Full cost method definition
/What is the Full Cost Method?
The full cost method is a cost accounting method used in the oil and gas industry. Under this method, all property acquisition, exploration, and development costs are aggregated and capitalized into a country-wide cost pool. This capitalization occurs whether or not a well is deemed successful.
These costs are then charged to expense using the unit-of-production system, based on proven oil and gas reserves. If the stream of expected cash flows from a project is expected to decline, either due to a reduction in estimated reserves or a decline in the market price of the commodity in question, then the full cost pool associated with that project may be impaired. If so, the amount of the impairment is charged to expense at once.
The reasoning behind this more aggressive accounting technique is that some unsuccessful efforts will inevitably be needed in order to discover reserves.
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Problems with the Full Cost Method
The full cost method presents several notable problems, which are as follows:
Overstated assets. Because all costs are capitalized, the balance sheet may include expenditures that provide no future economic benefit (from unsuccessful wells). This can lead to inflated asset values and misrepresent the true profitability of operations.
Delayed expense recognition. Costs are not immediately expensed unless the entire cost pool is impaired. This deferral can distort the timing of expenses and mislead stakeholders about a company’s operational efficiency and financial performance in the short term.
Less sensitivity to exploration risk. By treating failed explorations as capitalized costs, companies using the full cost method may appear more financially stable than those using the successful efforts method, which expends such costs. This reduces comparability between firms and masks the economic risks of exploration.
Infrequent impairment tests. The full cost method requires impairment testing only when net capitalized costs exceed a ceiling based on estimated future revenues. This "ceiling test" may delay recognition of asset impairments, allowing declines in asset value to go unreported for extended periods.
Distorted earnings. When successful wells are developed, profits may appear disproportionately high because earlier exploration costs—including failed attempts—are averaged across the entire cost pool, diluting their impact on current expenses.
These issues make the full cost method less transparent and potentially misleading to investors and analysts seeking a clear view of a company's financial health and operational success.
The Successful Efforts Method
A more conservative approach is the successful efforts method, under which exploration costs are only capitalized if a well is deemed successful. If a well is not considered successful, then the related costs are charged to expense. It is less likely that the successful efforts method will result in large non-cash charges, since the capitalized costs that could be subject to impairment are smaller than under the full cost method.
Neither of these methods capitalize the costs of corporate overhead or ongoing production activities.