You Go Your Way, I’ll Go Mine – Why Accounting Methods Matter. (No, Seriously, You Gotta Read This)

As E&Ps release a flood of year-end results, investors, analysts and industry observers scrutinize annual reports to compare the performance of upstream oil and gas companies. Yet, despite operating in the same shale basins, drilling similar wells and facing the same commodity price environment, some producers report markedly different financial results that are often not driven by geology, operational execution or management strategy. Instead, they stem from accounting methodology, specifically from whether a company uses the Full Cost (FC) or Successful Efforts (SE) method to account for its oil and gas properties. In today’s RBN blog, we explain why this seemingly mundane topic really matters.

Reading about accounting methods may not seem super exciting, but it’s not that much different than filing taxes. Every spring, millions of us sit down with our W-2s and yet two households earning almost identical money can report far different taxable income because of accounting rules — exactly what happens with upstream oil and gas companies, too. These rules are essential to understanding how oil and gas producers are doing financially and otherwise.

So, here it goes. Although the FC and SE approaches are permitted under U.S. Generally Accepted Accounting Principles (GAAP), they reflect fundamentally different philosophies about how exploration successes and failures should be recognized in financial statements. These differences influence reported earnings, asset values, depreciation and depletion rates, impairment behavior and, ultimately, how companies are perceived by the market. For decades, FC and SE accounting methodologies were viewed largely through the lens of conventional exploration. In that Pre-Shale Era, dry holes were common, exploration risk was high, and accounting methodology played a major role in determining financial results. FC tended to smooth results by spreading failures across large cost pools, while SE forced companies to recognize losses immediately.

The rise of large-scale shale development changed that dynamic. Modern shale drilling is more repeatable, more data-driven, and far less exposed to traditional exploration risk. As a result, many market participants assume that the differences between FC and SE have become less relevant. That assumption is only partly correct. While shale has reduced the importance of classic dry-hole risk, it has not eliminated the economic and analytical consequences of accounting choice. Instead, the battleground has shifted. 

Today, the most important differences between FC and SE appear in impairment timing, depreciation profiles, reserve revisions, and the way capital costs are embedded in balance sheets over time. (Wake up! We’re just getting to the good stuff.) However, it is important to recognize that despite whichever accounting methodology a company subscribes to, cash flow and cash flow-related metrics will still tell the economic truth about a company’s financial fortunes.

Accounting History

To understand why FC and SE accounting still matter today, it is necessary to briefly revisit the environment in which these methods were developed. Both emerged in an era when upstream oil and gas exploration was fundamentally different from the manufacturing-style drilling programs that dominate today’s shale basins.

From the 1950s through most of the 1990s, much of the industry’s capital was devoted to high-risk, high-cost exploration. Companies routinely drilled wildcat wells in frontier basins, offshore environments and geologically complex regions with limited subsurface data. In addition, seismic quality was rudimentary by modern standards. As a result, failure rates were high. In many basins, a significant portion of exploratory wells encountered no commercial hydrocarbons. A single unsuccessful well could cost tens of millions of dollars and generate no reserves. Exploration outcomes were often binary: either a discovery was made, or the entire investment was lost. In this environment, how companies accounted for exploration costs had a substantial impact on reported financial performance. 

Against that backdrop, two distinct accounting philosophies emerged. Under the SE method, companies are required to expense the costs of unsuccessful exploratory activities as they occur. Only expenditures associated with proved reserves and productive assets are capitalized. This approach emphasizes project-level accountability and rapid recognition of failure. Poor exploration results translate quickly into lower earnings. Supporters of SE argue that it provides a more transparent and conservative view of financial performance. By recognizing losses promptly, it prevents companies from carrying uneconomic investments on their balance sheets and forces management teams to confront unsuccessful strategies.

FC accounting adopts a different perspective. Rather than evaluating projects individually, it treats exploration as a portfolio activity. Under this method, most exploration and development costs are capitalized and accumulated in large cost pools, typically organized by country. Dry holes, abandoned prospects and unsuccessful acreage positions are viewed as unavoidable components of the exploration process — sort of like Gold Rush prospectors spending a lot of days panning for gold without success before hitting the jackpot. Proponents of FC argue that this approach better reflects the long-term economics of resource development. Individual failures are expected to be offset by future discoveries, and capitalizing costs smooths earnings over time. In their view, expensing dry holes immediately creates excessive volatility that does not reflect underlying business value.

During the 1960s and 1970s, there was intense debate in the oil and gas industry over which approach better represented economic reality. Large integrated oil companies generally favored SE, while smaller independent producers — some of them old-school wildcatters — often preferred FC. After years of controversy, U.S. regulators ultimately permitted both methods under GAAP, provided that companies applied them consistently and disclosed their policies clearly. The Securities and Exchange Commission (SEC) also introduced the “full cost ceiling test” to limit excessive asset capitalization under FC accounting. (More on that below.)

This compromise reflected the industry's diversity of business models. Companies that were focused on large-scale, diversified exploration programs gravitated toward SE. Smaller, exploration-oriented firms with limited capital bases often preferred FC, which reduced short-term earnings volatility and facilitated access to financing. This framework remained largely intact until the rapid expansion of shale development fundamentally altered the industry’s risk profile.