The Accounting Onion

SEC on Oil and Gas Disclosures: Current Prices Aren't "Meaningful"?

The issue I'm going to focus on is one that has been on everyone's mind for the last few months, although in a somewhat different context: the price of oil.

The SEC has issued proposed rulemaking release No. 33-8935, Modernization of the Oil and Gas Reporting Requirements, to "modernize and update the oil and gas disclosure requirements, and to align them with current practices and changes in technology." But buried underneath the high-minded title is a bone to big oil -- the prices that are used to measure the value of reserves.

Background

The strengths and weaknesses of an accounting principle are often best exposed when tested against extreme cases. For historic cost accounting, there may be no better illustration of its limited ability to provide relevant information to investors than the exploration and production (E&P) of underground natural resources—oil and gas, coal, precious metals, etc. Let's keep it simple by focusing on oil.

Without question, the most significant event in the life of an E&P company is discovery of oil; but, you couldn't tell that from the income statement or balance sheet. The affect on income is precisely nil until product is shipped to a customer, and that could be decades after discovery. The costs of discovery often bear little relation to the value of the discovery, so the balance sheet (even when all exploration costs are capitalized) doesn't provide relevant information to investors either. So, in 1978, the SEC tried to do the right thing for investors by introducing a new form of accounting known as Reserve Recognition Accounting (RRA). It required E&P companies to recognize in income the net present value of reserves discovered during the period, as well as changes to the NPV of existing reserves.

RRA didn't sit well with the E&P companies, ostensibly because the inputs required were too subjective, but more likely because it caused reported income to swing wildly. Everything else equal, nothing discovered in a period meant no income under RRA. Big Oil pined to return to the good ole days when their earnings could be manipulated simply by changing extraction rates.

So, under pressure in 1982, the SEC abandoned the RRA experiment, relegating it to notes (see SFAS 69) and created additional extensive disclosures with regards to present quantities of oil reserves. There is no way an analyst can begin to understand an E&P company's performance for a period without looking closely at the reserve disclosures, which brings us back to the SEC's current proposal.

Oil Price Volatility is So Inconvenient

Current disclosures of assessments of commercial feasibility and dollar values for reserves rely, logically enough, on the price of oil as of the balance sheet date. Now, the SEC is proposing to change the price used in calculating reserves from a single-day closing price to a 12-month average price. Before we look at what they said about it in their proposing release, let's think about it in general terms. Would you calculate the value of your personal investment portfolio based on the 12-month average prices of the securities you hold, or would you look at the current price quotes? If you held oil in your portfolio, does that change your answer? Of course not, but if you're BIG Oil, then this SEC is willing to listen to you, no matter how pathetic your whining might sound to others.

Here's what the SEC has to say about their proposal to use average prices:

"Most commenters on the Concept Release recommended that we replace our current use of a single-day, fiscal year-end spot price to determine whether resources are economically producible based on current economic conditions with a different test. Some believed that reliance on a single-day spot price is subject to significant volatility and results in frequent adjustment of reserves. [footnote omitted] These commenters expressed the view that variations in single-day prices provide temporary alterations in reserve quantities that are not meaningful or may lead investors to incorrect conclusions, do not represent the general price trend, and do not provide a meaningful basis for determination of reserve or enterprise value." [italics supplied by me]

Whew. Let's take a look at this piece-by-piece:

• Most commenters—Since when is the SEC in the business of counting votes, and are all votes equal? I LOL when I think about how the SEC ignored the protestations of "most [reasoned] commenters" who opposed eliminating the IFRS-to-GAAP reconciliation requirement for foreign companies listed in the U.S.
  
• Frequent adjustment of reserves—When the value of a marketable security changes because the price dropped on the last day of the period, should we ignore it? If you can't think of a single good reason that we should, then you shouldn't make an exception for oil.
  
