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The history of diversity in the application of accounting methods in the oil and gas industry is been for decades. This is because of peculiar nature of oil and Gas industry which include high risk, high investment cost, lack of correlation between expenditure size and the value of any resulting reserves especially as regards dry wells and proven wells, taxation, regulation and the expansive use of joint operations.
Between 1960 and 2005, significant things happened at international level regarding accounting standards. It started significantly in 1966, with the proposal to establish an International Study Group comprising the Institute of Chartered Accountants of England & Wales (ICAEW), American Institute of Certified Public Accountants (AICPA) and Canadian Institute of Chartered Accountants (CICA). This was followed by the formation of IASC in 1973 by the professional accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico, Netherlands, United Kingdom and Ireland, and the United States with intent of establishing new international standards capable of rapid acceptance and implementation world-wide. Between 1973 and 2000 the IASC released a series of IAS standards beginning with IAS 1 and ended with IAS 41. The need for an international accounting standard that would provide investors with relevant, reliable, and comparable financial information and global importance of oil was utmost while issuing these standards.
The IASC survived for 27 years, until April, 2001, when the organisation was restructured and the IASC was replaced by IASB. IASB continued promotion and the use of the standards by recognizing the prior IAS rules and further making rules under IFRS. The first IFRS was published in June 2003 (IFRS 1) and 2004 IFRS 6 was released.
This work aimed at critically looking at the reasoning behind the controversial approach surrounding adoption of full-cost and successful effort method from inception to International Financial Reporting Standard 6.
Meaning of Successful and Full-cost Efforts Method
Successful Efforts is a method of accounting for petroleum exploration and development expenditures that permits capitalization of expenditures only on successful projects. It capitalizes the costs to locate, acquire and develop reserves on a field by field basis and generally expensed geological and geophysical costs. On the other hand, full-Cost Method is a method of accounting for petroleum exploration and development expenditures that permits capitalization and amortization of all such expenditures, including that of productive and non productive wells. Here all costs associated with property acquisition, exploration, and development activities are capitalized, geological and geophysical studies, delay rentals, and exploratory dry holes are capitalized.
BACKGROUND TO IFRS 6
The need for a standardised approach to extractive industries accounting was recognised as early as 1905 by Curle. He said
I hope that the time is approaching when the system of standardisation will be extended to mining costs and mining accounts. At the present the methods for each of these are legion, and seem designed to conceal rather than reveal the financial position.... (Curle, 1905: 29, cited in Luther, 1996: 67)
Before 1959, Oil and gas exploration companies relied exclusively on successful efforts accounting, but 1959 Annual Report of Belco Petroleum Company brought the first documented use of the full-cost method [Deakin, 1980]. Since then some companies started adopting full-cost which led to controversy in the USA. Early adoption concentrated in 1963 and 1964 mostly by firms that were experiencing adverse economic conditions [Deakin, 1980]. In 1964, AICPA commissioned a study to investigate the full-cost versus successful efforts issue, the results of which supported the use of the successful efforts method with the issuance of ARS 11 in 1969(Flory & Grossman, 1978; Van Riper, 1994, p. 56).
In 1970, the study was reviewed to narrow alternative practices (Flory & Grossman, 1978, p. 56; Van Riper, 1994) as FC accounting was gaining widespread acceptance. Surprisingly, Financial Accounting Standards Board (FASB) declined to add oil and gas accounting to its agenda when it took over from the AICPA in 1973. These move Van Riper, (1994, p. 56) viewed as an exercise of "caution, or even wisdom."
The 1973 world oil crisis led to the enactment of the Energy Policy and Conservation Act in 1975 by the US government, which stipulated that standardised accounting practices for the extractive industries be established (R.A.Gallum et al; 2001 p.40). The act also empowered SEC to approve rules in oil and gas accounting. This resulted in issuance of SFAS No.19 in 1977 which recommended the SE method by December 1978. But in August 1978, ASR 253 was released and it allowed a new standard of using either full-cost or successful method. This actually led to different accounting methods and the controversy of today.
