The Accounting Onion

The Futility of SEC Oil and Gas Disclosures: Part II

A couple of posts ago, I wrote about the SEC's project for revamping the reserves disclosures made by oil and gas companies. In particular, I focused on appropriate prices to be used for measuring the value of recognized reserves. Notwithstanding the absence of logic in the SEC's proposals with respect to the pricing of disclosed reserves, I'm going to now focus on why the quantity of reserves being reported leaves much to be desired.

First, I need to acknowledge the essential contributions to this post of my good friend, Bob Hinkel. Bob recently co-founded Elang Energy, Inc., and when I first met him, he was matriculating in Thunderbird's two-year executive masters program, while working for Unocal as their head of procurement. After Bob was promoted to manager of all of Unocal's vast operations in Indonesia, I was fortunate enough to assist him on a couple of projects on the island of Borneo.

Among other fascinating things I learned about the country, its people and natural resources, Indonesia pioneered the oil and gas 'production sharing contract,' which has been subsequently adopted in many other parts of the world. In contrast to the royalty-based licenses common to the U.S., PSC contracts tightly align the interests of the oil company with the interest of resource owners. Basically, a PSC contract turns over a portion of the oil production to the host government on a basis similar to an income tax. The result is efficient in the respect that an investment project that is profitable before taxes will assuredly be profitable after taxes. The same can't be said of U.S. tax regimes, which takes a portion of the production 'off the top' as a royalty. Therefore, a domestic project that is profitable before taxes may not be profitable after taxes, having the effect of leaving oil in the ground that would have been extracted under a PSC.

Some Examples of Disclosure Problems New Rules Won't Fix

This discussion of PSC contracts might seem like a digression, but their relevance to the topic of SEC financial reporting lies with U.S.-centric disclosure rules. Bob gave me these two examples:

• Under a PSC, the oil company is credited with barrels of oil to offset the operating costs it pays in currency. If oil prices rise, it takes fewer barrels of oil to reimburse the oil company for its out-of-pocket costs. This is an unambiguously good thing for both the shareholders of the oil company and the foreign owner of the resources, because both share in the increased profit. But, paradoxically, the quantity of reserves that the oil company reports will decline as oil prices rise. That's because even though their "profit barrels" increase somewhat, their loss of "cost recovery barrels" can be greater.
  
  
• International gas discoveries cannot be booked as reserves until the reporting company actually has a sales contract in hand for the gas. In contrast, domestic gas discoveries, no matter how remote or deep the water, can be booked immediately. Bob says that all of the gas Unocal discovered in Indonesia during his tenure remained "unbooked" despite being directly adjacent to a pipeline feeding the largest liquefied natural gas plant in the world. Bob further contends that it allowed Chevron to purchase Unocal from its shareholders in 2005 for a lower price as a result. I believe him.

In order to understand the third example Bob gave me, you need to know that there are currently three layers of recognized reserves: (1) proven, developed and producing; (2) proven, developed and non-producing; and (3) proven and undeveloped. (The SEC is proposing to add disclosures of 'probable' in addition to 'proven' reserves, but that's another matter.) The first category is pretty straightforward, but for the latter two categories the oil company has to determine, on a field-by-field basis, that the reserves are justifiable on technical grounds – and only then on economic grounds based on some price (see my earlier post on this part) and estimated future production costs. The subjectivity associated with these more uncertain quantities combined with the so-called 'double trigger' for recognition in the disclosures permits companies to manage their reserves to ensure the appearance of a continually growing resource base.

The Lessons

From these observations, I want to make three points. First, I am not aware that anything the SEC does will fix any of these anomalies I have mentioned, and there are surely many more. Second, no matter how the SEC decides to tweak the disclosure rules, they are unlikely to result in better information for investors, due to the ease with which recognition of reserve quantities can be 'managed.' Moreover, I doubt if auditors provide anywhere near the same level of scrutiny to financial statement notes as they do to amounts in the statements themselves.