  Ironically, the normal approach to standard setting is to cure compromises made in financial statements with rigorous disclosure. Here, the exact opposite is taking place. The SEC is not proposing to change the prices that are used for accounting purposes, so for purposes of applying historic cost accounting in the financial statements (successful efforts method per SFAS 19, or full cost accounting per Regulation S-X), a company would use a value of proved reserves based on a single-day, year-end price. However, the SEC believes that RRA disclosures required by SFAS 69 should be prepared using the 12-month average price. In other words, it's okay to be loosey-goosey in the disclosures about prices, just so long as use the right price for the financial statements, which, being based on historic costs, have little relevance to investors anyway.
  
• Meaningful—I really dislike that '70s made-up word, especially when used in place of 'relevant.' Put 'relevant in that sentence and see if it makes any sense; it doesn't, of course.
  
• General price trend—Do they mean the future price trend? That's the only one that matters. If future prices of oil could be predicted by past prices, then any person who can perform that trick is in the wrong business—unless they are already oil speculators. I have vivid memories of consulting for an E&P company during a year when they sold their entire production forward, because they speculated that prices would go down. Of course, they went way up; the operations managers I was working with, whose bonuses and shareholdings depended on oil revenues, were not pleased with the 'economists' at corporate headquarters who conjured that one up.

Don't Bet Against Cox

I think I can always tell when the fix is in. First, big lies are woven into a large dose of truth, so they won't look to be as big as they are. There are certainly many things in the SEC's proposal to recommend it, especially along the lines of expanding the types of reserves that would be disclosed, and updating important definitions.

Second, when the justification for a proposal makes no sense, there can be no debate; you can't tell the emperor he's naked. The lesson of Cox's SEC is to never forget about the big special interests that write big checks to the big politicians who made him emperor for a day.

The SEC's Fair Value Roundtable: No Fireworks

On July 9, 2008, in Washington, DC, the SEC hosted a roundtable "to facilitate an open discussion of the benefits and potential challenges associated with existing fair value accounting and auditing standards." The roundtable was webcast and lasted about four hours. I admit that I literally fell asleep after listening to the discussion for the better part of three hours, so I missed the end. For all I know, the grand finale was a fireworks display, but I doubt it – this time, both literally and figuratively. When the SEC schedules these roundtable events for 9 a.m. on the east coast, I can't help but wonder what they are trying to tell those of us located in PAC-10 country (Go Sun Devils!). Maybe they would really prefer that no one listens.

Anyway, the topics included, among other things, discussions of the aspects of current standards that could be improved, and the usefulness of fair value accounting to investors. I'm going to address three issues that are so basic and important enough that accounting professors may want to consider using them for a class discussion.

Issue #1: "Held-to-Maturity" Investments

James Tisch of Loews Corp., when talking about his company's insurance subsidiaries, teed up this issue by describing a situation where his company would invest in marketable debt securities whose valuation might be affected by interest rate changes -- even though there would be no changes to the borrower's credit risk. Being an insurance company subject to various regulatory authorities, a rise in interest rates would supposedly force Loews to declare the investments in the held- to-maturity-category of marketable debt securities, the least onerous of three evils (the other two requiring fair value accounting).

Without the held-to-maturity option, the carrying amount of the investment would initially decline as interest rates rose, but could be expected to recover to the amount of the contractual obligation as the maturity date approached. Tisch's view seems to be that either fair value accounting would unreasonably record losses when it is highly probable that the entire investment plus interest will be recovered, or that constraints imposed by regulators trump the accounting that is most appropriate from an investor's viewpoint.

I think that the best way to approach a question like this is to ask yourself a simple question: did Mr. Tisch's company suffer a loss because it chose to invest in fixed-rate, as opposed to variable-rate, debt instruments? Yes it did. While regulators may find that it obscures their own peculiar needs, there must surely more straightforward ways to solve the conflict with investor needs than to muck up the financial statements.

And don't forget that apart from appeasing the needs of regulators, the held-to-maturity category is chicken salad for management: as Mr. Tisch implied, his company would manage its reported financial position by "cherry picking": if interest rates were to decline instead of rise, those same investments are probably classified as trading in order to get the asset and earnings bumps.