In 1979, the FASB proposed successful efforts as a single method of accounting for oil and gas pre-production costs (Cortese et al., 2008). But the full-cost proponents argued vigorously for the retention of both methods, stressing the importance of the full-cost method to the continuation and growth of US oil and gas exploration companies (Van Riper, 1994). As a result, Ad Hoc Committee on Full-Costing was formed by industry constituents. Congressional leaders were targeted by companies and lobby groups, and many on the receiving end commented that they had "never seen such aggressive lobbying in their Washington careers" (Gorton, 1991, p. 30 cited in Van Riper, 1994, p. 64). Lev (1979) argues that few, if any proposal for change in accounting has generated the level of controversy and reaction among stakeholders and interested parties as did the FASB proposal that the successful effort method be adopted as the mandated method of accounting for O&G companies.
The lobbyists eventually overcame and the proposal was rejected by SEC who instead issued a standard that required extensive disclosures about oil and gas producing activities without mandating any method for disclosure. ([Katz1985, Van Riper, 1994]. On this, Wise and Spear (2000: 30) said that at best it can be described as inadequate and might reasonably be referred to as an outstanding example of accounting flexibility.
The problem continued thereafter that SEC later proposed a new method, the Reserve Recognition Accounting (RRA) under which revenue would be recognised when reserves were discovered versus when they were produced and sold because both methods provides insufficient financial statements. But was replaced by SFAS No.69 by FASB in 1981 when the SEC noticed that RRA was not working. In 1996, SEC issued Reg. S-X 4-10 to mandate extensive disclosure but without mandating a particular method for disclosure (Katz, 1985; Van Riper, 1994).
IFRS 6 HISTORY
IASC in1998 added the extractive industries project aimed at addressing the divergent accounting and disclosure issues in the extractive industries (IASC, 2000a) to its agenda and eventually proposed one method of accounting.
But before the coming of IFRS 6, the IASB project team presented various approaches for addressing the issues. They queried the existing scope exclusions in IAS 16 and IAS 38, how other IAS/IFRS should be applied in the extractive industries, and whether the IASB should develop implementation guidance. The Board later developed an exposure draft that agrees to apply IAS/IFRS for pre-production cost that will remain scoped out of IAS 16, IAS 36, and IAS 38 by having a separate standard for extractive industries.
By 2004, the IASB released IFRS 6, which merely codified existing industry practice of double accounting method. This was with a clog that they have not addressed this issue of FC and SE not that they are agreeing with any method.
Worthy of note is that IFRS 6 is widely recognised as a temporary standard until after a more comprehensive review. IFRS 6 segregates capital expenditures into three categories: Pre exploration that is incurred obtaining the legal rights to explore; Exploration and evaluation and Post exploration development and production costs. But IFRS 6 limits FC accounting to exploration and evaluation activities only thereafter all other cost must be accounted for on a successful efforts type basis.
IFRS 6 in short technically permit successful efforts and full-cost accounting by permitting an accounting policy of either immediately expensing or capitalizing E&E expenditures provided the policy is applied consistently between periods and to similar items and activities associated with finding specific mineral resources. With this, most pre license costs, disaggregation of cost pools and impairment testing upon classification of E&E costs to the development or production phase are expensed. This is referred by some as "modified full cost" approach. The IASB is reviewing IFRS 6 and until that is complete, this is where we are.
IFRS 6 addresses special impairment triggers for E&E assets which are measured in accordance with IAS 36. The implementation of IFRS to allocate costs at field level becomes particularly complex for the issue of impairment because rules regarding impairment require companies to assess historical data for assets in impairment and such data is often times difficult to extract especially for companies without historical cost data to recalculate the cost of individual fields.
As a general rule every cost in full-cost is capitalized, but under the SE method, only proved costs are capitalized.
The key difference between the SE and FC accounting methods is which E&D costs are capitalized or expensed. Under the SE method, only successful E&D costs are capitalized and unsuccessful costs are expensed; while under the FC method both successful and unsuccessful E&D costs are capitalized.
Also, under successful efforts, pre-production costs can only remain capitalized if they relate to the successful discovery and development of a mineral reserve else the cost must be written off. If the project is successful, then the capitalized costs are amortized against the revenue earned from the project.
Under SE, gross acquisition costs are capitalized as unproved property until either proved reserves are found or until the property is abandoned or impaired.
