Peeling away financial reporting issues one layer at a time

The Double Illusion of Financial Statement Comparability and Auditability: Through the Lens of Falling O&G Prices

My inspirations for this post are the maiden speech of the SEC’s new chief accountant James Schnurr, and the joy of paying only $2.02/gallon at the pump.

As for Mr. Schnurr, I plan to dissect his remarks more fully in a blog post to come, but for now I’ll confine my review to his mentioning comparability of financial statements no less than seven times, e.g., “Comparability is a hallmark of U.S. financial reporting…”

As to the relevance of my satisfying gas station experience, the financial reporting implications of the 50% decline in oil prices over the past six months make for a timely illustration for why Mr. Schnurr’s statements about comparability are nothing more than hot air.

Why Comparability of Financial Statements is an Illusion

There are many, many reasons why financial reports are not comparable.  Tops on my list, though somewhat off topic, is the absence of adjustments for inflation.  No respectable economist would ever dream of comparing trends in costs or revenues without adjusting for inflation; so it really irks me that in accounting, we never adjust for inflation.

Truly, by ignoring the necessity for inflation adjustments, it makes the accounting profession (including our august chief accountant) look like a bunch of simpletons.  Some will argue over implementation details, but accounting for inflation is no harder or easier than dealing with multiple currencies (yet, see here and here for how the FASB managed to screw that up, too).

Adjustments for inflation are merely a pre-condition for making comparisons. Let’s get back to the drop in O&G prices that have made many of us joyous, but must surely frustrate the managers of companies whose recent investment decisions were predicated on higher and steadier prices.  These managers have many hard operational and strategic choices to make; and to make matters worse for them — e.g., the threat to their earnings-based bonus checks — they also have to deal with the accounting question of asset “impairment.”

To keep this explanation as simple as I can, let’s assume that we are testing one asset, an oil field, for impairment.  The wise men of the FASB, with ample assistance of special interests, pronounced in 1995 (FAS 121) that everyone would sing their own variation on the following tune:

Step 1:  If recent events indicate that the economic benefits to be derived from an asset group (i.e., oil field) could be less than its carrying amount, continue to Step 2.

In this example, the recent drop in O&G prices would be a pretty solid indicator that an impairment might exist. So, for a great many companies, on to Step 2 they go.  But as one more aside, it’s sort of fun to point out that “impairment” is actually one of those niggling accounting misnomers.  For example, every aspect of the oil field could be in perfect working condition, yet for some reason the FASB chooses to treat the asset as if it might be “impaired.”   Cynical me thinks they wanted to create the appearance of substance where none exists.  But the reality is very often that when write downs are made, they accomplish little more than to catch up the accounting to economic events that occurred in the distant past.

Step 2:  Sum the expected net cash flows to be generated by the asset being tested without adjusting for the time value of money.  If that sum is less than the carrying amount of the asset, continue to Step 3.

This the the dog’s breakfast aspect of impairment accounting.  The FASB blithely instructs issuers to violate the most fundamental commandment of finance: ‘thou shalt adjust future cash flows for the time value of money before adding or subtracting.’  (Actually, I don’t know which is the greater sin: not adjusting for inflation, or not adjusting for the time value of money.)

Step 3.  If the fair value of the asset is less than the aggregate carrying amount, write the asset down to its fair value, and report an “impairment” loss.

The first point of this post is that, even if the impairment protocol were auditable — which it is not, it will fail to provide investors with comparable information when oil and gas companies file their next 10-K.  For example, consider two oil fields, A and B, which are owned by two different companies:

  • Field A has a carrying amount of $10,000,000; expected net operating cash flows are $2,000,000 per year for five years; its fair value is $6,000,000.
  • Field B is identical to Field A, except that the expected cash flows from operating the oil field sum to $9,999,999.

Field A is not treated as “impaired,” even though its fair value is $4,000,000 less than its carrying amount; because it barely “passed” Step 2.  In contrast,  Field B is written down by $4,000,000; because it failed the Step 2 test by a mere $1.  A change in the Step 2 cash flows of $1 will in this case trigger an “impairment” charge of $4,000,000; or $40,000,000, or $400,000,000 for larger oil fields.  To quote my favorite tennis player of all time, “YOU CAN’T BE SERIOUS!”

But seriously, the above example plainly illustrates that even the most assiduous application of GAAP will not produce comparable information.  Impairment is just one of many examples that we can all think of.

Why Financial Statement Audits are an Illusion*

Which brings me to the second, and main point that I want to make: the impairment test is not auditable.  

This will be short and sweet, in part because I have made the same general points only a few weeks ago, here.

Imagine that you are the auditor assigned to examine the Step 2 process for your O&G client.  Management predicts that O&G prices will recover at a rate of 20% per year until it reaches $100 per barrel.  Because of this estimate, management concludes that it has passed Step 2 by a slim margin; and, consequently, no impairment will be recognized.

What will you do as the auditor to assess whether management’s predictions are reasonable?

I suppose, you could pull out your own crystal ball and compare it with your client’s.  But, that’s not realistic. If you really could predict future oil prices and be correct just a little more often than you’re wrong, you would definitely need to turn in your shingle and set forth on a much more lucrative career of trading oil and gas contracts.

Or, admitting that you wouldn’t be good at forecasting oil prices yourself, you could simply review what your client states it sees in its own crystal ball.  If their “analysis” looks “appropriate” than that’s what you will go with.  But what, pray tell, is an “appropriate” method of forecasting future oil prices?

