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Appendix 4-A

ESTIMATING OPERATING LEVERAGE

Appendix 4-A ESTIMATING OPERATING LEVERAGE W1

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APPENDIX 4-A

ESTIMATING OPERATING LEVERAGE

W2 APPENDIX 4-A ESTIMATING OPERATING LEVERAGE

Appendix 4-B

EARNINGS PER SHARE— ADDITIONAL ISSUES

Earnings per share is probably the most widely used indicator of corporate performance. Yet most of those who use it do not understand how it is computed. Fewer still understand how it is affected by the issuance of convertibles, options, or other potentially dilutive securities. In the text we have outlined the procedures used in its calculation. In this appendix, we discuss computational issues, disclosure requirements, and the few differences between US and IASB standards.

COMPUTATIONAL ISSUES

Weighted Average Number of Common Shares Outstanding

The denominator must reflect all stock dividends and stock splits effective during the period and those announced after the end of the reporting period (but before the financial statements are issued) as if they had been effective at the beginning of the reporting period. All prior pe- riods presented are restated for comparability.

Acquisitions

Shares issued in purchase method acquisitions (see Chapter 14) are included in the denomi- nator only for the period following the acquisition date. Similarly, only the postacquisition results of operations of the acquired firms are included in the numerator of the EPS computa- tion. Note that no restatement of prior periods is permitted for purchase method acquisitions. The impact of the pooling method is quite different. Merged firms are considered com- bined entities for all years presented. The shares issued in the combination are assumed to have been outstanding for all periods presented, and the results of operations for the two firms are also combined for those periods in the EPS calculation.

Contingent Shares

Acquisitions and incentive compensation plans may require the issuance of common shares if specific conditions, such as the passage of time, achievement of income levels, or specified market prices of the common stock, are met. Securities whose issuance depends solely on the passage of time are always included in the weighted average shares outstand- ing. Other contingent shares are included in the computation of basic and diluted EPS if the required income levels or market prices have been reached at the end of the reporting period. When the issuance of contingent shares depends on the achievement of earnings targets, and when it is likely that those targets will be achieved, the computation of diluted earnings per share includes both the incremental shares and the level of income assumed to have been achieved. These adjustments to the EPS measures are required even if the incremental shares are to be issued at a later date.

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APPENDIX 4-B

EARNINGS PER SHARE—ADDITIONAL SHARES

EPS Computations for Two-Class Securities

Some firms issue more than one class of common stock or have “participating” securities that are entitled to share in the dividends paid on common stock. EPS computations for each class of nonconvertible 1 two-class securities are based on an allocation of earnings according to dividends paid and participation rights in undistributed earnings.

Adjustments for Rights Issues

Both SFAS 128 and IAS 33 mandate the use of the ex-rights method in the computation of basic and diluted EPS for the bonus element (discount to market price prior to the offering) in a rights issue. Under prior US GAAP, the bonus element was ignored. The ex-rights method recognizes dilution when rights are issued to buy shares below the current market price.

Impact of New and Proposed Accounting Standards

SFAS 144 (2001) broadened the definition of discontinued operations as discussed on pages 54 and 275 of the text. This change means that, for firms disposing of unprofitable opera- tions, income from continuing operations will be higher than it would have been under prior accounting standards. Because income from continuing operations is the “control number” used to determine whether options and convertible securities are dilutive, higher income from continuing operations will result in more of these potential common shares entering into the computation of dilutive EPS. In its proposed reporting for securities with characteristics of liabilities or equity or both (see Box 10-2 on page 338 of the text), the FASB intends to redefine the control number as income from continuing operations attributable to controlling shareholders. Under current GAAP, income allocated to minority or noncontrolling shareholders is deducted in comput- ing the income from continuing operations. Thus, companies with profitable majority-owned subsidiaries will report higher control numbers under this proposed standard. Again, more potential common stock will be classified as dilutive securities.

