Market Effects of the Elimination of Full Cost Accounting in the Oil and Gas Industry

Abstract

o The SEC's new proposal on accounting for exploration efforts in the oil and gas industry undertakes to shift investors' emphasis away from the published income statement toward one that expenses outlays for exploration immediately and treats the estimated value of the resulting discoveries as current revenue. What effect will the SEC's proposal have on those companies, primarily engaged in oil and gas exploration and production, who have traditionally presented their performance to investors in terms of statements based on full cost accounting? The following article, written before the SEC issued its ruling, suggests that the shift in emphasis will have an adverse effect on the way the securities market values the shares of full cost companies, making it substantially more difficult for them to obtain funds in the capital market. A number of academic studies have concluded that elimination of full cost accounting would have little or no adverse effect on full cost firms' equity security prices. When the authors corrected for certain methodological deficiencies in those studies, however, this conclusion was reversed. Price declines during the test periods (centering on the APB's 1971 and FASB's 1977 proposals to eliminate full cost accounting) were much more dramatic for full cost firms. Moreover, the impact on full cost producing companies was greater than the impact on full cost companies. o THE MAJOR ISSUE before the Financial Accounting Standards Board (FASB) in its deliberations on accounting by oil and gas producing companies concerned the choice between full cost and successful efforts methods of accounting for prediscovery costs incurred in finding new oil and gas reserves. A company using full cost accounting capitalizes unproductive exploration and drilling costs from one field and writes them off against future income from productive reserves in another field, thus minimizing the earnings impact of unproductive exploration activity. A company using successful efforts accounting, on the other hand, immediately expenses the exploration and development costs associated with unproductive efforts. The Board's decision-as implemented in its Statement 19-was to require successful efforts accounting for all oil and gas producing companies.' This mandate will have little effect on most of the large, integrated oil and gas producing companies, which already use the successful efforts method of accounting. For many of the smaller oil and gas companies, however, Statement No. 19 will force a change from full cost to successful efforts accounting that will, in most cases, substantially reduce reported equity and earnings. Those opposing the elimination of full cost accounting argue that the resultant damage to full cost firms' financial statements will hinder their access to the capital markets and ultimately reduce exploration and competition in the oil and gas producing industry. Concerned over such possibilities, the Department of Energy (DOE) held public hearings in February of 1978 for the express purpose of collecting evidence on the competitive impact issue. The Securities and Exchange Commission (SEC), prompted by Congressional mandate (via public law 94-163 of the Energy Policy and Conservation Act Daniel Collins, currently Associate Professor of Accounting at Michigan State University, will be joining the faculty at the University of Iowa in January 1979. Warren Dent is Professor of Statistics and Economics at the University of Iowa and consultant to a number of international natural resources firms. Melvin O'Connor is Professor of Accounting at Michigan State University. 1. Footnotes appear at end of article.