INTRODUCTION TO OIL AND GAS ACCOUNTING

Petroleum operations
Today’s oil and gas companies may be involved in four different types of functions or segments:
 Exploration and production (E&P)
 Transportation
 Refining and gas processing
 Marketing and distribution
An integrated oil company is one involved in E&P activities as well as at least one of the other
segments listed above. An independent oil company is one involved primarily in only E&P
activities.
The oil and gas industry is uniquely characterized by
 a high level of risk
 a long time span before a return on investment is received
 a lack of correlation between the magnitude of expenditures and the value of any
resulting reserves
 a high level of regulation
 complex tax rules
 specialized financial accounting rules

These characteristics are most evident in the E&P functions of oil and gas companies.
This subject describes the accounting for transactions relating to the E&P activities of oil and gas
companies.

Exploration and production procedures and processes are essentially the same for any type of oil
and Gas Company. The procedures and steps involved in locating and acquiring mineral
interests, drilling and completing oil and gas wells, and producing and selling petroleum
products are briefly reviewed in this topic. A basic knowledge of these procedures is necessary in
order to understand their accounting implications which are discussed in the following topics.

The objective of oil and gas operations is to find, extract, refine and sell oil and gas, refined
products and related products. It requires substantial capital investment and long lead times to
find and extract the hydrocarbons in challenging environmental conditions with uncertain
outcomes. Exploration, development and production often take place in joint ventures or joint
activities to share the substantial capital costs.

The outputs often need to be transported significant distances through pipelines and tankers; gas
volumes are increasingly liquefied, transported by special carriers and then degasified on arrival
at destination. Gas remains challenging to transport; thus many producers and utilities look for

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long-term contracts to support the infrastructure required to develop a major field, particularly
off-shore.

The industry is exposed significantly to macroeconomic factors such as commodity prices,

currency fluctuations, interest rate risk and political developments. The assessment of
commercial viability and technical feasibility to extract hydrocarbons is complex, and includes a
number of significant variables. The industry can have a significant impact on the environment
consequential to its operations and is often obligated to remediate any resulting damage. Despite
all of these challenges, taxation of oil and gas extractive activity and the resultant profits is a
major source of revenue for many governments. Governments are also increasingly sophisticated
and looking to secure a significant share of any oil and gas produced on their sovereign territory.

ACQUISITION OF MINERAL INTERESTS IN PROPERTY

After an oil company has identified an area with potential, the company will seek to acquire the
right to explore, develop, and produce any minerals that might exist beneath the property, unless
it already holds those rights. This right, along with the right to simply share in proceeds from the
sale of any minerals produced, is referred to as a mineral interest or an economic interest. The
specific type of mineral interest that is owned determines how costs and revenues are shared. The
following section discusses the most common types of mineral interests and the typical methods
of acquiring them.

Mineral rights
In many countries, laws assumes that, for ownership purposes, the surface of a piece of property
can be separated from minerals existing underneath the surface. When a piece of land is
purchased, one may acquire ownership of the surface rights only, the mineral rights only, (or
both rights in few countries). An ownership of both the surface and mineral rights is called a fee
interest.

The surface owner has the right to use the surface in any legal way that the owner deems
appropriate. For example, the surface owner may use the land for farming, ranching, building a
residence, building apartments, etc. Mineral rights (MR) refer to the ownership, conveyed by
deed, of any mineral beneath the surface. If the mineral rights are owned by one party and the
surface is owned by another, the surface owner must allow the mineral rights owner, or his
lessee, access to the surface area that is required to conduct exploration and production
operations. The surface owner is entitled to compensation for any damages that may result from
exploration and production operations.

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Oil and Gas Accounting
Oil and gas accounting, as discussed in this subject, relates to accounting for the four basic costs
incurred by companies with oil and gas exploration and producing activities. These four basic
types of costs are as follows:

 Acquisition costs—costs incurred in acquiring property, i.e., costs incurred in acquiring the
rights to explore, drill, and produce oil and natural gas. Domestically, these rights are
normally acquired by obtaining an oil, gas, and mineral lease.

