Recognition Versus Disclosure in The Oil and Gas Industry

Recognition Versus Disclosure in The Oil and Gas Industry David Aboody Anderson Graduate School of Management University of California, Los Angeles Los Angeles, CA 90095-1481 E-mail: david.aboody@anderson.ucla.edu July 1996 I wish to thank Shlomo Benartzi, Nicholas Dopuch, Stephen Hansen, Robert Holthausen, Pat Hughes, Gil Mehrez, Judy Rayburn, and participants in the JAR conference for their helpful comments I also wish to thank the anonymous referees and editor for their patience and helpful comments I am especially grateful to Keith Klaver from Price Waterhouse LLP for providing me with a practitioner’s view of oil and gas accounting Recognition Versus Disclosure in The Oil and Gas Industry Introduction This paper investigates whether recognition and disclosure are equivalent in their pricing consequences in the oil and gas industry The investigation concentrates on the oil and gas industry because Securities and Exchange Commission (SEC) regulation SX 4-10 provides a unique opportunity for testing the stock price consequences of recognition versus disclosure The SEC regulation requires the firm-specific effect of a macroeconomic event to be formally recognized in the financial statements for oil and gas firms adopting the full cost method and disclosed in footnotes for firms following the successful efforts method Results of multivariate tests indicate that in an investment setting footnote disclosure is not equivalent to recognition Whether users of financial statements distinguish between recognition and disclosure is a central question in the debate over accounting standards However this question was never explicitly empirically tested (for a literature review, see Bernard and Schipper [1994]) Existing empirical studies (e.g., Amir [1993], Barth [1994]) investigate the association between the firm’s market value and an estimate of the disclosed item However, although the coefficient estimates on the disclosed item have the predicted sign, the coefficient estimates are significantly different (in both directions) from the theoretical predictions The results may be attributed to market inefficiency, measurement error in the disclosed items, or because disclosed items are less reliable than recognized items The experimental literature (Harper, Mister, and Strawser [1987,1991]) suggests that whether an item is recognized or disclosed influences financial statements users’ perceptions However, the experimental studies not address the issue of whether different users’ perceptions will result in different pricing in the marketplace The accounting treatment for oil and gas firms provides a unique opportunity for testing the pricing implications of recognition and disclosure SEC regulation SX 4-10 allows firms adopting the FC method to capitalize all costs associated with property acquisition, exploration, and developments activities However, if the net capitalized cost of FC firms exceeds the net discounted future cash flows from proved oil and gas reserves (termed “ceiling”), the excess is an ordinary loss The SEC regulation requires SE firms to disclose in footnotes the “ceiling” and their net capitalized asset value However, the SEC and Generally Accepted Accounting Principles (GAAP) force SE firms to recognize a write-down only if the capitalized costs exceed the net undiscounted future cash flows from proved oil and gas reserves Consequently, if the net capitalized costs exceed the “ceiling” but are less than the undiscounted cash flows, an FC firm must write-down its assets to the discounted cash flow while an SE firm will only report an as-if write-down in its footnotes This study focuses on a sample of 21 FC firms that formally recognize a write-down and a sample of 50 SE firms that discloses the economic loss in their footnotes I conduct an event study investigating the cross-sectional variation of stock returns at the write-downs announcement date and the 10-K filing date For FC firms the market generally observes the write-down at the write-downs announcement date and for SE firms the market can estimate the disclosed write-down at the 10-K filing.1 When investigating the market reaction, I test whether the market responds similarly to FC firms recognizing a loss and SE firms disclosing one.2 Pooled cross-sectional regression results document, at the write-downs announcement date, a significant negative market reaction to firms recognizing a write-down At the 10-K filing date there is no significant market reaction to firms disclosing a write-down In addition, at the 10-K filing date the increase in the probability of debt covenant violation is negatively associated with stock returns for both SE and FC firms The main result that investors price differently recognized and disclosed write-downs is robust to several competing hypotheses My results suggest that information