Successful Efforts Method
The Successful Efforts Method (SEM) is an accounting approach used primarily in the oil and gas industry for the exploration and drilling of new wells. This method allows companies to capitalize only the costs that are directly associated with successfully finding new oil and natural gas reserves. If the exploration effort is unsuccessful (often referred to as a “dry hole”), the associated costs are immediately expensed.
Here’s a breakdown of how costs are treated under the Successful Efforts Method:
- Exploration Costs:
- Successful: If the exploration results in the discovery of new reserves, the costs associated with that exploration are capitalized (added to the balance sheet as an asset) and are then depreciated or depleted over the life of the well.
- Unsuccessful: If the exploration is unsuccessful, the associated costs are expensed immediately in the income statement.
- Development Costs:
- These are the costs incurred after reserves are discovered to get them ready for production. Regardless of the outcome of development efforts, these costs are capitalized since they are directly tied to known reserves.
- Acquisition Costs:
- Costs associated with acquiring properties that have proven oil or gas reserves are capitalized.
- Production Costs:
- These are the costs related to extracting the oil or gas and delivering it to its initial storage location. These costs are expensed as incurred.
The primary advantage of the Successful Efforts Method is that it provides a clearer picture of the costs directly associated with finding new reserves. By expensing unsuccessful exploration efforts immediately, the balance sheet only reflects assets that have a future economic benefit.
This method contrasts with the Full Cost Method, where all exploration costs are capitalized regardless of the exploration outcome. The choice between these two methods can significantly affect a company’s financial statements, particularly in periods when there are many unsuccessful exploration activities.
Example of the Successful Efforts Method
Let’s use a fictional oil company named “DrillTech” to demonstrate the Successful Efforts Method (SEM) in action.
Scenario:
DrillTech decides to explore three potential oil sites this year, labeled Site A, Site B, and Site C.
- Site A: Exploration costs incurred = $2 million, and oil is discovered.
- Site B: Exploration costs incurred = $3 million, but no oil is found.
- Site C: Exploration costs incurred = $2.5 million, and oil is discovered.
Here’s how DrillTech would account for these costs using the Successful Efforts Method:
- Exploration Costs:
- Site A: The $2 million associated with the exploration is capitalized on the balance sheet since oil was successfully discovered.
- Site B: The $3 million associated with the unsuccessful exploration is immediately expensed on the income statement because no oil was found.
- Site C: The $2.5 million associated with the exploration is capitalized since oil was successfully discovered.
- Development Costs (assuming the company proceeds to develop the successful sites):
- Site A: Development costs of $1 million are capitalized.
- Site C: Development costs of $1.5 million are capitalized.
Financial Statement Impact:
On the Income Statement:
- An expense of $3 million would be recognized for the unsuccessful exploration of Site B.
On the Balance Sheet:
- An asset of $3.5 million (exploration cost of $2 million + development cost of $1 million) would be recognized for Site A.
- An asset of $4 million (exploration cost of $2.5 million + development cost of $1.5 million) would be recognized for Site C.
Over time, as the oil is extracted from Sites A and C, the capitalized costs would be depreciated or depleted, reflecting the consumption of the asset.
If DrillTech used the Full Cost Method instead, the costs for all three sites, even the unsuccessful Site B, would have been capitalized, providing a different representation on the financial statements.
