An Investigation of Recognition Versus Disclosure in The Oil and Ga

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An Investigation of Recognition Versus Disclosure in The Oil and Ga

     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


     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

    1. 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 do not address the issue of whether different users’ perceptions will result in different pricing in the marketplace.

    This study innovated in that it explicitly tests whether recognition and disclosure are priced equivalently. 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 earnings announcement date and the 10-K filing date. For FC firms the market generally observes the write-down at the earnings announcement date and for SE firms the market can

    1 When investigating the market estimate the disclosed write-down at the 10-K filing.

    reaction, I test whether the market responds similarly to FC firms recognizing a loss and

    2SE firms disclosing one.

    Pooled cross-sectional regression results document, at the earnings 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.

     1 All but two firms disclosed the write-down at the earnings announcement date. The 3-day return for the 2 firms disclosing the write-down before the earnings release was -66.67% and -12.5%.

    2 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 write-downs 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."


    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 equity, is that investors concentrate on firms’ net equity for

    3 valuation purposes.

    The remainder of the study is organized as follows. Section 2 includes the related oil and gas accounting background and the method for estimating the SE firms’ economic loss. Empirical tests are developed in section 3. Section 4 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 6.

2. Accounting Background and the Disclosed Write-Down for SE Firms

    2.1. 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

     3 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.”


    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

    4 related to the difference between book and tax basis of the properties involved.

     4 Cited from regulation SX 4-10, Full Cost Method paragraph (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 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

    5 Consequently, the different reporting rule causes FC their proved oil and gas reserves.

    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. My research

    objective is to examine the implications of recognition versus disclosure. In particular, 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

     5 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.


    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 other two components, cost of unproved properties and properties not being amortized, are provided in the audited part of the financial statements.

    The economic loss 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 do 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 write-downs. 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.

    3. 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. 5 (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. Firms recognizing a write-down

    release the information 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


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