The other basic difference is the size of the costs centres over which costs are accumulated or amortized. Under the SE the costs associated with locating, purchasing, and developing reserves are capitalized on a field-by-field basis while full-cost is based on the aggregation of fields around geographic cost centres mainly a country or region.
Under the FC method, the firm capitalizes all E&D costs and amortizes the resulting asset over the expected useful lives of the wells in the cost centre. Under the SE method, the firm initially capitalizes all E&D costs and amortizes the resulting asset over the expected useful lives of the wells in the specific oil field.
Another difference is that SE expenses geological and geophysical cost while FC capitalizes it.
ARGUMENT FOR AND AGAINST SUCCESSFUL -EFFORT AND FULL-COST
The literatures on accounting for O&G are divided on which method is appropriate for O&G companies. The successful efforts method is arguably consistent with accounting principles of matching convention because cost will be amortized against generated revenue (Cortese et al. (2008:2) (Ramakrishnan and Thomas, 1992). But with exploration uncertainty the income streams and asset balances of entities reporting under the successful efforts method can fluctuate significantly (Editorial, 1986 Frazier & Ingersoll, 1986). SE is argued to pose significant problems for smaller companies because losses absorption from unsuccessful ventures is low.
Under FC, the pre-production costs are carried forward indefinitely and then matched against revenue derived from successful ventures therefore an income smoothing effect results (Flory & Grossman, 1978: [Ingersoll, 1986], [IASC, 2000a and b). Here larger companies naturally receive a relatively smaller smoothing impact because of their size. But those against full-cost suggested that SE method will increase the volatility of earning over time as against the smoother earnings series resulting from FC method.
In supporting that SE is more conservative than FC, Ayres and Rayburn (1991)(Bandyopadhyay 1994)) found that SE method has a higher coefficient on the earning change variable than the FC when the annual security return is regressed against the annual earning change and the supplementary reserve information for both SE and FC firms. However, Bryant (2003, pp. 22) using a within-firm design suggested that, "over a long period of time the FC method is more value relevant than the SE and provides the most useful book value of equity and earnings numbers for investors."
The supporters of FC like (Sunder 1976) posit that in periods of increased exploration activity/risk, FC accounting leads to higher earnings levels, lower earnings variance, and more favourable return-on-assets and debt-equity ratios than does SE accounting while SE accounting will experience a deterioration in reported profits and retained earnings, and an increase in the variance of earnings. FC firms also exhibit significant increases in capital expenditures and debt financing when compared to SE firms.
Some said that the use of property, wells, fields and/or reservoir as cost centres under the SE method guide against inefficiencies and highlights the risk of exploration and development operation while the use of country and/or region as cost centres under FC method would underplay the risk of operation and cover inefficiencies.
FC produces more meaningful financial statements which based on the fact that unsuccessful expenditures are a necessary and unavoidable part of discovering those assets.
SE method is consistent with the IASB conceptual framework's definition of an asset and in line with other accounting principles, like accounting for Research and Development (IAS 38), which says that research should meet the definition of an asset only if it is directly related to any particular product with future economic benefits.
SE method also reduces the agency problem of information asymmetry by providing more detailed information on wells and fields. Though FC keep detail record like SE because of management, tax and regulatory requirements, but the information is not provided to investors/shareholders and some other users of financial statement (Wright and Gallun 2008: 228).
Those for FC accounting feared that the resultant damaging effects on FC firms' financial statements will hinder access to capital markets, and ultimately lead to exploration and competition reduction. They argued that the adoption of SE would substantially depress the earnings and equity figures of the FC companies (Collins and Dent, 1979).
Given that the major aim of financial accounting statements is to provide the users with useful information that help in decision-making, an appropriate accounting method should recognise the risks and returns of exploration and production. Katz (1985) argued that the SE method better portrays the risks and returns by recognising the discovery/non-discovery of reserve therefore assist shareholders in their decision making whereas capitalisation of both productive and non-productive costs under the FC obscures the risk of unsuccessful efforts from users of financial statement, hence the return demanded by the investors might not be commensurate with the actual risk of investment.
