Successful Efforts vs Full Cost: A Comparison of Oil and Gas Accounting Methods

Companies involved in oil and gas exploration have a choice between two accounting methods – the successful efforts (SE) method and the full cost (FC) method. These methods differ in their approach to recording expenses related to locating and developing oil and natural gas reserves.

Understanding the key differences between successful efforts and full cost accounting is important when analyzing financial statements of companies in the oil and gas industry. The accounting method impacts how earnings and cash flows are presented.

This comprehensive guide examines the successful efforts and full cost methods side-by-side. We’ll compare and contrast the two approaches to provide a clear understanding of their implications.

Overview of Successful Efforts and Full Cost

Successful efforts accounting allows companies to capitalize only those costs directly associated with successfully locating new oil and gas reserves, Expenses from unsuccessful exploration efforts are charged against revenues in the period they occur

In contrast, full cost accounting enables companies to capitalize all costs related to exploration, development and acquisition of reserves – regardless of whether the efforts are successful.

There are merits to both methods. Supporters of successful efforts argue it better matches expenses to revenues and provides a clearer picture of a company’s exploration successes and failures.

Advocates of full cost accounting contend it smooths out fluctuations in earnings caused by drilling activity, and better aligns capitalized costs with the complete investment in a company’s overall exploration program.

Currently no consensus exists on which approach is theoretically superior. The FASB recommends successful efforts, while the SEC allows companies to utilize either method.

Let’s look at the key differences between the two approaches:

How Costs Are Treated

The biggest distinction lies in how unsuccessful exploration costs are handled:

• Under successful efforts, all costs from unsuccessful exploratory ventures are expensed in the current period.

• With full cost accounting, expenses from both successful and unsuccessful activities are capitalized as assets.

This means a company using successful efforts will show higher expenses and lower net income early on compared to an equivalent company using full cost.

However, as reserves are depleted over time without new discoveries, the fuller cost company will report higher depreciation expenses against revenue, reducing its earnings relative to the successful efforts company.

Income Statement Impact

Depreciation, depletion and amortization (DD&A) of capitalized acquisition, exploration and development costs is a major non-cash expense on oil and gas company income statements.

The periodic DD&A charge under successful efforts is lower because fewer expenses are capitalized. Additionally, income is directly reduced by current period unsuccessful exploration costs.

Conversely, full cost accounting shows higher net income early on. The immediate write-off of unsuccessful efforts under successful efforts accounting creates volatile earnings in periods with significant exploration activity.

Cash Flow Statement Effects

In the cash flow from operations (CFO) section, successful efforts will show lower near-term cash flow due to the inclusion of exploration expenses.

However, over longer periods cash flows for the two methods converge. This is because adding back non-cash DD&A negates the impact of higher capitalized costs under full cost.

Balance Sheet Impacts

The higher capitalization of costs under full cost accounting leads to larger long-term asset balances on the balance sheet. Unsuccessful costs are recorded as assets until written off through DD&A.

Successful efforts has lower asset values because dry hole costs are expensed in the current period. Assets only include capitalized expenditures relating to successful efforts.

Key Accounting Differences

Here are some other key accounting differences between the successful efforts and full cost methods:

• With successful efforts, lease acquisition costs are capitalized when incurred. Full cost companies capitalize these when the leased property is evaluated and converted to proven reserves.

• Successful efforts firms perform impairment tests periodically and write down capitalized costs if necessary. Impairment tests are not required under full cost.

• Companies using full cost must perform a “cost ceiling test” each quarter. Costs are written down if the net book value of assets exceeds the present value of future after-tax cash flows from proven reserves.

• Full cost permits simpler accounting for consolidated joint ventures, providing more consistent reporting of assets.

• Abandonments under successful efforts are recorded as losses in current income. Full cost companies treat abandonments as depreciation expenses.

Financial Statement Effects

Income Statement

• Successful efforts – Lower near-term earnings, higher volatility, better matching of revenues and expenses.