Third, and this continues a theme of my recent post on off-balance sheet financing, disclosures could be greatly simplified, and would be more reliable, if oil companies were required to report some measure of the current value of their properties in the financial statements. We are learning the hard way that financial reporting is always better if disclosures supplement what is recognized in the financial statements, as opposed to what is not.

In the case of oil and gas companies, no one can seriously dispute that the numbers currently being reported on the financial statements aren't worth a fig anyway. The SEC is fiddling with the disclosures and ignoring the fundamental problem: untold millions of dollars are spent producing and auditing GAAP financial statements that bear no relation to the value and performance of companies in the extractive industries.

A Semi-Random Tidbit

Finally, this is somewhat of a digression, but perhaps some of you may find it worthwhile food for thought. If the U.S. revamped its inefficient royalty system of taxation on oil and gas operations, then many millions of untapped reserves in developed fields might become economic on an after-tax basis. The significance of the current political debate about whether we should be allowing new off-shore drilling could pale in comparison to the amount of oil that has been left in the ground from decades of tax-driven decision making.

No Escaping the Politics of Information

It's one thing to rely on misleading financial statements and invest in a company that soon thereafter goes bankrupt; and quite another to invest in a hip replacement operation that turns out badly because your doctor had misleading information concerning the artificial joint he chose for you. Or is it?

Even if you are too young to think about swapping bone for metal, you will be surprised to know that a recent article in the New York Times, "A Call for a Warning System on Artificial Joints," contains some interesting food for thought for us accounting policy wonks. If I were still teaching accounting, I would share and discuss this story with my students, be they freshmen, accounting majors, MBA or doctoral candidates. The principles of information economics are universal, and unfortunately, so it would appear are the politics.

The article is motivated by one doctor's experience in trying to understand why he had a spate of patients who suffered from post-surgery complications requiring corrective surgery. Of course, the device manufacturer blamed it all on the doc, until he got his colleagues to share their own sorry experiences with the same device. The lesson he learned is that valuable answers to his questions could have been identified much earlier if the United States had a national joint replacement database. But, despite the efforts of a very few good Samaritans, we're not even close. Sweden has one because its government saw fit to establish it, and Australia has one because the surgeons themselves took the initiative to set one up.

The cost of maintaining the database system is estimated to be $10 -$15 million per year. That's a drop in the bucket compared to the needless suffering caused by not having one, not to mention the billions of dollars spent on premature "revisions" to knee and hip replacement surgeries. The article states that the risk of complications in countries without databases can be double those of countries that have them.

Getting to the accounting lesson, the stupid reasons why we don't have a joint replacement database sound a lot like why we are stuck with some of our stupidest accounting standards. So, anyone familiar with the politics of financial reporting could probably guess what the problems are in the medical field:

• Doctors won't go through the effort of submitting information on their procedures unless they are forced to do it – Sounds like any number of FASB battles where issuers and auditors fight tooth and nail against improved financial reporting standards.  The almost complete absence of reliable information even harkens back to the conditions leading up to the federal securities laws in '33 and '34.
• Doctors are also concerned about jeopardizing their relationships with device manufacturers, who may be compensating them to use their product – Sounds like issuers attempting to influence auditors with large fees for non-audit services. A database could separate the pigs, kicking and squealing, from their troughs. 
• Device manufacturers are afraid that transparency will increase exposure to product liability lawsuits, and doctors of malpractice lawsuits along the same lines – Sounds like the U.S. auditors and issuers who are cheerleading the adoption of IFRS as a way to decrease their exposure to litigation.
• Most depressing is that government agencies, who could solve the problem with a stroke of the pen, are babbling nonsense.  Medicaid says it's not their job; the Food and Drug Administration says it would open the door for other medical procedures to be registered and tracked. Sounds eerily similar to the SEC's pandering to auditors and/or issuers with barely lip service to investor protection.  Don't get me started on recent examples.