 Exploration costs—costs incurred in exploring property. Exploration involves identifying

areas that may warrant examination and examining specific areas, including drilling
exploratory wells.

 Development costs—costs incurred in preparing proved reserves for production, i.e., costs
incurred to obtain access to proved reserves and to provide facilities for extracting, treating,
gathering, and storing oil and gas.

 Production costs—costs incurred in lifting the oil and gas to the surface and in gathering,
treating, and storing the oil and gas.

Common Terms
Reservoir. A porous and permeable underground formation containing producible oil or gas that
is confined by impermeable rock or water barriers and is individual and separate from other
reservoirs.
Field. An area consisting of a single reservoir or multiple reservoirs related to the same
geological structural feature. There may be two or more reservoirs in a field, separated by
intervening impermeable sections or geologic barriers. Reservoirs that are in overlapping or
adjacent fields may be treated as a single operational field.
Proved area. The portion of a property at a certain depth to which proved reserves have been
specifically attributed.
Development well. A well drilled within the proved area of an oil or gas reservoir to the depth of
an horizon known to be productive.
Service well. A well drilled for the purpose of supporting production, e.g., a gas injection well, a
water injection well, or a salt-water disposal well.

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Exploratory well. A well drilled to find and produce oil or gas in an unproved area, to find a
new reservoir in a field with another reservoir which is productive, or to extend a known
reservoir.

Oil and gas producing activities. Activities involving the acquisition of mineral interests in
properties, exploration, development, and production of crude oil and natural gas.

Proved properties. Properties with known proved reserves.

Unproved properties. Properties with no proved reserves.

HISTORICAL COST ACCOUNTING METHODS

The four basic types of costs incurred by oil and gas companies in exploration and production
activities must be accounted for using one of two generally accepted historical cost methods:
successful-efforts accounting (SE) or full-cost accounting (FC). In connection with the four
basic costs, the fundamental accounting issue is whether to capitalize or expense the incurred
costs. If capitalized, the costs may be expensed as expiration takes place either through
abandonment (SE only), impairment (SE only), or depletion as reserves are produced. If
expensed as incurred, the costs are treated as period expenses and charged against revenue in the
current period. The primary difference between SE and FC is in whether a cost is capitalized or
expensed when incurred. In other words, the primary difference between the two methods is in
the timing of the expense or loss charge against revenue.

The other basic difference between the two accounting methods is the size of the cost center over
which costs are accumulated and amortized. For SE, the cost center is a lease, field, or reservoir.
In contrast, the cost center under FC is a country. The cost center size has implications in
computing depreciation, depletion, and amortization (DD&A) and also in computing ceiling
write-downs.

Under SE, a direct relationship is thus required between costs incurred and reserves discovered.
Consequently, under SE only successful exploration costs that directly result in the discovery of
proved reserves are considered to be part of the cost of finding oil or gas and are capitalized.
Unsuccessful exploration costs do not result in an asset with future economic benefit and are
therefore expensed.

In contrast, because there is no known way to avoid unsuccessful costs in searching for oil or
gas, FC considers both successful and unsuccessful costs incurred in the search for reserves as a
necessary part of the cost of finding oil or gas. A direct relationship between costs incurred and
reserves discovered is not required under FC. Hence, both successful and unsuccessful costs are
capitalized, even though the unsuccessful costs have no future economic benefit.

Specifically, SE treats exploration costs that do not directly find oil or gas as period expenses
and successful exploration costs as capital expenditures. Under FC, all exploration costs are
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capitalized. Under both methods, acquisition and development costs are capitalized and
production costs are expensed. Although development costs could include an unsuccessful
development well, all development costs are capitalized under SE because the purpose of
development activities is considered to be building a producing system of wells and related
equipment and facilities, rather than searching for oil and gas. Table below shows the accounting
treatment of these costs under SE compared to FC.