INTERNATIONAL DIFFERENCES

As stated in the text, the FASB and IASB developed their new standards together. As a re- sult, there are few differences between the two. The most important difference is that US GAAP requires that EPS be reported for all components of net income. IASB GAAP re- quires disclosure of EPS only for net income; any other components of EPS reported, how- ever, must accord with the new standard. Under SFAS 128, earnings from continuing operations is the “control number” used to determine whether potential common shares are dilutive (see previous section). Thus, ac- counting changes, discontinued operations, and extraordinary items do not affect determina- tion of the dilutive effect. Under IAS 33, net income is the control number. Given the high frequency of extraordinary items and other differences between earnings from continuing operations and net income, it is likely that, for some firms, the dilutive effect will be different depending on whether they use US GAAP or IASB GAAP.

1 If shares of one class are convertible into shares of another class, as is normally the case, the if-converted method must be used for the convertible securities if the effect is dilutive.

Appendix 6-A

LIFO MEASUREMENT ISSUES

This appendix is concerned with two measurement issues that arise when the LIFO method is used:

Different varieties of LIFO

Difficulties when LIFO is applied to interim earnings

Although these issues arise frequently, they are segregated within this appendix to simplify the presentation in the chapter itself.

LIFO INVENTORY METHODS

The discussions in the chapter implicitly assume that:

Firms account for each inventory item

There is only one manner of applying the LIFO method of accounting

Neither assumption is correct. In practice, all but the smallest firms have far too many inven- tory items to use specific item-based costing methods efficiently. The potential for LIFO liq- uidations and the resulting loss of tax benefits are additional deterrents to the use of specific item methods. More efficient methods of applying LIFO to inventories involve the pooling of “substantially identical” inventory units to compute unit costs and physical quantities. Reeve and Stanga (1987) found that a majority of LIFO method companies use a single pool, generally defined by the natural business unit, and they use the same pooling method for financial reporting and taxes although conformity is not required. The number of pools used was inversely related to the magnitude of tax benefits (companies with large tax savings from LIFO tended to use fewer pools). They also reported substantial variation in the number of pools used within an industry and across all the firms in their sample. The impact on cash flows and financial statements suggests that analysts should carefully evaluate announcements of changes in LIFO pools to understand the impact of the change on reported earnings.

Example: Oxford

Oxford [OXM], a clothing manufacturer, uses the LIFO method for most inventories. In fis- cal 2002, Oxford reduced the number of inventory pools used to compute LIFO from five to three. As a result, the company avoided a LIFO liquidation that would have increased net in- come by 30% (and would have resulted in significant tax payments). 1 The company stated that one reason for the change was to “reduce the likelihood of LIFO layer liquidations.” The change was reported as a change in accounting principle. Inventories may also be pooled on the basis of similarity of use, production method, or raw materials used. Liquidations are reduced because these “dollar value” LIFO methods compute inventories using dollars, facilitating substitutions of items in the pools. Inventory

1 Despite the change in number of pools, Oxford reported a small LIFO liquidation for the year.

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APPENDIX 6-A

LIFO MEASUREMENT ISSUES

layers may be priced using indices published by the Bureau of Labor Statistics or internally developed indices. The differences can be substantial. For example, during 1990 Kmart switched to internally generated indices (from the U.S. Department of Labor’s Department Store Price Index) for its U.S. merchandise inventories. The financial statement footnote stated the firm’s belief that the internal index “results in a more accurate measurement of the impact of inflation on the prices of merchandise sold in its stores.” The change reduced its COGS by $105 million (net of tax), increasing income by $0.52 per share (32.3% of reported income for the year). Retailers use more complex LIFO methods. Interested readers are referred to intermedi- ate and advanced accounting texts for explanations of the LIFO Retail and Dollar Value LIFO Retail methods.

