What it means
Exploration is a numbers game in which most wells fail and a few pay for everything. The full-cost method treats the whole search as a single cost of finding the reserves that were eventually found, so every dollar spent goes into one capitalised pool.
That pool is then depleted using the units-of-production approach. A rate per barrel is calculated by dividing the pool by total proved reserves, and the charge for the period is that rate multiplied by the volume actually produced.
The alternative, successful efforts, capitalises only the costs of wells that found commercial quantities and expenses the rest immediately. The two methods eventually recognise the same total cost, but the timing differs enormously, which changes reported profit, asset values and the ratios that lenders and investors watch.
Full cost tends to produce smoother, higher early profits and a larger balance sheet, so it is more common among smaller exploration companies where a single dry hole could otherwise wipe out a year's earnings. Larger producers more often use successful efforts, which many analysts regard as the more conservative presentation.
The safeguard on full cost is the ceiling test. At each reporting date the capitalised pool must be compared with the estimated value of the reserves it relates to, and any excess written off immediately, which is why full-cost companies can report sudden large impairments when commodity prices fall.
In practice
Real-world examples.
Example
A newly listed exploration company drills six wells, of which two are commercial. It adopts the full-cost method so that the four failures do not obliterate its first reported profit, and discloses the policy prominently in its accounts.
Example
An established producer using successful efforts writes off $15,000,000 of unsuccessful drilling in a single quarter. Analysts comparing it with a full-cost peer adjust both sets of figures before drawing conclusions about relative performance.
Example
A lender reviewing a full-cost borrower's covenant compliance recalculates earnings on a successful efforts basis. The exercise reveals that the covenant headroom depends heavily on the accounting policy rather than on cash generation.
Formula
Calculation
Depletion Rate per Unit = Capitalised Cost Pool / Total Proved Reserves
Depletion Charge = Depletion Rate x Units Produced in the Period
A small producer has capitalised $60,000,000 of exploration and development costs, including $15,000,000 spent on wells that found nothing. Independent engineers certify proved reserves of 12,000,000 barrels, and the company produces 800,000 barrels during the year.
Depletion rate = $60,000,000 / 12,000,000 = $5.00 per barrel.
Depletion charge = 800,000 x $5.00 = $4,000,000.
Under the successful efforts method the $15,000,000 of dry hole costs would have been expensed at once, leaving a pool of $45,000,000, a rate of $45,000,000 / 12,000,000 = $3.75 per barrel and a depletion charge of 800,000 x $3.75 = $3,000,000. Total charges to profit would then be $3,000,000 + $15,000,000 = $18,000,000, against $4,000,000 under full cost, a $14,000,000 difference in reported profit for the same physical activity.Case study
Seen in the real world.
The following is an illustrative and fictional case. Braewater Energy, an invented small oil producer, capitalised $60,000,000 of exploration and development spending under the full-cost method, of which $15,000,000 related to wells that were plugged and abandoned.
With proved reserves of 12,000,000 barrels, the depletion rate was $5.00 per barrel, and production of 800,000 barrels generated a charge of $4,000,000. A competitor of similar size using successful efforts reported an $18,000,000 charge for comparable activity, and Braewater's shares traded at a visible premium on the strength of the earnings difference.
Two years later a fall in prices pushed Braewater's capitalised pool above the ceiling test limit and the company wrote off a large slice of it in one quarter. The illustrative lesson is that the full-cost method defers rather than avoids the cost, and the deferral can arrive all at once.
Watch out
Common mistakes.
- Comparing a full-cost company's profits directly with a successful efforts peer, when the accounting policy alone can account for most of the difference.
- Reading a large capitalised pool as evidence of valuable assets, when the ceiling test may not yet have caught up with lower commodity prices.
- Assuming the method changes total lifetime cost, when it only changes the timing of when that cost hits the income statement.
Questions
People also ask.
Which companies use the full-cost method?
It is used mainly in oil, gas and other extractive industries, and more often by smaller explorers whose results would otherwise swing wildly with each unsuccessful well.
What is the ceiling test?
It is a periodic comparison of the capitalised cost pool against the estimated value of the related reserves, with any excess written off immediately as an impairment.
Is full cost less conservative than successful efforts?
Generally yes, because it defers the cost of failed exploration into future periods rather than recognising it when the failure occurs.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related