The full cost method is an accounting approach primarily used by companies in the oil and gas industry to record their exploration and development expenditures. Under this method, all costs incurred in the search for and development of oil and gas reserves, regardless of whether they lead to successful discoveries, are capitalized as assets on the balance sheet. These capitalized costs are then systematically amortized, or expensed, over the economic life of the company's total proved reserves as oil and gas are produced. This method falls under the broader category of accounting principles that dictate how businesses recognize and report their financial activities. The full cost method's premise is that all efforts, both successful and unsuccessful, are necessary to find and develop reserves, and therefore, all related capital expenditures should be pooled and expensed together.
History and Origin
The divergence in accounting practices for the oil and gas industry, leading to the full cost method and its counterpart, the successful efforts method, has roots dating back decades. Before the mid-1950s, successful efforts accounting or variations thereof were predominantly used. However, a form of the full cost method emerged in the mid-1950s and gained popularity, particularly among smaller, newer entities. This method allowed for the deferral of costs, which was advantageous as it aligned with the long and uncertain lead times inherent in oil and gas exploration. By 1970, nearly half of public oil and gas producing companies in the U.S. were employing some form of the full cost method.25
The existence of two distinct accounting methods led to significant debate regarding financial transparency and comparability within the industry.24 Regulatory bodies, notably the U.S. Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB), intervened to establish standardized reporting. In the late 1970s, after extensive deliberation, including public hearings, the SEC issued rules that ultimately permitted both the full cost method and the successful efforts method to continue under specific guidelines for companies filing reports with the SEC.23 Today, SEC Rule 4-10(c) of Regulation S-X outlines the accounting and reporting requirements for oil and gas producing activities under the full cost method.22
Key Takeaways
- The full cost method is an accounting approach where all costs associated with oil and gas exploration and development are capitalized.
- These capitalized costs include expenses from both successful and unsuccessful drilling efforts and lease acquisitions.
- Capitalized costs are recorded as assets on the balance sheet.
- The costs are then amortized as depletion expense on the income statement over the life of the company's total proved reserves.
- This method is primarily used in the oil and gas industry and is one of two generally accepted methods in the U.S., alongside the successful efforts method.
Interpreting the Full Cost Method
Companies employing the full cost method present their financial results by capitalizing a broad range of exploration costs and development costs, including those from dry holes and abandoned leases. This approach means that, initially, a company's net income may appear higher than if unproductive costs were immediately expensed, and its asset base on the balance sheet will also be larger.20, 21
The interpretation of a company's financial performance under the full cost method must consider this capitalization policy. While it can smooth out reported earnings by spreading out the impact of costly unsuccessful ventures, it also necessitates a "ceiling test" (also known as an impairment test) at the end of each reporting period. This test, mandated by the SEC, ensures that the capitalized costs do not exceed the estimated present value of future net revenues from proved oil and gas reserves. If the capitalized costs exceed this ceiling, an asset impairment charge must be recognized, which reduces the asset value and impacts net income.18, 19 This mechanism is crucial for preventing the overstatement of assets.
Hypothetical Example
Consider "Horizon Oil Co.," a newly formed exploration and production company. In its first year, Horizon incurs the following costs:
- Acquisition of oil leases: $50 million
- Drilling Costs for Well A (successful): $30 million
- Drilling Costs for Well B (unsuccessful dry hole): $20 million
- General overhead related to exploration activities: $5 million
Under the full cost method, Horizon Oil Co. would capitalize all these costs, totaling $105 million ($50M + $30M + $20M + $5M). This entire amount is recorded as an asset on the company's balance sheet.
If Horizon Oil Co. had estimated proved reserves that would be produced over 10 years and produced 10% of those reserves in its first year, the company would recognize 10% of the $105 million, or $10.5 million, as depletion expense on its income statement. This approach contrasts with expensing the $20 million dry hole cost immediately, which would significantly impact first-year earnings under an alternative method.
