What if the FASB were to issue a proposal to require companies holding marketable equity securities of oil companies to calculate and report their investment as the number of shares owned multipled by the average share price over the past year. The average share price would be calculated from the closing share prices on the first day of each of the past twelve months. (In other words, changes to share prices over the last month of the year would not be counted.)
Assume that the FASB issued its proposal to respond to concerns of financial statement issuers with significant holdings of oil and gas shares that reporting full year-to-year fluctuations in investment values would not constitute "meaningful" information to investors.
Incredible? Yes. Impossible? No. As I am about to describe, something very close to my hypothetical scenario has left the station and is unlikely to be stopped before pooping on the financial statements of oil and gas producers.
In an earlier post, I imparted the common-sense view that the historical-cost based financial statements of oil and gas producers bear almost no relation to a firm's value; because, the historic cost of a producing field, however measured, bears no relation to the value of that field. There are a number of reasons for this, having to do with the luck of the draw or the price for the output that will be obtained from extracting the field's reserves over ensuing decades. To make a long story short, that's why disclosures are critical in the oil and gas industry.
In particular, two disclosures are critical, and it should come as no surprise that oil and gas companies go to great lengths to 'manage' them: (1) the quantities of oil and gas that can't be seen, but are estimated to be in the ground; and (2) a standarized calculation of the amount that the "proved" portion of those in-the-ground reserves are worth. The former is technically an SEC-required disclosure, and the latter, which I will refer to as the "present value of proved reserves" is to be found in the FASB's rules.
"Modernizing" Oil and Gas Disclosures
In December of last year, the SEC issued a final rulemaking release to update the three-decades-old oil and gas disclosure requirements for current practices and changes in technology. As I described in two previous posts (here and here), numerous important and overdue changes to the disclosure rules were made. But there were also numerous sops to the oil and gas industry. Among the biggest gifts was the SEC's statement of intention to get the FASB to muddy up oil and gas valuations -- pretty much in the manner I described in my hypothetical scenario -- by substituting a crude estimation of averages prices for year-end energy prices. The only differences from my scenario are that the measurements are made in disclosures of reserve values, and that they affect the investee's financial reporting (as opposed to the investor's in my hypothetical).
Just as they were commanded, the FASB did indeed issue with great alacrity its own proposal to alter the net present value calculation along the dubious lines specified by the SEC. The FASB's "basis for conclusions"? Here ya go:
"After taking into consideration more than 70 comment letters from financial statement users, preparers, auditors and other constitutents, the SEC refined its proosed rule on oil and gas reporting and issued the Final Rule on December 31, 2008."
There is some brief discussion of other specifics, but with respect to the change in measuring the net present value of proved reserves, there is absolutely nothing more. And even what is provided is grossly misleading. Of the 70 comment letters, virtually all came from oil and gas producers, lawyers representing oil and gas producers, engineers working for oil and gas producers, auditors whose largest clients are oil and gas producers, and consultants whose clients are oil and gas producers.
I could not find a single comment from an investor (even notice the weasel term "financial statement users" in the above quotation) among the list of comment letters posted on the SEC's website. A more accurate description from the FASB of their thinking (or lack thereof) would have been something like this: "The Cox-led SEC did their thing, and that's good enough fer us. Cuz they're the SEC. We got nuthin else to say about 'due process' or any other process."
But in case you are wondering what the FASB is proposing to swallow -- hook, line and sinker -- here it is from the SEC's proposing release:
"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]
Some Unsolicited Advice to the FASB
And, so, FASB, I'm going to pretend that you have not switched off your brains on this, and provide you with some unsolicited advice.
First, your job is not to help financial statement users predict a "general price trend." 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 oil and gas producer during a year in which they sold their entire production forward, because they speculated that prices would go down. Unfortunately for everyone involved in their ostensible "hedge," oil prices rose -- a lot. 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. And, those guys were privy to the best public and non-public information money could buy.
Second, beware of the use of the term "meaningful." To put it as gently as I can, the fundamental attributes of financial information are its relevance and reliability. For example, subsitute either: (1) "relevant," or (2) "reliable," or (3) "relevant and reliable" in the above quotation for "meaningful" and see if it makes any sense. It doesn't, of course. More bluntly, you should treat "meaningful" as if it doesn't exist when discussing the properties of accounting information. I suspect that "meaningful" owes its popularity to the fuzzy psycho-babble of the hippie generation (that would be me). SEC literature is already infested with "meaningful," and you need to put a stop to it before it infects accounting standards.
Finally, FASB, you should stiffen your backbone, clear your conscience and earn a gold star for bucking the single-minded, monied special interests. You omitted any reason for concluding that an average price should be substituted for the period-end price, because there is none possible. There is nothing you have ever done, and nothing that you could now say to rationalize the product of an SEC administration that would have babbled and blurted anything for the benefit of its political backers.
If the new SEC honchos are still intent on mucking up oil and gas disclosures, they have the statutory authority to do it without any assistance from the FASB. Gratuitous shilling shouldn't have to cost investors $500,000 per vote.
Dear Tom
Another interesting post. I am glad I read your blog. It keeps me up to date on the goings on at the SEC and FASB.
As far as this ED, well I do not rep Big Oil and Gas. I have small producers and they use idnependent geologists for their pre codification FAS 69 disclosures even if not public. This info is very helpful for the impairment test under pre codification FAS 144 and as you know we use undiscounted cash flows. But another issue I have is that it did not discuss which pricing index to use and there are multiple oil and gas price indexes most of which are not publicly quoted except for Brent crude and of course West Texas Intermedicate.
Posted by: Kevin Brown | October 21, 2009 at 07:31 PM
What can we expect from the FASB that caved in to the banks on SFAS 157?
Posted by: Independent Accountant | October 28, 2009 at 05:33 AM