Next, imagine that your firm has another client that claims it has a very different crystal ball to predict oil prices.  Like you, your fellow audit partner has managed to convince herself that management’s estimates are “reasonable.”  But, if the they were swapped from one client to the other, both sets of financial statements would be materially changed.  

Is this comparability?  Is this auditing?  Nope, it’s a crapshoot.

* * * * * *

Financial accounting standards like the one for the impairment of long-lived financial assets defeats, instead of promotes, comparability.  And, especially when facts and circumstances indicate to any extent that the past is not indicative of the future, not even the most independent and technically competent auditor on the planet could reliably assess the “reasonableness” of management’s estimates of variables like future oil prices.

There is only one reasonable solution.  Oil fields should be valued by independent appraisers, i.e., not (biased) management.  And auditing should be solely a verification function.  The auditor would verify that: the factual information provided by management to the independent appraiser is accurate and complete; that the appraiser performed its work in accordance with their engagement letter with the issuer; and that the appraiser’s calculations were performed accurately.

Nothing I have written here concerning the lack of comparability of financial statements is something that Mr. Schnurr doesn’t already know.  Instead of disingenuously blowing smoke about comparability being a hallmark of U.S. GAAP he should at least be raising real issues and getting the PCAOB and FASB to actually do something about them.

_____________

*I am a member of the Standing Advisory Group of the PCAOB.  The views expressed herein are my own and do not necessarily reflect the views of the Board or its staff.

5 Comments

  1. Reply James Ulvog December 31, 2014

    To illustrate your point, having an opinion on what future cash flows will be requires an assessment of what future crude oil prices will be. That requires reasonably solid knowledge of economics and the oil market so you can have a vague clue about how the market reacts.

    One’s evaluation of where prices will go on the six month and 1 year time horizon requires some estimates of what the Saudi Arabia oil minister will do and how the other OPEC may or may not follow along and what Russia and Venezuela might do. Then one needs to assess how U.S. drillers may respond as a group.

    My point is that all of those are highly subjective factors, completely dependent on a person’s depth of knowledge, and even one’s philosophical orientation on economics. I have a moderate knowledge of oil, having been blogging on shale oil in the Bakken area of North Dakota for a few years. My assessments (read that as deeply personal and strongly felt opinions) will be fairly firm and could easily be drastically different from the client and everyone else on the audit team.

    So whose personal, subjective, politically-based opinion is “reasonable?”

    • Reply FakeJamesSchnurr January 4, 2015

      In terms of prices – most (if not all) utilize futures prices to forecast out demand, and those bake in, at any given time, the market’s assessment of exactly those very subjective assessment.

      Your worried about predictability, which I agree, is impossible, otherwise there would never be any write-downs in the first place.

      The issue Tom is getting at is comparability, and that is a different issue altogether. As long as each filer is reporting using the same data for forecasting future oil prices (with some minor adjustments for local differences in fields, and costs), then comparability should not really be a big deal.

      My point below was that, ultimately, if anything, commodities driven valuations are likely more comparable than some DCF model on an asset group where forecasted cash flows are really truly “managements” estimate.

  2. Reply FakeJamesSchnurr January 4, 2015

    Well,
    a couple problems….

    A) Just like Executive Compensation firms, these “Independent Appraisers” would do nothing more than become Valuation Shops……and it would become real clear which shops would get the business.

    B) I have both audited and been audited on valuations. Even when hiring a 3rd party valuation specialist, the entire construct is one of forecasting the future, and often when dealing with impairment valuations, forecasting the future is an utter crap shoot (since clearly – the entire reason for the write-down is because any initial valuations in the determination to invest/buy that asset was incorrect.) And often, those very valuations were done by….3rd party valuation specialists.

    C) If you really wanted comparability, especially when it comes to commodity driven impairment valuations, the only way to get comparability would be for most if not all of the assumptions in regards to future oil and gas prices to be driven by a common, agreed-upon forecasting metric. One could argue, that the only metric allowed should be oil and gas futures that existed at the balance sheet date. And in fact, most do incorporate those (and most auditors should be including those as comparable metrics when evaluating such a forecast). So I am not sure your solution is really going to marginally improve the result, but it may give more of an appearance of an improvement…and is analogous to independence….in fact and appearance.

  3. Reply Marc January 28, 2015

    Tom,

    I think the S.E.C.’s average first-day-of-the-month is one of the solutions used to increase comparability. I would say it has worked to some extent. One trouble, it should be noted, is many firms get prices which diverge from the headline West Texas Intermediate figures. E.g., pricing in Midland, TX and, even then, many firms sell into the mid-stream system at discounts to midland prices. I can think of at least on natural gas producer which has a massive $0.80 discount from Henry Hub (and it would be greater if they hadn’t entered into a contractual agreement with mid-stream partner).

    Definitely agree that audits are pretty pathetic in this regard. But I think the engineering firms which produce the third party appraisals are fairly credible (assuming that is what you are talking about… e.g., Netherland, Sewell & Associates, Inc.). Not sure how credible with off shore, but I think they are pretty good onshore.

    Personally, I am OK with current impairment methodology, but I would greatly prefer if, within the annual 10-K, they still disclosed historic pricing excluding the impairment. This opinion would apply to goodwill impairments and intangible asset impairments. The reason being, just fyi, because I will be in a better place to judge the competence of management if historic prices are readily available. As you know, goodwill impairments (and share buybacks) skew ROE — a very unfortunate effect.

    Thanks for the post Tom.

  4. Reply ribanoor September 23, 2015

    Financial accounting standards like the one for the impairment of long-lived financial assets defeats, instead of promotes, comparability.

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