Accounting Updates for Southern Gas Association Accounting & Financial Executives Conference

Bob Jensen at Trinity University

Bob Jensen's threads on accounting theory are at http://www.trinity.edu/rjensen/theory.htm 

Systemic Problems of Accounting and Auditing ---  http://www.trinity.edu/rjensen/FraudConclusion.htm 

Equity Valuation in the Oil and Gas Industry 

DRILLING DEEPER:  MANAGING VALUE AND REPORTING IN THE PETROLEUM INDUSTRY, 
A Special Report from PricewaterhouseCoopers (PwC), 2002 --- http://www.pwc.com/images/gx/eng/about/ind/petro/drilling_deeper.pdf 

Executive Summary The traditional, predominantly financial, indicators used to measure corporate performance no longer meet the needs of the global capital markets. They do not tell a company’s full story and are not adequate to deliver true insight into its capacity to grow, adapt and change. Our survey of petroleum companies, investors and analysts, demonstrates the case for more comprehensive reporting.  Eighty per cent of petroleum companies in the survey believe their share price falls short of their company’s true value. But the reporting practices of petroleum companies in turn fall short of what investors and analysts say they need to assess companies for investment purposes. Investor feedback revealed that for about three of every five indicators they highlight as having particular value in assessing companies, the information flow from companies is significantly below what they need.  Only a few of the indicators fall into the category of traditional financial reporting. Instead, they cover ground such as the geopolitical environment, strategic direction and quality of management. Investors also express a desire for information to be better-segmented in the upstream and downstream sectors.  The survey indicates that petroleum companies need to work more effectively to achieve their investor dialogue goals. More than half of companies (52 per cent) believe they work proactively to initiate contact or maintain continuous dialogue with investors, yet only 14 per cent of investors characterised petroleum companies in this way.  A shift to more comprehensive reporting will help petroleum companies move away from the treadmill of continuous focus on short-term earnings. Investor cynicism about short-term earnings runs high. Three-quarters of investors feel that petroleum companies have considerable discretion on earnings figures, yet this leeway is firmly refuted by companies themselves.  A move to wider reporting is seen by companies, investors and analysts as likely to lead to tangible gains for companies. Reduced share-price volatility, increased valuations, more long-term investment, a lower cost of capital and greater management credibility are among the benefits of better disclosure cited by a majority of those surveyed.   Value indicators – Responses of analysts for the indicators in the general, upstream E&P and downstream refining sectors.     Value indicators – Responses of analysts for the indicators in the general, upstream E&P and downstream refining sectors.

KMPG's eValuation
"Services Calculate Net ROI Consulting firms update traditional business metrics for Internet" By Chuck Moozakis, Internet Week, August 24, 2000 ---  
http://www.internetwk.com/lead/lead082400.htm 

Calculating Net ROI

The fledgling oil and gas exchange PetroCosm knew it needed more than the backing of giants Chevron and Texaco to win over customers and suppliers. Even more important was the ability to demonstrate clear financial benefits for participants.

In the months leading up to its July launch, PetroCosm worked with consulting firm KPMG to develop a return-on-investment (ROI) model that would help potential customers make the case for participating in the exchange.

PetroCosm used a new KPMG service dubbed eValuation--announced last week--that takes into account traditional ROI variables, such as up-front development costs, as well as more Internet-centric variables, such as the additional sales that can be derived by participating in a wide range of online marketplaces. It also factors in the cross-company ramifications of Internet supply chains and how customers and suppliers can also benefit.

"We were able to come up with a business case that said this is a profitable business" for both suppliers and PetroCosm's founding members, said PetroCosm controller Rod Starr. "It sounds straightforward enough, but one of the great challenges is that there are no existing models to gauge ROI."

Armed with results from the ROI study that indicated the type of cost savings prospective members could realize by participating in a B2B exchange, PetroCosm has been able to sell prospective participants on the possibility of trimming anywhere from 5 percent to 20 percent of their procurement costs by joining the marketplace, Starr said. --Chuck Moozakis

Read the rest: http://www.internetwk.com/lead/lead082400.htm 

How might companies present their financial performance in a better light?

