Exploration and production companies of oil and gas have the option to choose between two different accounting standard - full cost method and successful effort method. The difference in treatment of exploration expense related to new natural gas reserve and resource, affect the P&L, cash flow and balance sheet numbers. Therefore, understanding of both methods is necessary to evaluate/compare companies involved in exploration and production
Successful effort method (SE):
This accounting method allows only exploration cost related with successful finding of new reserve to be capitalized (aggregate within fixed assets sections) and all other exploration cost (related to unsuccessful finding) should be expensed in current year income statement.
SE method assumes that ultimate objective of E&P companies is to produce from located and developed reserve. Thus SE method states that only successful findings should be capitalized because there is no change in productive assets from unsuccessful results and thus expensed
Full cost method (FC):
This accounting method allows any exploration cost related to finding of new reserve to be capitalizing (aggregate within fixed assets sections) regardless of outcome.
FC method assumes that foremost activity of E&P companies is exploration and development of oil and gas reserve, therefore all cost related to exploration and development must be first capitalized and then amortized during the period of time (Matching principal).
Note: IFRS limits usage of full cost method, but both the methods are usually followed in US GAAP- US and Canada (before Canada switched to IFRS)
Financial statement impact SE vs FC
As per SE method, exploration expense related to unsuccessful finding is charged in I/S which reduce the net income, on the other hand FC method capitalize the unsuccessful finding and thus accumulated assets in balance sheet are more in comparison to SE method and thus DD&A charged is more and will continue to be more in the periods to come
Note: Company follow FC method are require to do ceiling test impairment charge
Cash flow statement
Under indirect method, Cash flow from operation is calculated as Net Income + DD&A + Non cash non operation charges.
For identical operations in the period when exploration expenses are charged, CFO for company follow FC method will be superior in comparison to SE method due to exploration expenses (Paid in cash) related to unsuccessful finding have already reduced the net income.
But in the period to come CFO will be same for both FC and SE method because effect of DD&A will be cancelled out because it will be added back in Net income.
Unsuccessful finding expenses are also capitalized in FC method and therefore fixed assets will be more in FC methods in comparison to SE methods.
Note: For financial analysis purpose, EBITDAX is calculated in oil and gas industry rather than EBITDA, where X stands for exploration expense.