Understanding the Full Cost (FC) Method
In the realm of accounting, the full cost (FC) method is a specialized system predominantly embraced by extractive industries like oil and gas companies. This methodology entails the capitalization of all exploration operating expenses, regardless of their outcome, which are then spread out over time as reserves are developed.
This contrasts with the successful efforts (SE) accounting method, which only capitalizes expenses from fruitful extraction endeavors.
Key Takeaways
- Full cost (FC) accounting allows companies to capitalize all operating costs linked to identifying new oil and gas reserves, regardless of success.
- Delaying unsuccessful expenses inflates reported net income (NI), but exposes companies to substantial non-cash charges.
- The FC method provides an alternative to the SE accounting method, which capitalizes only expenses from productive extraction work.
- Due to disagreements, both methods persist as governing bodies strive to determine the most transparent avenue for reporting earnings and cash flow.
Understanding the Full Cost (FC) Method
Companies in the oil and gas sector invest significant resources in exploring untapped reservoirs, with no guarantee of success. These costs include land acquisition, permissions, equipment, labor costs, and transportation.
While unsuccessful exploration costs are typically expensed, the FC method integrates both successful and unsuccessful explorations into the balance sheet as costs.
Companies involved in oil and gas exploration have the choice of employing either the FC or SE accounting methods. Under SE, only successful efforts’ expenses are capitalized, with costs from failed ventures immediately recorded against revenues.
Two contrasting accounting methods endure due to regulatory discrepancies on transparent earnings reporting.
Full Cost (FC) Method vs. Successful Efforts (SE) Method
The divergence between the FC and SE methods arises from differing perspectives on oil and gas exploration and development expenses. Each view advocates for the method that best ensures transparent accounting of a company’s earnings and cash flows within the sector.
The SE approach emphasizes the goal of extracting oil and gas from reserves, capitalizing costs only from successful efforts and expensing unsuccessful ones due to no asset changes.
Conversely, proponents of the FC method argue that oil and gas companies’ primary focus is exploring and developing reserves, necessitating capitalization of all costs involved, followed by gradual write-offs over an operational cycle.
Advantages and Disadvantages of the Full Cost (FC) Method
Electing to follow the FC method path presents both advantages and drawbacks. Initial profits may appear inflated until an impairment occurs, giving an impression of higher net income that can attract investors and raise capital.
However, capitalizing unsuccessful exploration costs instead of expensing them makes a company more vulnerable to significant non-cash charges during expected cash flow decreases, impacting earnings and share prices.
Additionally, periodic impairment reviews increase accounting costs.
Special Considerations
The coexistence of two accounting methods reflects industry divisions on transparent earnings reporting for oil and gas companies. The Financial Accounting Standards Board (FASB) mandates the SE method, while the Securities and Exchange Commission (SEC) permits the FC method. As they grapple with ideological differences, investors must carefully navigate these reporting variations and understand their implications on a company’s NI and cash flows.
It’s essential for investors to discern the accounting method used to grasp the impact on financial metrics accurately.