Discovery Value Accounting
The term discovery value accounting refers to an accounting method used in the natural resources industry when there is a change in extractable assets. Also known as reserve recognition accounting in the oil and gas industry, this approach allows companies to adjust their financial statements for these changes.
A change in the value of assets will flow from the company’s balance sheet to the income statement. Supplemental schedules detailing these changes must accompany the company’s financial statements.
Typically, companies will record assets on the balance sheet at what is known as historical cost. Discovery value and reserve recognition accounting (RRA) use an approach known as current value. Historical cost advocates believe the balance sheet should be used to support the income statement. Advocates of current value accounting believe the income statement is used to explain changes to assets and liabilities appearing on the balance sheet.
The Securities and Exchange Commission favors the RRA since:
- The financial position of oil and gas producers is not accurately portrayed by historical cost accounting.
- Additional information, external to the company’s financial statements, is needed to provide a fair comparison between companies in the oil and gas industry and those external to this industry.
- A method that relies on current value of oil and gas reserves is needed to provide sufficiently useful information to potential shareholders, creditors, and analysts.
While RRA is unique to the oil and gas industry, discovery value applies to all natural resources, including mining, livestock, timber, and other extractive industries. One method used to record an increase in value involves a debit (or credit when a decrease) to the asset account and a corresponding credit (or debit when a decrease) to a revenue account.
Company A has determined the current value of its Marcellus Shale reserves is $10,000,000 higher than originally estimated due to a change in the quantity of proved reserves. The reserve recognition accounting method would record this change using the following journal entry:
|Oil and Natural Gas Reserves (Asset Account)||$10,000,000|
|Change in Quantities of Proved Reserves (Revenue Account)||$10,000,000|
The earnings statement for Company A would reflect this increase as follows:
|Revenues from Oil and Gas Sales||$125,000,000|
|Cost of Production||$80,000,000|
|Income from Producing Activities||$45,000,000|
|Revisions to Proved Properties|
|Change in Quantities of Proved Reserves||$10,000,000|
|Change in Production Rates||$0|
|Change in Current Price||$0|
|Profit Before Income Taxes||$55,000,000|