In line with Katz, Baker (1976) argues that the SE method provides a reasonable view of the risk, therefore leads to a more conservative reporting and prudent operation. For capitalizing all cost, FC companies are more aggressive in explorations (Deakin, 1979; Dhaliwal, 1980; Lilien Pastena, 1982) thereby experience a relatively high percentage of unsuccessful wells and cost, therefore more highly levered than SE firms (Johnson and Ramanan, 1988: 96-97; Bandyopadhyay, 1994).
The capitalisation of the cost of drilling productive well and expending cost of non-productive exploratory well under SE is in line with the definition of asset and other accounting principles. It is consistent with the matching and conservative principles, hence it provides more adequate and value relevant information. Furthermore, it provide better information to users of financial statement and give the investors the opportunity to demand returns commensurate to their risk since it highlights the risk as well as the efficiency of operation . In addition, the SE method reduces the agency problem of information asymmetry by providing more detailed information on property, wells, fields or reservoir in a cost centre.
SE is more conservative than FC because it has a higher coefficient on the earning change variable than the FC and also it uses a more prudent operation.
On the other hand, it increases volatility of earnings and therefore very unstable for accounting purposes and it is potentially dangerous. With SE there will be deterioration in reported profits and retained earnings and equity figures. SE also poses problems for smaller companies because of loss absorption. The conservative treatment by the SE will guide against the book value of assets growing beyond the value of underlying O&G reserve as against FC.
On the other hand, FC is used to improve the appearance of financial statements because unsuccessful expenditures are a necessary and unavoidable part of discovering. For smaller companies with limited sources of finance, strict debt covenants, and aggressive exploration programs, the full cost method represents an opportunity to expand and develop.
Also, with FC there is income smoothing especially for smaller companies. FC method is more value relevant than the SE over a long period and provides the most useful book value of equity and earnings numbers. Periods of increased exploration activity/risk, FC accounting leads to higher earnings levels, lower earnings variance, and more favourable return-on-assets and debt-equity ratios than does SE accounting. FC firms exhibit significant increases in capital expenditures and debt financing. Because FC capitalizes everything, it takes more financial risk and exploration expenditures. FC method leads to more aggressive in explorations and enhances competition which is very ideal in extractive industries. By allowing SE alone, the big companies will pursue the smaller ones out of business because they can absorb losses more than the smaller companies.
This work has discussed in briefs the history of IASC/IAS, IASB/IFRS in general, and in specific the history of FC and SE accounting method as well as the IFR6. It focussed on the controversy surrounding these two main methods of accounting for pre-production activities in the extractive industries. It showed how extractive industries economic strength and lobbying arguably influenced SEC who then thwarted the efforts of the FASB to limit accounting method to SE and how IFRS 6 technically codified existing industry practice of using both methods.
It is the considered view that FC is better than SE following the undermentioned points. It is true that SE favours matching convention, but with exploration uncertainty the income streams and asset balances of entities reporting can fluctuate significantly. Also, with SE smaller companies will hardly come up. SE also increases volatility of earnings and therefore very unstable for accounting purposes and potentially dangerous. SE though more conservative, FC is more value relevant than SE over time as it provides the most useful book value of equity and earnings numbers for investors.
The argument that SE is consistent with the IASB conceptual framework's definition of an asset and in line with other accounting principles does not hold waters because FC came into being because of the uniqueness of oil and gas exploration. Also the argument that SE method reduces the agency problem of information asymmetry is not proven anywhere from our research.
On the other hand, FC produces more meaningful financial statements. Also, with FC there is income smoothing especially for smaller companies. FC method is more value relevant than the SE over a long period. FC takes more financial risk by exploring than successful efforts and this is first step to success in oil and gas industry. When you don't risk explorations, result will not come.
FC method enhances competition. By allowing SE alone, the big companies will pursue the smaller ones out of business because they can absorb losses more than the smaller companies. FC companies are more aggressive in explorations thereby experience a relatively high percentage of unsuccessful wells and cost, therefore represents an opportunity to expand and develop.
FC accounting leads to higher earnings levels, lower earnings variance, and more favourable return-on-assets and debt-equity ratios than SE accounting.
Because of the foregoing reasons, FC is adjudged by this work to be a better accounting method for oil and gas exploration.