3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of consolidation – The accompanying consolidated financial statements include the accounts of VAALCO and its wholly owned subsidiaries. Investments in unincorporated joint ventures and undivided interests in certain operating assets are consolidated on a pro rata basis. All intercompany transactions within the consolidated group have been eliminated in consolidation.

Reclassifications – Certain reclassifications have been made to prior period amounts to conform to the current period presentation.  These reclassifications did not affect our consolidated financial results.

Use of estimates – The preparation of financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) requires estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the respective reporting periods. Our consolidated financial statements include amounts that are based on management’s best estimates and judgments. Actual results could differ from those estimates.

Estimates of oil and natural gas reserves used in the consolidated financial statements to estimate depletion expense and impairment charges require extensive judgments and are generally less precise than other estimates made in connection with financial disclosures. We consider our estimates to be reasonable; however, due to inherent uncertainties and the limited nature of data, estimates are imprecise and subject to change over time as additional information become available.

Correction of error

Impairment  – Subsequent to the issuance of our 2014 financial statements, we identified an error in the impairment charges recorded for the year ended December 31, 2014. As a result of this error, the impairment charge of $98.3 million recorded for the year ended December 31, 2014 was understated by $7.0 million and the net loss of $77.6 million was understated by the same amount. We recorded an out of period adjustment to impairment of $7.0 million in the year ended December 31, 2015 to correct the error related to the year ended December 31, 2014.

Prepaid royalty – Subsequent to the issuance of our 2014 financial statements, we identified an error in the prepaid royalty account. The prepaid royalty account is used to record royalty payments associated with volumes held in inventory on the FPSO at the end of each period. Under the PSC for the Etame Marin Block, royalties are paid in the month of production based on estimated prices and volumes, however, a receivable and offsetting reduction in the prepaid royalty asset is not recognized until the volumes have been sold. A true-up is performed at month-end to record as prepaid royalties what remains in the FPSO that relates to royalty volumes not sold. Any adjustment is recorded to revenue. The error identified relates to the true-up of the account not occurring since March 2014, resulting in revenues and prepaid royalty assets being overstated as of December 31, 2014. An out of period adjustment of $2.3 million was made in the fourth quarter of 2015 to correct the prior period error.

Cash and cash equivalents – Cash and cash equivalent includes deposits and funds invested in highly liquid instruments with original maturities of three months or less at the date of purchase.

Restricted cash and abandonment funding – Restricted cash includes cash that is contractually restricted. Restricted cash is classified as a current or non-current asset based on its designated purpose and time duration. Current amounts in restricted cash at December 31, 2015 and 2014 each include an escrow amount representing bank guarantees for customs clearance in Gabon. Long term amounts at December 31, 2015 and 2014 include a charter payment escrow for the Floating Production Storage and Offloading tanker (“FPSO”) offshore Gabon as discussed in Note 8. We also have funds restricted for the purposes of satisfying the asset retirement obligation on the Etame Marin block in Gabon. These funds are reflected under Abandonment funding on the consolidated balance sheet. Restricted cash at December 31, 2015 and 2014 included funds designated for our drilling commitment in Angola Block 5 as discussed in Note 8.

We invest restricted and excess cash in certificates of deposit and commercial paper issued by banks with maturities typically not exceeding 90 days.

Accounts with partners – Accounts with partners represent cash calls due or excess cash calls paid by the partners for exploration, development and production expenditures made by VAALCO Gabon (Etame), Inc., VAALCO Angola (Kwanza), Inc. and VAALCO (USA), Inc.

Allowances for bad debts – Quarterly, we evaluate our accounts receivable balances to confirm collectability.  When collectability is in doubt, we record an allowance against the accounts receivable and a corresponding income charge for bad debts which appears in the Other costs and expenses line of the consolidated statement of operations. The majority of our accounts receivable balances are with our joint venture partners, purchasers of our production and the government of Gabon for reimbursable Value-Added Tax (“VAT”). Collection efforts, including remedies provided for in the contracts, are pursued to collect overdue amounts owed us.

In 2015 and 2014, we recorded allowances of $2.7 million and $2.4 million related to VAT which the government of Gabon has not reimbursed. The remaining receivable amount is reported as a long-term item in the Value added tax receivable line at December 31, 2015 in the consolidated balance sheet. Because both the VAT receivable and the related allowance are denominated in the local currency of Gabon, the revaluation of these balances into U.S. dollars at each period end also has an impact on profit/loss. Such foreign currency gains/(losses) are reported separately in the Other, net, operating income (expense) line of the statement of consolidated operations.

