What Is a Full-Cost Method?
The full-cost method is a type of accounting used specifically with companies — usually oil and gas manufacturers — that have exploration costs as part of their operating expenses. Regardless of whether the exploration is successful, the full-cost method dictates that all projects are considered capital. After oil or gas is produced by successful exploration, then any associated costs are amortized by the profit of the production and the amount finally is considered an expense. When this is used instead of other accounting methods used with oil and gas exploration, the net income typically looks higher.
Companies that mine or drill for oil and gas incur expenses known as exploration fees. These fees are associated with getting the equipment, securing land to drill or mine, the expense of using the machines and hiring operators, and any other fees for getting the oil or gas. Regardless of the amount of money companies use for exploration, there can be unsuccessful ventures that yield little or no oil or gas.
When a company is unsuccessful in its exploration, the amount normally is written into the company ledgers as an expense. This is not so with the full-cost method. With this accounting method, both successful and unsuccessful explorations are written in as capital. Other accounting methods only include capitalization for successful projects, which decreases the total amount of capitalization funds.
While the expenses are capitalized, they are not forgotten. It is rare for a company to have a long string of unsuccessful projects that yield no oil or gas and, when a successful exploration occurs, the capitalized expenses are dealt with. After the yield is produced and sold to other entities, the profit is applied to the capitalized expenses from the full-cost method. The capitalized expense is altered into a regular expense because of amortization.
Using the full-cost method is perfectly legal and ethical in most areas, but it does have the potential to change a company's net income because of the different reporting methods used by this accounting type. When compared to the other accounting methods used for oil and gas exploration costs, the full-cost method often yields a higher net income, inflating the company. This usually attracts investors who note that the company is making more, even though this company actually may be making less than its competitors. The fact that this can happen means investors normally should check the accounting method used by the company before deciding which one makes the best investment.
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