2 - How Accounting Methods affect Oil & Gas Companies' Bottom Line
Updated: Aug 20, 2018
Oil & Gas Companies are committed to discovering and developing Oil & Gas reserves, as well as to producing from these reserves, ideally until abandonment, impairment, or depletion. This requires Oil & Gas companies to allocate funds and invest in exploration and production activities.
Such investment results typically in incurring four basic types of costs:
The manner these costs are allocated in the accounting system affects the net income and financial situation of an Oil & Gas company. There are two main accounting methods used:
Successful-Efforts Accounting (SE)
Full-Cost Accounting (FC)
Prior to examining the differences between the two methods, let's touch on the rational behind each method.
Successful-Efforts Accounting (SE) holds that Oil & Gas companies engage in exploration activities in order to produce hydrocarbons from discovered reserves. Therefore; only costs which arise from successful explorations should be associated with its respective producing reserve.
Full-Cost Accounting (FC) promotes a holistic view of Oil & Gas companies' activities. It holds that engaging in exploration and development of Oil & Gas reserves is the primary activity of any Oil & Gas company, and it is almost inevitable not to incur unsuccessful exploration cost.
This divergence raises three major questions:
1 - How To Treat Unsuccessful Exploration Cost
SE considers that any cost incurred during unsuccessful Oil & Gas exploration has to be treated as a period cost. Since It does not contribute to any future benefit, it has to be expensed against revenue as incurred.
On the other hand, FC considers that exploration is a crucial activity for discovering new reserves, and that it is almost inevitable to achieve such endeavor without enduring the cost of unsuccessful exploration activities. As such, any cost related to exploration activities, whether successful or not, has to be capitalized, and then written off across the life-cycle of the asset as Depreciation, Depletion, & Amortization expense (DD&A).
2 - How To Treat Dry Hole Cost During a Field Development Phase
Both methods agree on capitalizing this cost since they are part of a proven reserve that is intended to produce for future periods.
3 - How To Structure Responsibility Centers
Since SE suggest to ONLY capitalize the cost of successful exploration, it also suggests to treat a field, lease, or a reserve as a Responsibility Center. This helps facilitating accounting and allocating each cost to its respective field, lease, or reserve.
As for FC, any exploration cost has to be capitalized, therefore a country is usually considered as the Responsibility Center.
While Oil & Gas companies are given the freedom to chose which accounting method to adapt (unless regulations enforce one over the other), they must ensure that the selected method:
results in relevant and reliable information that can be used to make economic decisions,
reflects company's operations and activities, and
Having said that, it is important to realize that SE results in a lower net income (and probably loss) for periods of high exploration activities. On the other hand; it also results in a lesser amortization expense (since a lesser amount had been capitalized), thus, reducing the burden on net income in future periods.
Understanding the company's strategy, short and long term goals, risk profile, as well as taxation and local regulations is imperative to deciding which accounting system to adapt.
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Oea Services: Commercial Management