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Amortized full cost accounting

What Is Amortized Full-Cost Accounting?

Amortized Full-Cost Accounting is an accounting method predominantly used by companies in the oil and gas industry to account for their exploration and development costs. Under this approach, all costs associated with finding and developing oil and gas reserves within a large geographic cost center—such as a country or a significant geological basin—are capitalized. This means that both successful and unsuccessful exploration costs and development costs are accumulated as assets on the company's balance sheet, rather than being expensed immediately. The aggregate capitalized costs are then systematically amortized over the estimated life of the company's proved reserves as production occurs. This method falls under the broader category of extractive industries accounting.

History and Origin

The evolution of accounting standards for the extractive industries, particularly oil and gas, has been influenced by the unique challenges of capitalizing large, uncertain capital expenditures. In the United States, the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) have provided guidance on how companies should report these activities.

The full-cost method gained prominence as one of two primary accounting approaches for oil and gas producers. The SEC, through its Staff Accounting Bulletins (SABs), has historically addressed and provided interpretations regarding the application of the full-cost method. For example, SEC Staff Accounting Bulletin Topic 12, "Oil and Gas Producing Activities," specifically provides detailed guidance on aspects like the treatment of income tax effects, exclusion of costs from amortization, and the full-cost ceiling limitation. Thi11, 12s regulatory oversight helps ensure consistency and transparency in financial reporting within the industry. Internationally, IFRS 6, "Exploration for and Evaluation of Mineral Resources," provides guidance on accounting for exploration and evaluation expenditures, allowing entities some flexibility in their accounting policies for these assets, including approaches consistent with the principles of full-cost accounting.

##8, 9, 10 Key Takeaways

  • Amortized Full-Cost Accounting capitalizes all exploration and development costs, regardless of success, within a defined cost center.
  • These capitalized costs are treated as assets on the balance sheet.
  • The accumulated costs are amortized over the life of the proved oil and gas reserves as production takes place.
  • This method can result in higher reported asset values and potentially more stable earnings in the initial stages of exploration, as costs are not immediately expensed.
  • It is primarily utilized by companies in the extractive industries, most notably oil and gas.

Formula and Calculation

The amortization under Amortized Full-Cost Accounting is typically calculated using the units-of-production method. This means that the capitalized costs are expensed in proportion to the depletion of the company's total proved reserves.

The formula for the periodic amortization expense is:

Amortization Expense=(Current Period ProductionTotal Estimated Proved Reserves)×Net Capitalized Costs\text{Amortization Expense} = \left( \frac{\text{Current Period Production}}{\text{Total Estimated Proved Reserves}} \right) \times \text{Net Capitalized Costs}

Where:

  • Current Period Production: The volume of oil and gas produced during the accounting period.
  • Total Estimated Proved Reserves: The total estimated future production from the company's proved reserves within the cost center.
  • Net Capitalized Costs: The total capitalized exploration and development costs, less accumulated amortization and any related deferred income taxes.

Interpreting Amortized Full-Cost Accounting

When interpreting financial statements of a company using Amortized Full-Cost Accounting, it is important to understand its impact. This method generally results in higher reported asset values on the balance sheet compared to other accounting methods because unsuccessful project costs are not immediately expensed. Consequently, the income statement might show higher net income in early periods of significant exploration, as large exploration expenditures are deferred and expensed gradually through amortization rather than immediately.

Analysts and investors must consider this accounting choice when comparing the financial performance and asset bases of different companies in the oil and gas sector. A company employing Amortized Full-Cost Accounting may appear to have a stronger asset base and potentially more consistent earnings, even if a significant portion of its exploration efforts were unproductive. Understanding how these costs are capitalization and subsequently amortized is key to assessing the true economic performance and risk profile of the company.

Hypothetical Example

Consider "DrillCo Inc.," an emerging oil and gas company that began operations with a focus on a large shale basin. In its first year, DrillCo spent $50 million on various exploration activities. This included $30 million on drilling five wells, only two of which found commercially viable reserves, and $20 million on seismic surveys across the entire basin. All these expenditures, regardless of success, are capitalized under Amortized Full-Cost Accounting, becoming part of the company's asset base.

In its second year, DrillCo spent an additional $40 million on developing the two successful wells and conducting more exploratory drilling, discovering one more proved reserve. The total capitalized costs now stand at $90 million ($50 million + $40 million). At the end of year two, DrillCo's engineers estimate its total proved reserves to be 10 million barrels of oil equivalent (BOE). In that year, DrillCo produced 500,000 BOE.

Using the formula for amortization:

Amortization Expense=(500,000 BOE10,000,000 BOE)×$90,000,000\text{Amortization Expense} = \left( \frac{500,000 \text{ BOE}}{10,000,000 \text{ BOE}} \right) \times \$90,000,000 Amortization Expense=0.05×$90,000,000=$4,500,000\text{Amortization Expense} = 0.05 \times \$90,000,000 = \$4,500,000

Thus, DrillCo would record an amortization expense of $4.5 million for the year. This amount represents the portion of its total capital expenditures that is expensed, reflecting the depletion of its reserve base through production. This contrasts with methods that would immediately expense the costs of dry wells or unsuccessful surveys. The remaining capitalized cost of $85.5 million continues to be carried on the balance sheet and will be amortized in future periods as more oil and gas are produced.

