Protocol, Practice and Problems
When I sent out an open call for readers to suggest an operational accounting topic to write about, the response was overwhelmingly in favour of one topic: cash calls.
To begin, why do we have cash calls in industry? In essence, the Operator isn’t supposed to make money over the Non-Operators just by virtue of their role as Operator, but they aren’t supposed to lose money either. The financing costs of capital projects are a very real expenditure and carry a significant burden to an Operator when the amounts involved get high enough. If an Operator has paid cash to the vendors involved in a capital project but they don’t receive the Joint-Operators’ (Non-Operators’) share of the expenditures until a couple of months later, then the Operator has incurred a financing cost associated with carrying the Joint-Operators’ interests.
It is not surprising that both Operators and Non-Operators are wrestling with cash calls. Almost every JV Accountant in the Canadian oil and gas industry has run into a cash call problem whether it is a collection, reporting, management, or reconciliation issue. How should cash calls be administered? What do the agreements say about them? What is industry actually doing in practice? How do we resolve the problems that pop up? These are going to be the questions that we try to answer as we address the three Ps of cash calls: Protocol, Practice and Problems.
Cash Call Protocol – The Agreements
Ultimately, it is either the governing Joint Operating Agreement (JOA) or the Accounting Procedure attached to the JOA that discusses the protocol of cash call management. While the cash call clauses in the operating procedures and accounting procedures mostly say the same thing, I have seen a couple of (older) agreements here and there that have some unique phrasing or are silent on cash advances altogether. Therein lies the first step of cash call management – understand the terms of the particular Agreement governing your property.
For the purpose of this blog, let’s review just the terms of the Canadian energy industry’s most prevalent procedures, the 1990 CAPL Operating Procedure and the 1996 PASC Accounting Procedure that is typically attached to it. The clauses that are going to interest us are Clauses 503(b) and (c) (Advance of Costs) of CAPL 1990, and Clause 104 (Capital Advances) of PASC 1996.
In a nutshell, here’s what our industry protocol is supposed to be for cash call invoicing, payment, and reimbursement:
1) The Operator is to provide a written estimate of capital expenditures that are expected to be paid for a project for one month, which is the basis of the cash call invoice to the Non-Operator (i.e. Joint Operator). The Operator must send this estimate to the Non-Operator no earlier than 30 days before the start of the month the cash call applies to.
Let’s use capital expenditures for the month of May for an example. The Operator should submit May’s cash call estimate (and invoice) to the Non-Operators no earlier than April 1st (30 days before May 1st). Please note that the estimate is only to include the capital expenditures that are to be paid in the month of May and not just incurred or booked in May. An Operator may book an item in May but have payment terms of 60 days, in which case the expenditure should appear on the July cash call invoice.
2) The Non-Operator must pay the Operator’s cash call invoice either 20 days after receipt of the invoice, or on the 15th of the month that the estimate relates, whichever is later.
In this case, let’s say the Operator submitted the cash call invoice right on April 1st. The Non-Operator has until the latter of April 20th (20 days) or May 15th to pay that invoice. If the Operator waits until April 30th to submit the invoice, then the Non-Operator has until the latter of May 15th and May 20th to pay it.
3) The Operator spins off his JVB to the Non-Operator, and adjusts the amount owing for capital on the project in question (either manually or systematically) to reflect the advance.
Let’s say the May JVB spins off, which will likely be in early June some time. Hopefully the Operator has had time to book the advance and hopefully the Non-Operator has paid their invoice on time. If either of those conditions isn’t satisfied, we’re already going straight into a reconciliation effort, but let’s keep going anyway.
4) If the month’s actual capital expenditures are over the amount of that month’s cash call when the JVBs spin off, then the Non-Operator is required to pay the shortfall within 30 days pursuant to Clause 103 of PASC 1996. If there is an excess, however, then the Operator must refund it on the JVB to which it pertains. If the Operator doesn’t refund it, then the Non-Operator gets to charge interest to the Operator according to Clause 106.
Of note, Clause 503 of CAPL 2007 was changed slightly to suggest that the Operator may either apply the excess to the following month’s cash call or refund the difference.
5) For the next month, go back to step 1 and repeat the cycle until the end of the project.
The cash call clauses in CAPL 1990 and PASC 1996 largely say the same thing and are very complementary to each other. However, PASC 1996 has one additional detail that deserves attention. Clause 104 of PASC 1996 indicates that the Operator must submit to the Non-Operator a “reasonably detailed estimate of the costs proposed to be paid”. I would suggest that this means the Operator needs to break the cost estimate down to a major account level at the very least. It is true that the terms of CAPL will supersede PASC in the event of a discrepancy between the two, however this additional phrasing from PASC does not constitute a discrepancy but rather an additional requirement.
