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ACCOUNTING FOR EXPLORATION COSTS

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ACCOUNTING FOR EXPLORATION COSTS
Principles and procedures used in accounting for exploration costs are examined in this
chapter. General financial accounting principles are covered first, followed by details of
control systems, recording procedures, and special accounting problem areas.
These discussions assume that successful efforts is the chosen accounting method.
Except for costs of exploratory wells, all exploration costs are correctly charged to
expense as incurred. Full cost companies must capitalize their exploration costs.
However, the accounting systems and procedures employed by both types of oil and
gas companies are nearly identical.
GENERAL TREATMENT OF EXPLORATION COSTS
Exploration costs incurred in geological and geophysical (G&G) activities include the
following: costs of topographical, geological and geophysical studies; rights of access
to properties to conduct those studies (commonly referred to as shooting rights); and
salaries and expenses of geologists, geophysical crews, or others conducting studies.
Exploration costs also include the expenses of carrying and retaining undeveloped
properties, drilling and equipping exploratory wells, making dry hole and bottom-hole
contributions, and drilling exploratory-type stratigraphic test wells.
Under the successful efforts method, exploration costs are expensed when incurred.
The only exceptions are those costs for exploratory wells, including exploratory-type
stratigraphic test wells. Exploratory well costs are initially capitalized as work in
progress until the outcome is known. At that time, exploratory wells that do not find
proved reserves are charged to expense, while successful exploratory wells are
capitalized.
Special rules determine the proper treatment of costs of exploratory wells in progress or
wells for which drilling has been completed, but the existence of proved reserves
remains uncertain. These special rules are discussed more fully in Chapter 9.
Under the full cost method, all exploration costs are capitalized as part of the oil and
gas assets in the cost pool.
The following case illustrates the financial accounting treatment of exploration costs.
Assume that a broad exploratory study is undertaken by an E&P company at a cost of
$150,000. As a result of the reconnaissance survey, two areas of interest are
designated as Area A and Area B. Before attempting to acquire acreage, the company
conducts detailed surveys on the areas. Survey costs are $20,000 for Area A and
$10,000 for Area B. Exploration activities reveal little likelihood of oil or gas in Area B,
and the area is abandoned. However, results for Area A are positive, and two leases
are acquired. One contains 320 acres and the other encompasses 480 acres. The
company uses successful efforts accounting and charges all costs to current expense
as noted in the following entry:

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GENERAL TAX TREATMENT OF EXPLORATION COSTS
Current tax laws treat exploration costs differently than GAAP. Exploration costs for
tax purposes do not include carrying costs, test well contributions, drilling of exploratory
wells, or drilling of exploratory-type stratigraphic test wells.
According to the IRS, G&G expenditures are essentially capital in nature and are not
immediately deductible. Recent tax law changes require such costs incurred after
August 8, 2005, to be amortized over 24 months. Costs paid or incurred after May 17,
2006, by major integrated oil companies, as defined in I.R.C. §167(h)(5), are amortized
over a period of five years. G&G that is part of a broad reconnaissance-type survey to
find smaller areas of interest must be allocated equally to each area of interest found. If
no area of interest is found, the costs are classified as expenses in the year such a
determination is made.
Reconnaissance survey costs allocated to an area of interest, along with the cost of any
detailed survey on that area, are capitalized to any leases acquired in the area. If no
leases are acquired in the area of interest, the accumulated costs are charged to
expense in the year the area is abandoned. If more than one lease is acquired in an
area of interest, the deferred charges are allocated among the leases in proportion to
the acreage in each lease.
Costs applicable to projects and areas of interest include an allocable portion of
overhead, which should be applied on a logical and consistent basis. Capitalized
exploration costs, together with lease acquisition charges (such as bonuses), become
the leasehold cost for federal income tax purposes.
RECORDKEEPING PROCEDURES
The accounting system is designed to capture exploration costs for an E&P company’s
financial statements. However, it must also furnish data to meet other business needs.
Exploration focuses on specific projects undertaken to locate structures favorable to
hydrocarbons. Management must know the cost of each project in order to determine its
ultimate profitability.
Development of a budget for exploration is dependent on accounting system
information.
Cost control depends on an adequate accounting and reporting system. Regulatory
agencies, such as the Department of Energy, impose specific requirements on how data
is classified and accumulated.
Treatment of various costs for federal income taxes differs from financial reporting
purposes, and these differences require additional detailed records.
Frequently, detailed historical cost records are required for legal and contractual
purposes.
Obviously, accounting and record-keeping procedures must be designed to serve a
number of persons and users. No single system serves the needs of all E&P
companies; however, the procedures discussed in the following pages are typical in the
industry.

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