In short, FAS 115 on marketable securities could have been a lot simpler if the goals for financial statements could be (and should be) a lot simpler. As another panelist observed, one shouldn't need a legal degree to be capable of reading all the disclosures. I believe the disclosures he was referring to owe their existence to low-quality solutions cobbled together to meet the needs of someone else besides investors. The SEC should be telling other regulators to go and make their own accounting rules if they don't like the ones that are supposed to protect investors.

Issue #2: Fair Value of Liabilities

Joseph Price, the CFO of Bank of America, expressed his opposition to applying fair value measurements to contractual obligations such as litigation (and by the way, one of my more recent posts discusses the misguided way in which the IASB would require fair value measurement for some non-contractual obligations). Mr. Price has no problem with a mixed attribute model of accounting, which is just another way of saying that he has no problem adding apples and oranges.

The larger question, however, is whether any liability should be subject to fair value measurement. In addition to the claims that gain recognition on liabilities from deterioration of credit risk would distort earnings, other speakers pointed out that the character of the gain itself, often incapable of being monetized absent liquidation, creates problems.

The academic, Kathy Petroni, conceded that it can be confusing when an operating loss can be more than offset by gains from writing down the value of one's own debt. However, she is also of the view that the gain on the debt is representationally faithful; in other words, the problem is not with the current valuation of the debt, but with incomplete asset revaluation. This is because not all balance sheet assets are measured at fair value, and not all economic assets are even recognized. Tom Linsmeier, of the FASB and also an academic, made the interesting observation that a write-down to liabilities could be reasonably interpreted by investors as a signal of the asset losses that were not recognized.

As you may already have guessed, I am not sympathetic to stating liabilities at something other than current values. For one thing, we will never get to the point where all of the assets of a business are recognized, so we will never get to the point of measuring all of the components of economic income. Investor's don't expect financial reporting to account for all of the components of economic income. (Actually, that's what changes in stock prices do, but they have the distinct disadvantage of not allowing an analyst to directly identify the drivers of stock price changes.) What investors do expect is that the components of economic income that are measured are measured properly. If the deterioration of a company's credit worthiness creates an opportunity, amidst the other problems it must be experiencing, for it to restructure its debt advantageously, doesn't that opportunity benefit shareholders? Absolutely.

And, by the way, I am not advocating that all liabilities, regardless of the likelihood that a cash outflow will occur, be given recognition. And perhaps, some non-contractual liabilities, due to their nature, should be excluded from recognition. So the problem of incomplete recognition extends to the liability side just as much as to the asset side.

As the old saying goes, "perfection is the enemy of the good". What that means here is that we should not be distorting liability valuation just because some other element is not perfectly taken account of.

Issue #3: Fair Value Accounting for Non-Financial Assets

There was some discussion and support for measuring non-financial assets at fair value, but that support may have been even less enthusiastic than the support for fair value measurement of financial assets.

Logic dictates that whatever approach to fair value for financial assets is taken, that same approach should be applicable to non-financial assets. What's good for the goose is good for the gander; otherwise, we permanently consign ourselves to adding apples and oranges. And speaking of which, I have also pointed out here that some folks who don't care whether they are adding apples and oranges don't even care how assets and liabilities are measured -- just so long as they can control what is reported on the (their) income statement. One of my favorite examples is the historic cost of a tract of land carried on the balance sheet of a foreign subsidiary: when multiplied by today's current exchange rate to translate into dollars, we don't end up with an historic cost in dollars, or a current value in dollars. We end up with what is essentially a random number. How do you test impairment of a random number?

Speaking of impairment, for those of you who have had to apply FAS 144 on the impairment of long-lived assets, or FAS 142 on goodwill impairment, or even inventory impairment, you would know from that unfortunate experience that the impairment model of accounting is perhaps the biggest source of complexity, if not broken altogether. Some would argue that it is a reason, in and of itself, to abandon historic cost accounting and move to some version of current costs.

So, what if we went to fair value accounting for non-financial assets? That might solve the impairment problem, but it would raise another big issue, that being gain recognition before the non-financial assets, usually inventory, were actually sold. In a nutshell, that's why I think proponents of fair value are hesitant to extend the concept to non-financial assets -- more than anything, it exposes the main problem of fair value serving as a core accounting principle.

