What Is the Full Cost (FC) Method?
The full cost (FC) method is an accounting system used specifically by extractive industries such as oil and gas companies. Under this technique, all exploration operating costs are capitalized, regardless of whether they were successful or not, and then amortized into expenses over time as the total reserves are produced.
- Full cost (FC) accounting permits companies to capitalize all operating expenses related to locating new oil and gas reserves, regardless of the outcome.
- Deferring unsuccessful expenses to a future date inflates reported net income (NI) but also makes the company more susceptible to large non-cash charges.
- Full cost (FC) accounting is an alternative to the successful efforts (SE) accounting method, which only capitalizes expenses related to fruitful extraction ventures.
- These two accounting techniques coexist because governing bodies cannot always agree on which method most transparently reports earnings and cash flow.
Understanding the Full Cost (FC) Method
Oil and gas companies spend a lot of money exploring new untapped reservoirs without any guarantee that they will find anything. Costs include acquiring land, obtaining the necessary permissions to extract, buying or leasing relevant equipment, transportation, and paying a specialist workforce’s wages.
When a company’s exploration efforts come up short, any costs incurred are usually recorded as an expense on the income statement. The full cost (FC) method takes a different approach, recording all successful and unsuccessful explorations as a cost on the balance sheet.
Oil and gas explorers can account for costs using either the full cost (FC) method or the successful efforts (SE) accounting method. Under the latter, a company is permitted 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.
Two contrasting types of accounting methods coexist because governing bodies are divided about which one best transparently reports a company's earnings and cash flows.
Full Cost (FC) Method vs. Successful Efforts (SE) Method
The two alternative methods for recording oil and gas exploration and development expenses are the result of two differing 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 those efforts should be expensed.
Proponents of the full cost (FC) method, meanwhile, contend that the dominant activity of an oil and gas company is simply the exploration and development of oil and gas reserves, meaning that all costs incurred in pursuit of that activity should first be capitalized and then written off over the course of a full operating cycle.
Advantages and Disadvantages of the Full Cost (FC) Method
Choosing the full cost (FC) method path comes with a series of benefits and drawbacks. Until an impairment occurs, reported profit levels can appear to be deceivingly elevated, since the expense recognition for so many costs has been deferred to a future date. Higher net income (NI) may make the company immediately seem more attractive to investors than competitors and help it to raise new capital.
At the same time, capitalizing unsuccessful exploration costs rather than expensing them results in the company being more susceptible to large non-cash charges whenever the preceding factors result in an expected cash flow decline. These write-downs or accounting expenses have a tendency to weigh on earnings and share prices.
Finally, it’s worth pointing out that the need for periodic impairment reviews can also increase accounting costs.
The existence of two accounting methods represents conflicting views in the industry about how oil and natural gas companies can most transparently report their earnings. Ultimately, the two organizations that regulate accounting and financial reporting, the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC), cannot always agree on which method is most appropriate.
In its "Statement of Financial Accounting Standard No. 19," the FASB requires that oil and gas companies use the SE method. The SEC, on the other hand, allows companies to use the full cost (FC) method. In other words, these two governing bodies have yet to find the ideological common ground needed to establish a single accounting approach.
That ultimately means that investors must be vigilant, recognizing that there are reporting variations and being aware of their associated impacts. The choice between these two accounting methods affects a company's reported NI and cash flows, so investors should take note of the method used and the differences between the two.