Companies involved in the exploration and development of crude oil and natural gas have the

option of choosing between two accounting approaches: the "successful efforts" (SE) method
and the "full cost" (FC) method. These differ in the treatment of specific operating expenses
relating to the exploration of new oil and natural gas reserves.
The accounting method that a company chooses affects how its net income and cash
flow numbers are reported. Therefore, when analyzing companies involved in the exploration
and development of oil and natural gas, the accounting method used by such companies is an
important consideration.
Two Approaches
SUCCESSFUL-EFFORT METHOD
"A method of accounting for oil and gas exploration and development activities whereby
exploration expenditure which is either general in nature or relates to unsuccessful drilling
operations is written off. Only costs which relate directly to the discovery and development of
specific commercial oil and gas reserves are capitalised, and are depreciated over the lives of
these reserves. The success or failure of each exploration effort is judged on a well-by-well basis
as each potentially hydrocarbon-bearing structure is identified and tested."
Exploration costs capitalized under either method are recorded on the balance sheet as part of
long-term assets. This is because like the lathes, presses and other machinery used by a
manufacturing concern, oil and natural gas reserves are considered productive assets for an oil
and gas company; Generally Accepted Accounting Principles (GAAP) require that the costs to
acquire those assets be charged against revenues as the assets are used.
FULL COST
On the other hand, the view represented by the FC method holds that, in general, the dominant
activity of an oil and gas company is simply the exploration and development of oil and gas
reserves. Therefore, all costs incurred in pursuit of that activity should first be capitalized and
then written off over the course of a full operating cycle.
As a result, full cost companies accrue higher PP&E balances and therefore have higher
Depreciation numbers thats why the DD&A (Depreciation, Depletion & Amortization) number
for the full cost method is higher.
Successful Efforts: Lower Operating Income, Net Income, and PP&E
Full Cost: Higher Operating Income, Net Income, and PP&E
Discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using
the concepts of the time value of money. All future cash flows are estimated and discounted to
give their present values (PVs)the sum of all future cash flows, both incoming and outgoing, is
the net present value (NPV), which is taken as the value or price of the cash flows in question.
Present value may also be expressed as a number of years' purchase of the future undiscounted
annual cash flows expected to arise.

NET WORTH = total assets - total outside liabilities
NET PRESENT VALUE = Total asset- accumulated depreciation
The SEC cited three primary reasons for favoring the development of RRA:
1. Historical cost accounting fails to provide sufficient information on
financial position and operating results for oil and gas producers.
2. Additional information, outside the basic financial statements, is required
to permit assessments of the financial position and operating
results of an enterprise in the oil and gas industry and to allow comparisons
between it and other enterprises.
3. An accounting method based on valuation of oil and gas reserves is
needed to provide sufficiently useful information.


RRA
The valuation nmethod required for RRA was as follows:

1. Estimate the timing of future production of proven reserves, based on current (that is, balance
sheet date) economic conditions.
2. Estimate future revenue by using the estimate from (1) and applying current prices for oil and
gas, adjusted only for fixed contractual escalations.
3. Estimate future net revenue by deducting from the estimate in (2) the costs to develop and
produce the proven reserveson the basis of current cost levels.
4. Determine the present value of future net revenue by discounting the estimate in (3) at 10
percent.



As might be expected, RRA received significant criticism from the oil and gas industry. Most of
the criticism was based on concepts discussed in SFAC Nos. 1 and 2, which, although not in
place at that time, had been disseminated for public comment. Some questioned the relevance of
the information because it represented a relatively objective and uniform approach but did not
produce fair market value of an enterprises oil and gas properties. RRA considered only proven
reserves rather than total reserves; therefore, significant quantities could be ignored.
Moreover , it did not anticipate future price and cost changes and thus assumed that changes in
costs would result in similar changes in prices. This assumption is not necessarily true for oil and
gas operations where the price of oil and gas is significantly influenced by the actions of the
Organization of Petroleum Exporting Countries and supply and demand, while costs are
influenced more by local inflationary conditions. The selection of a discount rate of 10 percent
was nothing more than an arbitrary decision to force rigid uniformity and did not consider any of
the enterprise-specific factors, such as risk, that enter into the determination
of an appropriate discount rate.

Proven reserves are those reserves claimed to have a reasonable certainty (normally at least 90%
confidence) of being recoverable under existing economic and political conditions, with existing
technology. Industry specialists refer to this as P90 (i.e., having a 90% certainty of being produced).
Proven reserves are also known in the industry as 1P
.