In 2013, we recorded an allowance of $1.6 million related to the uncertainty in collecting the joint venture receivable in Angola. As discussed in Note 8, in March 2016 we received payment of this and other amounts owed, and we will record a reversal of the allowance in the first quarter of 2016. The table provides a rollforward of the aggregate allowance: 

 

Crude oil inventory – Crude oil inventories are carried at the lower of cost or market and represent our share of crude oil produced and stored on the FPSO, but unsold at the end of the period.

Materials and supplies – Materials and supplies, which are primarily used for production related activities, are valued at the lower of cost, determined by the weighted-average method, or market.

Property and equipment – We use the successful efforts method of accounting for oil and natural gas producing activities.

Capitalization – Leasehold acquisition costs are initially capitalized. Costs to drill exploratory wells are initially capitalized until a determination as to whether proved reserves have been discovered. If an exploratory well is deemed to not have found proved reserves, the associated costs are charged to exploration expense at that time.  Exploration costs, other than the cost of drilling exploratory wells, which can include geological and geophysical expenses applicable to undeveloped leasehold, leasehold expiration costs and delay rentals are charged to exploration expense as incurred. All development costs, including developmental dry hole costs, are capitalized.

Impairment – We review our oil and natural gas producing properties for impairment on a field-by-field basis whenever events or changes in circumstances indicate that the carrying amount of such properties may not be recoverable. If the sum of the expected undiscounted future cash flows from the use of the asset and its eventual disposition is less than the carrying amount of the asset, an impairment charge is recorded based on the fair value of the asset. We evaluate our undeveloped oil and natural gas leases for impairment periodically by considering numerous factors that could include nearby drilling results, seismic interpretations, market values of similar assets, existing contracts and future plans for exploration or development. When undeveloped oil and natural gas leases are deemed to be impaired, exploration expense is charged. Capitalized equipment inventory is reviewed regularly for obsolescence. We identified equipment inventory in Gabon and Angola that we do not expect to use and charged approximately $3.3 million to Other operating loss, net in the fourth quarter of 2015.

Depreciation, depletion and amortization – Depletion of wells, platforms, and other production facilities are calculated on a field basis under the unit-of-production method based upon estimates of proved developed producing reserves. Depletion of developed leasehold acquisition costs are provided on a field basis under the unit-of-production method based upon estimates of proved reserves. Support equipment and leasehold improvements related to oil and natural gas producing activities, as well as property, plant and equipment unrelated to oil and natural gas producing activities, are recorded at cost and depreciated on a straight-line basis over the estimated useful lives of the assets, which are typically five years for office and miscellaneous equipment and five to seven years for leasehold improvements. 

Capitalized interest – Interest costs from external borrowings are capitalized on major projects. Capitalized interest is added to the cost of the underlying asset and is depleted on the unit-of-production method in the same manner as the underlying assets.

Asset retirement obligations (“ARO”) – We have significant obligations to remove tangible equipment and restore land or seabed at the end of oil and natural gas production operations. Our removal and restoration obligations are primarily associated with plugging and abandoning wells, removing and disposing of all or a portion of offshore oil and natural gas platforms, and capping pipelines. Estimating the future restoration and removal costs is difficult and requires management to make estimates and judgments. Asset removal technologies and costs are constantly changing, as are regulatory, political, environmental, safety, and public relations considerations.

A liability for ARO is recognized in the period in which the legal obligations are incurred if a reasonable estimate of fair value can be made. The ARO liability reflects the estimated present value of the amount of dismantlement, removal, site reclamation, and similar activities associated with our oil and natural gas properties. We use current retirement costs to estimate the expected cash outflows for retirement obligations. Inherent in the present value calculation are numerous assumptions and judgments including the ultimate settlement amounts, inflation factors, credit-adjusted discount rates, timing of settlement, and changes in the legal, regulatory, environmental, and political environments. Initial recording of the ARO liability is offset by the corresponding capitalization of asset retirement cost recorded to oil and natural gas properties. To the extent these or other assumptions change after initial recognition of the liability, the fair value estimate is revised and the recognized liability adjusted, with a corresponding adjustment made to the related asset balance or income statement, as appropriate. Depreciation of capitalized asset retirement costs and accretion of asset retirement obligations are recorded over time. Depreciation is generally determined on a units-of-production basis for oil and natural gas production facilities, while accretion escalates over the lives of the assets to reach the expected settlement value. See Note 6 for disclosures regarding our asset retirement obligations.

