The Accounting Onion

The Speak-No-Evil FASB

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My previous post lambasted the FASB for shilling the SEC's whacky proposal to measure the year-end value of oil and gas reserves at average prices for the year – instead of the year-end price. Since then, I had two follow-on thoughts; the first one I'll mention is not related to the cheeky title of today's post, but it leads into the one that is.

A More Reasonable Way to 'Modernize' Oil and Gas Disclosures

A week ago, I forgot to mention that there really is a reasonable way to enhance the measurements of year-end values of oil and gas reserves, the ostensible goal of the SEC's recent actions.   But, it has nothing at all in common with the SEC/FASB approach of using averages.  What I have in mind is 'sensitivity analysis.'

Investors can use information about the current value of reserves today, but they also can use information concerning risk of changes in value. Financial reporting rarely reports that kind of information, but there have been movements in that direction of late, and by the SEC no less. Most prominently, Item 305 of Regulation S-K requires quantitative measures of market risk sensitive financial instruments, which often takes the form of some version of a sensitivty analysis.  In addition, Financial Reporting Release No. 60, urges companies to provide a sensitivity analysis covering assumptions underlying critical accounting policies.

So why not provide a sensitivity analysis regarding the value of oil and gas reserves? It doesn't have to be complicated, and the resulting disclosure could be as clear and simple as the following:

Using end-of-year energy prices, the present value of proven reserves is $100 million as of December 31, 20x0. Energy prices during the year ranged from 80 to 130 percent of the year-end prices. If the lowest (highest) energy prices during the year were substituted in our year-end present value calcultions, the lower end of the range would result in a $50 million valuation, and the higher end of the range would result in a $130 million valuation. The range of valuations is not proportional to the range of prices for the following reasons: [would be listed here.]

Sensitivity analysis of valuations can always be informative, but particularly so in the extractive industries. A significant portion of the value of the investment in a project can be traced to 'real options'; e.g., to invest in additional development if prices rise, or to shut down operations until such time as commodity prices recover. In fact, in the three decades since the SEC came out with its original version of oil and gas disclosures, the topic of 'real options' has gone from esoteric to an essential component of any capital budgeting decision by the larger players in the extractive industries. By the same token, investors are in a better position to value options (especially those that are not recognized on the balance sheet) if they can more reliably estimate the volatility of a project's value.

Covering Ears, Eyes and Mouths

Maybe you like my suggestion to add sensitivity analysis to the present value of reserves disclosures, or maybe you don't. Whatever your opinion, you should definitely be incredulous that the FASB appears unwilling to give any alternative to the SEC's hatchet job so much as lip service.

Now that the ball is in the FASB's court, one must ask whether all of them have truly put their brains in neutral, or whether they have even considered alternatives to the SEC's approach.  If they have chosen to put their brains in gear, we certainly can't tell from their proposing document or any other public comments. At least at the SEC, dissenting board members give speeches that reveal their own preferences and reasoning. It appears that FASB members, perhaps as a matter of basic economic incentives (i.e., money), don't dare to do the same. Based on the way the last investor representative on the board was treated, it's pretty safe to assume that, if you are not a go-with-the-flow sort of chap, chances of getting your $500,000/year position renewed for a second five-year term are slim to none.

Here's my prediction as to what is going to happen with the ED. The Board is going to vote 3 -2 in favor of measuring the value of proven reserves at average prices. Two board members, Linsmeier and Siegel, are going to furnish compelling dissents, and maybe another financial columnist will celebrate the dynamic duo for the strength of character they displayed while others around them were busy shilling. But in the final analysis, after-the-fact minority dissents will have no effect on anything real or important. As my father too-often said, "If all you have to stand on are your principles, then you may as well remain seated."

Yes, minutes of open meetings report board members' comments leading up to exposure documents, but who reads them? I might if I were to have trouble falling asleep at night. Why aren't formal dissents registered in exposure drafts? Why don't board members, as SEC commissioners often do, provide their individual views when they go around making speeches? For true 'due process' to occur, we need more open public debate on the issues. Commenters on FASB proposals need to have some idea of the level of consensus within the board.

I suspect that every single FASB member thinks that measuring the value of proven reserves by average, instead of current, prices is a significant step in the opposite direction from quality financial reporting. So, perhaps I am being unfair in calling on only Tom Linsmeier and Marc Siegel to carry the flag of reason and investors' interests. But, no good deed goes unpunished. That's what they deserve for taking principled stands in the past – even if, thus far, they have amounted to little more than empty gestures.

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FASB Proposed Changes to Oil and Gas Disclosures: A Crude Sham

Before I discuss the sordid details of a recent FASB proposal, please take a moment to read this hypothetical: 

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.

Announcing Our IFRS Survey!

This is a brief announcement of an online IFRS survey that I have prepared with Pat Walters of Fordham University. 

I invited Pat to collaborate with me because we have divergent views on the questions being asked.  Thus, I hope that together we have achieved a modicum of balance in the survey's design--particularly in the phrasing of the questions and response choices offered.  There are only 12 multiple-choice questions, and afterwards, I cordially invtie you to express your own opinions regarding its design by posting a comment to this blog post. 

We are also trying to reach many more stakeholders than any other survey has reached to-date on the IFRS adoption/convergence question.  To that end, we hope you will choose to email the link at the bottom of this post to anyone else whom you think might have an interest in taking it.

