Differences Between Full Cost Method and Successful Effort Method In Oil and Gas Accounting free essay sample

An accounting system used by companies that incur exploration costs for oil and natural gas that does not differentiate between operating expenses associated with successful and unsuccessful exploration projects. Regardless of the outcome, successful and unsuccessful operation expenses are capitalized. Under Full Cost Method, all property acquisition, exploration and development costs, even dry hole costs, are capitalized as oil and gas properties. These costs are amortized using a unit-of-production method based on volumes produced and remaining proved reserves. The net unamortized capitalized costs of oil and gas properties less related deferred income tax MAY NOT exceed a ceiling consisting primarily of a computed present value of projected future cash flows, after income taxes, from the proved reserves. Under this method, the Company capitalizes all acquisition, exploration and development costs for the purpose of finding oil and gas reserves, including salaries, benefits and other internal costs directly attributable to these finding activities. Although some of these costs will ultimately result in no additional reserves, we expect the benefits of successful wells to more than offset the costs of any unsuccessful ones. the full cost (FC) method, allows all operating expenses relating to locating new oil and gas reserves, regardless of the outcome, to be capitalized. In addition, gains or losses on the sale or other disposition of oil and gas properties are not recognized unless the gain or loss would significantly alter the relationship between capitalized costs and proved reserves of oil and natural gas attributable to a country. As a result, we believe that the full-cost method of accounting better reflects the true economics of exploring. The Successful effort Method The successful efforts (SE) method allows a company to capitalize only those expenses associated with successfully locating new oil and natural gas reserves. For unsuccessful (or dry hole) results, the associated operating costs are immediately charged against revenues for that period. . Successful Effort Method Only the cost of successful efforts is capitalized. Cost of exploratory dry holes, geological and geophysical (GG) costs in general, delay rentals, and other property carrying costs are expensed. The net unamortized capitalized costs are amortized on unit-of-production method, whereby property acquisition costs are amortized over proved reserves and property development costs are amortized over proved development reserves. The basic concept underlying the successful efforts method of accounting for oil and gas exploration and production activities is based on a direct cause-and-effect relationship. The successful effort method follows the premise that an enterprise is to capitalize only those costs it incurs that directly result in an asset that has future benefit measured in terms of future cash flows. Like many other oil and gas companies, the Company has chosen to follow the successful efforts method. It is believed that this method is preferable, as many oil Companies focus on exploration activities wherein there is risk associated with future success and as such earnings are best represented by attachment to the drilling operations of such Companies. Costs of successful wells, development dry holes and leases containing productive reserves are capitalized and amortized on a unit-of-production basis over the life of the related reserves. Other exploration costs, including geological and geophysical expenses applicable to undeveloped leasehold, leasehold expiration costs and delay rentals are expensed as incurred. In accordance with accounting under successful efforts method of accounting, oil Companies review proved oil and gas properties for indications of impairment whenever events or circumstances indicate that the carrying value of its oil and gas properties may not be recoverable. When it is determined that an oil and gas property’s estimated future net cash flows will not be sufficient to recover its carrying amount, an impairment charge must be recorded to reduce the carrying amount of the asset to its estimated fair value. This may occur if a field contains lower than anticipated reserves or if commodity prices fall below a level that significantly effects anticipated future cash flows on the field. Differences Between The Successful Effort Method And The Full Cost Method. Below are some of the differences between The Successful Effort Method and The Full Cost Method. By contrast, the successful efforts accounting method only capitalizes expenses related to successful ventures. 2. Under the successful-efforts method, costs such as geological and geophysical (GG), exploratory dry holes and delay rentals are expensed as incurred, where under the full-cost method these types of charges would be capitalized to their respective full-cost pool. In the measurement of impairment of oil and gas properties, the successful-efforts method of accounting follows the guidance provided in Statement of Financial Accounting Standards (SFAS) No. â€Å"Accounting for the Impairment or Disposal of Long-Lived Assets,† where the first measurement for impairment is to compare the net book value of the related asset to its undiscounted future cash flows using commodity prices consistent with management expectations. Under the full-cost method, the net book value (full-cost pool) is compared to the future net cash flows discounted at 10 percent using commodity prices in effect on the last day of the reporting period (ceiling limitation). If the full-cost pool is in excess of the ceiling limitation, the excess amount is charged through income. 