OIL AND GAS ASSET IMPAIRMENT BY FULL COST AND SUCCESSFUL EFFORTS FIRMS

Petroleum Accounting and Financial Management Journal, Fall 2004 by Al-Jabr, Yahya, Spear, Nasser

This study provides empirical evidence on reported write-downs associated with asset impairment by oil and gas firms during the sample period 1995-2001. During this sample period, full cost (FC) firms were required to test their oil and gas assets for potential impairment according to the ceiling test rules outlined in Regulation SX 4-10. Successful efforts (SE) firms, on the other hand, were required to test for potential impairment according to the rules outlined in SFAS 121. While FC firms have been required to test for asset impairment and recognize write-downs since 1978, SE firms were not formally required to do so until 1995 when SFAS 121 became effective. The presence of divergent asset impairment rules for FC vis-à-vis SE firms during our sample period may result in magnitude and frequency differences in reported write-downs. Our study aims to provide evidence on the reported magnitude and frequency of write-downs associated with asset impairment by FC and SE firms. We also provide evidence on the impact of write-downs on key financial and operating variables for both groups of firms.

Background

In the oil and gas industry, firms may follow either the SE accounting method according to SFAS No. 19, "Financial Accounting and Reporting by Oil and Gas Producing Companies", or the FC accounting method according to Accounting Series Release (ASR) No. 258, "Oil and Gas Producers-Full Cost Accounting Practices".1 The main differences between these two methods relate to the way they account for exploration costs and the way they account for impairment of oil and gas assets. The SE accounting method expenses exploration costs associated with unsuccessful wells and capitalizes only those related to successful (i.e., commercially viable) exploration. On the other hand, the FC accounting method capitalizes exploration costs associated with both successful and unsuccessful wells. The capitalized costs are then written off against future income.2 On average, SE accounting methods relative to FC accounting methods result in more conservative accounting numbers for total assets and net earnings.

Although FC firms are permitted to capitalize unsuccessful exploration costs and include them in their oil and gas assets, the SEC places a ceiling on the total costs FC firms can capitalize. Since 1978, the SEC has required FC firms under ASR 258 (Regulation SX 4-10) to perform a stringent quarterly impairment test, called the ceiling test. This test ensures that the capitalized costs for a cost center, defined as a country, do not exceed the cost center ceiling. The amount of the cost center ceiling is the sum of: (1) the present value of future net revenue from proved reserves, discounted at a uniform rate of 10% and based on end of quarter oil and gas prices and costs; plus (2) the cost of properties not being amortized; plus (3) the lower of cost or market of unproved properties being amortized; less (4) the lax effects associated with differences between the book and tax basis of properties. If the cost center's capitalized costs exceed the cost center's ceiling, the excess is written down, and an ordinary loss equal to that excess is recognized.

On the other hand, SE firms were encouraged but not formally required to adopt the SEC ceiling test rules. However, since 1995, SE firms are required to apply SFAS 121 to test whether a long-lived asset such as proved oil and gas reserves has been impaired when events or changes in circumstances suggest "the carrying amount of an asset may not be recoverable" (paragraph 4).3 Such events in the oil and gas industry may include significant decreases in oil and gas prices or significant increases in costs (see Gallun, Wright, Nichols and Stevenson, 2001). The existence of such events triggers the impairment process under SFAS 121.4 The impairment process under SFAS 121 starts by requiring SE firms to screen for impairment by comparing the carrying amount of an asset to the undiscounted future net revenue associated with the asset. If the undiscounted future net revenue is less than the carrying amount of the asset, the asset is considered to be impaired and an impairment loss must be recognized. The impairment loss is measured as the excess of the asset's carrying amount over the asset's fair value. The fair value of the asset is measured by the market value. If the asset's market price is not available, alternative methods such as the discounted future net revenue that the asset is expected to generate could be used to determine the fair value. In calculating future net revenue, SE firms apply future oil and gas prices as well as future costs.5

Ceiling Test Impairment Rules vs. SFAS121 Impairment Rules

While neither set of impairment rules allows the reinstatement of a write-down once recorded, the ceiling test is generally considered more stringent than SFAS 121 for several reasons. First, the ceiling test must be performed every quarter as opposed to testing for impairment only when events warrant it under SFAS 121. As a result of this difference, a temporary oil and gas price decline may force, at interim dates, FC firms (but not SE firms) to record an impairment write-down. Second, while the ceiling test must be performed using discounted net revenue, SFAS 121 screens for impairment using undiscounted net revenue. Third, the ceiling test must be performed using end-of-quarter oil and gas prices whereas SFAS 121 is applied using future oil and gas prices. The use of discounted net revenue based on "depressed" end-of-quarter oil and gas prices, as opposed to undiscounted net revenue based on future prices, will produce a smaller cost center ceiling which in turn could increase the likelihood of incurring more and/or bigger ceiling test write-downs. Fourth, another difference between the ceiling test and SFAS 121 relates to the use of different types of reserves when determining future net revenue. Gallun et al. (2001) indicate that under the ceiling test, future net revenue includes net revenue related to proved reserves only. However, under SFAS 121, future net revenue may include net revenue related to probable and possible reserves in addition to those related to proved reserves.6 Gallun and Nichols (1997) report that 24% and 6% of the SE firms surveyed in 1997 included net revenue of probable and possible reserves respectively in the calculation of their future net revenue under SFAS 121. Excluding net revenue associated with probable and possible reserves from the calculation of future net revenue under the ceiling test will produce a smaller cost center ceiling which in turn could contribute to more frequent and/or larger ceiling test write-downs.