INTERIM REPORTING UNDER LIFO

As discussed in Chapter 1, interim reporting creates special problems for both financial re- porting and financial analysis. Because LIFO is a tax-based inventory method, its use creates additional problems. The actual LIFO effect for the year cannot be known until the year is complete. Thus, LIFO charges for interim periods require management assumptions regard- ing both inventory quantities and prices at the end of the year. Technological changes, fluctuations in demand, and strikes may also result in a reduc- tion in LIFO layers during the year. The application of LIFO during interim periods may re- sult in substantial distortions (income statement and balance sheet) if the factors causing the LIFO liquidations are temporary and the layers will be replenished prior to year-end. Financial reporting for interim periods is governed by APB Opinion 28, which provides special inventory valuation procedures during interim periods when the firm experiences a LIFO liquidation during one or more of the first three quarters. Permanent liquidations must be reported in the quarter of occurrence. However, when management believes that the liquidated layer(s) will be replenished before year-end, the cost of goods sold for the quarter must include the estimated cost of replacing the temporary liquidation rather than the LIFO cost of the goods sold. The application of this method is il- lustrated using the following example:

Assumptions: All transactions occur during the second quarter

Beginning inventory (FIFO): 10 units @ $30

$300

LIFO reserve (@ $20)

($200)

LIFO inventory 10 units @ $10

$100

Purchases: 20 units @ $30

$600

Goods available for sale

$700

Sales: 21 units @ $40

$840

Management determines that the liquidation is temporary and expects the next purchase price (cost to replace) to be $35. GAAP requires the use of $35 rather than the unit cost of the liquidated layer. COGS is reported at

$635 (20 units @ $30 plus 1 unit @ $35)

Inventory is reduced by

$610 (20 units @ $30 and 1 unit @ $10)

The firm recognizes a current liability (called the LIFO base liquidation) for the differ- ence of $25, indicating that the firm has temporarily “borrowed” a unit from the base layer. 2 The next purchase of inventory is used to eliminate the current liability and replenish the

2 An AICPA issues paper, “Identification and Discussion of Certain Financial Accounting and Reporting Issues Con- cerning LIFO Inventories” (AICPA, 1984), suggests that the interim liquidation may also be credited directly to inventories.

INTERIM REPORTING UNDER LIFO

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LIFO base layer. This method eliminates any distortion in reported gross profit and income numbers due to temporary interim period liquidations. Year-end LIFO liquidations are permanent reductions in LIFO layers, and the reported gross profit must include the impact of the reduction in LIFO reserves. If the foregoing sce- nario occurs during the fourth quarter, the firm would report COGS of $610 [(20 $30) (1 $10)] and separately disclose the impact of the LIFO liquidation on COGS and net in- come in the footnotes.

Example: Nucor

The following example illustrates the impact of volatile prices and the procedures required for interim reporting. It is based on Nucor Corp., a steel and steel products manufacturer that uses the LIFO method of inventory accounting. Steel scrap is a major component of inventory cost, and since scrap prices can be volatile, Nucor must estimate its year-end position at the end of each interim period. That is, it must estimate both physical inventory and the price of scrap at year-end to establish the appropriate LIFO reserve at the end of each interim period. In 1981, scrap prices rose during the first part of the year, but declined in the second half. The LIFO reserve declined for 1981 as a whole, reflecting a decline in the price of steel scrap. (At the end of 1981, the difference between the LIFO and FIFO cost of its inventory was lower than it had been one year earlier.) During the first two quarters, Nucor assumed that scrap prices would be higher at the end of 1981 than one year earlier and accrued additional LIFO reserves. Because of the decline in steel scrap prices late in the year, these earlier accruals were reversed in the fourth quarter. The impact of the interim changes in the LIFO reserve can be seen in the following table:

Reported Nucor Quarterly Results 1981 ($ in thousands)

Quarter

I

II

III

IV

Year

Pretax income LIFO effect LIFO reserve (end of period) (12/31/80 $23,727)

$13,087

$11,204

$4,637

$15,901

$44,829

1,873

1,900

0

(5,134)

(1,361)

$25,600

$27,500

$27,500

$22,366

$22,366

Source: Nucor, 1981 annual and interim reports.

