Successful efforts method definition
/What is the Successful Efforts Method?
The successful efforts method is used in the oil and gas industry to account for certain operating expenses. Under the successful efforts method, a company only capitalizes those costs associated with the location of new oil and gas reserves when those reserves have been found. If exploration costs are incurred and no new reserves are found, then the costs are instead charged to expense as incurred. Some costs may be capitalized as wells-in-progress until there is additional information about the existence of future benefits; as soon as the additional information becomes available, these costs can either be charged to expense (if there are no future benefits) or reclassified as a fixed asset (if there are future benefits). In the latter case, these costs are amortized as production occurs, so that expenses offset revenues.
The successful efforts method is a conservative approach to oil and gas accounting, since it mandates immediate charges to expense when a "dry hole" is drilled. By doing so, expense recognition is accelerated, leaving the smallest amount of expenditures recorded as assets on the balance sheet. Also, since fewer expenses are capitalized, there is less risk that a large amount of capitalized assets will be suddenly charged to expense due to the impairment of a firm's oil and gas reserves.
Treatment of Exploratory Dry Holes
An essential accounting issue is that exploratory dry holes are charged to expense, while development dry holes are capitalized. Since this distinction can have a profound effect on the financial statements, you should carefully classify each well prior to the commencement of drilling.
Example of the Successful Efforts Method
Colorado Oil & Gas conducts exploratory drilling in two separate locations. Well A cost $2 million to drill and evaluate, resulting in proven oil reserves. Well B cost $1.5 million to drill and evaluate, resulting in no commercially viable reserves. Under the successful efforts method, the $2 million cost associated with Well A is capitalized as an asset, and will be depreciated over time as the oil is extracted and sold. Conversely, the $1.5 million cost of Well B is charged to expense immediately.
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FAQs
How does the successful efforts method differ from the full cost method?
Under the successful efforts method, costs related to unsuccessful exploration activities are expensed as incurred, while only costs associated with successful discoveries are capitalized. Under the full cost method, most exploration costs are capitalized regardless of whether they result in proved reserves. As a result, the successful efforts method produces more earnings volatility but more conservative asset values.