Accounting for Exploration & Evaluation Costs. Previously Published on the 5th of September 2011 in BFT Ghana

Ghana Discovers Oil: Accounting for Exploration & Evaluation Costs

Ghana´s recent discovery of oil has prompted many debates especially, concerns about oil revenue management, yet very few of such arguments centers on the accounting arrangements of oil and gas companies. In this edition of my regular publications on typical accounting issues, I aim to examine the accounting treatment for exploration and evaluation expenditure and its impact on the financial statements. Prior to the adoption of IFRS, there was no substantive accounting provision, or better still accounting standard in the Ghana National Accounting Standards that provided guidance on how these should be accounted for. IFRS 6 is the standard that deals with this provision. In fact it is yet another standard that received massive lobbying from oil companies during its development. IFRS 6 addresses the financial reporting for the exploration for and evaluation of mineral resources, including minerals, oil, natural gas, and similar non-regenerative resources. In clear language the standard identifies expenditures to be included in and excluded from exploration and evaluation assets. In doing so, IFRS 6 permits companies the use one of two ways in the recognition of such expenditure namely, successful efforts method or the full cost accounting method. 

Accounting choices under IFRS for exploration and evaluation are a variation on the capitalization and expensing discussion. Although generally many practitioners are in support of the capitalization of ‘investment type’ expenditure, I recommend that investors and other users of the financial statements should scrutinize capitalization and amortization policies related to this expenditure.

An important cost category for both integrated oil companies and their exploration and production counterparts is the cost of oil and gas exploration. Exploration and evaluation expenditures are those costs that are incurred by an entity in connection with the exploration for and evaluation of mineral resources before the technical feasibility and commercial viability of extracting a mineral resource are demonstrated. Mineral resources in this context include minerals, oil, natural gas, and similar non-regenerative resources.

These costs can be categorized into pre-exploration costs, exploration and evaluation (E&E) costs and development costs. In general, all the exploration and evaluation (E&E) costs associated with identifying new reserves are capitalized. However, if the exploration of new reserves turns out to be unsuccessful (dry hole), these so-called dry hole costs can either be expensed as incurred (successful efforts or SE) or capitalized to be amortized over the subsequent periods (full cost or FC).

Both IFRS and US GAAP allow companies to choose between SE and FC for all the E&E costs. However, there are some inherent differences between the two standards in terms of treatment of costs. Whereas IFRS 6 Exploration for and Evaluation of Mineral Resources allows capitalization of exploration and evaluation costs only, US GAAP standard FAS 19 Financial Accounting and Reporting by Oil and Gas Producing Companies allows capitalization of all the costs such as pre-exploration, exploration & evaluation and development costs.

To grasp the full concept of accounting for exploration expenditure, I present differences between the two methods.

Comparing successful efforts and full costs accounting
Successful Efforts	Full Cost
Expense exploration and evaluation costs for unsuccessful wells	Capitalize exploration and evaluation costs for unsuccessful wells
Cannot capitalize General & Administration expense	Capitalize portions of General & Administration expenses
Lower depreciation / amortization expense since dry hole costs are expensed	Higher depreciation / amortization expense as the dry hole costs are capitalized
Results in earnings volatility	Results in smoothed earnings

The main difference between the two methods for exploration and evaluation cost is a variation on the capitalization and subsequent amortization of such costs as opposed to the immediate expensing of certain expenditure. The conceptual basis for capitalization is that certain expenditure such as capital expenditure are expected to generate benefits that exceed one accounting period whereas immediate expenditure is based on the idea that expenditure such as cost of goods sold only generates a benefit in the current accounting period. The overall impact on earnings from the view point of Successful efforts method is that immediate expensing of E&E causes volatility in reported profits but provides sound argument as unsuccessful exploration means no future benefits are expected hence no reason to capitalize such costs. This also limits earnings forecasting using this method. Conversely the full cost method argument holds true as E&E expenditure represents investments with future earnings expectations. The effect of this is that depreciation and amortization are more predictable hence provides a sound forecasting basis for earnings.

