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.

The accounting method that a company chooses affects how its net income and cash flow numbers are reported. Therefore, it's an important consideration when analyzing companies involved in the exploration and development of oil and natural gas.

Two Approaches

The successful-efforts 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 company charges associated operating costs immediately against revenues for that period.

The alternative approach, known as the full-cost method, allows companies to capitalize all operating expenses related to locating new oil and gas reserves, regardless of the outcome.

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.

Why the Two Methods?

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 around a company's 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 the company should only capitalize those costs relating to successful efforts. Conversely, because there is no change in productive assets with unsuccessful results, companies should expense costs incurred with those efforts.

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, 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 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. 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.

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 the categories of acquisition, exploration, development, and production. 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.

The periodic depreciation, depletion and amortization expense charged to the income statement are 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.

Impact on Financial Statements

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 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 method of accounting.