That was easy, wasn’t it?
Cash Call Practice – The “Industry Method”
No, unfortunately the protocol specified in the agreements wasn’t easy at all. It is cumbersome to manage, difficult to implement, and administratively problematic. Hence, some companies started developing their own cash call practices and before long, everyone followed suit. Let’s call this the “Industry Method”, and we’ll break this procedure into some steps as we did above.
1) The Operator invoices the Non-Operators for the full amount of an AFE well in advance.
2) The Non-Operators may or may not pay the invoice.
3) If the invoice is paid, the Operator releases a JVB that systematically draws down the current month’s capital expenditures against the cash call balance.
4) Any shortfall over the full project cash call gets invoiced to the Non-Operator on the JVB, or the Operator hangs on to any excess in their subledgers until such time that a Non-Operator has done all of their reconciling and starts making phone calls to recover the balance.
5) The Operator and the Non-Operator argue over what the actual balance left over is.
Let’s be very clear. The above Industry Method is not as per the model agreements, yet many think that it is just because this process is so prevalent throughout the industry.
Cash Call Problems
a) Protocol Versus Practice
Let’s face it; MOST (notice the emphasis on most) companies aren’t able to adhere to the terms of the governing Agreement when it comes to cash calls. We’ve become a remarkably efficient industry as far as our use of technology and workflow systems, but when we’re doing more with fewer resources, it becomes less realistic to think that two companies will be able to manage the cash calls on a monthly basis within the tight timeframes specified in the agreements. Throw in the fact that there are disputes or reversals/corrections along the way, and the problem compounds. One thought process is that companies can just keep rolling balances and payments forward until the end of the project in an effort to take total cash calls paid less total capital expenditures to reach a balance owed one way or another, but the number of transactions involved has greatly complicated our reconciliations.
Another issue is that the cash call invoices are to be based on amounts paid for the Joint Account, but the JVBs are issued based on the accounting period in which the original invoice is booked. Most companies in industry don’t have zero day payment terms, so is the Operator really out the cash and is there a need to cash call in the first place?
The Industry Method resolves some problems as far as making cash calls somewhat administratively easier to manage, but it creates other problems as far as companies’ cash management goes. If you’re working with a major international oil and gas corporation, a $1MM cash call invoice is a drop in a bucket and that cash won’t make or break the company (especially if they’re similarly invoicing their Non-Operators for the full amount of a project).
Small companies, however, may have very tight cash flow and can be significantly impeded by an Operator’s demand for a large sum of cash up front. So what happens if the Non-Operator refuses to pay a cash call invoice?
b) Refusal To Pay a Cash Call
While the agreements don’t allow for it, it happens where an Operator will withhold information because a single cash call invoice (for the Non-Operators full share of the AFE) hasn’t been paid. The issue will involve a number of employees, then it will involve supervisors, then managers, then vice presidents – each individual that gets involved as we move our way up the corporate ladder increases the administrative cost associated with cash call management, perhaps even beyond the financing costs of the capital being cash called for.
At the end of the day, there is one simple reality that should guide our cash call management. Both parties have signed their name to a governing Agreement. Has the Operator invoiced their cash call in accordance with this Agreement or not? If the Operator has chosen the Industry Method and invoices the entire cost of a project well in advance and expects immediate payment, then a Non-Operator has every right to refuse payment of the cash call invoice. Operators that haven’t invoiced their cash calls according to the agreements they’ve signed need to be wary before taking action like withholding information or threatening to declare a party in penalty.
Non-Operators beware; this is not a ticket to start refusing payment on all of your cash call invoices. There might be some other considerations at hand.
First, what is your company’s own practice for invoicing out cash calls? It only makes sense to manage incoming cash call invoices the same way you manage outgoing ones, lest you start having your Non-Operators refuse payment of your cash call invoices.
Second, has the Operator made a reasonable argument that the project will be done within one month, that they are expecting the majority of the costs to be incurred in that first month and therefore have only cash called for that first month’s costs? If they have, then they are adhering to the terms of the Agreement (provided their invoice timing is as indicated above) even though they have chosen to only send the first month’s cash call invoice.
