Oil and Gas Audit Guide: Full Cost vs Successful Efforts, the Ceiling Test and Reserves

An oil and gas producer's balance sheet is mostly one asset: capitalized exploration, development and acquisition costs. How those costs are capitalized, depleted and tested for impairment depends on the method the entity elected, and the method is a policy choice with large consequences for earnings. Auditing this client means understanding the method first, then the reserve estimates that feed depletion and impairment.

The two methods

Both methods are acceptable under US GAAP. Regulation S-X Rule 4-10 sets the full cost rules for SEC registrants and requires successful efforts reporters to follow FASB ASC Topic 932, Extractive Activities, Oil and Gas (Rule 4-10(b)).

Successful efforts. Costs are capitalized when they lead to reserves and expensed when they do not. An exploratory well that does not find reserves is written off, and successful efforts properties are tested for impairment under ASC 360 and ASC 932.

Full cost. Acquisition, exploration and development costs are capitalized into a cost center, whether or not they find reserves. Under Rule 4-10(c):

• Cost centers are established on a country-by-country basis (c)(1).
• Capitalized internal costs must be directly identifiable with acquisition, exploration and development and cannot include production or general overhead (c)(2).
• Amortization uses the unit-of-production method on proved reserves. The base includes capitalized costs, estimated future development costs for proved reserves, and estimated dismantlement and abandonment costs net of salvage (c)(3).
• Costs of unproved properties may be excluded from amortization until proved reserves can be assigned or impairment occurs, and they must be assessed at least annually for impairment (c)(3)(ii).
• Production costs are expensed as incurred, including workovers that only maintain or increase production from an existing completion interval (c)(5).
• Sales are adjustments to capitalized cost with no gain or loss, unless the sale significantly alters the relationship between capitalized costs and proved reserves. A significant alteration is not ordinarily expected for sales of less than 25 percent of the reserve quantities of a cost center (c)(6)(i).

A change from one method to the other is an accounting change governed by ASC 250, so the file needs the analysis and the retrospective application.

The full cost ceiling test

Capitalized costs, less accumulated amortization and related deferred taxes, cannot exceed the cost center ceiling (Rule 4-10(c)(4)). The ceiling is:

• The present value of estimated future net revenues from proved reserves, at the prices defined in (c)(8) less estimated future development and production costs, using a discount factor of ten percent and assuming continuation of existing economic conditions;
• plus the cost of properties not being amortized;
• plus the lower of cost or estimated fair value of unproven properties being amortized;
• less the income tax effects of book and tax basis differences on those properties.

Current price is the unweighted average of the first-day-of-the-month prices for the 12 months before the end of the reporting period, unless contracts define the price (c)(8). Any excess of capitalized cost over the ceiling is charged to expense in the period it occurs, and the write-down is not reversed later (c)(4)(ii).

SEC staff guidance in SAB Topic 12 adds three points the auditor should test:

• Subsequent events. Reserves proved after year end on properties held at year end can show the costs were not impaired, but the disclosure must still explain why no charge was taken. Acquisitions after year end do not avoid a year-end write-down.
• Hedges. Qualifying cash flow hedges under ASC 815 are reflected through hedge-adjusted prices for the hedged reserves, with disclosure, and hedges entered into after year end cannot be used to avoid a write-down.
• Asset retirement obligations. Cash outflows for obligations already accrued are excluded from the ceiling's future net revenue so they are not counted twice, while the capitalized retirement cost stays in the asset base.

Revenue and other accounting areas

• Revenue. Oil and gas sales are recognized under ASC 606 when control transfers to the purchaser, which tracks delivery at the custody transfer point. Review the sales contracts for pricing, quality and location differentials, and for gas processing and gathering arrangements where principal versus agent matters.
• Joint interest billing. Operators bill partners for their share of costs, and non-operators receive those bills. Test the operator's allocation to the working interest owners and the non-operator's acceptance of charges.
• Imbalances. Over and under-delivered gas between owners.
• Asset retirement obligations. Plugging and abandonment liabilities depend on well count, cost estimates and timing. See our guide to asset retirement obligations.