Bob Jensen's Threads on "Core Earnings" Theory and Implementation --- http://www.trinity.edu/rjensen//theory/00overview/CoreEarnings.htm

Bob Jensen's Threads on Pro Forma Earnings --- http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#ProForma 

The New York Yankees today released their 4th Quarter 2001 pro forma results. Although generally accepted scorekeeping principles (GASP) indicate that the Yankees lost Games 1 and 2 of the 2001 World Series, their pro forma figures show that these reported losses were the result of nonrecurring items, specifically extraordinary pitching performances by Arizona Diamondbacks personnel Kurt Schilling and Randy Johnson. Games 3 and 4 results, already indicating Yankee wins, were not restated on a pro forma basis.
Ed Scribner, New Mexico State

Equity Valuation

FASB Standards of Particular Interest

 

Statement No. 148
Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123
(Issue Date 12/02)
[Summary] [Status]

Statement No. 147
Acquisitions of Certain Financial Institutions—an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9
(Issue Date 10/02)
[Summary] [Status]

Statement No. 146
Accounting for Costs Associated with Exit or Disposal Activities
(Issue Date 6/02)
[Summary] [Status]

Statement No. 145
Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections
(Issue Date 4/02)
[Summary] [Status]

Statement No. 144
Accounting for the Impairment or Disposal of Long-Lived Assets
(Issue Date 8/01)
[Summary] [Status]

Statement No. 143
Accounting for Asset Retirement Obligations
(Issue Date 6/01)
[Summary] [Status]

Statement No. 142
Goodwill and Other Intangible Assets
(Issue Date 6/01)
[Summary] [Status]

Statement No. 141
Business Combinations
(Issue Date 6/01)
[Summary] [Status]

Statement No. 140
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a replacement of FASB Statement No. 125
(Issue Date 9/00)
[Summary] [Status]

Statement No. 139
Rescission of FASB Statement No. 53 and amendments to FASB Statements No. 63, 89, and 121
(Issue Date 6/00)
[Summary] [Status]

Statement No. 138
Accounting for Certain Derivative Instruments and Certain Hedging Activities-an amendment of FASB Statement No. 133
(Issue Date 6/00)
[Status]

Statement No. 137
Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133—an amendment of FASB Statement No. 133
(Issue Date 6/99)
[Status]

Statement No. 136
Transfers of Assets to a Not-for-Profit Organization or Charitable Trust That Raises or Holds Contributions for Others
(Issue Date 6/99)
[Summary] [Status]

Statement No. 135
Rescission of FASB Statement No. 75 and Technical Corrections
(Issue Date 2/99)
[Summary] [Status]

Statement No. 134
Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise—an amendment of FASB Statement No. 65
(Issue Date 10/98)
[Status]

Statement No. 133
Accounting for Derivative Instruments and Hedging Activities
(Issue Date 6/98)
[Summary] [Status]

Statement No. 132
Employers' Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106
(Issue Date 2/98)
[Summary] [Status]

Statement No. 131
Disclosures about Segments of an Enterprise and Related Information
(Issue Date 6/97)
[Summary] [Status]

Statement No. 130
Reporting Comprehensive Income
(Issue Date 6/97)
[Summary] [Status]
Further disconnects income statement from the balance sheet

Free from the FASB
Accounting for Stock-Based Compensation: A Comparison of FASB Statement No. 123, Accounting for Stock-Based Compensation, and Its Related Interpretations, and IASB Proposed IFRS, Share-based Payment (Invitation to Comment)
November 18, 2002
(Comment period ends February 1, 2003)
[Download] --- http://www.fasb.org/draft/itc_intropg_stock_based_comp.shtml 

Note that adjustments for many more companies are available in the "Core Earnings" revisions from Standard and Poors at http://www2.standardandpoors.com/NASApp/cs/ContentServer?pagename=sp/Page/PressSpecialCoveragePg&b=5&r=1&s=3&ig=1026841911315 
I also created the shorter URL --- http://snurl.com/CoreEarnings 

In response to growing concern about companies earnings reports, Standard & Poor’s has introduced a new methodology called “Standard & Poor’s Core Earnings.” The ultimate goal is to lead investors and analysts to a consensus on earnings calculations, and bring more transparency and consistency to earnings analysis and forecasts.

