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 (An accounting method used to delay the recognition of expenses by recording the expense as long-term assets) 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 alloperating 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 thebalance 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.
Financial Statements Impact - FC Vs. SE
Income Statement
DD&A (depreciation, depletion and amortization ), 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.
Conclusion
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.
source: Investopedia
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