disclosed in footnotes to the financial statements is used differently by investors from information recognized in the primary financial statements The main finding is that the market reaction to firms recognizing a write-down significantly differs from the reaction to firms disclosing it One explanation is that the FC firms’ write-downs are visible while favorable information offsets SE firms’ write-downs released in the 10-K An alternative explanation, given the material impact of write-downs on firms’ net All but two firms disclosed the write-down at the earnings announcement date The 3-day return for the firms disclosing the write-down before the earnings release was -66.67% and -12.5% In a Wall Street Journal article dated April 17, 1992 Catherine Montgomery, an analyst with Donaldson, Lufkin & Jenrette, discusses the market reaction to FC firms recognizing a loss "I think that serious investors, institutions and analysts understand these writedowns and what they say about the companies forced to take them But the average investor out there has a knee-jerk response and stock prices may be affected." equity, is that investors concentrate on firms’ net equity for valuation purposes.3 The remainder of the study is organized as follows Section includes the related oil and gas accounting background and the method for estimating the SE firms’ economic loss Empirical tests are developed in section Section details the sample selection and descriptive statistics Results and diagnostic tests are presented in section 5, and summary and concluding remarks are presented in section In an interview with Mr Braverman, an investment officer with Standard & Poors, the Wall Street Journal (December 21, 1995) reports the following: “Nor says Mr Braverman should they [investors] ignore that a big write-off knocks down a company’s book value, known as shareholders’ equity, an important yardstick of a company’s worth.” 2.1 Accounting Background and the Disclosed Write-Down for SE Firms Accounting background Securities and Exchange Commission (SEC) regulation SX 4-10 prescribes financial reporting for firms engaged in oil and gas producing activities According to SX 4-10, firms adopting the FC method (from hereon FC firms) may capitalize all costs associated with property acquisition, exploration and development activities Firms are required to capitalize the costs within the appropriate cost center that is based on a country-by-country basis In contrast, firms following the successful efforts method (from hereon SE firms) are allowed to capitalize the same costs only if they result in an increase of proved oil and gas reserves The regulation states that FC firms must perform a “ceiling test” at the end of each quarter The ceiling for each country is the sum of: (1) the present value of proved oil and gas revenues from estimated production of proved oil and gas reserves, based on the oil and gas prices at the end of each quarter and a discount rate of 10%, (2) the cost of properties not being amortized, and (3) the lower of cost or estimated fair value of unproved properties included in the costs being amortized, less (4) income tax effects related to the difference between book and tax basis of the properties involved.4 Subsequently, if the net capitalized costs within a cost center, less related deferred income taxes, exceed the cost center ceiling, the excess is an ordinary loss FC firms cannot reinstate the loss (termed a write-down) due to a subsequent increase in the cost center ceiling The SEC did not apply this Cited from regulation SX 4-10, Full Cost Method paragraph (4) recognition requirement to SE firms because it contended that the write-down event should be rare Therefore, SE firms recognize a write-down only if their net capitalized costs are higher than the net undiscounted value of their proved oil and gas reserves.5 Consequently, the different reporting rule causes FC firms to recognize in the income statement the excess of the net capitalized cost over the ceiling while SE firms need only disclose the capitalized cost and ceiling in the supplementary unaudited part of the financial statements 2.2 Calculation of "as-if" write-downs for successful efforts firms Regulation SX 4-10 requires FC firms to recognize write-downs while for SE firms investors can only infer the economic loss from footnote disclosure This section details how footnote information for SE firms is used to calculate their economic loss, and the appendix details a specific example of how the footnote disclosure to calculate the “as-if” write-down is used As previously discussed four components compose the ceiling The supplementary unaudited section of the financial statements provides information on two components: the present value of future net revenues from the oil and gas proved reserves and the income tax effect related to them The audited part of the financial statements