Full Cost Method
Full cost method is a method of accounting for oil and gas exploration costs in which all exploration costs are capitalized when they are incurred, and none are expensed out.
Oil and gas exploration costs include cost of acquiring license to extract, cost of seismic data acquisition and analysis, cost of drilling wells, etc. Accounting for oil and gas exploration costs is different than accounting for costs incurred on other long-lived assets because not all exploration efforts result in discovery of oil, hence companies are not sure even when significant costs are incurred whether it would be commercially feasible to extract the oil and gas reserves discovered, if any. There are two methods adopted by the oil and gas industry in accounting for such costs: the full cost method and the successful cost method
The full cost method is most popular with smaller oil and gas companies because it is argued that because of the high risk in the oil and gas business, expensing exploration costs depresses the company’s net income which results in the company’s stock price which in turn impedes the companies from accessing new capital. The successful efforts method requiring expensing all exploration costs unless the oil reserves discovered as a result of a particular drilling effort is commercially feasible. The full cost method and the successful efforts method differs on the accounting treatment of exploration costs. Development costs i.e. costs incurred on development of an oil or gas field for extraction of known reserves, are capitalized under both methods. Further, production costs i.e. costs incurred on extracting the oil or gas, are expensed out.
Saghay Oil & Gas, Inc. a small company exploring oil and gas off the cost of Baluchistan. It acquired the offshore oil and gas exploration license for $1 million which entitles it to explore oil in K Block for two years. During the period, it must drill three wells in the block. It acquired seismic data for $5 million, hired external consultants for analysis of the data and paid them $3 million over the first year period. During the period, it drilled two wells, A and B, costing $20 million and $15 million respectively. At the end of the first year, it has decided to abandon Well A because it succeeded in hitting oil in Well B. It awarded a contract for oil field services company for development of the field for $10 million.
If the Saghay Oil and Gas, Inc. has adopted the full cost method, it shall capitalize the whole cost of $44 million (exploration license fee of $1 million plus seismic data acquisition cost of $5 million, seismic data analysis costs of $3 million and oil drilling costs of $35 million).
Written by Obaidullah Jan, ACA, CFA and last revised on