Risk areas

• Reserve estimates that drive depletion, impairment and the ceiling test, prepared by engineers, some of whom are employees.
• Method application: capitalization of costs that belong in expense.
• Unproved property impairment judgments.
• Completeness of retirement obligations.
• Revenue cutoff on production and imbalances.
• Going concern for highly leveraged producers. See going concern under AU-C 570.

Audit procedures

1. Obtain the reserve report and evaluate the engineer's competence, objectivity and the data given to them. Treat the engineer as management's specialist.
2. Test the reserve inputs. Production history, prices, operating costs, capital costs and ownership interests. Compare to actual results and to the prior report.
3. Recompute depletion on the unit-of-production method using the reserve quantities and the correct cost base.
4. Recompute the ceiling test under full cost, or test impairment under successful efforts, using the price rules above.
5. Test capitalization. Vouch additions to AFEs, invoices and joint interest billings, and challenge whether each item is an exploration, development or production cost.
6. Review suspended exploratory wells under successful efforts and evaluate whether the well found reserves and whether sufficient progress is being made.
7. Test revenue with production reports, purchaser statements and cash receipts, and test imbalance balances.
8. Test the retirement obligation estimate against well inventory and recent plugging costs.
9. Review disclosures. Supplemental reserve information, capitalized cost tables and the disclosures required by Rule 4-10(c)(7), as they apply to the entity.

Worked example

A full cost producer has one cost center (illustrative numbers). Net capitalized costs after accumulated amortization and related deferred taxes total $48,000,000.

• Present value of proved future net revenues, discounted at 10 percent using the 12-month average price: $41,000,000.
• Unevaluated properties excluded from amortization: $3,000,000.
• Ceiling: $41,000,000 + $3,000,000 = $44,000,000 (before income tax effects, assumed nil here).
• Excess: $48,000,000 less $44,000,000 = $4,000,000 impairment, expensed in the period.

After year end, prices rise and the engineer's updated estimate would have produced a $46,000,000 ceiling. The auditor does not reduce the write-down. Rule 4-10(c)(4) measures the ceiling at the balance sheet date with the 12-month average price ending on that date, so the later price rise does not change the year-end result. The write-down is not reinstated in later periods.

PBC items

• Third-party reserve report and the data package given to the engineer.
• Price deck and the 12-month first-of-month price support.
• Depletion calculation and ceiling test or impairment workpaper.
• Capitalized cost rollforward and AFE listing.
• Joint interest billing statements and operating agreements.
• Purchaser statements and production reports.
• Retirement obligation schedule with well inventory.
• Lender credit agreement and borrowing base notices.

Red flags

• Reserve revisions that arrive late and just clear a covenant.
• Ceiling test performed on current spot prices rather than the 12-month average.
• Production costs capitalized as development.
• Retirement obligations that have not changed despite more wells.

Frequently asked questions

Which method is required?

Neither. Full cost capitalizes all costs in a cost center and tests them against a ceiling. Successful efforts expenses unsuccessful exploration and tests impairment under ASC 360 and ASC 932.

Can a ceiling write-down be reversed?

No. Under Rule 4-10(c)(4)(ii), written-off amounts are not reinstated in later periods.

Does the ceiling test use spot prices?

No. It uses the unweighted 12-month average of first-day-of-the-month prices, unless contracts define prices.

Sources

• 17 CFR 210.4-10, Financial accounting and reporting for oil and gas producing activities, law.cornell.edu/cfr/text/17/210.4-10
• SEC, Staff Accounting Bulletin Topic 12 (SAB 106), Oil and Gas Producing Activities, sec.gov/interps/account/sab106.htm
• PwC Viewpoint, SAB Topic 12, Oil and gas producing activities, viewpoint.pwc.com
• FASB ASC Topic 932, Extractive Activities, Oil and Gas (as referenced in Rule 4-10(b))

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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error