Companies involved in the exploration and development of crude oil and natural gas have the option of choosing between two accounting approaches: the "successful efforts" (SE) method and the "full cost" (FC) method. These differ in the treatment of specific operating expenses relating to the exploration of new oil and natural gas reserves.

The accounting method that a company chooses affects how its net income and cash flow numbers are reported. Therefore, when analyzing companies involved in the exploration and development of oil and natural gas, the accounting method used by such companies is an important consideration. (For background reading, see Unearth Profits In Oil Exploration And Production.)

Two Approaches
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.

The alternative approach, known as the full cost (FC) method, allows all operating expenses relating to locating new oil and gas reserves - regardless of the outcome - to be capitalized.

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.

Why the Two Methods?
Two alternative methods for recording oil and gas exploration and development expenses is the result of two alternative views of the realities of exploring and developing oil and gas reserves. Each view insists that the associated accounting method best achieves transparency relative to an oil and gas company's accounting of its earnings and cash flows.

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. (For related reading, check out Oil And Gas Industry Primer.)

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.
The choice of accounting method in effect receives regulatory approval because the Financial Accounting Standards Board (FASB), which is responsible for establishing and governing GAAP, and the Securities and Exchange Commission (SEC), which regulates the financial reporting format and content of publicly traded companies, are divided over which is the correct method.

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.

What's the Difference?
In general, SE and FC methods differ in their approach to treating costs associated with the unsuccessful discovery of new oil or natural gas reserves. Although both methods are indifferent as to the type of reserves, oil versus natural gas, that are associated with the costs incurred, the specific treatment of those costs by each method is responsible for the difference in the resulting periodic net income and cash flows numbers.

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:

  1. 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.
  2. Exploration Costs
    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 period's 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.

  3. Development Costs
    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.

  4. 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.

The Impact of Differing Levels of Capitalized Assets
The effect of choosing one accounting method over another is apparent when periodic financial results involving the income and cash flow statement are compared with the effect of highlighting the way each method treats the individual costs falling into these four categories. But such a comparison will also point out the impact to periodic results caused by differing levels of capitalized assets under the two accounting methods.

Much in the same way the financial results of a manufacturing company are impacted by depreciation expense for plant, property and equipment, those for an oil and gas company are equally affected by periodic charges for depreciation, depletion and amortization (DD&A) of costs relating to expenditures for the acquisition, exploration and development of new oil and natural gas reserves. They include the depreciation of certain long-lived operating equipment; the depletion of costs relating to the acquisition of property or property mineral rights, and the amortization of tangible non-drilling costs incurred with developing the reserves. (For related reading, check out Appreciating Depreciation.)

The periodic depreciation, depletion and amortization expense charged to the income statement is determined by the "units-of-production" method, in which the percent of total production for the period to total proven reserves at the beginning of the period is applied to the gross total of costs capitalized on the balance sheet.

Financial Statements Impact - FC Vs. SE

Income Statement
DD&A, production expenses and exploration costs incurred from unsuccessful efforts at discovering new reserves are recorded on the income statement. Initially, net income for both an SE and FC company is impacted by the periodic charges for DD&A 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.

However, without the subsequent discovery of new reserves, the resulting decline in periodic production rates will later begin to negatively impact revenues and the calculation of DD&A for both the SE and FC company. Due to the FC company's higher level of capitalized costs and resulting periodic DD&A expense in the face of declining revenues, the periodic net earnings of the SE company will improve relative to those for the FC company, and will eventually exceed those costs.

Statement of Cash Flows
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 DD&A added back so, despite a relatively lower charge for DD&A, CFO for an SE company will reflect the net income impact from expenses relating to unsuccessful exploration efforts.

However, when there are no new reserves being added, reported net income under longer term SE and FC, each company's CFOs will be the same. This is because adding back the non-cash charge for DD&A effectively negates the relatively larger impact to net income under the FC method of accounting. (For background reading on analyzing cash flow, see Fundamental Analysis: The Cash Flow Statement.)

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.

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