Accounting Choice and Financial Information – Oil and Gas Industry

1. Vicki Curtis, Jeremy Wei, Jordan Hill, Cody Rice Accounting Choice and Financial Information – Oil and Gas Industry

2. Agenda • Introduction • CICA Handbook (ACG-16) • Damage Awards and Earnings Management in the Oil Industry (article) • Questions

3. AcG 16 – Oil and Gas Accounting • A guideline on how to account for exploration, development and production activities for Canadian oil and gas companies • Two methods of accounting: • Full cost • Successful efforts • AcG 16 only considers application of full cost

4. Key Definitions

5. Acquisition Costs • Costs incurred to inquire a property • Property includes: • Any interest representing the right to extract (e.g. permit, license, agreement) • Non-operating interests in properties operated by others (e.g. royalty interests) • Agreements with foreign governments/authorities in which company serves as producer of underlying reserve • Note: Properties do not include agreements that represent the right to purchase, rather than extract

6. Question Time! • Royal Dutch Shell spent $4.5 million in costs for the right to purchase oil sands property in Northern Alberta. Are they allowed to capitalize?

7. NO! • As per AcG 16 p. 4... • Properties do not include agreements that represent the right to purchase, rather than extract

8. Development Costs • Costs incurred to obtain access to reserves and to provide facilities for extraction • Costs include any depreciation or operating costs of support equipment to: • Gain access and prepare extraction • Drill and equipment wells • Acquire, construct and install production facilities • Provide improved recovery systems

9. Exploration Costs • Costs incurred in identifying areas that may contain oil and gas reserves • Costs may be incurred before and after acquiring property, and include: • Costs of geographical land studies • Costs of carrying and retaining unproved properties • Dry hole and bottom hole contributions • Costs of drilling and equipping exploratory wells

10. Probable Reserves • Estimated remaining quantities of oil and gas that are anticipated to be recoverable • There is a 50% probability amounts actually recovered will exceed estimate • Judgement based on available data • Reserves are estimated using forecasted future prices and costs

11. Proved Reserves • Estimated remaining reserves that are anticipated with a high degree of certainty to be recoverable • Estimated 90% probability that actual extraction exceeds estimate • Proved reserves can be further subdivided into: • Proved developed reserves • Proved undeveloped reserves

12. Proved Reserves (cont’d) • Proved developed reserves • Reserve can be extracted with low expenditure to firm • Proved undeveloped reserves • Reserve can be extracted with significant expenditure to firm

13. Question Time! • BP has forecasted with an 95% probability that their oil reserve in Venezuela will meet or exceed production of $400 million. What type of reserve is this? • Probable Reserve • Proved Reserve

14. Answer... • Proved Reserve • If the probability that extraction is greater than 90%, this meets the criteria of proved

15. Recognition and Measurement

16. Costs to be Capitalized • All costs associated with exploration and development activities should be capitalized • Internal Costs • Should be limited to those than can be directly identified with exploration and development activities

17. Costs to be Excluded • Costs of acquiring and evaluating unproved reserves may be excluded from depletion and depreciation (D and D), until reserve is determined • Costs include: • Acquisition costs • Costs of carrying unproved reserves • Costs of drilling unproved reserves • Asset retirement costs of unproved reserves

18. Costs NOT to be Excluded • Costs of proved properties • Costs that have been subject to D and D • Costs of drilling a dry well • Exploration costs not related to unproved properties already acquired • Impaired costs for unproved properties

19. Major Development Projects • May exclude certain costs for major development projects subject to D and D, until the earliest of: • Property becomes capable of production • Development activity ceases • Impairment occurs

20. Property Impairment • A property becomes impaired when: • A dry hole has been drilled and the company has no firm plans to continue drilling • Negative geological and/or geographical data • Insufficient time to produce with leased data • All exploratory dry holes are considered impaired to the extent of the cost of the dry hole

21. Disposals of Properties

22. Other than by sale • Unproved property abandoned - carrying amount less impairments  subject to D&D, loss recognized if D&D rate increases by 20% of more • Proved property exchanged - no gain or loss • Unproved property exchanged - carrying amount of received = carrying amount of given up, immediately test for impairment • Proved property distributed - calculate netbook values according to par. 25, no gain or loss. If FMV < NBV, recognize loss. • Unproved property distributed - test for impairment, recognize loss if necessary

23. By sale • only applied to • sales resulting in 20% or more change in the D&D rate • sales of properties classified as held for sale at acquisition • approved properties where costs not subject to D&D • Net carrying amounts of other properties are unknown under full cost accounting

24. Depletion and Depreciation

25. Costs Included • Costs to be depleted and depreciated include: • all capitalized costs, less accumulated D&D - other than costs of unproved properties and major developments • estimated future costs to develop proved reserves - including asset retirement costs

26. Costs Included (cont’d) • For D&D purposes, estimated future development costs and estimated proved reserves  shall reflect the development method to be adopted • Calculated on a unit-of-production basis • Computed by cost centre  on the basis of units of proved reserves • expressed in a common unit of measure such as a unit of energy or unit of revenue • In certain cases, processing plants and similar tangible assets may be depreciated on a more appropriate basis - useful life • Must be calculated each time financial statements are issued • D&D determined on a consolidated basis for each cost centre • NCI is calculated at the subsidiary level and is not changed even if D&D changes upon consolidation.