Bob Jensen's threads on these this controversy can be found at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm 

New
FASB Now Expects to Issue the proposed limited-scope statement, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, in the second quarter of 2003

Project Update --- http://www.fasb.org/project/liabeq.shtml 

RECENT DEVELOPMENTS

• The Board issued two FASB Exposure Drafts, Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both, and Proposed Amendment to FASB Concepts Statement No. 6 to Revise the Definition of Liabilities, on October 27, 2000. (Copies of both Exposure Drafts may be downloaded from this Website, along with the analysis of the proposed Statement’s impact on EITF consensuses.) The Board began its redeliberations of the issues in the Exposure Drafts in the light of comments received on those Exposure Drafts, in December 2001, starting out with issues addressing separation of compound instruments.

  Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both (Proposed Statement of Financial Accounting Standards)
  October 27, 2000

  Exposure Draft
  [Download] --- http://www.fasb.org/draft/ed-fi.pdf 
  
  EITF Analysis --- http://www.fasb.org/draft/eitfliabeq.shtml
  

• On June, 5, 2002, before resolving the separation issues, the Board decided to change the order of issues it would address in its redeliberations so that it could immediately address concerns relating to financial instruments embodying obligations that could be settled by the issuance of an entity’s own shares. After redeliberating those issues, on November 13, 2002, the Board decided to issue a limited-scope Statement addressing the following instruments:

   

  1. Financial instruments embodying, or indexed to, an obligation to repurchase an issuer’s equity shares that requires or could require settlement by transfer of assets

      

  2. Mandatorily redeemable instruments

      

  3. Financial instruments embodying an obligation that the issuer must or could settle by issuing a variable number of its equity shares if the monetary value of the obligation is based solely or predominantly on (a) a fixed monetary amount known at inception, (b) variations in something other than the fair value of the issuer’s equity shares, or (c) variations in the fair value of the issuer’s equity shares, but in the direction opposite to those variations.

      

• The Board decided to issue a final Statement. The Board believes that rapid issuance of the Statement, even though separation and conceptual issues affecting other instruments are not yet resolved, is needed to provide timely and necessary guidance for certain troublesome instruments.

April 2, 2003 message from Terry Bechtel [bechtelt@nsula.edu]

Dr. Jensen,
I would suggest that the use of 3-D and 4-D seismic is of significance. I am told that the probability of success when an oil well is drilled is now about 75%. In the past successful wells occurred about one time in nine and even less frequently in wildcat situations. It would seem to me that this might have implications regarding the use of the full-cost versus the successful efforts methods of accounting. I hope that you find this useful. Also please say hello to Petrea for me as we are old friends.

Terry B.

Comparisons of International IAS Versus FASB Standards --- http://www.deloitte.com/dtt/cda/doc/content/pocketiasus.pdf 

SEC Proposed Rule: on Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies --- http://www.sec.gov/rules/proposed/33-8098.htm  (Relates to the older FR-60)

• Basic information needed to understand estimates, such as the underlying methodology and assumptions
• Effect of estimates on financial presentation
• Sensitivity of the financial results to changes in the estimates or their underlying assumptions
• Statement as to whether or not management discussed the development, selection, and disclosure of the estimates with the company’s audit committee
• Requires management to make assumptions about matters that are “highly uncertain” at the time the estimate is made, and it must be an estimate for which different estimates reasonably could have been used, or changes are reasonably likely to occur, that would have a material impact on financial results
• Examples
  • Revenue recognition policies and methods
  • Related party transactions
  • Valuation of investments 
  • Debt and debt covenants
  • Deferred tax assets
  • Commitments and contingencies
  • Oil and gas reserves (Plans to develop PUDs, Proved Undeveloped Reserves)
  •  Impairment of oil and gas properties (significance of probable/ possible reserves)

What's Right and What's Wrong With (SPEs), SPVs, and VIEs --- http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm 

FIN 46 
Revised FIN 46 Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements,
Consolidation of VIEs on the basis of risk rather than voting control 
From the January 17, 2003 FEI Express

Those FEI members whose companies have November 30 or December 31 fiscal year-ends need to take a close look at FASB Interpretation No. 46, Consolidation of Variable Interest Entities, as soon as possible for two reasons: (1) FIN 46 has disclosure requirements that become effective for financial statements issued after January 31, 2003; (2) FIN 46 applies to all types of unconsolidated entities (e.g., joint ventures, partnerships, cost basis investments, etc.). For those who have not followed this project closely, FIN 46 could affect your company's financial statements even if it has no involvement with so-called "special purpose entities" (SPEs). The following is a brief synopsis of the rule. The complete document is available now at the FASB's web site at: http://www.fasb.org/interp46.pdf.

