Two potential methods of accounting for the cost of oil drilling are full cost and successful efforts.
Under the full-cost method, a drilling company capitalizes costs both for successful wells and dry holes. This means it classifies all costs as assets on its balance sheet. A company charges these costs against revenues as it extracts and sells the oil. Under the successful-efforts method, a company expenses the costs of dry holes as they are incurred, resulting in immediate charges against earn ings. Costs of only successful wells are capitalized. Many small and midsized drilling companies use the full-cost method and, as a result, millions of dollars of drilling costs appear as assets on their balance sheets.
The SEC imposes a limit to full-cost accounting. Costs capitalized under this method cannot exceed a ceiling defined as the present value of company reserves. Capitalized costs above the ceiling are expensed. Oil companies, primarily smaller ones, have been successful in prevailing on the SEC to keep the full-cost accounting method as an alternative even though the accounting profession took a position in favor of the successful-efforts method. Because the imposition of the ceiling rule occurred during a time of relatively high oil prices, the companies accepted it, confident that it would have no practical effect on them.
With a subsequent decline in oil prices, many companies found that drilling costs carried as assets on their balance sheets exceeded the sharply lower ceilings. This meant they were faced with write offs. Oil companies, concerned about the effect that big write-offs would have on their ability to con duct business, began a fierce lobbying effort to change SEC accounting rules so as to avoid sizable write-offs that threatened to lower their earnings as well as their equity capital. The SEC staff supported a suspension of the rules because, they maintained, oil prices could rise and because companies would till be required to disclose the difference between the market value and book value of their oilreserves.Theproposalwouldhavetemporarilyrelaxedtherulespendingtheresultsofastudyby the SEC on whether to change or rescind the ceiling test. The proposal would have suspended the requirement to use current prices when computing the ceiling amount in determining whether a write-off of reserves is required. The SEC eventually rejected the proposal that would have enabled 250 of the nation's oil and gas producing companies to postpone write-downs on the declining values of their oil and gas reserves while acknowledging that the impact of the decision could trigger default on bank loans. The SEC chairman said" the rules are not stretchable at a time of stress." Tenneco Co. found a way to cope with the SEC's refusal to sanction postponement of the write-offs. It announced a switch to successful-efforts accounting along with nearly $1 billion in charges against prior years' earnings. In effect, Tenneco would take the unamortized dry-hole drilling costs currently on its balance sheet and apply them against prior years' revenues. These costs would affect prior year results only and would not show up as write-offs against currently reported income.
a. Discuss what conclusions an analyst might derive from the evolution of accounting in the oil and gas industry.
b. Explain the potential effect Tenneco's proposed change in accounting method would have on the reporting of its operating results over the years.