provide the other two components, cost of unproved properties and properties not being amortized Before December 15, 1995 managers of SE firms with net capitalized assets higher than the undiscounted value of proved reserves had discretion over whether the assets should be written down to the discounted or undiscounted value I found only one SE firm stating that if a write-down occurs, the asset value will be reduced to the discounted value After December 15, 1995, FAS 121 (Accounting for the Impairment of Long-lived Assets) requires the asset to be written down to its discounted value The as-if write-down is the excess of the disclosed ceiling amount over the net after-tax capitalized cost of proved oil and gas assets The audited part of the financial statements reports the before-tax net capitalized cost of oil and gas properties However, the sample firms not detail the amount of deferred income taxes associated with the capitalized costs in their tax footnote Therefore the pretax as-if write-down is calculated by adding back to the ceiling its fourth component, namely the present value of income taxes The sample of 50 SE firms includes 16 firms that explicitly disclose the present value of income taxes and 34 firms that disclose the future value of income taxes For the 34 firms, the discount rate they use to discount their future net cash flows is applied to the future value of income taxes Since, this procedure can underestimate or overestimate the write-down given the firm’s specific pattern of cash flows, the calculation is repeated by using the minimum of the discount rate, over the past three years resulting in the elimination of two as-if writedowns Finally, out of seventeen firms operating outside the United States, seven firms did not provide a country-by-country breakdown of the information Therefore, because the as-if write-down is estimated on an aggregate level the write-down is underestimated for these firms In this study, the pretax economic loss for SE firms is the excess of the pretax net capitalized costs over the pretax ceiling Consequently, users of SE firms’ financial statements could also perform the above calculation and arrive at an “as-if” write-down for the SE firms’ properties Therefore, SE firms are considered the disclosing firms, and FC firms are the recognizing firms Research Design for Testing Recognition and Disclosure in an Investment Setting In an investment setting, recognition and disclosure could have different implications for valuation of stocks for several reasons This section develops the reasons and the research design applied to address them 3.1 Reliability of recognized and disclosed items Statement of Financial Accounting Concepts No (SFAC 5) specifies four criteria for recognition Among others, the item must be relevant, in the sense of affecting decisions, and measured with “sufficient reliability” to be recognized Therefore, the act of recognizing an item is revealing with respect to the underlying relevance and reliability of the information A major component in the ceiling calculation for firms in the oil and gas industry is the quantity of proved oil and gas reserves An independent consulting firm calculates and provides the quantity at the end of each year The amount of the write-down also depends on the book value of the oil and gas properties that is audited for both FC and SE firms Therefore, the reliability of the write-down amount should be similar for recognizing and disclosing firms The SEC required FC firms to recognize a write-down if the net value of the oil and gas properties exceeded the discounted cash flow from proved oil and gas reserves The accounting practitioners, before SFAS 121, required SE firms to recognize a write-down if the net value of the oil and gas properties exceeded the undiscounted cash flow from proved oil and gas reserves The FASB adopted this practice in SFAS 121, stating that “The board adopted the recoverability test that uses the sum of the expected future cash flows (undiscounted and without interest charges) as an acceptable approach for identifying when an impairment loss must be recognized In many cases, it may be relatively easy to conclude that the amount will equal or exceed the carrying amount of an asset without incurring the cost of projecting cashflows.” Therefore, choosing the undiscounted value as the threshold was a cost-benefit tradeoff and not a reliability issue The cost-benefit tradeoff does not apply to the oil and gas industry, since the SEC requires the projection of the cashflows for both the SE and FC firms Therefore, in the oil and gas industry investors are not expected to consider the estimate of a recognized write-down to be more reliable than an estimate of a disclosed write-down 3.2 Time line of recognition and disclosure Except two firms the recognized write-downs are released at the earnings announcement date The release