Transactions that will come under FIN 46 scrutiny include the following:

• off-balance-sheet R&D ventures, 

• synthetic leases, 

• asset-backed commercial paper, 

• collateralized debt obligation, and 

• exploration ventures, 

• others.

FR-61 SEC Disclosure in Management's Discussion and Analysis About Off-Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments

• Off balance sheet arrangements (SPEs, VIEs)
• Contractual obligations and commercial commitments
• Energy trading activities
• Related party transactions

FAS 133 and IAS 39 --- Accounting for Financial Instruments Derivatives and Hedging Activities

• Fair Value Hedges (Inventory On Hand, Firm Commitments, Tolling, Capacity, Transportation Agreements, Fixed Rate Debt)
• Cash Flow Hedges (Forecasted Transactions Other Than Derivatives, Interest Rate Risk)
• Normal Purchases, Normal Sales
• Terminating cash flow hedges is not an earning event --- No basis adjustment
• EITF Topic D-102 Documentation
  • The hedging instrument
  • The hedged item
  • The nature of the risk being hedged
  • Prospective and retrospective effectiveness tests
• Post-Enron meltdown of energy trading sector
  • Credit downgrades will affect fair value measurements
  • Tighter watch on what qualifies for hedge accounting
• Netting of Financial Contracts --- http://www.mccannfitzgerald.ie/legal_briefing/banking_financial_services/netting_protection.html 

One objective of risk management in the context of derivatives transactions is to reduce overall credit risk, by using netting agreements to set off the market value of gains and losses on transactions. Netting agreements provide for the termination of the transactions in specified circumstances (including insolvency circumstances), provide a mechanism for valuing the lost economic value and related termination costs of the terminated transactions and aggregate those individual values/costs to a single net sum. Only the net sum arising is then payable. Without netting, in an insolvency situation, a non-defaulting party may have to pay in full in respect of the out-of-the-money transactions whilst, as an ordinary creditor, receiving little or nothing in respect of the in-the-money transactions.

FAS 143 --- Accounting for Asset Retirement Obligations

• The new rule requires businesses to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, the entity capitalizes a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement.
• Measure the liability at fair value
• Methodology will be a change for many oil and gas companies
  • Most do not discount the liability and recognize accretion expense
  • Most do not measure the liability at fair value
  • Many do not gross up the balance sheet (i.e., the liability is embedded in accumulated depletion, depr., and amortization (DD&A)
  • Many assume salvage value of surface equipment will offset reclamation costs

FAS 146 --- Accounting for Costs Associated with Exit or Disposal Activities

• This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)."
• The Board decided to address the accounting and reporting for costs associated with exit or disposal activities because entities increasingly are engaging in exit and disposal activities and certain costs associated with those activities were recognized as liabilities at a plan (commitment) date under Issue 94-3 that did not meet the definition of a liability in FASB Concepts Statement No. 6, Elements of Financial Statements.
• The principal difference between this Statement and Issue 94-3 relates to its requirements for recognition of a liability for a cost associated with an exit or disposal activity. This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost as defined in Issue 94-3 was recognized at the date of an entity’s commitment to an exit plan. A fundamental conclusion reached by the Board in this Statement is that an entity’s commitment to a plan, by itself, does not create a present obligation to others that meets the definition of a liability. Therefore, this Statement eliminates the definition and requirements for recognition of exit costs in Issue 94-3. This Statement also establishes that fair value is the objective for initial measurement of the liability.
• Applies to costs of terminating contracts and closing or consolidating facilities

• Non-derivatives no longer marked to market (e.g., storage contracts, tolling agreements, capacity contracts, inventory)
• Fair value accounting model for inventory challenged
• Disclosures no longer required
• Valuation and disclosure to be taken up later by the FASB

FIN 45 --- Guarantor’s Accounting and Disclosure requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others

The Interpretation should significantly improve the reporting of guarantees that are issued in conjunction with other transactions, such as when a seller also guarantees its customer’s repayment of the funds borrowed to pay the seller for the customer’s purchases.”  This guidance does not apply to certain guarantee contracts, such as those issued by insurance companies or for a lessee’s residual value guarantee embedded in a capital lease. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations would not apply to product warranties or to guarantees accounted for as derivatives.