Bottom line for me is that the reasons we should not leave the medical database decision to private interests are the same as why we can't do it with accounting.  As to my aching knees, as things currently stand, I would prefer to have my them replaced in transparent Australia or Sweden.  On the other hand, I would prefer to invest in stocks listed on the New York Stock Exchange instead of the Australian Securities Exchange where opague IFRS is the coin of the realm.

But, the sad part is that if the U.S. switches to IFRS and I'm a beer-drinking, beach-and-tennis-loving investor in need of a joint replacement, I just might be better off moving to Australia.

Postscript

My good friend and former colleague, Jim Noel, had this to say about my post:

"Your post raises the question of whether databases providing information on items will become available worldwide.  Of course, the US can suppress data by allowing different products (statements) or enforcement in this country, but commuting for information is pretty cheap these days.  When I read the hip replacement comments by you, I was thinking that the financial statements problem is even easier to solve.  All that is required is one country giving adequate disclosure.  For reasons that the USA should try to remain that country, I would refer you to one of many articles about getting care abroad, so-called 'medical tourism', in the Economist.  A URL is:

http://www.economist.com/opinion/displayStory.cfm?source=hptextfeature&story_id=11920756

While enforcement mechanisms will differ across countries for financial statements (possibly the information that is allowed in the court system), information flows will not.  The world is potentially changing, and the question is whether we in the US want to give up the premier position as provider of financial information." [italics supplied by me}

FAS 140: Let's Call the Whole Thing Off

I concluded my previous post by stating that financial reporting could be a lot less complex if the exclusive focus were on providing information of value to investors. There are many examples of the costs of failing to adhere to this basic principle, but certainly none more timely than FAS 140, that bric-a-brac of off-balance sheet accounting gimmickry.

A Grim History Lesson

The bells and whistles of SFAS 140 are best seen in the context of the FASB's financial instruments project, which was started way back in 1986, and spewed out sub-prime accounting standards over the ensuing decade and a half. This chronological listing gives you some flavor as to how hypersensitive the FASB has been to offending the sensibilities of big banking and big industry:

• FAS 105 and 107 tippy-toed around fair value or impairment questions with watery disclosure requirements.
• After the savings and loan collapse, the FASB reluctantly stuck its tootsies in waters made frigid by banking interests with FAS 114 and 118. The standards require some modicum of consistency with regard to assessing and measuring loan impairment, but implementation is an unprincipled mess to permit unwarranted delays in the recognition of bad loans and to avoid taking the deeper plunge toward market-based valuation.
• FAS 115 on marketable equity securities created the ludicrous notions of 'held-to-maturity' and those weasel words, 'other-than-temporary decline in market value.' But, at least some financial assets were required to be measured at their market values.
• FAS 122 (superseded by FAS 140) on mortgage servicing rights allowed for liberal impairment evaluations and earnings manipulation.
• In FAS 123 on stock-based compensation, the entire FASB should have threatened resignation in response to Congress's bluff to shut them down; instead they permitted a disclosure-only alternative to fair value of stock options that perpetuated a corrupt system of executive compensation.
• FAS 125 was the predecessor to FAS 140 for the accounting for transfers of financial assets. Bankers didn't like it, because off-balance sheet financing wasn't easy enough.
• FAS 133 requires certain derivative financial instruments to be measured at fair value. However, its byzantine hedge accounting rules permitting management to smooth earnings is costly and of absolutely no benefit to investors. If there is life on another planet, it surely won't be so primitive as to have an accounting rule like FAS 133.
• FAS 140 was created out of FAS 125 by tinkering with, among other things, the control criteria and the rules to determine whether an entity is a QSPE – you know, that cute little bug we're trying to squish, but can't.

The Basic Idea and Problem with FAS 140

Given the checkered history of financial instrument accounting, it is somewhat ironic that the core provision of FAS 140 is deceptively straightforward and even sensible: a transferor may only derecognize a financial asset, or a component of a financial asset, if it has surrendered 'control' over it. Thus, upon de-recognition, a gain or loss is recognized for the difference between the carrying amount of the transferred asset and the proceeds received in exchange.

