3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of consolidation – The accompanying consolidated financial statements (“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 related to reclassifying material and supplies to prepayments and other. These reclassifications did not affect our consolidated financial results.

Use of estimates – The preparation of the 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 Financial Statements and the reported amounts of revenues and expenses during the respective reporting periods. Our 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 to estimate depletion expense and impairment charges require extensive judgments and are generally less precise than other estimates made in connection with financial disclosures. Due to inherent uncertainties and the limited nature of data, estimates are imprecise and subject to change over time as additional information become available.

Cash and cash equivalents – Cash and cash equivalents 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, 2017 and 2016 each include an escrow amount representing bank guarantees for customs clearance in Gabon. Long term amounts at December 31, 2017 and 2016 include a charter payment escrow for the floating, production, storage and offloading vessel (“FPSO”) offshore Gabon as discussed in Note 9.

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 the excess of charges billed over cash calls paid by the partners for exploration, development and production expenditures made by us as an operator.

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 “Bad debt expense and other” line item of the consolidated statements 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. Portions of our costs in Gabon (including our VAT receivable) are denominated in the local currency of Gabon, the Central African CFA Franc (“XAF”). As of December 31, 2017, the outstanding VAT receivable balance, excluding the allowance for bad debt, was approximately XAF 21.2 billion (XAF 7.1 billion, net to VAALCO). As of December 31, 2017, the exchange rate was XAF 547.5 = $1.00.

In June 2016, we entered into an agreement with the government of Gabon to receive payments related to the outstanding VAT receivable balance of XAF 16.3 billion (XAF 4.9 billion, net to VAALCO), representing the outstanding balance as of December 31, 2015, in thirty-six monthly installments of $0.3 million net to VAALCO. We received one monthly installment payment in July 2016; however, no further payments have been received as of December 31, 2017. We are in discussions with the Gabonese government regarding the timing of the resumption of payments.

In 2017, 2016 and 2015, we recorded allowances of $0.4 million, $0.7 million and $2.7 million, respectively, related to VAT which the government of Gabon has not reimbursed. The receivable amount, net of allowances, is reported as a non-current asset in the “Value added tax and other receivables” line item in the consolidated balance sheets. Because both the VAT receivable and the related allowance are denominated in XAF, the exchange rate revaluation of these balances into U.S. dollars at the end of each reporting period also has an impact on profit/loss. Such foreign currency gains/(losses) are reported separately in the “Other, net” line item of the consolidated statements of operations.

The following table provides an analysis of the change in the allowance:


	Year Ended December 31,
	2017		2016		2015
	(in thousands)
Allowance for bad debt
Balance at beginning of year	$	(5,211)	$	(4,221)	$	(2,400)
Charge to cost and expenses		(452)		(1,222)		(2,699)
Reclassification related to Sojitz acquisition		(694)		—		—
Foreign currency gain (loss)		(676)		232		878
Balance at end of period	$	(7,033)	$	(5,211)	$	(4,221)

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 included in the “Prepayments and other” line item of the consolidated balance sheet, are primarily used for production related activities. These assets 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 quarterly or 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, lease expiration terms 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 that we do not expect to use and charged $0.3 million, $0.3 million and $1.5 million to the “Other operating loss, net” line item of the consolidated statement of operations in the years ended December 31, 2017, 2016 and 2015, respectively.

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 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 and commitment fees from external borrowings are capitalized on exploration and development projects that are not subject to current depletion. Interest and commitment fees are capitalized only for the period that activities are in progress to bring these projects to their intended use. 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.

We capitalized no interest costs for the years ended December 31, 2017 or 2016. We capitalized $0.8 million in interest costs during the year ended December 31, 2015.

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 7 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, 2017 and 2016, 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 measure 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. The fair value of stock appreciation rights (“SARs”) is based on a Monte Carlo simulation at grant date and at each subsequent reporting date. The Monte Carlo simulation to value our SARs uses the following inputs: (i) the quoted market price of our common stock on the valuation date, (ii) the maximum stock price appreciation that an employee may receive, (iii) the expected term which is based on the contractual term, (iv) the expected volatility which is based on the historical volatility of the our stock for the length of time corresponding to the expected term of the SARs, (v) the expected dividend yield is based on our anticipated dividend payments, (vi) the risk-free interest rate which is based on the U.S. treasury yield curve in effect as of the reporting date for the length of time corresponding to the expected term of the SARs.

Our stock-based compensation expense is recognized based on the awards as they vest, using the straight-line attribution method over the requisite service period for each separately vesting portion of the award as if the award was, in-substance, multiple awards.

When awards are forfeited before they vest, previously recognized expense related to such forfeitures is reversed in the period in which the forfeiture occurs.

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 income. Within the consolidated statements of operations line item “Other income (expense)—Other, net,” we recognized gains on foreign currency transactions of $0.5 million in 2017, while we recognized losses on foreign currency transactions of $30 thousand and $0.8 million in 2016 and 2015, respectively.

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 report interest related to income tax liabilities in the “Interest expense” line item on the consolidated statements of operations, and we report penalties in the “Other, net” line item on the consolidated statements of operations.

Derivative Instruments and Hedging Activities – We use derivative financial instruments to achieve a more predictable cash flow from oil production by reducing our exposure to price fluctuations. Our derivative instruments at December 31, 2016 consisted of fixed price oil puts, which give us the option to sell a contracted volume of oil at a contracted price on a contracted date in the future.
All of our oil put contracts, which provided for settlement based upon reported the Brent price, had expired as of December 31, 2017.

We record balances resulting from commodity risk management activities in the consolidated balance sheets as either assets or liabilities measured at fair value. Gains and losses from the change in fair value of derivative instruments and cash settlements on commodity derivatives are presented in the “Other, net” line item located within the “Other income (expense)” section of the consolidated statements of operations. We received cash settlements of $0.2 million during the year ended December 31, 2017 related to matured derivative contracts.

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, derivative assets, accounts payable and guarantee. As discussed further in Note 10, derivative assets and liabilities are measured and reported at fair value each period with changes in fair value recognized in net income. With respect to our other financial instruments included in current assets and liabilities, 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 market rates currently in effect.

General and administrative related to shareholder matters – Amounts related to shareholder matters for the years ended December 31, 2016 and 2015 relate to costs incurred related to shareholder litigation that was settled in 2016. For 2016, the amounts also include the offsetting insurance proceeds related to these matters.

Other, net – “Other, net” in non-operating income and expenses includes gains and losses from derivatives and foreign currency transactions as discussed above. In addition, “Other, net” for the year ended December 31, 2017 includes $2.6 million related to the reversal of accruals for liabilities we are no longer obligated to pay.