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Chapter10: Property, Plant, and Equipment and Intangible Assets: Acquisition and Disposition

Appendix 10: Oil and Gas Accounting

Chapter 1 characterized the establishment of accounting and reporting standards as a political process. Standards, particularly changes in standards, can have significant differential effects on companies, investors and creditors, and other interest groups. The FASB must consider potential economic consequences of a change in an accounting standard or the introduction of a new standard. The history of oil and gas accounting provides a good example of this political process and the effect of possible adverse economic consequences on the standard-setting process.

   There are two generally accepted methods that companies can use to account for oil and gas exploration costs. The successful efforts method requires that exploration costs that are known not to have resulted in the discovery of oil or gas be included as expense in the period the expenditures are made. requires that exploration costs that are known not to have resulted in the discovery of oil or gas (sometimes referred to as dry holes) be included as expenses in the period the expenditures are made. The alternative, the full-cost method allows costs incurred in searching for oil and gas within a large geographical area to be capitalized as assets and expensed in the future as oil and gas from the successful wells are removed from that area., allows costs incurred in searching for oil and gas within a large geographical area to be capitalized as assets and expensed in the future as oil and gas from the successful wells are removed from that area. Both of these methods are widely used. Illustration 10A-1 compares the two alternatives.

ILLUSTRATION 10A-1

Oil and Gas Accounting

The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells drilled in 2011 in west Texas. Eight of the 10 wells were dry holes.

   The accounting treatment of the $20 million in total exploration costs will vary significantly depending on the accounting method used. The summary journal entries using each of the alternative methods are as follows:

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   Using the full-cost method, Shannon would capitalize the entire $20 million which is expensed as oil from the two successful wells is depleted. On the other hand, using the successful efforts method, the cost of the unsuccessful wells is expensed in 2011, and only the $4 million cost related to the successful wells is capitalized and expensed in future periods as the oil is depleted.

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   In 1977 the FASB attempted to establish uniformity in the accounting treatment of oil and gas exploration costs. A standard was issued requiring all companies to use the successful efforts method.31

   This Standard met with criticism from the oil and gas companies that were required to switch from full cost to successful efforts accounting. These companies felt that the switch would seriously depress their reported income over time. As a result, they argued, their ability to raise capital in the securities markets would be inhibited, which would result in a cutback of new exploration. The fear that the standard would cause domestic companies to significantly reduce oil and gas exploration and thus increase our dependence on foreign oil was compelling to the U.S. Congress, the SEC, and the Department of Energy.

   Extensive pressure from Congress, the SEC, and affected companies forced the FASB to rescind the Standard. Presently, oil and gas companies can use either the successful efforts or full-cost method to account for oil and gas exploration costs. Of course, the method used must be disclosed. For example, Graphic 10A-1 shows how Chevron Corp. disclosed its use of the successful efforts method in a note to recent financial statements.

Many feared that the requirement to switch to successful efforts accounting would cause a significant cutback in the exploration for new oil and gas in the United States.

GRAPHIC 10A-1

Oil and Gas Accounting Disclosure—Chevron Corp.

Real World Financials

Properties, Plant and Equipment

The successful efforts method is used for crude oil and gas exploration and production activities.

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