The appropriate non-financial asset attribute to measure is replacement cost (entry prices), and not fair value (exit prices). To further appreciate this, take for example the issue of transaction costs to acquire inventory. If FAS 157 were applied to purchases of raw materials inventory, transaction costs (perhaps a brokerage fee) would be expensed immediately upon acquisition. We all know that this makes no sense: we immediately have an expense to report before we have any chance at all to generate a return on our investment. (By the way, the same anomaly applies to financial assets, but it has already been established by FAS 157 that the FASB doesn't seem to care much about this.)

A replacement cost approach, on the other hand, would mean that all of the expenditures required to replace the asset should be part of the carrying amount of the asset. If we ultimately sell inventory for an amount greater than it would cost us to replace it, then we have a profit.

Getting back to geese and ganders, if replacement cost is the appropriate attribute to measure for non-financial assets, then it must be the appropriate attribute for financial assets as well.

Oh, Well…

Overall, the roundtable contributed very little to the fair value debate that hasn't already been expressed and considered before. Nonetheless, it reinforces two points that may well conclude that class discussion I've suggested:

First, I would prefer to have a dialogue at the SEC instead of in London at IFRS headquarters. Chairman Cox himself unwittingly pointed this out when he asked one set of panelists whether they believe current accounting rules contributed in some way to the economic issues the financial institutions are now dealing with. What if the answer to his question is "yes"? That, by itself, should settle forever the debate about who should be setting accounting standards for the U. S. capital markets. What if the answer to Cox's question is "we don't know"? QED.

Second, it would be refreshing if for once, an issue were settled by simply asking what it is that investors would want. Why does it seem that policy makers are incapable of doing that?

The Fairy Tale of 'True and Fair View' and a Modest Proposal for Real 'Core Principles'

I had a pleasant back and forth correspondence with one my readers a few weeks ago. Carlomagno, as he called himself (I don't know his true identity), is a proponent of IFRS; and like me, he is of the opinion that IFRS overlaid with the distinctive system of corporate governance in the U.S. could be disastrous.

Carlo and I also agree that the generalizations of 'rules-based' US GAAP and 'principles-based' IFRS aren't as clear-cut as they are often made out to be by proponents of IFRS. Carlo wrote, "I think David Tweedie goes around the lecture circuit saying that the only truly principles-based accounting standard would consist of one sentence: 'The accounts shall present a true and fair view of the company's financial situation.'" Searching the internet, I found this Tweedie quotation in a KPMG publication, which is reasonably close to Carlo's assertion: "We should start off [a financial reporting standard] with the core principle, which is really the 'true and fair' core of the standard."

Ironically, any discussion of the 'true and fair' principle does not exist in IFRS, save for one boiler plate reference in Paragraph 46 of the IASB's conceptual framework. The purpose of this post is to expose the idea of true and fair in accounting as little more than faith-based accounting, and most certainly not the appropriate starting point for any process of developing high-quality accounting standards.

'True and Fair' as Fairy Tale

One of my hobbies is collecting plain English words and phrases that accounting policy makers have cunningly exploited to dress up an accounting procedure that is anything but what is implied by the straightforward term associated with it. Examples I have discussed previously include foreign currency 'translation' in accordance with FAS 52 or IAS 21, which would be more accurately characterized as 'random number generation'; 'goodwill' would be more accurate as 'the lump left over.' 'True and fair view,' commonly found in auditor reports outside of the U.S., is in a category all by itself: ineffable as either every-day English, or term of art.

At least, and however unsatisfying it may be, U.S. auditing standards provide us with a technical definition for the meaning of 'present fairly in accordance with U.S. GAAP.' Ask 100 accountants who prepare financial statements purporting to be a true and fair view of financial condition and results of operations and they will give you one hundred different explanations as to its meaning. Ask the two Big Four audit firms who confidently stated that Société Générale's financial statements were true and fair and you'll get version number 101.