includes current and last year’s earnings per share and sales In addition, the earnings announcements will include a separate line specifying the amount of the non-cash write-down included in the current year’s earnings per share The subsequent release of the financial statements provides a variety of additional information including the cash flow statement, drilling activities, reserves, and the causes of the write-down For SE firms the earnings properties by a company that is primarily in the oil and gas business should be included in EPS forecasts Out of 15 FC firms only forecast is below the actual EPS The median analyst forecast error deflated by the firm’s market value is 0.8% (95.6% of the reported EPS) In contrast, 17 out of the 28 SE firms’ forecasts are below the reported EPS, and the median error as a proportion of the market value is -0.006% (-15% as a percentage of the reported EPS) This results indicate that analysts are not able to accurately predict the recognized write-downs.29 Finally, equations (1) and (2) are estimated by replacing the recognized and disclosed write-downs with the write-down surprise (actual or as-if writedown minus the expected write-down) The coefficient estimates are similar but the t-statistic on the recognized write-down at the write-downs announcement date drops to -1.951 Given the large estimation error in predicting the expected write-down the drop in the t-statistic is not surprising Annual report filing date precedes the 10-K filing date For SE firms and FC firm the annual report filing date proceeded the 10-K filing date Using the earlier of the two dates for testing equation (2) increased the adjusted R2 to 0.051, mainly because of the increase in the t-statistic on the debt covenant violation variable 10-K contains financial and non-financial favorable information that nullifies the negative implications of the disclosed write-down The 10-K contains a vast amount of information that is not included in equation (2) 29 The median age of the analyst forecast for the FC firms is 27 days and 13 days for the SE firms Repeating the analysis with the analysts consensus estimate yielded similar results 28 Therefore it is plausible that the 10-K of SE firms includes favorable information that negates the negative information of the disclosed write-down Table panel B reports the acquisition, sale and revision of reserves in place There are no significant differences between FC and SE firms in the acquisition, sale and revision of reserves in place Therefore, the recognized and disclosed write-downs are caused by the decline in oil and gas prices and not by the purchase, sale or revision of oil and gas reserves Table panel C details the exploration, drilling and development activity of FC and SE firms The median FC firm increased its exploration and development activities both in dollar amounts and in number of wells drilled In contrast, the median SE firm only increased the dollar expenditures on well development and decreased the dollar expenditures on exploration of wells and the quantity of wells explored and developed However, the implications of those descriptive statistics are not clear, since they are firm-specific A contract might oblige a firm leasing the acreage to explore and develop several wells or lose the developed and undeveloped acreage Therefore, an increase in exploration activity by a FC firm might have positive implications on price by indicating that it has positive net present value investments even after a large decrease in oil and gas prices On the other hand, if firms are forced to undertake negative present value projects to hold to currently producing wells, an increase in exploration activities may contain negative pricing implications Finally, The FC firms success rate, defined as the ratio of producing wells to total wells drilled, is significantly higher than the SE firms’ success rate This 29 result might be due to FC firms specialization in exploring for oil or because they undertake low risk low yield exploration activities I estimate equation (2) with additional variables that include change in reserve value and quantity, dividend changes, level and changes of the success rate (defined above) The estimated coefficients on the disclosed write-down, reported in table panel B, not significantly change The results of the robustness tests are consistent with the interpretation that the decision of whether to recognize or disclose is associated with a different market reaction Summary This paper investigates whether investors value recognized information differently from disclosed information This conjecture is tested in the oil and gas industry where FC firms recognize a write-down and SE firms disclose it I argue that this is a powerful test since I concentrate on a single industry where the value of oil and gas reserves is important for firms’ valuations I find that