Pat and I thank you in advance for clicking here to take the survey, or by pasting this ugly link in your web browser:

http://www.surveymonkey.com/s.aspx?sm=pF0E3UgdSV_2bHMQvdAnXv8w_3d_3d

S-OX 404(b) for Non-Accelerated Filers: A Political Crime Waiting to Happen

Section 404(a) of the Sarbanes-Oxley Act, together with SEC rules implementing the provisions of the Act, require management to assess and report on the effectiveness of internal control over financial reporting (ICFR). It took a few years for the SEC to phase everybody in, but all public companies, large and small, are now subject to the requirement.

As pretty much everyone knows, however, S-0X 404 doesn't stop with a management report. Auditors get in on the action in Section 404(b). Therein is the lucrative requirement that an independent auditor attest to management's assessment regarding the effectiveness of their internal controls over financial reporting (ICFR). One person testifying before Congress has called the provisions of S-OX 404(b) the largest windfall to audit firm partners in history, and as I will soon describe, 6,000 more public companies await a new 'service' for which the benefits are, to be charitable, unclear.

Why S-OX 404(b) is Little More than Chicken Salad for Auditors

The corporate corruption scandals that got politicians moving on the Sarbanes-Oxley Act of 2002 were the result of fraud by CEOs and CFOs. ICFR can have little to no impact on the actions of the top executives, because they always possess the power to override internal controls, or sometimes to orchestrate collusive schemes that circumvent those controls. Thus, Section 404 cannot possibly do much to mitigate these particular sources of fraud risk; and there is no better example of that than Enron itself. I have been told (but have not verified) that Enron was the only public company to disclose with much pride and pomp that it paid its world-class, independent auditor to perform a separate evaluation of internal controls. Andersen's report was, of course, clean as a whistle.  

No one should doubt as well, that Enron's relationship with its auditors wasn't much cozier than the norm, either. No matter who the client is, and especially if it is a big one, material weakness are generally only reported after an error has occurred; i.e., after a control has obviously failed. Thus, all the machinations to test ICFR, and prevent a control from failing, don't add much beyond the testing of account balances that occurs as part of the regular financial statement audit.

So, it remains questionable at best, that S-OX 404(b) has created a safer environment for investors to trade their shares. Auditors, on the other hand have been champing at their bits, waiting for the SEC to throw them some fresh meat: the 6,000-odd smaller public firms (technically, "non-accelerated filers) who are not yet required to pay for an ICFR report.

Chicken Salad Days Appear on the Horizon

The auditors received some good news on that front a few days ago when the SEC announced that the stay of execution for non-accelerated filers would be extended only until their annual reports for fiscal years ending on or after June 15, 2010. Chair Schapiro and one other commissioner also issued statements to 'assure investors' that no further extensions would be granted.

Indeed, the SEC's Office of Economic Analysis has completed the last of the SEC's go-through-the-motions machinations to steer S-OX 404(b) through the gauntlet of thousands of irate registrants who resent the additional audit fees imposed upon them -- and the additional hoops they must jump through. And, what did OEA's report have to say? As it turns out, not much at all. Although changes to SEC and PCAOB guidance may have reduced the cost of S-OX 404(b) implementation for companies that currently must comply, OEA did not even address the key question: whether the costs of complying with S-0X 404(b) has been less than the benefits, or whether benefits can be expected to exceed the costs of compliance for the 6,000 companies in line to be plucked. It must surely be the case for non-accelerated filers that initial implementation costs are most onerous, especially in an economic down cycle. But nothing so obvious and significant was to be found in the OEA's report.

The Skinny on the Costs and Benefits of Section 404(b)

If I were writing OEA's report, I might have begun and ended with the following modest, albeit virtually dispositive, back-of-the envelope calculation: The total value of all public traded equities in the U.S. is very approximately $14 trillion, based on information available from indexes published by Wilshire Associates. Let's conservatively assume that each and every non-accelerated filer has a total market cap of $75 million, which is the maximum market cap for a non-accelerated filer. Even under that very conservative assumption, 6,000 non-accelerated filers comprise (at the very most) only 3.2% of aggregate equity values.

In the best of worlds (i.e., assuming that there is real information in an auditor's attestation report) can the new fees that auditors will charge these 6,000 smaller companies provide loss protection that will cover the billions of dollars in aggregate fees? Don't bet on it.

In fairness, the SEC would say that their hands are tied; S-OX directs the SEC to require ICFR attestation reports from all public companies. So, what should really happen is for Congress to wake up and amend S-OX to permanently exempt non-accelerated filers from the requirements of Section 404(b). Will it happen? Don't bet on that one, either.

What upsets me the most is that chair Schapiro is once again catering to the wishes of the Big Four instead of affecting much needed reform, as she has pledged to do. Schapiro should use her bully pulpit to inform Congress that they have created an obvious case of excess regulation. Notwithstanding the sorry fact that S-OX 404(b) has devolved into a waste of time for all issuers, to extend it to non-accelerated filers would be nothing less than criminal.

Instead, of rushing to require ICFR audits, why don't we just sit back and wait to see how many non-accelerated filers will voluntarily submit to an examination of their ICFR – just like Enron did.