ACCOUNTING FOR OIL AND GAS RESERVES: Implications for Investors

By Ejiroghene Elizabeth Agbude

Ejiroghene is an Accounting and Finance professional with interest in tax, corporate governance and policy analysis.

 (Professional contacts only: grandejiro@hotmail.com)

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Accounting regulatory bodies usually formulate industry specific standards when an industry has peculiar characteristics e.g. accounting for banks and non-bank financial institutions. The oil and gas industry is one of such industries that has specific accounting standards, this can be attributed to its peculiarity in terms of huge capital requirements, earnings volatility, regulation, type of business ownerships, taxation, non-correlation between the amount of investment made and returns obtained (Wright & Gallun, et al., 2008) and high sensitivity to risk like price risk and foreign exchange risk.

Up until 2012 when the International Financial Reporting Standard (IFRS) was adopted by exploration companies in Nigeria, Nigerian companies in the upstream sector prepared their financial statements in line with the Statement of Accounting Standard 14 (Accounting in the Petroleum Industry: Upstream Activities) and SAS 17 (Accounting in the Petroleum) formulated by the Nigerian Accounting Standard Board.

By its adoption of IFRS, Nigeria joined over 100 countries who either use or have adopted the accounting guidelines as stipulated by the International Accounting Standard Board (IASB). This will ensure harmony and easy comparison of financial statements, this is particularly useful in the oil and gas industry considering that it is one of the most global industries. The adoption of a common accounting framework also widens access to investment opportunities.

IFRS 6 (Exploration for and Evaluation of Mineral Resources) touches on issues that are unique to the extractive industry, other standards relevant to the oil and gas are IAS 16 (Property, Plant and Equipment), IAS 31 (Interests in Joint Ventures), IAS 36 (Impairment of Assets) and IAS 38 (Intangible Assets).

IFRS 6 applies to expenditures incurred by an entity in connection with the search for mineral resources. The standard divides upstream activities into two groups namely exploration & evaluation activities and development activities. The standard under paragraph 9 discusses exploration and evaluation activities. Examples of expenditures that can be categorized as exploration and evaluation according to paragraph 9 are acquisition of right to explore, topographical, geological, geochemical and geophysical studies, exploratory drilling, trenching, sampling costs, costs incurred in trying to evaluate the technical feasibility and commercial viability of extracting resource. These cost are capitalized and classified as tangible or intangible. (IFRS, 2011). Developing activities involves developing the results from extractive activities. This usually requires huge amount and paragraph 10 of IFRS 6 states that these expenditures should be categorized as intangible assets and treated as per the guideline provided in IAS 38 (Intangible Assets).

Accounting for the upstream sector is quite controversial, and companies may choose from either the successful efforts method or full cost method.

Successful efforts is a method of accounting for petroleum exploration and development expenditures that permits capitalization of expenditures only on successful projects while expenditures on unsuccessful wells are expensed. A drilling effort is classified as successful if it results in the extraction of economically recoverable oil and gas and classified as unsuccessful if it results in a dry hole.

On the other hand, the full cost method allows for the capitalization and amortization of all exploration and development expenditures i.e. both successful and unsuccessful efforts.

The main difference between the two accounting methods is that only costs on proven wells are capitalized in the successful efforts method while every cost is capitalized under the full-cost method.

Accounting professionals and literatures are divided on which of the methods best reflects true and fair value. Ayres and Rayburn (1991) argue that the successful effort method is more conservative and is consistent with the matching concept in that capitalized expenditure will be amortized against generated revenue. It is also consistent with IASB definition of assets as “a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity” and with consistent with IAS 38 (Research and Development) which stipulates that research should meet the definition of an asset only if it is directly related to any particular product with future economic benefits. However, supporters of the full cost method argue that consistency with accounting principles is not relevant because the full cost method came into existence due to the uniqueness of oil and gas exploration. They added that the full cost method produces more realistic financial statements because unsuccessful expenditures are a necessary and unavoidable part of discovering assets.

It is also argued that the successful efforts method is more informative. It allows users of the financial statements to get a clear picture of the efficiency of operation and gives them the opportunity to request for returns which is commensurate to their risk. However, the full cost method provides a net effect result thus masking inefficient operations. Investors are therefore left with limited information under the full cost method.

Proponents of the full cost method suggest that it promotes competition which is necessary for the industry growth. Bigger companies are more likely to absorb losses better than smaller companies, therefore, allowing only the successful efforts method will pursue smaller companies out of business. The fact that all expenditures can be capitalized under the full cost method encourages smaller companies to be more aggressive in their exploration which is necessary for discovering more viable wells and for expansion. However, the resultant increase in risk appetite may spell doom for the company if not well managed. A study by Cortese et al (2008) suggests that smaller companies tend to favour the use of full cost method.

Implications for analysts and Investors.

The choice of accounting method has some implications which analysts and investors should put into consideration when evaluating an exploration & production company or when comparing companies that do not use the same accounting method.

Firstly, investors must realise that financial statements are historical in nature and regardless of the method choice, the accounts might not reflect the current reality of the company’s financial state especially its reserves. Companies that use the successful efforts method (especially companies with high success rate) are more likely to report on the balance sheet a value of reserve that is far lower than the actual economic value of the reserves. On the other hand, companies that use full cost method are more likely to report on the balance sheet a value of reserves that is closer to the economic value of the reserves.

Companies that use successful efforts method immediately post to the income statement, as expenses, all expenditures on dry holes thus reducing the profit figure. However, companies that use the full cost method capitalize all exploration expenditures regardless of its success thus they are likely to present a higher profit figure.

Companies sometimes employ the impact of the accounting method choice on profit as a tax planning tool. Companies that seek to reduce their taxable expenses will prefer to use the successful effort method because expenses from dry holes will be posted to the income statement thus reducing taxable profit. On the other hand, companies that want to report high profit figures will prefer to use the full cost method. Capitalizing all the expenditures incurred will overcapitalize an entity and defer recording of expenses so that companies register excess income in their first years (Endale, 2011). This partly explains why smaller companies tend to favour the use of full cost method. Reporting high profit figures puts them in a better position to negotiate with investors.

Investors should always apply a bit of scepticism when reading or analysing any financial statements because more often than not the board tend to magnify the positives and play down on the negatives. This is particularly true with the full cost accounting method where expenditures from both successful and unsuccessful efforts are combined. With the full cost method there is a likelihood that details of some non-viable and risky investments would be masked by the profitable investments. Financial statements prepared with the successful effort method are more prone to earnings volatility than that prepared with the full cost method. Thus investors should always ask questions and not assume that everything is as it is presented.

The choice of accounting method depends on a company’s philosophies, its motives etc. The onus therefore lies on investors to combine the knowledge of the impact of accounting method choice on the financial statement with other quantitative and qualitative investment appraisal tools to determine the worthiness of prospective and current investments.