Acquired full cost accounting

What Is Acquired Full-Cost Accounting?

Acquired Full-Cost Accounting refers to the application of the full-cost method of accounting within a company, particularly in the context of a business acquisition or when an entity adopts this specific accounting policy for its oil and gas operations. This method, a component of financial accounting in the oil and gas industry, allows companies to capitalize nearly all costs associated with the acquisition, exploration, and development costs of oil and gas reserves, regardless of whether those activities result in successful proved reserves or "dry holes." These capitalized costs are then recorded as long-term assets on the balance sheet and are systematically charged against revenue over the life of the productive assets through depletion, depreciation, and amortization (DD&A). The philosophy behind full-cost accounting is that all costs incurred in the search for oil and gas are necessary to find productive reserves, and thus, should be pooled and expensed over the asset's useful life rather than immediately.²⁵, ²⁶

History and Origin

The debate and adoption of accounting methods for the volatile oil and gas industry have a long history, influenced heavily by regulatory bodies. Prior to standardized rules, companies had significant discretion in how they accounted for exploration costs. The Financial Accounting Standards Board (FASB) was established in 1973 as the independent, private-sector organization responsible for establishing Generally Accepted Accounting Principles (GAAP) in the United States, recognized by the Securities and Exchange Commission (SEC) as the designated standard setter for public companies.²⁴

The Energy Policy and Conservation Act of 1975 specifically mandated that the SEC develop accounting practices for oil and gas companies.²³ This led to significant discussions and ultimately, the SEC allowing companies to choose between two primary methods: Full-Cost and Successful Efforts. The SEC subsequently adopted major revisions to its rules governing disclosures for oil and gas activities in late 2008, which also conformed the full-cost accounting rules to these revised disclosures, effective in 2010.²² These changes aimed to modernize rules that had not kept pace with technological advancements and market volatility.²¹

Key Takeaways

• Acquired Full-Cost Accounting capitalizes nearly all costs related to oil and gas exploration and development, pooling them as an asset acquisition.
• These pooled costs are then amortized (depleted, depreciated, and amortized) over the economic life of the company's total proved reserves.
• The method generally results in higher reported assets and lower initial income statement expenses compared to the successful efforts method, potentially leading to higher reported net income in the short term.
• A crucial aspect of Acquired Full-Cost Accounting is the quarterly "ceiling test" to prevent overstatement of capitalized costs relative to the value of reserves.
• This accounting method is predominantly used by smaller oil and gas companies, as it can smooth earnings and make financial results appear more stable.

Formula and Calculation

A critical component of Acquired Full-Cost Accounting is the "full cost ceiling test," an impairment test required by SEC Regulation S-X Rule 4-10. This test is performed quarterly to ensure that the capitalized costs of oil and gas properties do not exceed their recoverable value. If capitalized costs exceed the ceiling, the excess must be written down as a non-cash charge against earnings.¹⁹, ²⁰

The full cost ceiling is generally calculated as follows:

Where:

• PV10 of Proved Reserves: The present value of estimated future net revenues from proved reserves, discounted at an annual rate of 10%. This calculation uses a 12-month average price, calculated based on the first day of each month during the reporting period, as mandated by the SEC.¹⁷, ¹⁸
• Cost of Unproved Properties: The lower of cost or estimated fair value of properties that have not yet been evaluated or proved.¹⁶
• Associated Tax Effects: The income tax effects related to differences between the book and tax basis of the properties.¹⁵

If the net capitalized costs of the company's oil and gas properties exceed this calculated ceiling, an impairment charge is recorded, reducing the asset's book value.¹⁴

Interpreting Acquired Full-Cost Accounting

When a company utilizes Acquired Full-Cost Accounting, it signals a particular approach to valuing its underlying oil and gas assets. The interpretation of financial statements from such a company must consider that unsuccessful exploration costs are not immediately expensed but are instead added to a larger "cost pool" and then amortized. This contrasts sharply with other methods that expense dry hole costs as incurred.

Analysts interpreting financial results should note that a company using Acquired Full-Cost Accounting will typically report higher asset values on its balance sheet and potentially smoother, higher net income in periods of significant exploration activity, especially if much of that activity is unsuccessful. This can make the company appear more profitable and stable in the short term than it might be under an alternative accounting method. However, without continuous additions of new reserves, the depletion rate of the large cost pool can become substantial, eventually impacting the reported net income more heavily in later periods.¹², ¹³

Hypothetical Example

Imagine "OilSprout Inc.", a newly formed oil and gas exploration company that has chosen Acquired Full-Cost Accounting for its operations. In its first year, OilSprout incurs $100 million in various costs:

• $20 million for land lease acquisitions.
• $50 million for drilling 5 exploration wells.
• $30 million for developing infrastructure around a successfully drilled well.

