Success or Full: Cost Accounting Challenges in the Petroleum Industry
Introduction
Corporations are allowed to utilize either a ‘full-cost’ or a ‘successful effort’ method to treat their operating expenses about intangible and tangible exploration cost, and, as a result, could observe significant differences in their periodic net income and cash flow. Due to this reason, the investors become confused in making the evaluation and comparison between the companies, according to the level of their earnings. It is also indicated by a study that the flow of cash is like the preferred way to measure financial performance regardless of the used accounting method (Misund, 2017).
The framework of the IFRS makes many successful efforts that may prove more compatible. The transaction under the GAAP that is adopted previously for the transaction from full-cost accounting to the efforts that are successful is included with the relief in a transaction according to IFRS 1. Successful efforts are identified by the IFRS for the methods in which one of the widely accepted methods is by the companies of oil and gas (Misund, 2017).
ADNOC Company can be taken as an example; the Abu Dhabi National Oil Company provides its financial base report on the method that is successful. The IFRS regulations are followed by the company to provide its financial report. The company is also using the cost basis historically as per IFRS for assets valuation (ADNOC, 2015).
Literature Review
The debate over the measure of cost-accounting utilized in oil & gas exploration industry is a prolonged and well-documented one. Lev (1969) in his work ‘Accounting and Information Theory,’ proposed the concept of loss of information in accounting reports. Downes and Dyckman, (1973) in their work ‘A Critical Look at the Efficient Market Empirical Research Literature as it Relates to Accounting Information’ objected to the hypothesis that accounting change can bring a positive capital flow in the industry, without any change in the underlying economic circumstances.
Norr (1974) supported the argument of unreasonable smoothening of operating income, while based on statistical observations and Norr (1974) and Wagner (1975) established that over 80% of exploration expenditure carried on balance sheet eventually turned into operating losses.
Analysis
Norr, (1974) and Babich, (1975) of opinion that the cost of dry holes should not be matched against the revenues from the drilled holes with hydrocarbon resources, however, the point to be considered here is the fact that the enterprise and effort as to risk the drilling of dry holes eventually gives rise to the holes producing required resource resulting in revenues. Accordingly, it should be a natural adjustment to allow this expenditure to be expensed over a period, rather than in the immediate one.
There is another paper that examined the relevant value of the accounting method that is used for exploration and development of gas and oil firms. On the contrary, this study may find the method of the full cost that may prove more valuable as well as relevant to other methods (Bryant, 2003). Another study eliminates fully in the process to eliminate the cost accounting in the industry of petroleum (Collins & Dent, 1979).
Bakaer (1976) correctly emphasizes the futility of this method at a smaller business level. As long as the method could be employed by all the players, irrespective of their size, financial competitiveness could not be forced upon a particular segment of the industry.
Full cost accounting permits the capitalization of tangible exploration costs of proven successes as well as failures. For the investor who is willing to ascertain the current value of reserves processed by the company, this could be a misleading indicator as it involves the cost of efforts which will not be fruitful in future. Similarly, the resultant number cannot be a fair value indicator of net realizable value, as upon the divestment of firm’s assets such costs would be excluded from the valuation calculations. Here it can be stated that it is statistically unlikely that the deferred costs will bear for exploration will bear an exact relationship with the value of the discovery of reserves of hydrocarbon. Similarly, his rebuttal to the manipulation of accounting principles to accommodate political requirements is well justified (Bakaer, 1976).
On the other hand, it is well argued that an accounting shock based on adherence to the full-cost method is not justified. It does not accompany any real change in the economic circumstances and, thus, misleads the capital market participants. It also violates the principles underpinning the governance of modern economy and capital markets.
In contrast to what Norr, (1974) and Babich, (1975) opined, it also seems reasonable not to allow the deferral of expenditure which is not expected to bring any future benefit.
Irrespective of the method employed, all the costs are expensed at any point of time; accordingly, the inexact procedure of reserve estimation is equally expected to influence the valuation under both the methods. However, what naturally follows is the timing difference impact and resultant tax allocation being higher for companies of full cost.
Eskew (1975) work highlights the reduction in investor utility due to the higher information cost involved in the translation of data from the full-cost method. It is corroborated by the fact that there exists a lower correlation between the number of accounting is generated under the method of full cost and the market generated numbers, in comparison with the successful efforts’ method.
