Impairment of Oil and Gas Properties; Is a Ceiling Test Needed for Successful Efforts Companies?

The accounting profession is devoting considerable attention to the financial reporting problems of the impairment of long-lived assets. Because of inconsistencies in practice and lack of authoritative guidance, in December 1990 the Financial Accounting Standards Board issued a Discussion Memorandum, Accounting for the Impairment of Long-Lived Assets and Identifiable Intangibles. In view of the profession's concerns about asset impairment, this is an appropriate time to focus on certain measurement, recognitiion and disclosure issues of asset impairment affecting a major sector of the economy--the oil and gas industry. There has been considerable debate whether the full cost or the successful efforts method is the most appropriate accounting treatment for oil and gas companies. Simply stated, the full cost method capitalizes all exploration costs and allocates them over the life of all producing wells. Thus, dry holes are included in the cost of successful wells. The successful efforts method expensed the costs of unsuccessful wells as they are incurred and capitalizes only the costs of successful wells. The successful efforts method is considered more conservative because it results in an early writeoff of unsuccessful exploration costs. Both methods, however, are acceptable and widely used today. This article does not debate which of the two methods is preferable but, rather, describes an inconsistency in the Securities and Exchange Commission requirements governing the reporting of impaired oil and gas properties. This inconsistency stems from the SEC's placing a ceiling on capitalized costs for full cost companies but not for successful efforts companies. This has made it difficult to assess the financial performance of some successful efforts companies, particularly reported net income and asset values. Further, the inconsistency has affected the behavior of some full cost companies in a way the SEC had not anticipated; numerous companies changed from the full cost to the successful efforts method apparently to avoid impairment write-downs. FAST REPORTING REQUIREMENTS One of the problems in accounting for oil and gas companies is the companies make large expenditures on oil and gas properties whose value is very volatile. Thus, significant changes in oil and gas prices can have a dramatic effect on the value of these properties and, in turn, on the value of the companies. The SEC's concern for informing investors about the current value of oil and gas reserves caused the FASB to issue Statement no. 69, Disclosures about Oil and Gas Producing Activities, in 1982. Statement no. 69 requires several supplemental disclosures. These include capitalized costs relating to oil and gas producing properties and the discounted future net cash flows from proved oil and gas reserves, with an indication of changes in this value since the preceding year. In effect, application of this standard recognizes revenue when new proved reserves are found, rather than when they are sold. Statement no. 69 is only for supplemental disclosure. The FASB does not require companies to write down the value of properties below cost based on the result of this disclosure. In theory, generally accepted accounting principles require that when an asset becomes impaired--when the historical carrying cost exceeds its appropriate measure of value--the asset should be written down. How to measure the value of an asset or group of assets appropriately is central to theh issue of impairment. In its asset impairment DM, the FASB identifies five attributes that could be used to measure evidence of impairment. These are current cost, current market value, net realizable value, present value of future cash flows and the sum of future cash flows. For some specific assets such as inventories, restructed loans and marketable equity securities, existing GAAP provides guidance on the measurement attribute to be used in determining the amount to which these assets should be written down. …