27. Calculation of D&D provision (Production/Reserves at beginning of period adjusted for major changes in estimates during the period) x Net book value at the end of the period plus estimated future costs to be incurred in developing proved undeveloped reserves, net of estimated salvage values

28. Cost Centre Impairment

29. Cost centre impairment (ceiling test) • Section 3063 - Impairment of Long-Lived Assets • specifically excluded • Conducted at each annual balance sheet date • Recognize an impairment loss when the carrying amount of a cost centre is not recoverable and exceeds its fair value • not recoverable if carrying amount > sum of undiscounted cash flows

30. Future cash flows • Prices and costs used • estimates shall be reasonable in relation assumptions used in developing other information • based on the best information available to the enterprise • quoted prices in futures market • price forecasts • adjusted for enterprise specific differences • Incorporate contractual fixed prices, hedged transactions, and government regulated prices • Future cash flows include only those resulting from development, production, and sale of the cost centre reserves, not financing cash flows • All proved reserves are included in future cash flows • The cost of unproved reserves and of major development projects excluded from D&D is included in future cash flows

31. Carrying amount • all proved properties • all unproved properties • all major development projects

32. Measurement of impairment • The amount by which the carrying amounts of assets capitalized exceed the sum of: • the fair value of proved and probable reserves and • the cost of unproved properties not subject to D&D • Fair value calculation • expected present value due to uncertainty and risk • assumptions market participants would use

33. Presentation • Disposal of a subset of properties vs. entire cost centre • Properties held for sale are classified separately

34. Disclosures If following the full cost method, an enterprise must disclose: • interest and general and administrative costs capitalized • costs excluded from D&D at balance sheet date • method used in calculating D&D • disclosures required by Section 3063 and 3475 • factors when planned principal operations in a new cost centre have not commenced • the disclosure requirements of measurement uncertainty (Section 1508)

35. Steven C. Hall William W. Stammerjohan Damage Awards and Earnings Management in the Oil Industry

36. Introduction • Purpose: hypothesis that managers make accounting choices to reduce reported earnings during litigation in which the firm is a defendant and faces potentially major damage awards • Evidence: manager often manipulate accounting numbers to lower costs of the firm

37. Hypotheses • Firms make income decreasing accruals during periods in which they are defendants in litigation with high potential damage awards relative to other periods. • Firms under-report new reserves during periods in which they are defendants in litigation with high potential damage awards relative to other periods.

38. Research Design • Limited to the Oil industry • Industry with potential for damage awards substantially higher than the norm • E.g. risks involved with transportation and refining of oil • Omitted variables that are correlated with industry • Reduce specification error

39. Research Design (cont’d) • Management can manipulate earnings in a variety of ways • Accruals can be separated into working capital and non-working capital accruals

40. Data and Method • Criteria for Oil Firm: • Sufficient data available to calculate: • Change in sales • Fixed assets • Listed in Wall Street Journal • One of the 20 largest oil firm, based on total assets • Accrual Equation:

41. Litigation Events • Amoco - super-tanker wreck off the coast of French Brittany • Diamond Shamrock - suit filed by Viet Nam veterans who suffered illness • Exxon - super-tanker crashed into reef in Alaska

42. Litigation Events (cont’d) • Occidental Petroleum - company dumped 21,000 tons of chemical wastes into the Love Canal near Niagara Falls, NY • Shell Oil - Sued by U.S. Army for clean up costs related to non-military chemical manufacturing • Texaco - Pennzoil sued to block acquisition of Getty Oil

43. Test Results • Test/Litigation period lasts several years • Effect of the understatement on assets is cumulative • Damages is not a significant predictor

44. Test Results (cont’d) • No Control Firms: • Possible that results are caused by inherent differences between the 6 test firms • Damages remains significant in non-working capital accruals

45. Test Results (cont’d) • Reserve Estimate • Non-working capital component of accruals • Calculated as a function of depreciation, depletion and deferred taxes • FASB 1975 • Damages remains significant when (Texaco & Exxon) firm years are excluded

46. Conclusion • Consistent with hypothesis that defendants in major litigation use non-working capital accruals to decrease earnings during period of litigation • Estimates of reserves were under-reported during the test period • No evidence of accounting manipulation in the financial statement disclosures

47. Conclusion (cont’d) • Earnings are understated during major litigation • Study examines only the oil industry • Future research required to examine effects on other industries

48. Question and Comments? Thank you for your attention!