As simple as that sounds, implementation has been complicated for two related reasons. First, a loss-of-control derecognition threshold still allows an entity to have all kinds of continuing interests in a financial asset subsequent to being "transferred." Second, allowing derecognition, while at the same time allowing the transferor to have certain forms of a continuing interest in transferred financial assets, opens a Pandora's box of detailed additional criteria for a broad range of specially-defined off-balance sheet financing gimmicks. Naming them is a bit like reciting the FBI's ten most-wanted list: securitizations (via SPEs and QSPEs), variable interest entities, repurchase agreements, securities lending, transfers of receivables with retained interests, etc. Investors have grown to despise each one of these, as the accounting too often obfuscates important risks that have come back to bite far too many.

My point is that from an investor's standpoint, none of these special accounting rules for achieving off-balance sheet financing are necessary or appropriate. If an investor could write the most basic and only rule of FAS 140, this is a version that would be far simpler and superior to what we have now: a transferor derecognizes a financial asset, or a component of a financial asset, if it no longer has any continuing interest in it. Therefore, all proceeds are accounted for as liabilities until all continuing interests in the transferred financial assets are terminated. (I would also add by way of clarification that any options exchanged as part of a transfer that meet the definition of a derivative in FAS 133 are, in the regime I propose, accounted for under that Statement. So, for example, if a portfolio of loans is transferred without recourse, but the transferee receives a qualifying option to put the loans back at a later date, the transferor would derecognize the loans receivable – and recognize the put option at fair value.)

Not Utopia, But Close Enough

The FASB's decades-long, quixotic quest to find just the right definition of 'control' that will make everybody happy is never going to end well, and it is clearly time to look for a workable solution somewhere else. Having stated what should be obvious to the FASB, but apparently is not, I will, with utmost alacrity, be the first to admit that my proposal is not perfect. This is because I am proposing asymmetric recognition and de-recognition criteria. Specifically, entities should recognize assets when they obtain control of them; and they must stay on the books until the entity no longer has any continuing interest in them.

Such a policy must inevitably lead to asymmetric accounting by transferors and transferees, but that is where we have been for a very long time in the accounting for non-financial assets. For example, consider revenue recognition on the sale of goods; if the buyer has a right of return, the SEC is adamant that a sale, and hence transfer of inventory, has not occurred until the buyer's right of return has expired, except in the special case where estimates of return rates can be made from a history of numerous similar transactions. In other words, if there is more than a trivial probability that the inventory is coming back to you, and you don't have reliable historic base rate information to estimate what that probability is, you have a continuing interest in the inventory.

And, let me also add that any time we can eliminate an off-balance sheet financing gimmick, disclosures get a lot simplier. Under my proposal to eliminate all the off-balance sheet trickery in FAS 140, the revised disclosures could go something like this:

Separately identify, either on the balance sheet or in the notes to the financial statements, those assets that are controlled by the entity, and those that have been transferred. For transferred assets, explain the nature of the continuing interests, and identify any related liabilities.

FAS 140 currently has about 2000 words (ignoring additional implementation guidance)worth of disclosure requirements, with more soon to come. In short, it is much simpler to provide disclosures pertaining to on-balance sheet amounts than it is for off-balance sheet amounts.

Parting Words of Wisdom

Both the FASB and IASB concluded back in 2006, before this latest current financial crisis, that FAS 140 was "irretrievably broken." Now, far too late (as usual), FAS 140 will be modified to eliminate QSPEs, and FIN 46(R) will also be modified to reign in some of the severest known abuses of securitization accounting. But as I hope I have demonstrated in this post, much more can, and should, be done. Otherwise, it's just a matter of time before some enterprising Ira Fastow-type financial executive or banker will serve us up yet another latest and greatest off-balance sheet vehicle that blows up in our faces.

