Accounting For Differences in

Oil and Gas Accounting

By James Vitalone | Updated March 29, 2017 — 6:00 AM EDT

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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.

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.

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.

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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 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.
The Bottom Line
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.

Read more: Accounting For Differences In Oil And Gas

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gas.asp#ixzz594JpeP6X
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