Financial Statements

Tyler Oil Company began operations on March 3, 2010, with the acquisition of a lease
in Texas. During the first year, the following costs were incurred, DD&A (depreciation,
depletion, and amortization) recognized, and the following revenue was earned:

G&G costs . . . . . . . . . . . . . . . $ 60,000

Acquisition costs . . . . . . . . . . . . 100,000
Exploratory dry holes . . . . . . . . . 1,400,000
Exploratory wells, successful . . . . . . 800,000
Development costs. . . . . . . . . . . . 500,000
Production costs . . . . . . . . . . . . 50,000
DD&A expense . . . . . . . . . . . . . 40,000 (SE); 90,000 (FC)
Revenue.. . . . . . . . . . . . . . . . . 250,000

Income Statements

Successful Efforts Full Cost

Revenue . . . . . . . . . . $ 250,000 $ 250,000

Expenses:
G&G . . . . . . . . . . . $ 60,000 $ 0
Exploratory dry holes . . 1,400,000 0
Production costs . . . . . 50,000 50,000
DD&A . . . . . . . . . . 40,000 90,000
Total expenses . . . . . . 1,550,000 140,000
Net income . . . . . . . . $(1,300,000) $ 110,000

Partial Balance Sheets

Successful Efforts Full Cost

G&G costs . . . . . . . . . . $ 60,000

Acquisition costs . . . . . . . $ 100,000 100,000
Exploratory dry holes . . . . 1,400,000
Exploratory wells, successful . 800,000 800,000
Development costs . . . . . Total . 500,000 500,000
assets . . . . . . . . Less: . 1,400,000 2,860,000
Accumulated DD&A. Net . (40,000) (90,000)
assets . . . . . . . . . . $ 1,360,000 $2,770,000
EXAMPLE

EXAMPLE

Overview of Entries—Successful Efforts

a. On January 1, Tyler Company spends $900,000 on G&G activities to locate and
explore an oil prospect. (This is an exploration activity that cannot directly find oil or
gas
and so cannot be termed successful. Only by drilling a well can oil or gas normally be
found.)

Entry

G&G expense . . . . . . . . . . . . . . . . . . . . . . . 900,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

b. On January 15, Tyler Company acquires a 100-acre lease, paying a $500-per-acre bonus
(acquisition cost).

Entry

Unproved property (100 × $500) . . . . . . . . . . . . . 50,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

c. On February 20, Tyler Company drills a dry exploratory well at a cost of $700,000
(unsuccessful or nonproductive exploration cost).

Entry

Dry-hole expense . . . . . . . . . . . . . . . . . . . . . 700,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000

d. On March 29, Tyler Company drills a successful exploratory well at a cost of

$825,000 (successful exploration cost).

Entry*

Wells and equipment . . . . . . . . . . . . . . . . . . . 825,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 825,000
 As a result of the successful exploratory well, Tyler must also reclassify the property.

Entry

Proved property . . . . . . . . . . . . . . . . . . . . . . 50,000

Unproved property . . . . . . . . . . . . . . . . . . 50,000

e. On April 10, Tyler Company spends $850,000 on production facilities such as

flow lines. (This cost is incurred in preparing proved reserves for production and,
therefore, is a development cost.)

Entry

Wells and equipment . . . . . . . . . . . . . . . . . . . 850,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 850,000

f. On June 3, Tyler Company incurs $50,000 in production costs (production cost).

Entry

Production expense . . . . . . . . . . . . . . . . . . . . 50,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Overview of Entries—Full Cost

a. On January 1, Tyler Company spends $900,000 on G&G activities to locate and
explore an oil prospect (exploration cost).

Entry

G&G costs . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

b. On January 15, Tyler Company acquires a 100-acre lease, paying a $500-per-acre

bonus (acquisition cost).

Entry

Unproved property—acquisition . . . . . . . . . . . . . 50,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

c. On February 20, Tyler Company drills a dry exploratory well at a cost of

$700,000 (exploration cost).

Entry

Exploratory dry hole . . . . . . . . . . . . . . . . . . . 700,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000

d. On March 29, Tyler Company drills a successful exploratory well at a cost of

 $825,000 (exploration cost).

Entry

Wells and equipment . . . . . . . . . . . . . . . . . . . 825,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 825,000

As a result of the successful exploratory well, Tyler must also reclassify the property.

Entry

Proved property—acquisition . . . . . . . . . . . . . . . 50,000

Unproved property—acquisition . . . . . . . . . . . 50,000
e. On April 10, Tyler Company spends $850,000 on production facilities such as
flow lines (development cost).

