.
The following types of carried interest arrangements are discussed below:
• carried interest arrangements in the E&E phase (see 6.1.2 below);
• financing-type carried interest arrangements in the development phase (see 6.1.3
below); and
• purchase/sale-type carried interest arrangements in the development phase
(see 6.1.4 below).
6.1.2
Carried interest arrangements in the E&E phase
While IFRS 6 should be applied to accounting for E&E expenditures, the standard does
not address other aspects of accounting by entities engaged in the exploration for and
evaluation of mineral resources. [IFRS 6.4]. That leaves unanswered the question of
whether carried interest arrangements can ever fall within the scope of IFRS 6. In the
case of a purchase/sale-type carried interest arrangement the transaction, at least in
economic terms, leads to the acquisition of an E&E asset by the carrying party and a
disposal by the carried party. Therefore, we believe that purchase/sale-type carried
interest arrangements in the E&E phase would fall within the scope of IFRS 6. Hence
an entity has two options: either to develop an accounting policy under IAS 8 as
discussed at 6.1.4 below, or, on transition to IFRS or first application under IFRS, to
develop an accounting policy under IFRS 6 that is based on a previous national GAAP
that contains such guidance. In practice this usually means that:
• the carrying party accounts for its expenditures under a carried interest arrangement
in the same way as directly incurred E&E expenditure (see 3.2 and 3.3 above); and
• the carried party would not record expenditure incurred by the carrying party on
its behalf subsequent to the arrangement commencing. However, the carried party
may need to recognise a loss when the terms of the transaction indicate that the
existing carrying value of the asset is impaired. Alternatively, to the extent that an
arrangement is favourable, the carried party would – depending on its accounting
policy – recognise the gain either in profit or loss or as a reduction in the carrying
amount of the E&E asset.
On the other hand, a finance-type carried intere
st arrangement (which is generally not
as common in the E&E phase) that has no significant impact on the risks and rewards
that an entity derives from the underlying E&E working interest, may be more akin to a
funding arrangement. As IFRS 6 deals only with accounting for E&E expenditures and
assets, it is a matter of judgement whether or not the accounting for finance-type carried
interest arrangements is considered to be outside the scope of IFRS 6. If an arrangement
is considered to be outside the scope of IFRS 6, it might be appropriate to account for
it in the same way as finance-type carried interest arrangements that relate to projects
that are not in the E&E phase (see 6.1.3 below).
6.1.3 Financing-type
carried interest arrangements in the development phase
As financing-type carried interest arrangements do not result in the transfer of the
economic risks and rewards of the underlying working interest between parties, such
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arrangements are not accounted for as a sale (purchase) by the carried party (carrying
party). Instead these arrangements are in effect secured borrowings in which the
underlying asset is used as collateral that provides an identifiable stream of cash flows.
These arrangements are most appropriately accounted for as giving rise to a financial
asset for the carrying party and a financial liability for the carried party.
The carried party will continue to recognise the expenditure incurred in relation to its
full share of the working interest prior to the execution of the carried interest
arrangement, and a corresponding financial liability for the amount that it is expected
to reimburse to the carrying party as the pre-production costs being met by the carrying
party are incurred, irrespective of whether it is a non-recourse arrangement or not.
Under IFRS 9 – Financial Instruments – any financial liability would likely be measured
at amortised cost unless it meets the definition of a derivative or is designated at fair
value through profit or loss. See Chapter 44 at 3 for more information. As a financial
liability measured at amortised cost, under IFRS 9 the carried party should accrete
interest on the liability and reduce the loan to the extent the carrying party recovers its
costs. It should be noted, however, that the application of the effective interest rate
method under IFRS 9 requires adjustment of the carrying amount when the entity
revises its estimates of the payments to be made. [IFRS 9.B5.4.6].
Conversely the carrying party should recognise a financial asset for the amount that it
expects to recover as a reimbursement as the pre-production costs (which are being
met by the carrying party) are incurred. Under IFRS 9 an entity would need to determine
the classification of the financial asset based on an assessment of the entity’s business
model for managing financial assets and the contractual cash flow characteristics of the
financial asset. See Chapter 44 at 2 for more information. Where the entity expects to
recover all of its investment (so it is considered a debt instrument and not an equity
instrument), the terms are solely payments of principal and interest and its business
model is to hold the investment in order to collect contractual cash flows, the financial
asset will be carried at amortised cost. This may be the case in financing-type carried
interest arrangements. Where there is exposure to other factors, e.g. uncertainty about
recovery and the exposure is through something other than principal and interest, the
financial asset may have to be carried at fair value through profit or loss.