• Full cost – Smoother earnings, higher early profits, improved profitability trending.

Cash Flow

• Successful efforts – Lower short-term cash flow, long-term convergence.

• Full cost – Higher initial cash flow, long-term convergence.

Balance Sheet

• Successful efforts – Lower asset values, costs directly written off.

• Full cost – Higher asset balances, higher DD&A.

Successful Efforts vs Full Cost Example

Let’s look at a simplified example to illustrate the accounting differences between successful efforts and full cost methods.

Suppose an oil and gas company has the following exploration activities and results during the period:

• Drilled 10 wells at a total cost of $20 million
• 7 wells successfully found proven reserves
• 3 wells were dry holes with no reserves

Under successful efforts accounting:

• $14 million in costs from successful wells capitalized as assets
• $6 million in dry hole/unsuccessful costs expensed on income statement

Under full cost accounting:

• The entire $20 million capitalized as assets on balance sheet

As this example demonstrates, the full cost method results in higher asset values and earnings, while the successful efforts method provides better matching of costs and revenues.

Pros and Cons of Each Method

There are strengths and limitations inherent in both approaches to oil and gas accounting:

Successful Efforts Pros:

• Matches expenses to associated revenues.
• Income reflects exploration success ratio.
• Balance sheet better reflects asset value.

Successful Efforts Cons:

• Volatile earnings from write-offs.
• Discourages risky exploration – expense risk is high.
• More complex accounting for joint ventures.

Full Cost Pros:

• Smooths earnings by capitalizing all exploration costs.
• Encourages exploration by deferring expense.
• Simpler consolidated JV reporting.

Full Cost Cons:

• Assets may be overstated compared to economics.
• Earnings less indicative of exploration success.
• No periodic impairment test required.

Industry Preferences

In general, smaller pure exploration companies tend to prefer the full cost method. It allows them to defer expenses and present smoother earnings numbers. Major integrated oil companies typically favor successful efforts since it better matches costs to revenues.

However, exceptions exist on both sides. Overall, successful efforts is the more conservative approach, while full cost provides more flexibility in asset capitalization.

Changing Methods

Because the choice of accounting method has a significant impact on financial reporting, the SEC has strict requirements for changing methods. Companies must receive explicit permission from the SEC to switch from one approach to the other.

Changes are only permitted in rare circumstances, such as a major shift in the business focus. Companies must clearly justify that the alternate method is preferable and present updated financials under both the old and new method for comparison.

Regulatory Bodies and Guidance

As mentioned earlier, the FASB recommends successful efforts accounting in its Statement of Financial Accounting Standard No. 19. However, the SEC also allows companies to use the full cost approach.

In addition, the IRS has specific regulations related to tax treatment of costs that may influence a company’s accounting choice. Guidance can be found in IRS Tax Code Section 613A.

Financial Analysis Considerations

When analyzing and comparing financial performance of companies involved in oil and gas exploration and production, it is essential to consider the accounting method used, as this materially impacts results.

Be aware of key metrics like earnings volatility, DD&A expense, impairment charges, cash flow adjustments, and asset carrying values when evaluating companies using different methods. Normalizing the data may provide a more equivalent comparison.

Also keep in mind that the accounting choice may indicate management’s business strategy and risk tolerance regarding exploration activities.

Key Takeaways

• Successful efforts expense dry hole costs immediately, while full cost capitalizes all exploration costs.

• Successful efforts produces more volatile earnings but better matching of revenues and expenses.

• Full cost shows smoother income trends but may overstate asset values on the balance sheet.

• There are merits to both approaches – neither method is inherently “superior” in all cases.

• The accounting method indicates management’s strategy and risk posture towards exploration.

The choice between successful efforts and full cost accounting can have significant implications on the financial statements of oil and gas companies engaged in exploration and development of reserves.

Evaluating financial reports requires awareness of the method used, along with an understanding of how the differences in expense recognition impact earnings, cash flow, and asset valuation over both short and long-term horizons.