Entry

Wells and equipment . . . . . . . . . . . . . . . . . . . . 850,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 850,000

f. On June 3, Tyler Company incurs $50,000 in production costs (production cost).

Entry

Production expense . . . . . . . . . . . . . . . . . . . . . 50,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

1. Revenue and costs for Optimistic Company for the year 2015 are presented below:

Revenue. . . . . . . . . . . . . .... $ 600,000

G&G Costs. . . . . . . . . . . .... 600,000
Acquisition costs . . . . . . . .... 2,000,000
Exploratory dry holes . . . .... 4,000,000
Successful exploratory wells .... 3,000,000
Development wells, dry . . . . .... 1,000,000
Development wells, .... 800,000
successful Production .... 700,000
facilities . . . . . . Production .... 100,000
costs . . . . . . . .
Successful Efforts Full Cost

Amortization for 2015 . . . . . . . . . $200,000 $

400,000 Accumulated DD&A . . . . . . . . . 500,000
700,000

Prepare income statements and unclassified balance sheets for a successful efforts (SE)
company and a full cost (FC) company and explain the difference in net income
2. Elizabeth Corporation incurred the following costs during 2015:

January 12 G&G Costs . . . . . . . . . . . . . . . . . $ 75,000

February 15 Lease acquisition costs . . . . . . . . . . .
150,000 March 16
Exploratory dry-hole costs . . . . . . . . .
350,000 April 29
Successful exploratory well costs . . . . . .
500,000
June 15 Developmental well costs . . . . . . . . . .
200,000 August 4
Production facility costs. . . . . . . . . . .
100,000 September 20
Production costs . . . . . . . . . . . . . . .
55,000

Elizabeth uses the successful efforts method of accounting. Prepare the journal
entries for the year-end December 31, 2015.

Cost Allocation

Expenses for Field Office A of Tyler Oil Company amounted to $10,000 for the month of
May. The field office has supervision over the following leases and wells:

Lease Number of Wells Barrels of Oil Produced

A 1 1,000
B 3 500
C 4 2,000
D 2 1,500
Total 10 5,000

a. If the field office expense is allocated on the basis of the number of barrels
(bbl) produced, each lease would be charged the following amount:
number of wells supervised, each lease would
be charged the following amount:

Lease
Lease Computations Am
A ($10,000 × 1,000 bbl/5,000 bbl)
A ($10,000 × 1 well/10 wells) $1
B ($10,000 × 500/5,000)
B ($10,000 × 3/10) 3
C ($10,000 × 2,000/5,000)
C ($10,000 × 4/10) 4
D ($10,000 × 1,500/5,000)
D ($10,000 × 2/10) 2
Total
Total $10

b. If the field
office expense
is allocated on
the basis of the
 EXAMPLE

Completion Decision

Proved property cost (acquisition cost) . . . . . . . . . $ 40,000

Drilling cost incurred to date . . . . . . . . . . . . . . 500,000
Estimated completion cost. . . . . . . . . . . . . . . . 260,000
Estimated selling price per bbl. . . . . . . . . . . . . . $50
Estimated lifting costs per bbl . . . . . . . . . . . . . . $25
State severance tax . . . . . . . . . . . . . . . . . . . . 5%
Working interest share of revenue. . . . . . . . . . . . 90%
Royalty interest percentage . . . . . . . . . . . . . . . 10%

REqUIRED: Should the well be completed assuming the following total gross
production?

Production

Case A: 7,500 bbl

Case B: 15,000 bbl
Case C: 30,000 bbl
 Computations
Case A Case B Case C
Total revenue (bbl × $50) $375,000 $750,000 $1,500,000
Less: Royalty (10%) (37,500) (75,000) (150,000)
Net WI revenue 337,500 675,000 1,350,000
Less: Severance tax (5% × net WI revenue) (16,875) (33,750) (67,500)
Net revenue before lifting costs 320,625 641,250 1,282,500
Less: Lifting costs ($25 × bbl) (187,500) (375,000) (750,000)
Net cash flow to WI owner $133,125 $266,250 $ 532,500

Case A: The well should not be completed. The net cash flow to the
working interest owner is only $133,125, and estimated completion
costs are $260,000. Reserve estimates for new production are often
higher than actual. Therefore, the actual net cash inflow may be
even less.
Case B: Further analysis of reserve estimates may be needed. The net cash
inflow is projected to be $266,250 as compared with completion
costs of $260,000. If the reserve estimate is off on the downside,
completion costs would not be recovered.
Case C: The well should be completed. The estimated cash flow is $532,500,
and completion costs are $260,000.