the decision of whether to recognize a write-down or to disclose it has a significant impact on firms’ value The stock price reactions to firms recognizing losses are negative and differ significantly from the reactions to firms disclosing losses This study has some limitations First, my sample consists of twenty-two FC firms and fifty SE firms in the oil and gas industry Therefore, generalization for other industries may be limited Second, the evidence is restricted to write30 downs that are generally large and might not be generalized to other components of earnings that are smaller in nature Third, the results might be influenced by the different noise levels in announcement dates since writedowns announcement dates are more precise than 10-K filing dates Finally, this study seems to have a caveat because the economic loss for SE firms is disclosed in the financial statements Therefore, the effects of disclosing the write-down “compete” with other information contained in the 10-K that might be favorable In contrast, the recognition of the write-down in the earnings announcement is highly visible This allows managers of SE firms to “put the right spin” on the economic loss in the 10-K The 10-K will generally include about 30 pages describing the firm’s business, including positive events such as drilling a new well, increase in reserves, and highlights of financial performance Following that, the 10-K will include management discussion and analysis, that includes managers description of past events and the future actions the firm will take to resolve the current “challenges” facing it Therefore, it is plausible that favorable information disclosed in the 10-K dominates the news about the economic loss I believe this is not a caveat to the study of recognition versus disclosure The FASB and, in particular, the SEC are responding to external pressure by replacing recognition with disclosure, resulting in a tremendous increase in information supplied to investors If investors put the same weight on the managers’ description of the business, management discussion and analysis, footnote information, and the supplementary unaudited information, this 31 study’s results are not surprising Future research should concentrate on whether investors value differently firms mixing bad financial performance with positive management information in their 10-K versus firms that disclose this information as an independent press release TABLE Distribution of Recognized and Disclosed Write-Downs ═══════════════════════════════════════════════════════════════════ ══════════════════════════════════ Panel A: Quarterly Distribution of Recognized Write-Downs Year 87 88 89 90 91 92 93 94 total ─────────────────────────────────────────────────────────────────── ────────────────────────────────── First Quarter 1 5 0 15 Second Quarter 0 0 Third Quarter 0 1 Fourth Quarter 3 13 33 -Total 21 60 Panel B: Annual Distribution of Disclosed (“As-If”) Write-Downs Year 89* 32 90 91 92 93 Total ─────────────────────────────────────────────────────────────────── ────────────────────────────────── Number of “As-If” Write-Downs 17 15 46 ** Number of Actual SE Write-downs 0 1 ─────────────────────────────────────────────────────────────────── ────────────────────────────────── The period of 1990 to 1993 was chosen for the disclosed write-downs because during that period oil and gas prices declined * The 1989 financial statements are not used in this study, however if an “as-if” writedown is detected in 1990, prior years’ financial statements are analyzed to discover which year the “as-if” write-down belongs in ** In this study SE firms recognizing a write-downs elected to write-down the assets to the undiscounted value Therefore, the “as-if” write-down is equal to the undiscounted value of proved reserves minus the discounted value of proved reserves TABLE Descriptive Statistics for SE and FC Firms: 1989-93 ═══════════════════════════════════════════════════════════════════ ══════════════════════════════════ SE firms - 50 events FC firms - 22 events ───────────────────────────────── ───────────────────────────────── Variable mean median Q1 Q3 Mean Median Q1 Q3 T-test ─────────────────────────────────────────────────────────────────── ────────────────────────────────── ΔEPS -0.137 -0.023 -0.107 0.016 -0.091 -0.041 -0.170 0.076 0.707 Δcf 0.072 -0.002 -0.083 0.063 -0.041 -0.024 33 -0.089 0.027 0.344 Wt 0.168 0.096 0.036 0.224 0.260 0.152 0.107 0.287 0.232 Δdcv 0.149 0.000 0.000 0.097 0.110 0.000 0.000 0.167 0.553 Indcon 0.648 0.752 0.277 0.983 0.799 0.970 0.705 1.000 0.096 MV 2318.7 164.9 35.95 830.7 110.1 99.76 50.95 134.0 0.360 3yrexp 0.812 0.570 0.191 1.146 1.125 0.910 0.690 1.180 0.078 Δ$res -0.248 -0.112 -0.298 0.005 -0.233 -0.143 -0.500 -0.063 0.895 Δqres -0.018 -0.001 -0.023 0.014 -0.009 -0.013 -0.029 0.001 0.703 ─────────────────────────────────────────────────────────────────── ────────────────────────────────── The