Ceiling/Impairment Tests
• Accounting Standards IAS 36, FRS 11 and FAS 121

Accounting For Decommissioning/Site Restoration
• Accounting Standards IAS 37, FRS 12, and US GAAP

Impact Of Accounting Policy Choices

Analysis Of Oil And Gas Company Financial
Statements

Financing Arrangements
• Accounting for farm ins/farm outs and carried interests

Sales Revenue Accounting
• Accounting for overlift and underlift
• Accounting for take or pay sales agreements

Pending Revision of FAS 123

Stock Options
If the FASB and the IASB require expensing of stock options when vested rather than exercised, it will have really adverse effects on the bottom lines of some companies who rely heavily upon employee stock options for compensation.  This is why the U.S. House and Senate are already gearing up for a fight with the FASB and possibly SEC due to heavy lobbying pressures.  In the March 31, 2003 issue of Barron's on Page 28, the following sample impacts are provided:

See Bob Jensen's letter to Senator Charles E. Schumer --- http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm 
(Includes updates not sent to Senator Schumer)

S&P Core Earnings Theory --- http://www.trinity.edu/rjensen//theory/00overview/CoreEarnings.htm 

"Bubble Redux," by Andrew Bary, Barron's, April 14, 2003, Page 17.

Amazon's valuation is the most egregious of the 'Net trio.  It trades for 80 times projected "pro forma" 2003 profit of 32 cents a share.  Amazon's pro forma definition of profit, moreover, is dubious because it excludes re-structuring charges and, more important, the restricted stock that Amazon now is issuing to employees in lieu of stock options.  Amazon's reported profit this year under generally accepted accounting principles (which include restricted-stock costs) could be just 10 cents to 15 cents a share, meaning that Amazon's true P/E arguably is closer to 200.

Yahoo, meanwhile, now commands 70 times estimated 2003 net of 35 cents a share, and eBay fetches 65 times projected 2003 net of $1.35 a share.

What's fair value?  By our calculations, Amazon is worth, at best, roughly 90% of its projected 2003 revenue of $4.6 billion. That translates into $10 a share, or $4.1 billion.  This estimate is charitable because the country's two most successful brick-and-mortar retailers, Wal-Mart Stores and Home Depot, also trade for about 90% of 2003 sales.

Yahoo ought to trade closer to 15.  That's a stiff 43 times projected 2003 earnings and gives the company credit for its strong balance sheet, featuring over $2 a share in cash and another $3 a share for its stake in Yahoo Japan, which has become that country's eBay.

Sure, eBay undoubtedly is the most successful Internet company and the only one that has lived up to the growth projections made during the Bubble.  As the dominant online marketplace in the U.S. and Europe, eBay saw its earnings surge to 87 cents a share last year from three cents in 1998, when it went public at a split-adjusted $3.00 a share.

Why would eBay be more fairly valued around 60, its price just several months ago?  At 60, eBay would trade at 44 times projected 2003 profit of $1.35 a share and 22 times an optimistic 2005 estimate of $2.75.  So confident are analysts about eBay's outlook that they're comfortable valuing the stock on a 2005 earnings estimate.

Fans of eBay believe its profit can rise at a 35% annual clip in the next five years, a difficult rate for any company to maintain, even one, such as eBay, with a "scalable" business model that allows it to easily accommodate more transactions while maintaining its enviable gross margins of 80%.  If the company earns $5 a share in 2007--nearly six times last year's profit--it would still trade at 18 times that very optimistic profit level.

Continued in the article.

Bob Jensen's threads on pro forma earnings are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#ProForma 

Equity Valuation