EXAMPLE

Payback Method

Tyler Company has two proved properties in which it owns a 100% WI. It has
identified two wells that could be drilled. However, Tyler does not have sufficient cash
to drill both wells and must decide which of the two wells to drill. Information related
to each of the wells follows:
Well A Well B
Drilling cost . . . . . . . . . . . . . . . . . . . . . . . . $200,000 $500,000
Completion cost . . . . . . . . . . . . . . . . . . . . . . 560,000 450,000
Selling price per bbl . . . . . . . . . . . . . . . . . . . . $52 $52
Lifting costs per bbl . . . . . . . . . . . . . . . . . . . . $28 $28
State severance tax. . . . . . . . . . . . . . . . . . . . . 5% 5%
Royalty interest percentage . . . . . . . . . . . . . . . . 10% 10%
Estimated monthly production 1,000 bbl 2,000
bbl
 REqUIRED: Using the payback method, determine which well Tyler should drill.
Computations

Well A Well B
Total monthly revenue (bbl × $52) $52,000 $104,000
Less: royalty (10%) (5,200) (10,400)
Net WI revenue 46,800 93,600
Less: Severance tax (5% × net WI revenue) (2,340) (4,680)
Net revenue before lifting costs 44,460 88,920
Less: Lifting costs ($28 × bbl) (28,000) (56,000)
Net cash flow to Tyler $16,460 $ 32,920

Payback period
$760,000
Well A: = 46.17 months
$16,460

Well B: $950,000
= 28.86 months
$32,920

Either well might be a viable investment. However, given that Well B should return its cost to the owner
much more quickly than Well A, Well B would be the most likely well to be drilled.

EXAMPLE

IRR
IRR, NPV, PI Using the cash flows for Field 1, Field 2, and Field 3, the IRR of the
projects is calculated, as well as the NPV and PI of the projects using both 10% and 13%
discount rates
Year Field 1 Field 2 Field 3
cash flow cash flow cash flow
0 (75000) (175000) (475000)
1 10000 25000 150000
2 20000 25000 150000
3 20000 25000 150000
4 15000 25000 75000
5 10000 25000 75000
6 5000 25000 50000
7 0 25000 20000
8 0 25000 20000
9 0 25000 20000
10 0 25000 20000

IRR
Field 1 12%
Field 2 7%
Field 3 14%

Present value Factors

Present value Present value
years Factors 10% Factors 13%
0 1.000 1.000
1 0.909 0.885
2 0.826 0.783
3 0.751 0.693
4 0.683 0.613
5 0.621 0.543
6 0.564 0.480
7 0.513 0.425
8 0.467 0.376
9 0.424 0.333
10 0.386 0.295
 Calculations

——————10% —————— —————— 13% ——————

Field 1 Field 2 Field Field 1 Field 2 Field
years 3 NPv NPv NPv 3 NPv NPv NPv
0 $(75,000) $(175,000) $(475,000) $(75,000) $(175,000) $(475,000)
1 27,270 22,725 136,350 26,550 22,125 132,750
2 16,520 20,650 123,900 15,660 19,575 117,450
3 15,020 18,775 112,650 13,860 17,325 103,950
4 10,245 17,075 51,225 9,195 15,325 45,975
5 6,210 15,525 46,575 5,430 13,575 40,725
6 2,820 14,100 28,200 2,400 12,000 24,000
7 0 12,825 10,260 0 10,625 8,500
8 0 11,675 9,340 0 9,400 7,520
9 0 10,600 8,480 0 8,325 6,660
10 0 9,650 7,720 0 7,375 5,900
NPV $ 3,085 $ (21,400) $ 59,700 $ (1,905) $ (39,350) $ 18,430
NPV of future $ 153,600 $ 534,700 $ 73,095 $ 135,650 $ 493,430
Cash inflows $ 78,085

Discount Factor of 10%

NPV: As can be seen from the table above, only Field 1 and Field 3 have positive NPVs at
10%. PI: Only Field 1 and Field 3 have PIs greater than 1.

Field 1: PI = $78,085/ $75,000 = 1.041

Field 2: PI = $153,600 /$175,000 = 0.878
Field 3: PI = $534,700 /$475,000 = 1.126

Discount Factor of 13% NPV: As can be seen from the table above, only Field 3 has a
positive NPV. PI: Only Field 3 has a PI greater than 1 at 13%
.
Field 1: PI = $73,095 /$75,000 = 0.9746
Field 2: PI = $135,650 /$175,000 = 0.7751
Field 3: PI = $493,430/ $475,000 = 1.0388

Conclusion: Field 3 has the largest NPV and PI at either 10% or 13%. It also has the
largest IRR. Based on this analysis, Tyler should rank Field 3 first. If the appropriate rate
of return is 10%, Field 1 would also be a viable project. However, Field 2 would not be
selected.