OIL AND GAS ACCOUNTING - swlearning.com

1 555 CHAPTER15 OIL AND GAS ACCOUNTINGLEARNING OBJECTIVESA fter reading this chapter, you should be able to: Understand the nature of full cost (FC) and successful efforts (SE) ACCOUNTING . Grasp the background and politics of standard setting for oil andgas ACCOUNTING . Understand the SEC s reserve recognition ACCOUNTING (RRA) pro-posal. Understand SFAS No. 69 and its relationship to and gas ACCOUNTING is an interesting though specialized area,one that demonstrates many theoretical problems of the typediscussed in this book.

2 Standard setting in this area has beenthe subject of controversy for nearly two decades. Moreover, several ofthe decisions rendered by standard-setting agencies have been ex-tremely dubious. From a theoretical point of view, financial accountingand reporting in the oil and gas industry illustrates very well a situationin which information produced by the historical cost model generally isconsidered to be much less relevant for decision makers than infor-mation produced by some form of current valuation. Because of this fac-tor and the politics of the oil and gas ACCOUNTING controversy, we haveseen more empirical research using security price movements to ascer-tain the economic impact of an ACCOUNTING standard in this area than inany other single area of this chapter we first look at an example of the impact on financialstatements of full cost (FC) versus successful efforts (SE) ACCOUNTING (thetwo broad methods of applying historical cost).

3 Then we take up a dis-cussion of the conceptual differences between the two methods in the ap-plication of historical costing. We also review standard setting for oil 6/8/2000 10:21 AM Page 555556 Chapter 15 Oil and Gas Accountinggas ACCOUNTING and the various empirical studies, compare oil and gasaccounting to the conceptual framework, and examine the current valueapproach proposed by the Securities and Exchange Commission that wascalled reserve recognition ACCOUNTING (RRA). Last, we take up the currentstatus of financial ACCOUNTING and reporting in the oil and gas practice, there are variations in the application of both FC and SEbecause of such factors as the definition of a cost center (to be discussedlater).

4 However, in this chapter the two methods will be examined intheir broadest sense. The basic difference between the two is their treat-ment of incurred exploration costs that do not result in the discovery ofoil or gas reserves. Under FC, all the costs of exploration are capitalized,regardless of whether those costs lead to a specific discovery of rationale supporting FC is the probabilistic nature of exploration: itmay require, on average, that numerous exploratory wells be drilled inorder to find a reservoir that can be developed.

5 Therefore, costs of all ex-ploration are included in the cost of successful wells. Under SE, only theexploration costs that result in a producing well are capitalized; explo-ration costs that result in dry holes are expensed immediately. If fourexploratory wells are drilled and three are dry holes, the costs of thosethree will not provide future benefits and therefore should be following example will illustrate the possible impact on financialstatements of applying FC versus SE for a relatively young Corporation was formed three years ago and has drilled four ex-ploratory wells per year with a success rate of 25 percent.

6 Depletion ex-pense is 20 percent of beginning-of-year oil properties (that is, XYZ pro-duces 20 percent of its proven reserves each year), and depreciationexpense is 10 percent of beginning-of-year other assets. Production costis 8 percent of revenues. In the current year, 100,000 barrels of oil weresold at $32 per barrel. Four exploratory wells were drilled at an averagecost of $525,000. One well was successful. Exhibit 15-1 presents the be-ginning-of-year balance sheets, 15-2 the current-year income state-ments, and 15-3 the end-of-year balance sheets under both the FC andSE the illustration is hypothetical, it does point out that the twomethods may have a significant impact on financial statements, particu-larly for a relatively new or developing enterprise.

7 In this illustration, as-sets differ by $ million, or approximately 54 percent (FC as base) atyear end. The difference is even more pronounced in stockholders eq-uity, where SE s stockholders equity is only 24 percent of FC s. Net in-come varied by $843,000, or 45 results appear unusually large; however, the potential effectsare substantiated by several studies of the financial statements of oper-ating enterprises. For example, in a study of 28 enterprises, Klingstedt 6/8/2000 10:21 AM Page 556 Chapter 15 Oil and Gas Accounting557 EXHIBIT 15-1 XYZ Corporation Balance Sheets, Beginning of YearFCSEA ssetsCurrent assets$ 800,000$ 800,000 Oil properties4,880,0001,220,000 Other assets1,000,0001,000,000 Total$6,680,000$ 3,020,000 Liabilities and Stockholders EquityCurrent liabilities$ 600,000$ 600,000 Long-term liabilities2,000,0002,000,000 Common stock2,000,0002,000,000 Retained earnings (Deficit)2,080,000(1,580,000)

8 Total$6,680,000$ 3,020,000 EXHIBIT 15-2 XYZ Corporation Income Statements, Current YearFCSER evenues (100,000 barrels at $32)$3,200,000$ 3,200,000 Expenses:Production costs$ 256,000$ 256,000 Depletion976,000244,000 Depreciation100,000100,000 Exploration costs 1,575,000$1,332,000$ 2,175,000 Net Income$1,868,000$ 1,025,000data revealed that earnings may increase from 10 percent to several hun-dred percent by merely switching from the SE method to the Ross & Company (now Deloitte and Touche) found in astudy of 36 enterprises that net income would be reduced by 20 percent,assets by 30 percent, and stockholders equity by 16 percent if the en-terprises were required to switch from FC to , the FirstBoston Corporation s analysis showed net income reductions as high as1 Klingstedt (1970, pp.)

9 79 86).2 Touche Ross & Co. (1977). 6/8/2000 10:21 AM Page 55755 percent as a result of switching from FC to Financial Ac-counting Standards Board staff found similar but smaller variations in astudy of its DIFFERENCES BETWEEN FC AND SEBoth FC and SE methods of ACCOUNTING in the oil and gas industry areallowed under generally accepted ACCOUNTING principles. The fundamen-tal difference between FC and SE is the size of the cost center used inthe capitalize/expense decision for exploration costs. Under FC, thelargest possible cost center is the country or even a continent, and allcosts of finding oil and gas reserves would be capitalized regardless ofwhether a specific local effort is successful.

10 Under SE, the smallest pos-sible cost center is the property (lease), reservoir, or field (most SE com-panies use the field), and all costs of that well would be expensed unlessoil and gas reserves are found. Establishing a direct cause-and-effect re-lationship between costs incurred and reserves discovered is not rele-vant to recording the costs as assets under FC, while such a relationshipmust exist to record the costs as assets under SE. Both methods eventu-ally will produce the same ACCOUNTING results because the same costs areincurred and the same discoveries made.