On the other hand, it seems reasonable and fair to see a financial metric as an asset only if it provides a discernible future benefit. Bakaer (1976) thus correctly highlights the significance of the successful efforts’ method. Similarly, this method also adheres to the word and intent of FASB statement 2, which requires immediate expensing of research & development costs uncertain to bring future benefits. The immediate expense of unsuccessful exploration cost is a validation of FASB’s arguments. Apart from that, it satisfies the conservatism maxim of accounting by delaying the recognition of benefit and immediately expensing the cost.
Wagner (1975) observed that about 80 percent of exploration effort fails to discover commercially viable quantities is a logical proponent of the successful effort method in the sense that under full-cost method about 80% of capitalized costs would eventually be capitalized losses.
A study indicated that reporting performance of the oil and gas companies is very multidimensional, with the flow of cash, reserves, changing, earning and show different performance aspects of the firms. The discoveries and cash flow are identified like a better way to measure performance, however, the overstatement of the flow of cash as well as the figures of earnings due to the adoption of the method of the full-cost in the complex situation (Cormier & Magnan, 2002).
Finally, based on Eskew (1975) observation that method of successful efforts with the risk of congruent evaluation of petroleum companies in the security market, it could be concluded that favorable accounting method is the one which reflects the economic realities rationally and is cost-effective in the sense that it does not incur the information cost.
Summary
Bakaer (1976) has given the arguments showing the futility of ‘Full-Cost’ accounting method in comparison with the ‘Successful Efforts’ method in the oil & gas exploration industry. The author’s view is supported by various studies as shown in the case that has proved the proposition of the loss of information in accounting. His opposition to the argument which change of accounting without changes underlying in the circumstances of economic may motivate the will positive capital flow into an industry, is supported by the work of research conducted by researchers in this area. The studies have supported the argument of unreasonable smoothening of operating income, while some studies highlighted the excess carrying of operating losses on the balance sheet. Thus, the case, in summary, highlights the favoring arguments, its weak foundations, the opposing argument, and their solid foundation for the full-cost accounting method.
Recommendation and Conclusion
It has been duly established that the primary purpose of accounting in general and cost-accounting, in particular, is to provide correct estimates to the stakeholders to facilitate decision making and resultant resource allocation. Seen in this context and the background of oil & gas exploration industry, it could be opined that the cost-accounting method so utilized should be the one which takes into consideration all the factors about the present and future, as well as the basic economic and accounting principles.
Accordingly, the requirement is the culmination of present practices in a unique method which is based on the best practices, thereby overcoming current limitations and removing the confusion that arises due to differential cost accounting treatment. While it is important to match expenditure to its source of revenue, it is also vital to ensure that a rational method exists to distribute unsuccessful cost. This requirement assumes significance for oil & gas exploration, as the implications of the numbers so reported are far-reaching.
References:
ADNOC. (2015). Publications. Retrieved May 26, 2018, from https://www.adnoc.ae/en/news-and-media/publications?page=2
Babich, G. (1975). The Application of Information Theory to Accounting Reports: An Appraisal. Abacus, 172-181.
Bakaer, R. C. (1976). Defects in Full-Cost Accounting in the Petroleum Industry. Abacus, 152-158.
Bryant, L. (2003). Relative Value Relevance of the Successful Efforts and Full Cost Accounting Methods in the Oil and Gas Industry. Review of Accounting Studies, 8(1), 5-28.
Collins, D. W., & Dent, W. T. (1979). The proposed elimination of full cost accounting in the extractive petroleum industry: An empirical assessment of the market consequences. Journal of Accounting and Economics, 1(19), 3-44.
Cormier, D., & Magnan, M. (2002). Performance reporting by oil and gas firms: contractual and value implications. Journal of International Accounting, Auditing and Taxation, 131-153.
Downes, D., & Dyckman, T. R. (1973). A Critical Look at the Efficient Market Empirical Research Literature as it Relates to Accounting Information. Accounting Review, 312-313.
Eskew, R. K. (1975). An Examination of the Association between Accounting and Share Price Data in the Extractive Petroleum Industry. Accounting Review, 50(2), 316-324.
Lev, B. (1969). Studies in Accounting Research. In Accounting and Information Theory. American Accounting Association.
Misund, B. (2017). Accounting method choice and market valuation in the extractive industries. Cogent Economics & Finance, 1-14.
Norr, D. (1974). Accounting Theory Illustrated. New York: First Manhatten Co.
Wagner, F. J. (1975). North American Drilling Activity in 1974. American Association of Petroleum Geologists Bulletin.
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