This approach to accounting for carried interest arrangements might not be
appropriate if there were more than an insignificant transfer of risk (without
necessarily resulting in a purchase/sale-type carried interest arrangement). The
transfer of risk would suggest that:
• the carried party should recognise a provision under IAS 37 rather than a liability
under IFRS 9; and
• the carrying party should account for its right to receive reimbursement as a
financial asset at fair value through profit or loss under IFRS 9 or a reimbursement
right under IAS 37.
Any financial liability would likely be measured at amortised cost unless it meets the
definition of a derivative or was designated at fair value through profit or loss.
See Chapter 44 at 3 for more information.
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6.1.4
Purchase/sale-type carried interest arrangements in the development
phase
The accounting suggested in this section for the carried party is the same as that set out
in paragraph 155 of the former OIAC SORP, which stated that the disposal should be
accounted for in accordance with the entity’s normal accounting policy.
Historically, some entities have accounted for these types of transactions on a cash
basis, i.e. the carried party does nothing and the carrying party accounts for its actual
cash outlays. It is hard to see how this can be justified under IFRS.
In purchase/sale-type carried interest arrangements, the carried party effectively sells
part of its interest in a project to the carrying party. For example, the carried party may
sell part of its interest in the mineral reserves to the carrying party which, in exchange,
is obliged to fund the remaining costs of developing the field. Consequently, the
arrangement has two elements, the purchase/sale of mineral reserves and the funding
of developments costs, which should be accounted for in accordance with their
substance. Therefore, the carried party should:
• derecognise the part of the asset that it has sold to the carrying party, consistent
with the derecognition principles of IAS 16 or IAS 38. [IAS 16.67, IAS 38.112].
Determining the amount to be derecognised may require a considerable amount
of judgement depending on how the interest sold is defined;
• recognise the consideration received or receivable from the carrying party;
• recognise a gain or loss on the transaction for the difference between the net
disposal proceeds and the carrying amount of the asset disposed of. Recognition
of a gain would be appropriate only when the value of the consideration can be
determined reliably. If not, then the carried party should account for the
consideration received as a reduction in the carrying amount of the underlying
assets. See 12.6.1.A below and Chapter 28 for discussion of how IFRS 15 – Revenue
from Contracts with Customers – may impact such calculations; and
• test the retained interest for impairment if the terms of the arrangement indicate
that the retained interest may be impaired.
In accounting for its purchase the carrying party should:
• recognise an asset that represents the underlying (partially) undeveloped interest
acquired at cost in accordance with the principles of IAS 16 or IAS 38.
[IAS 16.15, IAS 38.21]. Cost is defined in these standards as ‘the amount of cash or cash
equivalents paid or the fair value of the other consideration given to acquire an
asset at the time of its acquisition or construction or, where applicable, the amount
attributed to that asset when initially recognised in accordance with
the specific
requirements of other IFRSs’; [IAS 16.6, IAS 38.8] and
• recognise a liability for the obligation to make defined payments on behalf of the
carried party, which relate to the carried party’s share of future investments.
The application of this approach is illustrated in Example 39.5 below.
Example 39.5: Carried interests (2)
An oil and gas company is developing an oil field. Assume that the company did not capitalise any E&E
costs in relation to the field, but that by 1 January 2018 it had capitalised $250 million of costs in relation
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to the construction of property, plant and equipment. To complete the development of the oil field and
bring it to production a further investment in property, plant and equipment of $350 million is required in
the first half of 2018.
At 1 January 2018, the oil and gas company (the carried party) enters into a purchase/sale-type carried
interest arrangement with a carrying party, which will fund the entire $350 million required for the further
development of the field. Upon entering into the carried interest arrangement the carried party’s
entitlement to oil is expected to be reduced from 15,000,000 barrels of oil to 9,000,000 barrels of oil, i.e.
its interest in the oil field and the related property, plant and equipment has been reduced to 60%
(9,000,000 ÷ 15,000,000). In practice, calculating the portion of the interest sold may require a
considerable amount of judgement (e.g. in scenario 2 in Example 39.4 above it would not be
straightforward to calculate the portion of the interest sold).
Both parties believe that the fair value of the oil field and related property, plant and equipment will be
$1 billion once the remaining investment of $350 million has been made. Consequently, the fair value of
the oil field and related property, plant and equipment at 1 January 2018 is $650 million ($1 billion –
$350 million).
The fair value of the interest acquired (which comprises a portion of the oil field and a portion of the related
property, plant and equipment) by the carrying party is $260 million (40% × $650 million). In exchange for
its interest, the carrying party will pay $50 million in cash and undertakes to pay the remaining investments