Practical Applications

Amortized Full-Cost Accounting is primarily applied within the oil and gas industry, particularly by companies with extensive exploration programs or those operating in regions where the probability of successful discovery for any single well is low, but overall success across a broad area is anticipated. This method allows companies to pool the risk of individual drilling ventures by capitalizing all costs within a large cost center.

For instance, a company engaged in widespread hydraulic fracturing ("fracking") operations across a vast shale play, as seen in the Permian Basin of West Texas and New Mexico, might find this method appealing. The significant costs associated with multiple well completions, even if some are less productive than others, are aggregated. Thi7s accounting choice aligns with the long-term investment horizon characteristic of energy resource development.

From a regulatory standpoint, companies adhering to U.S. GAAP and reporting to the SEC must follow specific guidelines outlined in the Codification of Staff Accounting Bulletins related to oil and gas producing activities. Thi5, 6s ensures that while companies have the option to use the full-cost method, their application and disclosures are consistent with regulatory expectations. The approach is also relevant for understanding the asset valuations and financial structure of large, integrated energy companies.

Limitations and Criticisms

Despite its prevalent use in the extractive industries, Amortized Full-Cost Accounting faces several limitations and criticisms. A significant concern is that it can obscure the actual efficiency of a company's exploration efforts. By capitalizing all exploration costs, including those of unsuccessful wells, the method can mask the impact of "dry holes" or unproductive ventures on the company's income statement. This can potentially lead to an overstatement of assets on the balance sheet, as assets include costs that did not directly lead to productive reserves.

To mitigate this, the SEC mandates a "full-cost ceiling limitation" test. This rule requires companies to write down capitalized costs if the net book value of their oil and gas properties exceeds the present value of future net revenues from proved reserves. This impairment testing mechanism acts as a safeguard against excessive capitalization and ensures that the carrying amount of assets does not exceed their economic value. However, critics argue that even with the ceiling test, the method can still present a less conservative view of financial performance compared to alternative methods. The International Financial Reporting Standards (IFRS) in IFRS 6, while allowing for capitalization of exploration and evaluation assets, emphasizes the need for impairment tests to ensure assets are not carried at more than their recoverable amount. Thi3, 4s reflects a global consensus on the importance of re-evaluating the carrying value of these assets.

The Bureau of Economic Geology at the University of Texas, which conducts extensive research on oil and natural gas, often highlights the complexities in accurately assessing proved reserves, which directly impacts the amortization calculations and potential for impairment under the full-cost method.

##1, 2 Amortized Full-Cost Accounting vs. Successful Efforts Accounting

The primary alternative to Amortized Full-Cost Accounting in the extractive industries is Successful Efforts Accounting. The fundamental difference lies in how unsuccessful exploration costs are treated.

Under Amortized Full-Cost Accounting, all exploration and development costs incurred within a specified cost center (e.g., a country) are capitalized, regardless of whether they lead to the discovery of commercial reserves. This means costs associated with dry holes or unsuccessful geological surveys are still added to the asset base.

In contrast, Successful Efforts Accounting requires that only the costs directly associated with successful discoveries and the development of proved reserves are capitalized. Costs related to unsuccessful exploration activities, such as dry holes, are expensed immediately in the period they are incurred. This typically results in a more conservative financial presentation, with lower asset values and more volatile earnings (due to immediate expensing of failures) compared to the full-cost method. Companies often choose between these methods based on their risk tolerance, industry practices, and strategic objectives, with each method presenting a different picture of profitability and asset intensity.

FAQs

Why do companies use Amortized Full-Cost Accounting?

Companies, particularly smaller and mid-sized ones in the oil and gas sector, often use Amortized Full-Cost Accounting because it allows them to capitalize all exploration and development costs. This can result in higher reported assets and potentially smoother earnings, as the large, upfront costs of exploration are spread out over the productive life of the reserves rather than expensed immediately.

What industries primarily use this accounting method?

Amortized Full-Cost Accounting is almost exclusively used by companies in the extractive industries, predominantly the oil and gas sector. Its application is specifically tailored to the unique nature of exploring for and developing natural resources.

How does amortization in this context differ from regular depreciation?

While both amortization and depreciation are methods of expensing the cost of an asset over its useful life, amortization in full-cost accounting applies specifically to the capitalized costs of exploration and development. It is typically calculated using the units-of-production method, meaning the expense is tied directly to the volume of natural resources produced. Depreciation, on the other hand, is generally used for tangible assets like machinery and buildings, and can be calculated using various methods (e.g., straight-line, declining balance).

Does Amortized Full-Cost Accounting hide losses?

It doesn't "hide" losses, but it can defer the recognition of certain losses. Costs from unsuccessful exploration efforts, such as dry wells, are capitalized rather than expensed immediately. This means that a series of unsuccessful ventures might not immediately impact the income statement as a large expense, but rather contribute to a higher capitalized cost base that will be amortized over time, or potentially written down if an impairment testing is required.