Discuss the Impact of and Motivation for Writing Off Exploration and Evaluation Costs
The decision on the accounting method that accountants should use in the oil and gas industry is one that has a lot of contention on whether to use the successful efforts method or the full cost method. The full cost method requires all the operating expenses incurred in the location of a new oil and gas reserve to be capitalized irrespective of whether the oil was discovered or not. In the successful efforts method, a company capitalizes expenses that only relate to successful oil and gas discoveries. In the cases of unsuccessful results, this method requires the accountants to charge the operating costs in the income statement. The supporters of the successful efforts method argue that since the main objective of an oil company is to produce natural gas, therefore, only costs on successful efforts should be capitalized. In addition, they argue that unsuccessful efforts are unproductive. In effect, they say that all unsuccessful oil and gas explorations should be written off. On the contrary, those who are for full cost method argue that the main activity of an oil and gas company is to explore for these resources (Abushaiba, & Eldanfour, 2014). As a result, unsuccessful explorations should be capitalized over the course of the business. In light of this, this report discusses on the motivation of writing off costs of unsuccessful exploration and evaluation of oil and gas.
The main stakeholders in the oil and gas industry are the government, the oil and gas companies, the shareholders, customers, and financial and accounting regulators such as Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). Among the oil and gas companies, the decision to write off all costs enables these businesses to reflect unsuccessful costs in the annual report and promotes the matching concept related to revenue. Among the shareholders, this method is able to alert them of the company’s overextension of exploration programs (Umobong, 2015).
This method is important for the government and shareholders since it is more difficult for the management to manipulate and lie about a business performance than the full cost method (Macintosh, & Baker, 2002). Companies that use full concept method may show huge profits even if they have incurred a lot of expense in exploring unsuccessful oil wells since the costs in exploring dry wells are capitalized over a long period. In the successful efforts method, the immediate writing off of these costs enables a business balance sheet to present a better assessment of its assets. On the contrary, the full cost method violates this rule since it argues that the dry wells are essential in the discovery of productive wells.
In the process of exploration of oil and gas, a business incurs four major categories of cost: acquisition, exploration, development, and production cost. In the successful efforts method, acquisition costs refer to expenses such as exploration rights, title search charges, and lease bonus. This cost is capitalized. Exploration costs are expenses related to drilling a well. If the well is successful, the cost is capitalized, otherwise, it is expensed. Developments cost refers to expenses incurred in the installation of support infrastructure for an oil well. These costs are capitalized irrespective of whether the drilling has succeeded or failed. Production costs are those expense incurred in the direct production of oil and gas (Abushaiba, & Eldanfour, 2014). These costs are expensed in the income statement.
The successful efforts method eliminates all exploration and evaluation costs in unsuccessful explorations, which enables it to form a direct link between exploration and production. Through this method, the financial statements of a company are able to show only assets that relate to future cash flows of an asset. In particular, this method is able to fulfill the going concern aspect of financial statements (Abushaiba, & Eldanfour, 2014). Financial statements should be composed of the sum of monetary assets and postponed costs that may result in future economic benefits.
In addition, the successful efforts method improves the matching concept of a business. When businesses reflect the unsuccessful costs on the period that they are incurred, the business is able to match revenues for each period. As a result, this method provides realistic and accurate financial statements (Raiborn, 2009). Moreover, the matching concept enables a business to have a proper valuation of its assets.
The use of successful efforts is effective in matching revenues in a given period. In particular, this is necessary for the fulfillment of the matching concept. In addition, the successful efforts method is more exact in giving the estimated volumes of hydrocarbon reserves, which are used in amortization and depletion calculation. The amount of hydrocarbons available are amortized and depleted over time, therefore, if oil companies consider non-oil producing wells, when using the full cost method, the amount of error is usually high (Conkling, 2011). Since the successful efforts method writes-off all costs on non-successful wells, it does not recognize them when calculating amortization and depletion, which in turn enables it to reduce the error margin.
Another implication of writing-off unsuccessful exploration and evaluation costs is that it enables a business to reflect the current earnings from its operations. The capitalization of unsuccessful operations, using full cost method, leads to misleading information by investors. For instance, the motivation to postpone the cost of unsuccessful oil findings in the full cost method leads to an increase in current earnings reported to shareholders and a decrease in future earnings (Abushaiba, & Eldanfour, 2014). As a result, it becomes difficult for shareholders to tell how successful their company is performing. On the contrary, the immediate writing-off of unsuccessful exploration and evaluation enables shareholders to know the performance of their company in all its operating periods.
One negative implication of writing-off all evaluation and exploration cost is that it leads to the production of financial statements that have huge variances between various periods. Generally, in periods that have had a number of unsuccessful efforts, the company will have a huge decline in its earnings, while in periods that it has been successful it will have a huge rise in its earnings (Brock, Klingstedt, & Jones, 1981). As a consequence, these huge variations are unattractive for investors and can result in these companies lacking enough capital inflow from these individuals (Abushaiba, & Eldanfour, 2014). In particular, the instant accounting for such huge costs in small businesses may lead to their closure because they will become less competitive in the exploration of oil and gas.
To sum up, the instant writing-off of unsuccessful exploration and evaluation costs is appropriate in the treatment of these expenses. To begin with, this method is able to match revenues earned in a given period. In addition, these method is transparent since all expenses are disclosed when they are incurred. On the contrary, the full cost method hides these costs by discounting them in future. In effect, shareholders are unable to make proper decisions since they are unaware of any unsuccessful activities in a business. In fact, the total capitalization of costs, through full cost methods, makes a business to appear as profitable, which is misleading to shareholders.
Abushaiba, I., & Eldanfour, I. (2014). Argument of accounting for oil and gas upstream activities. International Journal of Humanities and Management Science, 2(3), 120-123.
Brock, H., Klingstedt, J., & Jones, D. (1981). Accounting for oil and gas producing companies-part 2: Amortization, conveyances, full costing and disclosures (1st Ed.). New York, NY: Professional Development Institute.
Conkling, R. (2011). Energy pricing: Economics and principles: Energy systems (2011th Ed.). New York, NY: Springer Publishing.
Macintosh, B., & Baker, R. (2002). A literary theory perspective on accounting: towards heteroglossic accounting reports, Accounting, Auditing & Accountability Journal, 15 (2), 184-222.
Raiborn, C. (2009). Core concepts of accounting (2nd Ed.). Hoboken, NJ: John Wiley and Sons.
Umobong, A. (2015). Choice of accounting methods and reported earnings by oil and gas producing firms in Nigeria: A critical evaluation of full cost versus successful effort methods. Kuwait Chapter of Arabian Journal of Business and Management Review, 4(12), 1-8.