CIFiR Fumbles, Stumbles and Bumbles at the Goal Line

Pre-eminent:

• "surpassing all others" (Compact Oxford English Dictionary);
• "having paramount rank, dignity, or importance" (Merriam-Webster's Online Dictionary).

I have interrupted composing a post that will solve all of the problems of securitization accounting to bring you this: my latest discovery of a plain English word that has been mutated beyond recognition by some group promoting their particular brand of financial reporting. I found it in one of my favorite blogs, Edith Orenstein's FEI Financial Reporting Blog, which reported on how the decamping SEC Advisory Committee on Improvements to Financial Reporting (CIFiR) zapped the perfectly good 'pre-eminent' with a massive dose of gamma rays:

One item on the list of 9 changes was to insert a new footnote … to define what CIFIR means by 'investor preeminence" as that term is used in Recommendation 2.1, which says, in part: "Therefore, investor perspectives should be given pre-eminence¹⁵ by all parties involved in standards-setting."

Footnote 15 states: "We recognize the need for balance among all parties involved in the standard-setting process. We do not intend to suggest by this recommendation that investor input trumps all others. Instead, in cases where constituent views cannot be reconciled, we believe that all the investor perspectives should be afforded greater weight."

Pozen explained in describing the change at the meeting, "Not that it [investor perspectives] always wins, but it has greater weight."

{bolded text in original; italics and line breaks supplied by yours truly}

Well, if Footnote 15 is what CIFiR actually means, would it not have been more straightforward to state it that way in the main text, instead of relegating a mutated definition to a footnote that few will read? The main text could then state what CIFiR supposedly intends to say: Therefore, investor perspectives should be given greater weight.  Yuk.

And, come to think of it, 'perspectives' and 'inputs' are just two weasel words masquerading for needs. Maybe auditors and issuers have perspectives and inputs, but investors have those and needs for information to boot. It makes me more than a little uneasy that the committee could not plainly acknowledge investors' needs for information, for those are the raisons d'etre for the SEC, FASB and the whole financial reporting ball of wax.

That's why this key element of CIFiR's report should have been written thusly: Therefore, the needs of prospective investors for information are pre-eminent.

Period. The only relevant considerations for establishing financial reporting rules are (1) the value of information to prospective investors, and (2) the costs of producing information. Auditors, issuers and regulators may provide input and perspective, and they do have needs; however, CIFiR should have made it clear they understood that the information needs of prospective investors should be the only needs that count. If CIFiR, for whatever reason, needed this eleventh-hour qualifying footnote, they should have also given us at least one itty bitty sniff of an example that can counter the notion underlying the plain English from which they now distance themselves. They didn't, because they couldn't.

Yet, despite CIFiR having regurgitated the same clear-as-mud financial reporting objective that hoplessly complicates everything, Chief Accountant Conrad Hewitt appears to have fallen over himself to thank the members of CIFiR for helping to provide guidance on simplifying the financial reporting system. I'm not going to dismiss everything that CIFiR did as vacuous, because they certainly provided constructive input in a number of areas (some others, not).  But in this most critical and fundamental respect, they chose to muddy the same waters that they themselves had clarified -- just hours before getting out of Dodge. When I get around to evaluating some of the other recommendations, for example error materiality and restatements, it will be with a sense of skepticism honed sharper by this goal-line fumble.

And by the way, Chairman Pozen's gratuitous explanation for that Footnote 15 helps not at all; if investor perspectives always get greater "weight" when differences cannot be reconciled, doesn't the revised language also mean that inestors always "win"?  If not, there must be some other secret ingredient to the policy making recipe (like who paid whom) that Pozen thinks is the real pre-eminence.

It's a shame -- if not one of the greatest financial tragedies of our time -- that financial reporting could be so much simpler if this one core principle, investor pre-eminence, were faithfully observed. I will have more to say about this in my next post when I discuss the mess that is securitization accounting.  I can't wait.