Item SE FC
Acquisition costs Capitalize Capitalize
Geological and geophysical costs Expense Capitalize
Exploratory dry hole Expense Capitalize
Exploratory well, successful Capitalize Capitalize
Development dry hole Capitalize Capitalize
Development well, successful Capitalize Capitalize
Production costs Expense Expense
Amortization cost centre Property, field or reservoir Country

The divergent accounting treatment of unsuccessful exploratory drilling costs under SE versus
FC can have a substantial impact on the income statements of exploration and production
companies. A company with a large exploratory drilling program and a normal unsuccessful
drilling rate would, under SE, have a significant amount of dry-hole expense. Those dry-hole
costs would adversely affect the net income of a successful-efforts company. On the other hand,
a full-cost company would capitalize exploratory dry-hole costs, and therefore, these costs would
typically have no immediate effect on net income. They would, however, reduce net income
through future amortization. The adverse effect on net income of expensing exploratory dry-hole
costs under SE may be especially significant for smaller companies.

The following example illustrates the impact of the FC and SE accounting methods on the
financial statements of Lucky Company.

Lucky Oil Company began operations on March 3, 2015, with the acquisition of a lease in
Tanzania. During the first year, the following costs were incurred, DD&A (depreciation,
depletion, and amortization) taken, and the following revenue was earned.
Geological &Geophysical costs (G&G costs) . . . . $ 30,000
Acquisition costs . . . . . . . . . . . . . . . . . . . . . . . 50,000
Exploratory dry holes . . . . . . . . . . . . . . . . . . . . 1,200,000
Exploratory wells, successful . . . . . . . . . . . . . . 400,000
Development costs . . . . . . . . . . . . . . . . . . . . . . 200,000
Production costs . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
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DD&A expense . . . . . . . . . . . . . . . . . . . . . . . . 40,000 (SE) 90,000 (FC)
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Statement of Profit or Loss

Statement of Financial Statement “extract”

As shown in the example above, the SE method results in a much greater loss than the FC
method: $1,195,000 compared with $15,000. The majority of the $1,180,000 difference is caused
by the different treatment of the G&G costs and dry hole costs; under the SE method the costs
were expensed, while under the FC method, the costs were capitalized. Another difference is the
amount of amortization (DD&A) recognized under each method; under the FC method more
costs were capitalized, resulting in a greater amortization expense.

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Another major impact can be made on the statement of profit or loss of successful-efforts
companies (but not full-cost companies) by the order in which successful versus unsuccessful
wells are drilled.

INTRODUCTION TO SUCCESSFUL-EFFORTS ACCOUNTING

Figure below presents a flow chart overview of the treatment of the four basic costs under SE.
An example follows that gives a brief illustration of typical costs incurred by oil and gas
companies and their treatment under SE. As shown in the flowchart and in the example, gross
acquisition costs are capitalized as unproved property until either proved reserves are found or
until the property is abandoned or impaired. If proved reserves are found, the property is
reclassified from unproved property to proved property. Exploration costs are recorded in two
different ways, depending upon the type of incurred costs. If the costs are non-drilling, they are
expensed as incurred. If the exploration costs are drilling costs, they are capitalized temporarily
as wells in progress until a determination is made whether proved reserves have been found. If
proved reserves are found, the drilling costs are transferred to wells and related equipment and
facilities, and are charged to expense, specifically DD&A expense, as production occurs. If
proved reserves are not found, i.e., a dry hole, the drilling costs are expensed. Development
costs, which include the costs of drilling development wells, are capitalized regardless of
whether or not proved reserves are found. All production costs are expensed as incurred.

The SE method allows a company to capitalize on only those expenses associated with
successfully locating new oil and natural gas reserves. For unsuccessful (or "dry hole") results,
the company charges associated operating costs immediately against revenues for that period.