3. According to the view behind the SE method, the ultimate objective of an oil and gas company is to produce the oil or natural gas from reserves it locates and develops so that only those costs relating to successful efforts should be capitalized. Conversely, because there is no change in productive assets with unsuccessful results, costs incurred with that effort should be expensed. On the other hand, the view represented by the FC method holds that, in general, the dominant activity of an oil and gas company is simply the exploration and development of oil and gas reserves. Therefore, all costs incurred in pursuit of that activity should first be capitalized and then written off over the course of a full operating cycle. 4. In Statement of Financial Accounting Standard (SFAS) 19, the FASB requires that oil and gas companies use the SE method, while the SEC allows companies to use the FC method. These two governing bodies have yet to find the ideological common ground needed to establish a single accounting approach. 5. Initially, net income for both an SE and FC company is impacted by the periodic charges for DDA and production expenses, but net income for the SE company is further impacted by exploration costs that may have been incurred for that period. Thus, when identical operational results are assumed, an oil and gas company following the SE method can be expected to report lower near-term periodic net income than its FC counterpart. As with the income statement, when identical operational outcomes are assumed, for a company following the FC method of accounting near-term results (shown in the cash flows from operations (CFO) portion of the statement of cash flows), will be superior to those for a company following the SE method. CFO is basically net income with non-cash charges like DDA added back so, despite a relatively lower charge for DDA, CFO for an SE company will reflect the net income impact from expenses relating to unsuccessful exploration efforts. Similarities Between The Successful Effort Method And The Full Cost Method Below are some of the similarities between The Successful Effort Method and The Full Cost Method: 1. The two methods represent conflicting views in the industry about how oil and natural gas companies can most transparently report their earnings. 2. Exploration costs capitalized under either method are recorded on the balance sheet as part of long-term assets. This is because like the lathes, presses and other machinery used by a manufacturing concern, oil and natural gas reserves are considered productive assets for an oil and gas company; Generally Accepted Accounting Principles (GAAP) require that the costs to acquire those assets be charged against revenues as the assets are used. 3. Each view insists that the associated accounting method best achieves transparency relative to an oil and gas companys accounting of its earnings and cash flows. 4. When there are no new reserves  being added, reported net income under longer term SE and FC, each companys CFOs will be the same. This is because adding back the non-cash charge for DDA effectively negates the relatively larger impact to net income under the FC method of accounting. 5. Regardless of the method it chooses to follow, an oil and gas company engaged in the exploration, development and production of new oil or natural gas reserves will incur costs that are identified as belonging to one of four categories: i. ) Acquisition Costs  Acquisition costs are incurred in the course of acquiring the rights to explore, develop and produce oil or natural gas. They include expenses relating to either purchase or lease the right to extract the oil and gas from a property not owned by the company. Also included in acquisition costs are any lease bonus payments paid to the property owner along with legal expenses, and title search, broker and recording costs. Under both SE and FC accounting methods acquisition costs are capitalized. Typical of exploration, costs are charges relating to the collection and analysis of geophysical and seismic data involved in the initial examination of a targeted area and later used in the decision of whether to drill at that location. Other costs include those associated with drilling a well, which are further considered as being intangible or tangible. Intangible costs in general are those incurred to ready the site prior to the installation of the drilling equipment whereas tangible drilling costs are those incurred to install and operate that equipment. All intangible costs will be charged to the income statement as part of that periods operating expenses for a company following the SE method. All tangible drilling costs associated with the successful discovery of new reserves will be capitalized while those incurred in an unsuccessful effort are also added to operating expenses for that period. For an oil and gas company following the FC method, all exploration costs, including both tangible and intangible drilling costs, are capitalized by being added to the balance sheet as part of long-term assets. Development costs involve the preparation of discovered reserves for production such as those incurred in the construction or improvement of roads to access the well site, with additional drilling or well completion work, and with installing other needed infrastructure to extract (e. g. , pumps), gather (pipelines) and store (tanks) the oil or natural gas from the reserves. Both SE and FC methods allow for the capitalization of all development costs. iv. ) Production Costs The costs incurred in extracting oil or natural gas from the reserves are considered production costs. Typical of these costs are wages for workers and electricity for operating well pumps. Production costs are considered part of periodic operating expenses and are charged directly to the income statement under both accounting methods. Conclusion When investing in companies involved in the exploration and development of oil and natural gas reserves, company analysis should include recognizing which accounting method a company follows. The differences between the two methods and their impact on near- and long-term net income and cash flow should prove helpful when comparing individual companies past results and future expectations.