Although the interim LIFO accruals (LIFO effect change in reserve) were made in good faith, in retrospect we can see that they were incorrect and distorted operating results. To correct that distortion, we can (with perfect hindsight) reallocate the decrease in the LIFO reserve for the year so that an equal amount is credited to each interim period. We can obtain the “true” interim results by restating the LIFO impact as follows:

Adjusted Nucor Quarterly Results 1981 ($ in thousands)

Quarter

I

II

III

IV

Year

Pretax income LIFO adjustment* Adjusted pretax % Change from reported

$13,087

$11,204

$4,637

$15,901

$44,829

$12,213

$12,240

$4,340

$ (4,793)

$44,820

$15,300

$13,444

$4,977

$11,108

$44,829

16.9%

20.0%

7.3%

(30.1)%

0

*Difference between original LIFO effect and true LIFO effect (one-fourth of annual). For example, the first quarter adjustment is $1,873 ( $1,361/4).

The Nucor case indicates that management assumptions can play a major role in re- ported interim earnings and the application of LIFO accounting to interim periods can result in large distortions in interim comparisons. It should also be noted that there are many ways of making interim LIFO calculations. This illustration also serves as an example of fourth- quarter adjustments that have a significant impact on reported earnings and trends reflected during the previous three quarters.

Appendix 6-B

THE FIFO/LIFO CHOICE:

EMPIRICAL STUDIES

As noted in the chapter, the LIFO to FIFO choice provides an ideal research topic as the choice has

1. conflicting income and cash flow (tax effect) implications, and

2. data availability allowing for adjustment from one method to the other permitting “as-if” comparisons in research design.

Earlier research focused on market reaction to FIFO-to-LIFO switches and the motivation for using one method as compared to the other. This line of research was consistent with the market-based and positive accounting approaches 1 to research prevalent at that time. More recently, in line with the renewed interest in security valuation issues, researchers have examined the relationship between equity valuation and alternative methods of in- ventory reporting.

Equity Valuation Issues

Jennings, Simko, and Thompson (1996) examined the contention that

1. LIFO income statements were more useful than non-LIFO statements, and

2. Non-LIFO balance sheets were more useful than LIFO balance sheets

by comparing which set of statements better explained the distribution of equity values for a set of LIFO firms. The “as if” non-LIFO statements were created by using the LIFO reserve disclosures and the methodology described in the chapter. Their results were mixed. Consistent with their expectation, they found that LIFO-based income statements explained more of the variation in equity valuations than non-LIFO in- come statements. However, they found that LIFO balance sheets were more useful than their non-LIFO counterparts—a surprising result given that non-LIFO balance sheets are closer to current (rather than outdated LIFO) costs. Jennings et al. explained these results by noting the negative empirical relationship (re- ported earlier by Guenther and Trombley (1994))—between a firm’s value and the magni- tude of the LIFO reserve. 2 They argue (and demonstrate using a theoretical model) that if firms cannot (fully) pass on input price increases to their customers, a larger LIFO reserve in- dicates lower future profitability. In such cases, a negative relationship is expected between firm value and the LIFO reserve. Thus, the poor performance of the non-LIFO balance sheet may be explained as follows. When the LIFO reserve is added to LIFO inventory to create the non-LIFO balance sheet in- ventory, the positive relationship between value and assets may be offset by the loss of infor-

1 See Chapter 5 for further discussion.

2 This result seems anomalous because a higher LIFO reserve is indicative of higher asset values.

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THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES

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mation (with respect to the effects of inflation) that is provided by the LIFO inventory and LIFO reserve individually.

As the elasticity of output prices with respect to input price changes fall, the LIFO and LIFO reserve components of non-LIFO inventory have increasingly different implications for future net resource inflows, and loss of information through aggregation increases. 3

An alternative “deferred tax” explanation for the negative relationship between firm value and the LIFO reserve is offered by Dhaliwal, Trezevant and Wilkins (2000). They argue that the LIFO reserve indicates a potential future tax liability if the inventory (or firm) is liquidated or sold. Whichever argument is correct in explaining the negative relationship between firm value and the LIFO reserve, these results and those with respect to the comparison of LIFO and non-LIFO balance sheets point out the need for well-grounded economic analysis when preparing a research design for empirical testing.