Most Oil Companies prefer the Successful Efforts method

A survey of oil companies especially companies with interests in Ghana’s Oil fields indicate that most of them prefer the Successful Efforts method (see table below)

Common Method of Accounting for E&E
Company	Method of Accounting for Exploration Expenditure
Kosmos Energy	Successful Efforts
Shell	Successful Efforts
British Petroleum	Successful Efforts
Statoil	Successful Efforts
Luk Oil	Successful Efforts
Anadarko	Successful Efforts
Vitol	Full Cost
Tullow Oil	Successful Efforts
Soco International	Full Cost
Total Group	Successful Efforts
Source: Notes to Financial Statements

The choice of accounting treatments of exploration and evaluation costs impacts the financial statements and ultimately obscures comparability of firms. The fundamental difference between the two methods lies in how the revenues correspond to the costs of finding reserves. The proponents of full cost accounting argue that the cost of dry holes are an integral part of the overall exploration and evaluation costs to be matched with future revenues, an assumption which exalts the matching principle. Quite contradictorily, those who favor successful efforts accounting defend it as intellectually more robust, by expensing all the costs that are no longer going to be beneficial in future. Undoubtedly these costs could be material in the financial statements of oil giants and hence there is the need to fully understand the impact.

Tullow Oil is a perfect example to illustrate the impact of E&E costs. Extracts from its financial statements indicate that E&E expenditure once written off in a particular accounting period could be as highs as c30% of gross profits. See table below;

Measuring the Impact of E&E costs on earnings of Tullow Oil
All amounts in million US $	2009	2010
Sales revenue	1,089.80	915.9
Cost of sales	(611.4)	(625.5)
Gross profit	478.40	290.40
Exploration costs written off	(154.7)	(82.7)
Intangible exploration and evaluation assets	2,121.60	4,001.20
Total Non-current assets	4,372.80	7,087.30
E&E cost written off as % of Gross Profit	32%	28%
E&E Assets as % of Total Non-current Assets	49%	56%
Source: Annual Report, Own Calculation

A choice of method could strongly impact earnings.

To fully understand the impact of choice of accounting method in measuring E&E expenditure, I use a numerical example to review the implications of applying successful efforts as opposed to the full cost accounting method. Assuming identical revenue and cost structure, a ‘successful efforts’ company will report lower earnings than its ‘full cost’ counterpart. The table below shows that ‘successful efforts’ would yield operating earnings of $100, whereas the ‘full cost’ company will record an operating profit of $370. This is because the ‘successful efforts’ company expenses all the 300 exploration related costs while the ‘full cost’ company amortizes it over a ten-year period. This difference in accounting affects comparability across companies.

Comparing Income under different accounting methods for E&E Costs
All amounts in $	Successful Efforts	Full Cost
Revenue	1,000	1,000
Production and other costs	(500)	(500)
Exploration costs	(300)	0
Depreciation & Amortization	(100)	(130)
Total costs	(900)	(630)
EBIT	100	370
EBITDA	200	500
Source: Own Calculations

The ‘full cost’ method treats the expenditure as investing, whereas under the successful efforts approach companies classify it as operating as it is deducted from EBIT. Note that there is no cash flow impact (see table below)

Comparing Cash Flows under different accounting methods for E&E Costs
	Successful Efforts	Full Cost
EBIT	100	370
Add: Depreciation & Amortization	100	130
Operating cash flow	200	500
Capital expenditure	0	-300
Free cash flow	200	200
Source: Own Calculations

Conclusively, gauging the impact of E&E expenditure on financial statements can be a challenge particularly when comparing firms as a mixed application of either approach is generally permissible as per the accounting standard. I recommend a thorough review of the notes to the financial statements to fully understand the method used in the recognition and measurement of such costs. For tax experts, there need to be clear guidance on the implication of either method.