According to the theory behind the SE method, the ultimate objective of an oil and gas company
is to produce the oil or natural gas from reserves it locates and develops, so the company should
only capitalize on those costs relating to successful efforts. Conversely, because there is no
change in productive assets with unsuccessful results, companies should expense costs incurred
from those efforts.

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INTRODUCTION TO FULL-COST ACCOUNTING
Figure below presents a flow chart overview of the treatment of the four basic costs under FC.
The example used to illustrate SE accounting is also used to illustrate FC accounting. As shown
in the flow chart and in the example, acquisition, exploration, and development costs are
capitalized under the full cost method, regardless of whether the costs result in a discovery of
reserves.
As in SE accounting, gross acquisition costs are placed in an unproved property account and are
moved to a proved property account if proved reserves are found. If the property is abandoned or
impaired, the costs continue to be capitalized but are transferred to an abandoned or impaired

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cost account. All acquisition, exploration, and development costs incurred in each country are
capitalized into one pool, so that theoretically, individual properties lose their identities.
However, companies maintain subsidiary records on individual properties for tax, regulatory, and
management purposes. All production costs are expensed as incurred.

The FC method allows companies to capitalize on all operating expenses related to locating new
oil and gas reserves regardless of the outcome.

The theory behind the FC method holds that, in general, the dominant activity of an oil and gas
company is simply the exploration and development of oil and gas reserves. Therefore,
companies should capitalize all costs they incur in pursuit of that activity and then write them
off over the course of a full operating cycle.

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COMPARISON OF THE SE AND FC METHODS
The effect of choosing one accounting method over another is readily apparent when comparing
the financial results involving the income and cash flow statements. Each method highlights the
individual costs which fall into the categories of acquisition, exploration, development and
production differently. Such a comparison also demonstrates the impact on periodic results
caused by differing levels of capitalized assets under the two accounting methods (Vitalone,
2020).

As the financial results of a manufacturing company are impacted by depreciation expense for
plant, property and equipment (“PP&E”), so too are the financial results of an oil and gas
company affected by periodic charges in regard to depreciation, depletion and amortization
(“DD&A”).

One of the primary differences between the SE and FC accounting methods is the manner by
which costs for unsuccessful wells are accounted for. Under the SE method, the costs for an
unsuccessful exploratory well is expensed immediately upon the determination that the well will
not produce. Under the FC accounting method, the costs are capitalized and then amortized over
the estimated life of the company’s oil and gas reserves.

Using the example of the unsuccessful exploratory well, the company using the SE method will
expense a higher amount of costs in the earlier life of a field compared to a company using the
FC method. This will result in the SE company reporting lower net income when compared to
the FC Company.

The FC Company, on the other hand, will amortize and recognize the costs of the unsuccessful
wells later into the life of the field. This is because the FC method amortizes the costs of the
unsuccessful well over a longer period (i.e. the expected life of the company’s reserves). As a
result, the FC Company reports a higher net income earlier in the life of the field than does the
SE company.

A second difference between the SE and FC accounting method is how costs are accounted for in
regard to exploratory costs and the costs of carrying unproved properties. These costs, which
include geological and geophysical survey costs, are expensed immediately under the SE
accounting method which directly impacts the income statement. Under the FC method, such
costs are capitalized and amortized over the estimated life of the company’s reserves.

A third difference between the two methods is the published guidance provided by governing
accounting organizations. For example, the Financial Accounting Standards Board (FASB)
issues guidance in the Accounting Standards Codification (“ASC”) for generally-accepted
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accounting principles (“GAAP”). While the ASC provides guidance to oil and gas exploration
companies in regard to the SE method of accounting, it does not provide such guidance in
respect of the FC method (Financial Accounting Standards Board). The SEC, on the other hand,
does provide guidance on accounting using the FC method (Securities and Exchange
Commission, 2011) however they allow publicly traded companies to choose either the full cost
or successful efforts method of accounting.