Third, are you, as a Non-Operator, organized well enough and have the resources available to accommodate the administrative difficulty that will ensue if the Operator happens to agree that they will cash call according to the specific terms of the Agreement. I’m familiar with some Operators in this industry that ARE organized enough to manage their cash calls according to CAPL 1990 and PASC 1996, but have chosen the Industry Method for simplicity and to ease the administrative burden. If cash flow is an issue, then you won’t need to pay a cash call invoice for an entire project at the start, but be prepared to pay more for administrative time, bookkeeping and reconciliation along the way if the Operator instead chooses to do things by the book.
Finally, as a word of caution to organizations whose policy is to not pay cash calls, please note that your company’s policy does not supersede the governing Agreements.
Cash Call Reconciliation
Let’s say we pass the first hurdle of the initial administration and payment, and the two companies have agreed on how a cash call will be paid (one way or another). The project goes forward, costs are incurred, and the cash call balances are drawn down. Hopefully both parties have been doing monthly cash call reconciliations along the way and have done timely reversals to make things easier, but this doesn’t always happen.
Quite often, the Non-Operator will make a phone call to the Operator well after the end of a project to ask for reimbursement on a cash call. The parties find that the Operator’s and Non-Operator’s cash call balances don’t match, or perhaps the Operator doesn’t show a left over cash call payable balance at all. The discrepancy typically occurs because of disputes on JIBLink whereby the Non-Operator has only drawn down amounts that have been accepted, but the Operator has drawn down amounts that have been billed. If there are no disputes, then are there JVBs circulating in the workflow systems that have not been booked to the Accounting System? Has something been booked to A/P rather than to the cash call receivable account as a cash call draw down?
When it comes to a Non-Operator’s cash call reconciliation, I would suggest that you make sure you’re not just reconciling balances against your own books for financial reporting purposes on a monthly basis, but rather also reconcile against the Operator’s cash call balances on the JVBs on a monthly basis. It will make it far easier to see where there are discrepancies along the ways and what they are.
For Operators, I would strongly suggest that this is yet another reason to do reversals through a DOI rather than reversing something directly from a subledger account to another general ledger account. The Non-Operator won’t be able to tell that you’ve reversed an item or changed their cash call balance when you do this type of reversal entry directly against the subledgers. If you do it through a DOI, the accounting system will usually do the rest of the work for you, the Non-Operator clearly sees what you’ve done, and there’s no need to spend excessive time on cash call reconciliation at the end of the day.
PASC 2011 – Improvements to the Cash Call Process
In my first blog on the new Board approved 2011 PASC Accounting Procedure, I discussed a few of the changes that were made to the cash call clause in PASC 2011. To reiterate, PASC wasn’t able to write our existing practice into the new Accounting Procedure because they realized the impact this would have on smaller companies that may struggle with cash flow. They did, however, try to ease the burden by writing in some additional procedure that may work even if you’re using the 1996 PASC Accounting Procedure.
Instead of monthly statements, the Operator now only provides a schedule showing all anticipated payments for the entire project by month, and the Non-Operator may elect to pay either according to the Operator’s schedule or the full amount of the cash call. This eases the burden on both parties slightly by allowing the Operator to provide only one statement in advance (rather than one statement every month), and also by allowing the Non-Operator to book all of their cash calls in future accounting periods at once, eliminating the need for monthly cash call invoice management. There will still be some increased reconciliation effort along the way if the Non-Operator chooses to not pay the full amount in advance, but at least we’re getting closer to something manageable.
If you’re reading this blog, you’re likely having a specific cash call issue and are working to resolve it. You’re not alone. There are few companies in industry where cash calls haven’t been a problem at some point in time.
One of Integrity’s goals in creating these blogs is to help Operators and Non-Operators alike resolve their issues and find common ground by providing opinion on interpretation. Hopefully, this blog has provided some guidance on what the governing agreements say and at least why the cash call issues you’re experiencing are appearing in the first place.
If your cash call issues persist after reviewing the information contained in this blog, then I might also suggest that you refer to Clause 503(a) of CAPL 1990, which describes how Operators have the option of requiring a letter of credit from the Non-Operator’s bank. This might not help you with your current cash call issue at hand, but it will at least be a consideration for future dealings.
Cash calls will unfortunately continue to be a problem in industry, but to resolve the three Ps of cash calls, I would like to propose the three Cs of cash call resolution: communication, compromise and coordination. Communicate with your counterparts, compromise to reach something that works for everyone, and coordinate your reconciliations with your partners.
If you have any questions on the subject matter contained within this blog or would like additional information on cash calls or other joint venture issues, please feel free contact us through our website at www.integrity-audit.com.
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