What Are Successful-Efforts and Full-Cost Accounting?
Companies involved in the exploration and development of crude oil and natural gas can choose between two accounting approaches: the successful-efforts (SE) method and the full-cost (FC) method. These approaches differ in how they treat specific operating expenses related to the industry.
- Successful-efforts accounting allows a company to capitalize on only those expenses associated with successfully locating new oil and natural gas reserves.
- Full-cost accounting allows companies to capitalize on all operating expenses related to locating new oil and gas reserves, regardless of the outcome.
- The reason for the two types of accounting methods is that people are divided on which method they believe best achieves transparency around a company's earnings and cash flows.
Understanding Successful-Efforts and Full-Cost Accounting
The accounting method that a company chooses affects how its net income and cash flow numbers are reported. Therefore, the accounting method is an important consideration when analyzing companies involved in the exploration and development of oil and natural gas.
Companies record exploration costs capitalized under either method on the balance sheet as part of their long-term assets. This is because, like the machinery used by a manufacturing company, oil and natural gas reserves are considered productive assets for an oil and gas company. Generally accepted accounting principles (GAAP) require that companies charge costs to acquire those assets against revenues as they use the assets.
The reason that two different methods exist for recording oil and gas exploration and development expenses is that people are divided on which method they believe best achieves transparency of a company's earnings and cash flows.
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 Standards No. 19, the FASB requires that oil and gas companies use the SE method. 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.
The SE method allows a company to capitalize on only those expenses associated with successfully locating new oil and natural gas reserves. For unsuccessful (or "dry hole") results, the company charges associated operating costs immediately against revenues for that period.
According to the theory 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 the company should only capitalize on those costs relating to successful efforts. Conversely, because there is no change in productive assets with unsuccessful results, companies should expense costs incurred from those efforts.
The alternative approach, known as the FC method, allows companies to capitalize on all operating expenses related to locating new oil and gas reserves regardless of the outcome.
The theory behind 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, companies should capitalize all costs they incur in pursuit of that activity and then write them off over the course of a full operating cycle.
The effect of choosing one accounting method over another is apparent when periodic financial results involving the income and cash flow statement are compared. Each method highlights the individual costs, which fall into the categories of acquisition, exploration, development, and production, differently. However, such a comparison also points out the impact on periodic results caused by differing levels of capitalized assets under the two accounting methods.
The financial results of a manufacturing company are impacted by depreciation expense for plant, property, and equipment. Similarly, the financial results for an oil and gas company are equally affected by periodic charges in depreciation, depletion, and amortization (DD&A) of costs relating to expenditures for the acquisition, exploration, and development of new oil and natural gas reserves. The charges 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.
The periodic depreciation, depletion, and amortization expense charged to the income statement are determined by the "units-of-production" method, for 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.
DD&A, production expenses, and exploration costs incurred from unsuccessful efforts to discover new reserves are recorded on the income statement. Initially, net income for both an SE and an 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.
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 a SE and FC company. Due to an FC company's higher level of capitalized costs and resulting periodic DD&A expenses in the face of declining revenues, the periodic net earnings of the SE company will improve relative to those of the FC company and will eventually exceed those costs.
Statement of Cash Flows
As with the income statement for a company following the FC accounting method, when identical operational outcomes are assumed, near-term results (shown in the cash flows from the 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 added, each company's CFO 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 accounting method.