Proponents of the FC method believe that it stimulates investment, especially for smaller
companies. This is because the FC method allows those companies to report financial statements
which offer a more favorable view of their income and financial position due to the capitalization
(rather than expense) of costs associated with unsuccessful exploration activities. In this way, the
company’s costs per barrel oil equivalent (“BOE”) are reduced. The cost per BOE is a key
financial metric used by investors when evaluating a company’s profitability. Under the SE
method, the BOE metric is more variable due to accounting for the costs associated with
unsuccessful exploration activities as an expense in the applicable period.

The SE method, on the other hand, results in a more conservative approach as the costs
associated with unsuccessful activities are expensed as incurred. Furthermore, supporters of the
SE method believe that it more directly portrays the relationship between exploration and
production. This is because only those costs which are expected to provide an economic benefit
in the future are capitalized. By capitalizing only those costs associated with successful efforts,
the company’s assets will only reflect those that relate to future cash flow.

Proponents of the SE method argue that the capitalization of unsuccessful efforts under the FC
method leads to an over-statement of the company’s asset valuation as it recognizes the cost of
assets which provide no future economic benefit.

A fundamental concept of accounting is the matching principles. The matching principle requires
a company to report an expense on its income statement in the period in which the related
revenues were earned. Defenders of the SE method argue that it more closely follows the
matching principle as it only classifies those costs associated with a future economic benefit as
an asset. As a result, the asset base reported by the company more accurately matches the
company’s cost base to economic performance.

An additional argument in support of the SE method is that it is less prone to manipulation than
the FC method for the purpose of misstating company performance. Under the FC method,
executive and management could influence the profit reported for a company thereby increasing
their performance-based compensation (Cooper, 1979).

Supporters believe that the SE method provides a better measurement of assets on the balance
sheet than does the FC method.

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Defenders of the FC method, on the other hand, argue that dry wells are a necessary cost
incurred to find productive wells and, therefore, should be recognized as a long- term asset on
the balance sheet.

There is a strong argument to be made that the capitalization of unsuccessful costs violates the
matching principle as, in the future, these costs will not support the economic benefits.
According to Baker, it is difficult to understand how the costs of a formally abandoned property
can provide a future benefit. As the costs of dry holes do not provide any future benefit, these
costs are losses and should not be postponed (Baker, 1976).

Critics of the FC method believe that it inflates a company’s current earnings as the unsuccessful
costs are capitalized. As a result, it is difficult for an investor to determine the success of a
company’s drilling efforts.

Supporters of the FC method argue that using the SE method does not represent an accurate
depiction of the economic reality of the petroleum industry (Dyckman, 1979). This is because a
large amount of costs are expensed under the SE method and the asset base is minimized. As a
result, the earnings for a company would vary significantly from period to period making it less
attractive to investors (Pruett, 2003). As a primary activity of petroleum companies is to search
for oil and gas, there is an expectation that some efforts will be unsuccessful. In accordance with
this view, it would be unreasonable to not include all of the costs associated with locating
reserves in the company’s asset base.

Test your understanding

Given the following costs for River oil Company, all incurred during 2018,
Acquisition costs . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
G&G costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Exploratory dry holes . . . . . . . . . . . . . . . . . . . 1,500,000
Successful exploratory holes . . . . . . . . . . . . . . . 350,000
Development wells, dry . . . . . . . . . . . . . . . . . . 200,000
Development wells, successful . . . . . . . . . . . . . 475,000
Cost of production facilities . . . . . . . . . . . . . . . 250,000
Production costs . . . . . . . . . . . . . . . . . . . . . . . . 60,000
DD&A* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 (SE) 125,000 (FC)
Accumulated DD&A . . . . . . . . . . . . . . . . . . . . 150,000 (SE) 360,000 (FC)
Revenue from sale of oil . . . . . . . . . . . . . . . . . . 225,000
* Depreciation, depletion and amortization

Required
Show how the above transactions would be reported in the financial statements of River Oil
Company for the year ended 2018.

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