As far as I can tell, the concept of 'true and fair view' was first introduced into British law by the 1947 Companies Act. It was later adopted by the European Union in 1978 in its Fourth Directive as the ultimate criterion for financial reporting. To be as generous as I can be, the term appears to express an overriding concern for substance over form in the application of professional judgment; financial statements are valued not so much for their compliance with particular rules as their ability to create an overall picture of a company's financial affairs. (Note: you can read a somewhat more expansive discussion in International Financial Reporting Standards: A Contextual Emphasis, a textbook that I co-authored with Mark Haskins and Ken Ferris in 1996 on pp. 71-73, 416.  That is, if you can still find a copy.)

The elusiveness of a meaning for 'true and fair' in an accounting context stems from a lack of meaning for that quintessentially British phrase in a capital markets context. Financial reporting is about producing information: is it possible that truth telling could not result in fair reporting? Answer: no way. Therefore, 'and fair' adds nothing whatsoever.  That leaves us with 'true'; everyone learns in Accounting 101 that accrual accounting and 'truth' don't mix anyway.

The point is that cunning Tweedie, like Soc Gen and its auditors, can construe 'true and fair' to mean anything, at any time to suit their own agenda.  Just like the emperor in the cautionary fairy tale, IFRS wears no clothes; his royal highness and subjects are deceived by the Tweedie tailor (pun intended) to disbelieve their eyes, and to behave as if IFRS is adorned with some noble British bromide.

A Modest Statement of Core Principles for the IASB or FASB

Though David Tweedie's abuse of 'true and fair' has been the direct object of this particular rant, I am generally weary of the pap that standard setters have offered up as core principles, principles-based standards, or what have you. Today's hodgepodge of rules has little or nothing to do with substantive core principles. They can only be seen as the product of the incentives of those who wrote them, or paid for them to be written: accounting board members seeking compensation, security and status; company men seeking influence over reported earnings; and auditors seeking what company men are seeking—without being exposed to malpractice litigation. Notice, too, that investors' incentives are generally absent. That's because, for whatever reason, they haven't been able to muster the dough to buy enough seats at the table.

But, financial reporting is not rocket science: it shouldn't be too hard to set forth investor-friendly core principles for financial reporting, should it? It also should not be hard to establish a core set of principles that, going forward, may not be violated as changes to accounting standards are made. I am not asking you to assume that my motives are purer than others who have set pen to paper, but I am inviting you to consider whether these principles, below, in contrast to what we now have, are what accounting should be based on in a fully consistent manner:

• The sole purpose of financial reporting standards promulgated by the IASB or FASB is to provide timely and relevant information to investors, period.
• Investors should be provided with information relevant to assessing the amount of wealth available to the reporting entity, claims on wealth, and how wealth has changed over time.
  • The balance sheet is the principle financial statement for reporting wealth (assets) and claims on wealth.
  • The claims on wealth are distinguished by non-owner claims (liabilities) and owner claims (owners' equity).
  • The income statement reports changes in assets and liabilities for a given period resulting from transactions between the reporting entity and non-owners (or owners in a non-owner capacity). Such changes should clearly delineate the effects of operating and financing activities.
• Wealth is the command over goods and services.
• Providing information about wealth is costly. Financial reporting standards must weigh the aggregate costs an entity will incur in producing information against the benefits of being provided with information. This weighing of costs and benefits, has, among other things, the following implications:
  • Not all assets and liabilities of the reporting entity may be recognized on the balance sheet.
  • The most accurate approach to measurement of some recognized assets and liabilities may not be economically justifiable. Therefore, financial reporting standards may require or permit alternative measures that are less accurate, without sacrificing the objective of wealth measurement.
• The needs of regulators, managers, or auditors are not directly germane to establishing financial reporting standards, except to the extent that their past and future actions cause the costs of producing information for investors to change.

The More Things Change…

Because 'true and fair' means bupkis, it could mean anything, and David Tweedie could say that what I have set forth is, more or less, what he meant by 'true and fair' all along.