descriptive statistics are for the entire sample at the year the recognized or disclosed write-down occurred All variables except Δdcv and Δqres are in dollars The Ttest displays the two-tailed p-value for the difference in means The p-values not differ significantly for the non-parametric Wilcoxon test and the median test ΔEPS = (net incomet - net incomet-1 ) / MV (for FC firms, write-down is included in income) Δcf = (cash flow from operationst - cash flow from operationst-1 ) / MV Wt = the recognized write-down (the reported number) is deflated by the market value The as-if write-down is calculated by estimating the fourth quarter write-down The estimated fourth quarter write-down is calculated by first estimating the write-down using the footnote information at year t and repeating the calculation using oil and gas prices at the end of the third quarter Δdcv = the increase / decrease in the probability of debt covenant violation at the 10-K filling date indcon = revenue from oil and gas producing activities divided by total revenue at year t MV = price multiplied by the number of shares (in millions) at the fiscal year end 3yexp = average of the last three years’ exploration expenditures deflated by the average of the last three years’ oil and gas revenue Δc$vres = change in the dollar value of proved oil and gas reserves from year t-1 to t deflated by MV Δqres = change in the quantity of proved reserves from year t-1 to t deflated by MV The variable is in millions of equivalent barrels, where 6000 cubic feet of natural gas are equal to one barrel of oil 34 TABLE Univariate Statistics for Recognized Write-Downs ═══════════════════════════════════════════════════════════════════ ══════════════════════════════════ Panel A: Market Reaction for Three Days Surrounding Recognized Write-Down Announcements Write-downs of FC firms - 51 events Write-downs of SE firms - events ───────────────────────────────── ───────────────────────────────── Variable Day -1 Day Day +1 3-day Day -1 Day Day +1 3-day ─────────────────────────────────────────────────────────────────── ────────────────────────────────── mean return -0.016 -0.013 -0.015 -0.040 -0.022 0.032 0.005 0.012 Two-tailed p-value 0.039 0.052 0.147 0.017 0.251 0.050 0.786 0.522 # of stock return > 12 12 14 14 5 # of stock return < 21 27 19 33 3 Panel B: Market Reaction, By Quarter, for Three Days Surrounding FC Firms Recognized Write-Down Announcements FC Firms recognizing a write-down - 51 events ────────────────────────────────────────────────── first second third fourth ─────────────────────────────────────────────────────────────────── ────────────────────────────────── Number of firms 14 6 34 3-day return -0.0190 0.0172 0.0123 0.0566 Two-tailed p-value 0.2380 0.6943 0.5829 0.0178 # of 3-day return >0 # of 3-day return < 23 ─────────────────────────────────────────────────────────────────── ────────────────────────────────── Panel A: Two-tailed p-value is the p-value for the test that the average return is different from zero 35 Day -1 = one day before the write-down announcement Day = day of the write-down announcement (retrieved from the Nexis Wires Services) Day +1 = one day after the write-down announcement 3-day = three day cumulative return surrounding the write-down announcement Panel B: # of 3-day return > = number of firms where the 3-day return is greater than zero TABLE Pooled Estimation Results of 3-day average return surrounding the Earnings Announcement, and the 10-K filing on explanatory variables Sample of disclosing and recognizing firms, 1989-93 (t-Statistics in Parentheses) ═══════════════════════════════════════════════════════════════════ ══════════════════════════════════ Panel A: Three Days Surrounding the Write-downs announcement (1) RETit = α + β1UEit + β2WTFCit + β3DCVIOLit + β4INDCONit + β5MVit + εit α β1 β2 β3 β4 β5 Adjusted R2 n ─────────────────────────────────────────────────────────────────── ─────────────────────────────────── 0.012 (1.54) 0.008 (2.34) -0.061 -0.060 (-3.75) (-2.20) -0.001 (-0.22) -0.001 ( -1.15) 0.336 69 Panel B: Three Days Surrounding the 10-K Filing RET10Kit = α + β1UOCFit + β2WTFCit +β3WTSEit + β4DCVIOL10Kit + β5INDCON10Kit + β6MVit + εit (2) α β1 β2 β3 β4 β5 β6 Adjusted R2 n ───────────────────────────────────────────────────────────────────────── ───────────────────────────── -0.014 0.002 0.024 -0.003 -0.017 0.007 0.001 0.042 69 (-1.62) (0.35) (1.53) (-0.28) (-1.88) (0.99) (0.97) ───────────────────────────────────────────────────────────────────────── ───────────────────────────── 36 The regression excludes FC firm since it is an outlier and SE firms with no information on their previous year’s oil and gas operations RET = average of the 3-day return surrounding the write-downs announcement date The announcement date (day 0) is retrieved from Lexis UE = change in net income where the recognized