Practical Applications
The full cost method finds its primary application in the oil and gas industry, where companies undertake significant exploration costs and development costs with inherently uncertain outcomes. For public companies in the U.S., the use of the full cost method is governed by Generally Accepted Accounting Principles (GAAP) and specific rules issued by the Securities and Exchange Commission (SEC).17
Companies applying the full cost method must comply with detailed SEC requirements, including Rule 4-10 of Regulation S-X, which outlines how to categorize and report costs.16 These regulations specify how costs for acquiring properties, drilling successful and unsuccessful wells, and related production costs are accumulated into a "cost center," typically on a country-by-country basis.15 The SEC also provides interpretive guidance through Staff Accounting Bulletins (SABs), such as SAB 105, which clarify accounting for oil and gas producing activities.14 This method allows for a smoothing of reported earnings, as the substantial costs of exploration, including those that yield no reserves, are spread over the life of all discovered reserves, rather than being expensed immediately.13
Limitations and Criticisms
While the full cost method aims to reflect the overall investment necessary for a portfolio of oil and gas reserves, it faces several criticisms. One major limitation is that it can potentially overstate a company's assets on the balance sheet because it capitalizes costs related to unsuccessful ventures, such as dry holes and abandoned leases.11, 12 Critics argue that these unsuccessful efforts do not generate future economic benefits and therefore should not be treated as assets.10
This capitalization of all costs can lead to a less conservative financial presentation compared to methods where unsuccessful costs are expensed immediately.9 It may also obscure the true profitability of individual projects, making it challenging for investors to assess the efficiency of a company's exploration activities. The periodic "ceiling test" mandated by the SEC helps mitigate the risk of asset overstatement by requiring an asset impairment if capitalized costs exceed the discounted value of proved reserves.7, 8 However, this can lead to significant, sudden impairment charges in periods of declining commodity prices, impacting net income.6 The debate over the appropriateness of the full cost method versus other approaches has been a long-standing one in the accounting profession.5
Full Cost Method vs. Successful Efforts Method
The full cost method and the successful efforts method are the two primary accounting approaches for oil and gas exploration and production companies, differing fundamentally in their treatment of unsuccessful exploration costs.
| Feature | Full Cost Method | Successful Efforts Method |
|---|---|---|
| Treatment of Costs | All exploration costs and development costs (successful and unsuccessful) are capitalized. | Only costs related to successful discoveries and development are capitalized. Unsuccessful costs are expensed immediately. |
| Asset Recognition | Higher capitalized asset base on the balance sheet. | Lower capitalized asset base; reflects only productive assets. |
| Impact on Net Income (Initial) | Tends to result in higher initial reported net income due to cost deferral. | Tends to result in lower initial reported net income due to immediate expensing of unsuccessful costs. |
| Volatility of Earnings | Generally less volatile earnings in the short term, as costs are spread out. | Potentially more volatile earnings, as unsuccessful efforts create immediate expenses. |
| Depletion | Calculated based on the total capitalized cost pool, amortized over all proved reserves. | Calculated based on capitalized costs of only successful properties. |
| Philosophy | Views all costs as necessary to find total reserves. | Views only productive efforts as creating future benefits. |
The core difference lies in their conservatism. The successful efforts method is generally considered more conservative as it expenses unproductive costs as they are incurred, providing a more immediate reflection of exploration success or failure.4 In contrast, the full cost method pools all costs, leading to a potentially higher asset base and smoother earnings, particularly for companies with significant but often unsuccessful exploration activities.3 This distinction is critical for investors when comparing the financial statements of oil and gas companies.
FAQs
What type of companies typically use the full cost method?
The full cost method is predominantly used by companies in the oil and gas exploration and production sector. This is due to the unique nature of their operations, which involve substantial, often uncertain, expenditures on finding and developing reserves.
Does the full cost method apply to all industries?
No, the full cost method is specifically permitted and regulated for the oil and gas industry under Generally Accepted Accounting Principles (GAAP) in the U.S. and similar standards elsewhere. It is not generally applicable to other industries, which follow different rules for capitalizing and expensing capital expenditures.
How does the full cost method affect a company's reported assets?
Under the full cost method, a company's reported assets on its balance sheet will typically be higher than if it used the successful efforts method. This is because all exploration costs, including those for unsuccessful wells, are capitalized rather than expensed immediately, leading to a larger capitalized cost pool.
What is the "ceiling test" in the full cost method?
The "ceiling test" is a quarterly impairment test required by the SEC for companies using the full cost method. It ensures that the net book value of capitalized oil and gas property costs does not exceed a "ceiling," which is generally the present value of future net revenues from proved reserves. If the capitalized costs exceed this ceiling, an asset impairment charge must be recorded, which reduces assets and net income.2
Why are there two different accounting methods (full cost and successful efforts) for oil and gas?
The existence of two methods stems from a long-standing debate within the accounting profession about how best to reflect the economics of oil and gas exploration. Proponents of full cost view all exploration spending as part of the overall cost of acquiring reserves, while advocates of successful efforts believe that only costs directly leading to discoveries should be capitalized. Regulatory bodies have allowed both to exist under specific rules.1