Revenue recognition – We recognize oil and natural gas revenues when production is sold to a purchaser at a fixed or determinable price, when delivery has occurred and title has transferred and collectability of the revenue is reasonably assured. We follow the sales method of accounting for crude oil and natural gas production imbalances. We recognize revenues on the volumes sold based on the provisional sales prices. The volumes sold may be more or less than the volumes to which we are entitled based on our ownership interest in the property, and we would recognize a liability if our existing proved reserves were not adequate to cover an imbalance. As of December 31, 2015 and 2014, we had no recorded oil and natural gas imbalances.

Major maintenance activities – Costs for major maintenance are expensed in the period incurred and can include the costs of workovers of existing wells, contractor repair services, materials and supplies, equipment rentals and our labor costs.

Stock based compensation - We measures the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award on the date of the grant. Grant date fair value for options is estimated using the Black-Scholes option pricing model. The model employs various assumptions, based on management’s best estimates at the time of grant, which impact the calculation of fair value and ultimately, the amount of expense that is recognized over the life of the stock option award. For restricted stock, grant date fair value is determined using the market value of our common stock on the date of grant.

Our stock-based compensation expense is recognized based on management’s best estimate of the awards that are expected to vest, using the straight-line attribution method for all service-based awards with a graded vesting feature. We estimate the number of instruments that will ultimately be issued, rather than accounting for forfeitures as they occur. If actual forfeiture results are different than expected, adjustments to recognized compensation expense may be required in future periods.  

Foreign currency transactions – The U.S. dollar is the functional currency of our foreign operating subsidiaries. Gains and losses on foreign currency transactions are included in net income. Within the income statement line Other income (expense)—Other, net, we recognized gains on foreign currency transactions of $1.5 million in 2015 and losses on foreign currency transactions of $0.7 million and $0.1 million in in 2014 and 2013.

Income taxes – We account for income taxes under an asset and liability approach that recognizes deferred income tax assets and liabilities for the estimated future tax consequences of differences between the financial statements and tax bases of assets and liabilities. Valuation allowances are provided against deferred tax assets that are not likely to be realized. We classify interest related to income tax liabilities as Interest expense and penalties as Other, net on the consolidated income statement.

Fair Value – Fair value is defined as the price that would be received to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date. Inputs used in determining fair value are characterized according to a hierarchy that prioritizes those inputs based on the degree to which they are observable. The three input levels of the fair-value hierarchy are as follows:

Level 1 – Inputs represent quoted prices in active markets for identical assets or liabilities (for example, exchange-traded commodity derivatives).

Level 2 – Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly (for example, quoted market prices for similar assets or liabilities in active markets or quoted market prices for identical assets or liabilities in markets not considered to be active, inputs other than quoted prices that are observable for the asset or liability, or market-corroborated inputs).

Level 3 – Inputs that are not observable from objective sources, such as internally developed assumptions used in pricing an asset or liability (for example, an estimate of future cash flows used in our internally developed present value of future cash flows model that underlies the fair-value measurement).

Fair value of financial instruments – Our current assets and liabilities include financial instruments such as cash and cash equivalents, restricted cash, accounts receivable and payable. The carrying value of each financial instrument approximates fair value primarily due to the short-term maturity of these instruments. The carrying value of our long-term debt approximates fair value, as the interest rates are adjusted based on rates currently in effect.

General and administrative related to shareholder matters – During 2015, a shareholder group consisting of by Group 42, Inc., Bradley L. Radoff and certain other participants (collectively, the "Group 42-BLR Group"), which beneficially own approximately 11.1% of the Company's outstanding stock, attempted to gain control of our Board of Directors. In December 2015, we reached an agreement with the Group 42-BLR Group that included changes to the Board of Directors composition and other shareholder friendly actions. In connection with this agreement, we reimbursed the Group 42-BLR Group for $350,000 of its legal expenses. Related shareholder litigation filed in Delaware is ongoing at December 31, 2015. See Note 8 for further discussion of the litigation.