DEFINITION of 'Full-Cost Method'

The full-cost method is 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. By contrast, the successful efforts accounting method only capitalizes expenses related to successful ventures.

BREAKING DOWN 'Full-Cost Method'

The two methods represent conflicting views in the industry about how oil and natural gas companies can most transparently report their earnings, and the two organizations that regulate accounting and financial reporting, the Financial Accounting Standards Board and the Securities and Exchange Commission, cannot always agree on which method is most appropriate.

The choice between these two accounting methods affects the company's reported net income and cash flows, so investors in such companies should be aware of the method used and the differences between the two.

The full cost method renders a company more susceptible to large non-cash charges whenever the preceding factors result in an expected cash flow decline. 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. The need for periodic impairment reviews also increases the accounting cost associated with the full-cost method.

Full-Cost Method Alternatives

As an alternative to the full-cost 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.

The 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.

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. Explore these difference further.

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