Whatever… I prefer to refer to my enunciation of core financial reporting principles as 'efficient,' if you know what I mean.

SFAS 157: 'Fair Value' is Not Fair Measurement for Illiquid Assets

I am finally ready to contribute my two cents to the debate as to whether SFAS 157 is at least partly responsible for the subprime mortgage mess. I have pointed out in other contexts (here and here) the serious shortcoming of SFAS 157 as a rules-based standard, but the widespread coverage of the subprime mortgage crisis, and the allegations that accounting has caused much of it, may be the best chance I will get in a long while to explain how much better a principles-based standard would work.

The issues are well-articulated in an article that recently appeared in the New York Times (July 1, 2008), entitled "Are Bean Counters to Blame?," by Andrew Ross Sorkin. Sorkin constructs his story around the much-publicized critiques of Stephen H. Schwarzman, co-founder of the private equity firm Blackstone Group. Basically, Schwarzman argues that SFAS 157 exacerbated the subprime mortgage crisis; because among other things, inappropriate write-downs by public companies somehow all by themselves induced companies to raise new capital at onerous rates. The example held highest is the required accounting for those collateralized debt obligations (CDOs) that were completely written off because markets in which to sell them had dried up. As quoted by Sorkin, Schwarzman says, "the concept of fair value accounting is correct and useful, but the application during periods of crisis is problematic. It's another one of those unintended consequences of making a rule that's supposed to be good that turns out the other way."

The phenomena that poor quality accounting leads to poor quality decision-making by financial statement issuers has been demonstrated far too often to be plausibly denied, and problems with SFAS 157 are also self-evident. In that sense, Schwarzman's complaint has merit; however, if he is right, it is for the wrong reasons. So, I'm going to presumptuously do him the favor of making the right argument—and at the same time show him that he is not as right as he thinks he is.

The very beginning is the right place to start: wealth is defined by economists as the 'command over goods and services.' A corollary principle is that the utility of an asset is derived from the amount it would cost to replace it. (For acknowledgement of this in the accounting literature, see ARB 43, on the accounting for inventories). Hence, the fundamental flaw in SFAS 157 is that its concept of 'fair value' is built around the notion of an 'exit price', but the economic definition of wealth is built around the concept of a replacement cost, or 'entry price'.

The distinction between the ability to demand cash and command over goods and services becomes critical when an asset has value in use (or in the case of a financial asset, by holding on to it and collecting the cash flows), but little or no current value through sale. If there exists no current market in which to sell a CDO, there is no one else from whom one can currently demand cash in exchange for the asset. Is the CDO worthless? Absolutely not.

To see why the replacement cost approach is principles-based, now ask yourself what it might cost today to replace an illiquid CDO that was acquired, say, three years ago. Since it's a financial instrument, the question could even be more general: what would it cost to replace the contracted-for stream of future cash flows from counterparties of the same creditworthiness? Asking the right question will almost certainly give you an answer that is less than the amount paid to acquire the CDO before the subprime mess hit the fan, but it is certainly greater than zero, which is the wrong answer that SFAS 157 would give.

Although this doesn't explicitly come out in Sorkin's article, I infer that Schwarzman would argue that balance sheet carrying amounts for CDOs would most appropriately be based on their historic costs. While I do agree with Schwarzman that zero would be wrong, historic cost-based management would be equally wrong. It is also the reality that, like SFAS 157, replacement cost-based measurement can require significant doses of judgment, but often less so. But most critically, estimating replacement cost is the only process out of which there is some chance of coming up with a logically valid result.

So, Schwarzman is right to claim that we should not be subjecting ourselves to an accounting rule that can destroy shareholder value, especially if it can be demonstrated that application of the rule will yield a ludicrous result under conditions when it is most important that it yield something better. But, he would be wrong to suggest that measuring CDOs at anything close to their historic costs would solve any problem at all. If there is any hope of gaining agreement on this point among Schwarzmans, accounting standard setters and investors, it is only through the use of clear and convincing economic logic, and not by a futile defense of the hash of rules that is SFAS 157.