Full Cost (FC) Method

Full Cost (FC) Method

Full Cost (FC) Method, What Is the Full Cost (FC) Method?

Understanding FC Method in Extractive Industries

The full cost (FC) method is an accounting system tailored for extractive industries like oil and gas companies. In this approach, all exploration operating costs are capitalized, irrespective of success, and then amortized into expenses over time as the total reserves are produced.

Key Takeaways

Full cost (FC) accounting allows companies to capitalize all operating expenses related to locating new oil and gas reserves, regardless of the outcome. Deferring unsuccessful expenses to a future date inflates reported net income (NI) but also makes the company more susceptible to large non-cash charges.

This method is an alternative to the successful efforts (SE) accounting, which only capitalizes expenses related to fruitful extraction ventures. The coexistence of these two methods stems from the ongoing debate about which one transparently reports earnings and cash flow.

Exploring the Cost of Exploration

Oil and gas companies invest significantly in exploring untapped reservoirs without guarantees of success. Costs include acquiring land, obtaining necessary permissions, buying or leasing equipment, transportation, and paying specialist workforce wages.

Typically, unsuccessful exploration costs are recorded as expenses on the income statement. However, the full cost (FC) method takes a different approach by recording all exploration costs, successful or not, on the balance sheet.

FC Method vs. SE Method

The full cost (FC) method and the successful efforts (SE) method represent two contrasting views on how to account for oil and gas exploration expenses. The SE method capitalizes only successful efforts, while the FC method capitalizes all costs related to exploration and writes them off over a full operating cycle.

The SE method emphasizes capitalizing only costs related to successfully locating and developing reserves. In contrast, the FC method argues that all costs incurred in the pursuit of exploration should be capitalized and then expensed over time.

Pros and Cons of the FC Method

Opting for the full cost (FC) method has its benefits and drawbacks. Reporting profit levels may appear elevated until an impairment occurs, making the company more attractive to investors. However, capitalizing unsuccessful exploration costs makes the company more susceptible to large non-cash charges during expected cash flow declines.

It's crucial to note that periodic impairment reviews may increase accounting costs. Investors should be vigilant, recognizing reporting variations and understanding the impact of the chosen accounting method on a company's reported net income (NI) and cash flows.

Accounting Regulatory Divergence

The existence of two accounting methods reflects conflicting views within the industry on transparently reporting earnings. The Financial Accounting Standards Board (FASB) requires the use of the SE method, while the Securities and Exchange Commission (SEC) allows companies to use the full cost (FC) method.

The lack of agreement between these governing bodies means investors must be aware of reporting variations and their associated impacts. The choice between these two accounting methods significantly affects a company's reported NI and cash flows.