write-down is added back to net income (deflated by MV) WTFC = recognized write-down (in positive value) and zero for disclosing firms (deflated by MV) DCVIOL = the increase or decrease in the probability of debt covenant violations given the information available at the write-downs announcement date INDCON = percentage of oil and gas sales out of total sales (using the preceding year’s sales figures) MV = markets value at the fiscal year end (in a natural log) RET10K = average of the three-day return surrounding the 10-K filing date The announcement date (day 0) is retrieved from the Access Disclosure database UOCF = change in the cash flows from operating income (deflated by MV) WTSE = disclosed write-down (in positive value) and zero for recognizing firms (deflated by MV) DCVIOL10K = increase or decrease in the probability of debt covenant violations given the information available at the 10-K filing date INDCON10K = percentage of oil and gas sales in the current year out of total sales TABLE Results of robustness tests ═════════════════════════════════════════════════════════════════════════ ════════════════════════════ Panel A: Descriptive Statistics on Expected Write-Down and Analyst Forecast SE firms (50) FC firms (21) ────────────────────────────────────────── ───────────────────────────────────────── Standard Standard Median deviation Q1 Q3 #>0 Median deviation Q1 Q3 #>0 ───────────────────────────────────────────────────────────────────────── ───────────────────────────── wt-ewt -0.071 0.555 -0.237 0.047 16 -0.087 0.589 -0.327 0.106 EPS - AF 0.000 0.259 -0.001 0.000 11 -0.008 0.038 -0.043 -0.005 Panel B: Descriptive Statistics on Reserves In Place SE firms (50) FC firms (21) ───────────────────────────────── ─────────────────────────────────── Standard Standard Mean Deviation Q1 Q3 Mean Deviation Q1 Q3 37 ───────────────────────────────────────────────────────────────────────── ───────────────────────────── Sale of reserves -0.013 0.080 0.000 0.000 0.000 0.000 0.000 0.000 Purchase of reserves 0.002 0.016 0.000 0.000 0.000 0.003 0.000 0.000 Revision of reserves -0.002 0.011 0.000 0.000 -0.001 0.006 -0.001 0.000 Panel C: Descriptive Statistics on Exploration and Development Activities SE firms (50) FC firms (21) ──────────────────────────────── ──────────────────────────────── Standard Standard Median Deviation Q1 Q3 Median Deviation Q1 Q3 ───────────────────────────────────────────────────────────────────────── ───────────────────────────── Δexploration expenditures -0.004 0.159 -0.043 0.007 0.016 0.527 -0.049 0.111 Δexploration wells -0.073 0.852 -0.431 0.440 0.063 3.038 -0.204 1.000 Δdevelopment expenditures 0.022 0.209 -0.007 0.088 0.033 0.220 -0.027 0.180 Δdevelopment wells -0.333 1.240 -0.667 0.286 0.160 0.421 -0.211 0.481 ───────────────────────────────────────────────────────────────────────── ───────────────────────────── Panel A: wt-ewt = actual or disclosed write-down minus the expected write-down deflated by the market value at year end The expected write-down is last year’s net oil and gas properties minus the calculated ceiling To calculate the ceiling the future cash flows are estimated by multiplying the last year’s oil and gas reserves by the oil and gas prices at year end To calculate the after-tax net cash flows the future production cost, future income tax expense, and aggregate discount rate are estimated using their average of the past three-year EPS-AF = reported EPS minus the analyst forecast deflated by the market value at year end The analyst forecast (from Zacks Investment Database) is the forecast that is the closest to the earnings announcement There are 15 analyst forecasts for FC firms and 28 for SE firms Panel B: Includes descriptive statistics on proved oil and gas reserves in place at the current year Panel C: Δexploration expenditures = change in the dollar amount allocated to exploration activities deflated by MV Δexploration wells = change in the number of exploration wells drilled deflated by the previous year’s number of exploration wells drilled Δdevelopment expenditures = change in the dollar amount allocated to developing existing wells deflated by MV Δdevelopment wells = change in the number of development wells drilled deflated by the previous year’s number of development wells drilled REFERENCES 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Research (Supplement 1988) : 91-119 “Financial Accounting and Reporting for Oil and Gas Producing Activities Pursuant to the Federal Securities Laws and Energy Policy and Conservation Act of 1973" SEC Rules found in the Code of Federal Regulations, Reg SX 210:4-10 (December 1978) Financial Accounting Standards Board Statement of Financial Accounting Standard No 69: “Disclosure About Oil and Gas Producing Activities.” Norwalk, CT: FASB (1981) Frost, B., and V Bernard “The Role of Debt Covenants in Assessing the Economic Consequences of Limiting