Full Cost Method
The Full Cost method is an accounting approach primarily used in the oil and gas industry. It treats all exploration and development costs as capital expenditures, regardless of whether the drilled wells are productive or non-productive. These costs are capitalized and amortized over the life of the reserves they are associated with.
Here’s a basic breakdown of the Full Cost method:
- Capitalizing Costs: All costs related to finding and developing new reserves, such as drilling costs, geological and geophysical expenses, are capitalized (recorded as assets on the balance sheet). This is done regardless of whether the exploration effort was successful or not.
- Amortization: These capitalized costs are then spread out over the life of the total proven reserves. This process is called depletion, which is similar to depreciation but specifically related to natural resource reserves.
- Ceiling Test: At the end of each period, companies have to perform a “ceiling test”. This test compares the net capitalized costs with the discounted future net revenues from proven reserves (basically, the value that the company can obtain from its reserves). If the net capitalized costs are found to be higher, an impairment loss is recognized, reducing the value of the assets on the balance sheet.
The Full Cost method is contrasted with the Successful Efforts method, another accounting approach used in the oil and gas industry. Under the Successful Efforts method, only the costs related to successful ventures (i.e., wells or reserves that are commercially viable) are capitalized, while the costs related to unsuccessful exploration efforts are expensed immediately.
Each method has its pros and cons and can significantly impact a company’s financial statements. Which method is chosen depends largely on the company’s business strategy, the nature of its operations, and the accounting standards followed in its jurisdiction. It’s also important to note that different jurisdictions may mandate the use of one method over the other. For example, U.S. GAAP allows for both methods, while IFRS requires the use of the Successful Efforts method.
Example of the Full Cost Method
Imagine a company called PetroProd Inc., an oil exploration and production company. Over a year, PetroProd incurs $10 million in costs exploring and developing new oil reserves. This includes costs for surveying, drilling, and labor. Some of these efforts are successful, finding commercially viable oil reserves, while others do not yield any usable oil. Regardless of the outcome, under the Full Cost method, all these costs are capitalized.
So, PetroProd adds $10 million to its oil and gas properties on its balance sheet.
Next comes the amortization or depletion process. Suppose the $10 million in costs are related to reserves that are expected to yield oil for 20 years. The company would then spread the $10 million cost over the 20 years. If we use straight-line amortization for simplicity, the company would record an expense of $500,000 ($10 million/20 years) each year as a depletion expense.
Lastly, PetroProd conducts a ceiling test at the end of each accounting period. This test compares the net book value of its capitalized costs with the present value of future cash flows expected from the proven reserves.
If the net book value of the capitalized costs exceeds the present value of future cash flows from the proven reserves, PetroProd would have to write down the value of its oil and gas properties, recognizing an impairment loss. This step helps ensure that the company’s assets are not carried at a value exceeding their economic benefit.
This is a simplified explanation of the Full Cost method, but it should give you a basic understanding of how this accounting method works in the oil and gas industry. In practice, the calculations can be more complex and subject to various rules and regulations.