Out of the five exploration wells drilled, only two prove to be productive, while the other three are "dry holes."

Under Acquired Full-Cost Accounting, OilSprout Inc. would capitalize all $100 million of these costs on its balance sheet. This includes the costs of the unsuccessful dry holes, as the philosophy dictates that all costs contribute to the overall effort of finding reserves. These costs are pooled together.

If OilSprout Inc. had instead used the successful efforts method, the costs associated with the three dry holes (a portion of the $50 million drilling costs) would have been immediately expensed to the income statement, resulting in lower reported net income for the period but potentially a clearer picture of the immediate success rate of individual drilling efforts.

Practical Applications

Acquired Full-Cost Accounting is primarily applied by oil and gas companies, particularly smaller and medium-sized exploration and production (E&P) firms. For these companies, the method allows them to spread the substantial, often speculative, costs of exploration and development costs over a longer period, thus mitigating the immediate impact of unsuccessful drilling efforts on their reported earnings.¹¹

This accounting choice affects how companies present their financial health to investors, creditors, and other stakeholders. For example, a company using Acquired Full-Cost Accounting will report a larger base of oil and gas assets on its balance sheet compared to a company using the successful efforts method, assuming similar operational results. The large capitalized cost pool is subject to ongoing depletion charges as reserves are extracted.¹⁰

Furthermore, the SEC, through its rules like Regulation S-X Rule 4-10, provides specific guidance for companies employing the full-cost method, particularly concerning the calculation of the full cost ceiling test. This regulatory oversight ensures some level of comparability and prevents excessive overstatement of assets.⁹

Limitations and Criticisms

Despite its advantages for certain companies, Acquired Full-Cost Accounting faces several significant limitations and criticisms. A primary concern is that it can potentially distort a company's financial performance by masking the immediate impact of unsuccessful exploration activities. By capitalizing the costs of dry holes, the method can inflate reported assets and present a smoother, potentially higher, net income compared to companies using the successful efforts method.⁷, ⁸ Critics argue that this treatment can make it more difficult for investors to discern the actual efficiency and success rate of a company's drilling programs, as it obscures the costs of unproductive efforts.⁵, ⁶

Another major limitation is the quarterly "ceiling test," which, while designed to prevent asset overstatement, can lead to significant, sudden impairment charges during periods of low oil and gas prices.⁴ If the discounted future net revenues from reserves fall below the capitalized costs, a large write-down becomes necessary, severely impacting reported earnings in that period. Such impairments cannot be reversed, even if commodity prices recover.³ This inherent volatility, though less frequent than the immediate expensing of dry holes, can still be a significant concern.

The full-cost method can also make it challenging to compare the financial health and operating performance of companies that use different accounting methods. This lack of comparability complicates financial analysis for investors and analysts attempting to evaluate companies across the sector.²

Acquired Full-Cost Accounting vs. Successful Efforts Accounting

Acquired Full-Cost Accounting and Successful Efforts Accounting are the two primary accounting methods permitted for oil and gas exploration and production companies under U.S. GAAP, each with distinct treatments for exploration and development costs. The fundamental difference lies in how "dry hole" costs—expenses incurred for wells that do not find commercial quantities of oil or gas—are handled.

The choice between these methods often reflects a company's philosophy regarding exploration risk and its desire to manage earnings visibility.

##¹ FAQs

What type of companies typically use Acquired Full-Cost Accounting?

Acquired Full-Cost Accounting is primarily used by smaller to mid-sized oil and gas exploration and production (E&P) companies. This method can help them present a more stable financial picture by spreading the high, often speculative, costs of finding reserves over many accounting periods.

How does Acquired Full-Cost Accounting affect a company's financial statements?

This method results in higher asset values on the balance sheet because unsuccessful exploration costs are capitalized rather than expensed immediately. Consequently, it can lead to higher reported net income in the short term, as fewer costs are charged against revenue initially. Over time, these capitalized costs are subject to depletion, depreciation, and amortization.

What is the full cost ceiling test?

The full cost ceiling test is a quarterly impairment test required by the SEC for companies using Acquired Full-Cost Accounting. It ensures that the capitalized costs of oil and gas properties do not exceed their estimated fair value, primarily determined by the present value of future net revenues from proved reserves. If capitalized costs exceed this ceiling, the excess must be written down, reducing asset values and reported earnings.