The full cost method is a specific accounting technique primarily employed in the oil and gas industry. It is characterized by the capitalization of all exploration and development costs, irrespective of whether the drilled wells are productive or not. These costs are recorded as assets on the balance sheet and subsequently amortized over the life of the associated reserves.
Key Facts
- Capitalizing Costs: Under the Full Cost method, all costs related to finding and developing new reserves, such as drilling costs and geological expenses, are capitalized. This means they are recorded as assets on the balance sheet, regardless of the success of the exploration effort.
- Amortization: The capitalized costs are then spread out over the life of the total proven reserves through a process called depletion. This is similar to depreciation but specifically related to natural resource reserves.
- Ceiling Test: At the end of each accounting period, companies using the Full Cost method must perform a “ceiling test.” This test compares the net capitalized costs with the discounted future net revenues from proven reserves. If the net capitalized costs are higher, an impairment loss is recognized, reducing the value of the assets on the balance sheet.
- Contrasted with Successful Efforts method: The Full Cost method is contrasted with the Successful Efforts method, another accounting approach used in the oil and gas industry. Under the Successful Efforts method, only costs related to successful ventures are capitalized, while costs related to unsuccessful exploration efforts are expensed immediately.
Key Elements of the Full Cost Method
Capitalizing Costs:
Under the full cost method, all costs incurred in the process of finding and developing new reserves are capitalized. This includes expenses such as drilling costs, geological and geophysical expenses, and labor costs. The capitalization of these costs, regardless of the outcome of the exploration effort, is a distinctive feature of the full cost method.
Amortization:
The capitalized costs are not recognized as expenses immediately but are spread out over the life of the total proven reserves. This process, known as depletion, is analogous to depreciation but specifically pertains to natural resource reserves. The depletion expense is recorded on the income statement, resulting in a gradual recognition of the costs associated with the extraction of the reserves.
Ceiling Test:
At the end of each accounting period, companies using the full cost method are required to conduct a “ceiling test.” This test involves comparing the net capitalized costs with the discounted future net revenues anticipated from the proven reserves. If the net capitalized costs exceed the discounted future net revenues, an impairment loss is recognized. This loss reduces the value of the assets on the balance sheet, ensuring that the assets are not carried at a value higher than their economic benefit.
Comparison with the Successful Efforts Method
The full cost method stands in contrast to the successful efforts method, another accounting approach prevalent in the oil and gas industry. The fundamental difference between these two methods lies in the treatment of exploration costs. Under the successful efforts method, only costs related to successful ventures (i.e., wells or reserves that are commercially viable) are capitalized, while costs associated with unsuccessful exploration efforts are expensed immediately.
Conclusion
The full cost method is a specialized accounting technique used in the oil and gas industry. It entails the capitalization of all exploration and development costs, followed by their amortization over the life of the proven reserves. The ceiling test ensures that the carrying value of the assets does not exceed their economic benefit. The full cost method differs from the successful efforts method in its treatment of exploration costs, with the latter capitalizing only costs related to successful ventures. The choice between these methods depends on factors such as the company’s business strategy, the nature of its operations, and the accounting standards followed in its jurisdiction.
References
- Investopedia. (2021, August 27). Full Costing. Retrieved from https://www.investopedia.com/terms/f/full-costing.asp
- Investopedia. (2021, August 27). Full Cost Method. Retrieved from https://www.investopedia.com/terms/f/full-cost-method.asp
- SuperfastCPA. (n.d.). What is the Full Cost Method?. Retrieved from https://www.superfastcpa.com/what-is-the-full-cost-method/
FAQs
What is the full cost method?
The full cost method is an accounting technique used primarily in the oil and gas industry. It involves capitalizing all exploration and development costs, regardless of whether the drilled wells are productive or not. These costs are recorded as assets on the balance sheet and amortized over the life of the associated reserves.
How does the full cost method differ from the successful efforts method?
The full cost method capitalizes all exploration and development costs, while the successful efforts method only capitalizes costs related to successful ventures. In other words, the full cost method expenses unsuccessful exploration costs over the life of the reserves, whereas the successful efforts method expenses them immediately.
What are the key steps involved in the full cost method?
The key steps in the full cost method are:
– Capitalizing all exploration and development costs
– Amortizing the capitalized costs over the life of the proven reserves
– Conducting a ceiling test at the end of each accounting period to compare the net capitalized costs with the discounted future net revenues from proven reserves
What is the purpose of the ceiling test in the full cost method?
The ceiling test is performed to ensure that the carrying value of the assets does not exceed their economic benefit. If the net capitalized costs exceed the discounted future net revenues, an impairment loss is recognized, reducing the value of the assets on the balance sheet.
When is the full cost method used?
The full cost method is primarily used in the oil and gas industry to account for exploration and development costs. It is also used in other industries that involve the extraction of natural resources, such as mining.
What are the advantages of using the full cost method?
The advantages of using the full cost method include:
– It provides a more comprehensive view of the costs associated with finding and developing reserves.
– It can result in higher reported profits in the early stages of a project when exploration and development costs are high.
What are the disadvantages of using the full cost method?
The disadvantages of using the full cost method include:
– It can result in lower reported profits in later stages of a project when the capitalized costs are being amortized.
– It can lead to asset values that are higher than their economic benefit, especially if impairment losses are not recognized promptly.
Is the full cost method required by GAAP or IFRS?
The full cost method is not required by GAAP or IFRS. Companies have the option to use either the full cost method or the successful efforts method, depending on their specific circumstances and the accounting standards followed in their jurisdiction.