Capitalization of Exploration Costs.” The Accounting Review (October 1989): 788-808 Harper, R., W Mister, and J Strawser “The Effect of Recognition Versus disclosure of Unfunded Postretirement Benefits on Lenders’ Perceptions of Debt.” Accounting Horizons (September 1991) : 50-56 Harper, R., W Mister, and J Strawser “The Impact on New Pension Disclosure Rules on Perceptions of Debt.” Journal of Accounting Research (Autumn 1987) : 327-330 Malmquist, D “Efficient Contracting and the Choice of Accounting Method in the Oil and Gas Industry.” Journal of Accounting and Economics 12 (1990) : 173-205 Strong, J., and J Meyer “Asset Writedowns: Management Incentives and Security Returns.” Journal of Finance (July 1987) : 643-663 39 APPENDIX The following are excerpts from the fiscal 1991 10-K of Adobe Resources: UNAUDITED INFORMATION TO THE CONSOLIDATED FINANCIAL STATEMENTS - Oil and Gas Reserves and Related Financial Data (amounts in thousands) The following tables set forth certain information regarding the corporation's oil and gas exploration, development and production activities: December 31, 1991 United States Indonesia Other Foreign Total Oil and gas properties Proved $511,655 59,348 571,003 Unproved 10,960 3,253 14,213 Total 522,615 62,601 585,216 Accumulated depreciation, depletion and amortization 220,444 37,108 257,552 Net capitalized costs 302,171 25,493 327,664 Discounted Future Net Cash Flow from Proved Reserves (amounts in thousands) December 31, 1991 United States Indonesia Total Future cash inflows $598,332 102,873 701,205 Future production costs 185,736 47,709 233,445 Future development costs 51,705 6,748 58,453 Future income tax expenses 11,259 18,620 29,879 Future net cash flows 349,632 29,796 379,428 Discount at 10% for timing of cash flows 112,211 8,168 120,379 Discounted future net cash flows from proved reserves 237,421 21,628 259,049 The discounted future net cash flows from estimated production of proved oil and gas reserves after income taxes are presented in accordance with the provisions of Statement of Financial Accounting Standards No 69, "Disclosures about Oil and Gas Producing Activities" (SFAS No 69) In computing this data, using assumptions other than those mandated by SFAS No 69 could produce substantially different results This information should not be viewed as a forecast of future economic conditions, revenues or profits The standardized measure of discounted future net cash flows is determined using estimated quantities of proved reserves and taking into account the future periods in which they are expected to be developed and produced based on economic conditions at each year-end The estimated future production is priced at year-end prices The resulting estimated future cash flows are reduced by estimated future 40 costs to develop and produce the proved reserves based on year-end cost levels The pretax net cash flows are then reduced by deducting income tax expenses determined by applying the appropriate statutory tax rates to the future pretax net cash flows, reduced by the tax basis of the properties involved and net operating loss carryforwards The resultant future net cash flows are reduced to present value amounts by applying the 10% discount factor mandated by SFAS No 69 The amount of “as-if” write-down is calculated as follows Net asset cost United states $302,171 Indonesia $25,493 Ceiling = Discounted future net cash flows from proved reserves + unproved reserves + discounted future income tax 41 Since discounted future income tax is not provided, the discount factor used by the firm is applied to the future income taxes Hence, the firm’s discount factor is equal to the discounted net cash flows divided by the undiscounted cash flows The ceiling for each cost center is: United States = $237,421 + (237,421 / 349,632) * 11,259 + 10960 = 256,026.5 Indonesia = $21,628 + (21,628 / 29,796) * 18,620 + 3,253 = 38396.69 There is no economic loss in Indonesia while the economic loss in the United States is the net asset cost (302,171) minus the ceiling (256,026.5), that is 46.1445 million dollars Notice that the pre-tax undiscounted future net cash flow in the United States is equal to 349,632 which is larger than the net asset cost Therefore, prior and subsequent to FAS 121, Adobe Resources records no asset write-down 42 .. .Recognition Versus Disclosure in The Oil and Gas Industry Introduction This paper investigates whether recognition and disclosure are equivalent in their pricing consequences in the oil and gas. .. revealing with respect to the underlying relevance and reliability of the information A major component in the ceiling calculation for firms in the oil and gas industry is the quantity of proved oil. .. between the write-downs announcement date and the 10-K filing date nullified the negative information contained in the 10-K write-down To investigate the influence of the changes in the oil and gas