The LIFO/FIFO Choice

As the chapter discussion indicates, there may be sound reasons for firms to stay on FIFO. In addition to those related to LIFO liquidations and declining prices, these reasons include bur- densome record keeping requirements, the inability to write down obsolete inventory, and the desire to maximize taxable income when using up a tax loss carryforward. Another reason is the desire to avoid the negative effect of LIFO on a firm’s reported earnings. This motivation depends on whether (as discussed in Chapter 5) a market-based or financial contracting argument is used. The market-based argument says that, whether or not the market is efficient and can see through the FIFO/LIFO choice to the real economics of the firm, managers who believe that the market can be fooled by lower reported earnings are reluctant to use LIFO. Alternatively, the financial contracting approach considers the impact of the FIFO/ LIFO choice on management compensation and debt covenant restrictions. The bonus plan hypothesis argues that when top management compensation is based on income, the firm is less likely to use the LIFO method if the resultant lower earnings reduce their compensation. The debt covenant hypothesis argues that the negative effect of LIFO on a firm’s re- ported income and ratios increases the probability that a firm will violate debt covenants re- garding such financial measures as working capital, net worth, income, and the dividend payout ratio. Highly leveraged firms may be especially reluctant to use LIFO for that reason, notwithstanding the tax benefits. Studies of the FIFO/LIFO choice generally examine the impact of the choice on firms’ financial performance in terms of both market reaction and management behavior, as well as the effect on firms’ financial statements. These studies and the hypotheses tested are affected by both the progression in academic accounting theory and economic factors (such as higher inflation) that caused a resurgence in the adoption of LIFO in the mid-1970s.

Market-Based Research

LIFO has been permitted in the United States since before World War II, and its rate of adoption understandably follows the rate of inflation. In the 1970s, when the rate of inflation reached double-digits, LIFO adoptions soared. Approximately 400 companies switched from FIFO to LIFO in 1974 alone. This period coincided with heavy academic emphasis on mar- ket-based empirical research and the efficient market hypothesis, and the effect of the FIFO/LIFO switch was viewed as an ideal area for research. Given these conditions, the functional fixation hypothesis was tested to see whether:

• The market accepts financial statements as presented and thus views the switch to LIFO unfavorably since income is depressed.

3 Ross Jennings, Paul J. Simko, and Robert B. Thompson III, “Does LIFO Inventory Accounting Improve the In- come Statement at the Expense of the Balance Sheet?,” Journal of Accounting Research, (Spring 1996), p. 105.

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APPENDIX 6-B

THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES

The market is efficient in the sense that it sees through reported data and views the switch to LIFO positively since cash flow increases.

Proponents of the efficient market hypothesis predicted that the market would see through the switch and react favorably to the cash flow effects. Surprisingly, the results were equivocal. Sunder (1973) examined a sample of firms that changed to LIFO in the period 1946 to 1966 and found that prior to the switch these firms ex- perienced positive abnormal returns (Figure 6B-1a). At the time of the change itself, the re- action was slightly negative or nonexistent, as investors seemed to ignore the positive cash flow effect. Moreover, the risk (beta) of firms that switched to LIFO increased in the months surrounding the switch. This result was similar to that of Ball (1972), who examined the market reaction to sev- eral accounting changes, FIFO/LIFO included. The positive reaction in the year of the switch was interpreted by some as a sign that the market anticipated the switch and had reacted prior to the actual announcement. Others felt that firms that switched had been having good years and could thus “afford” the negative impact of the switch, and that these studies suffered from a self-selection bias. Subsequent studies such as Eggleton et al. (1976), Abdel-khalik and McKeown (1978), Brown (1980), and Ricks (1982) extended this research by controlling for earnings-related variables and focusing on the large number of firms that switched in the 1974 to 1975 period. Generally, their results confirmed a negative market reaction in the year of the switch. Ricks, for example, used a control sample of non-LIFO adopters (matched on the basis of industry and earnings calculated “as if” the control company was also on LIFO) and com- puted the cumulative average return differences between the two groups. His results, pre- sented in Figure 6B-1b, clearly indicate better market performance for firms that did not adopt LIFO. Although these lower market returns were reversed within a year, the initial pro- longed negative reaction is difficult to understand. One explanation for this anomalous behavior is that firms that switched to LIFO were those most affected by inflation. Thus, the market may have reacted negatively to the added risk (higher inflation) of these firms, explaining the lower returns and higher risk measures. 4 The difficulty with this explanation is that the sample firms were matched by industry. Thus, we must assume that the sample firms were somehow more adversely affected by in- flation than other firms in the same industry. Biddle and Ricks (1988), discussed shortly, also found evidence consistent with this explanation. Implicitly, these studies help explain why firms stayed on FIFO; they wanted to avoid the unfavorable market reaction resulting from the adoption of LIFO. Biddle and Lindhal (1982) attempted to resolve some of these issues by arguing that pre- vious studies did not consider the amount of tax savings from the LIFO adoption. They found a positive association (see Figure 6B-1c) between the market reaction and the esti- mated tax savings:

The results in this study are consistent with a cash-flow hypothesis, which suggests that in- vestor reactions to LIFO adoptions depend on the present value of tax-related cash-flow sav- ings. After controlling for abnormal earnings performance, larger LIFO tax savings were found to be (cross-sectionally) associated with larger cumulative excess returns over the year in which a LIFO adoption (extension) first applied. 5

Biddle and Lindhal studied 311 LIFO adopters from the period 1973 to 1980. The pat- tern of abnormal returns reported is similar to Sunder’s findings (Figure 6B-1a). Neither study used a control group, 6 making these results not directly comparable to those of Ricks.

4 This argument is consistent with the Jennings et al. (1996) explanation (discussed earlier) that the negative associa- tion between equity values and the LIFO reserve was related to the inability of firms to pass on higher input prices.

5 Gary C. Biddle and Frederick W. Lindahl, “Stock Price Reactions to LIFO Adoptions: The Association Between Excess Returns and LIFO Tax Savings,” Journal of Accounting Research, Autumn 1982, Part II, pp. 551–588.

6 Biddle and Lindahl instead used the size of the tax saving as a “within-group” control.

THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES

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FIGURE 6B-1 Abnormal returns: Inventory method studies. Sources: (a) 1946–1966 Adopters: Shyam Sunder, “Relationship
FIGURE 6B-1 Abnormal returns: Inventory method studies. Sources:
(a) 1946–1966 Adopters: Shyam Sunder, “Relationship Between Ac-
counting Changes and Stock Prices: Problems of Measurement and
Some Empirical Evidence,” Journal of Accounting Research, Supple-
ment 1973, pp. 1–45, Fig. 2, p. 18. (b) 1974–1975 Adopters: William E.
Ricks, The Market’s Response to the 1974 LIFO Adoption,” Journal
of Accounting Research, Autumn 1982, pp. 367–387, Fig. 2, p. 378.
(c) 1973–1982 Adopters: Gary C. Biddle and Fredrick W. Lindahl,
“Stock Price Reactions to LIFO Adoptions: The Association Between
Excess Returns and LIFO Tax Savings,” Journal of Accounting Re-
search, Autumn 1982, pp. 551–588, Fig. 1, p. 569.

Thus, it is possible that there was some systematic but unexplained factor affecting the 1974 to 1975 adoptions, and that the research results were sensitive to the research design and the time horizon examined.

Biddle and Ricks (1988), using daily data, confirmed that there were negative excess market returns around the preliminary dates of firms adopting LIFO in 1974. There is little evidence of

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APPENDIX 6-B

THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES

significant excess returns (negative or positive) near the preliminary dates of firms adopting LIFO in other years. 7

To explain the negative returns, they examined analyst forecast errors for the 1974 LIFO adopters. They found that analysts significantly overestimated the earnings and did not fully appreciate the magnitude of the impact of inflation. 8 In other years, however, the error in analyst forecasts for LIFO adopters was not significant. Further, they found that the negative returns were positively correlated with the forecast error, indicating that the market (as well as analysts) was surprised by the actual reported earnings. Thus, the nega- tive returns were due to the “surprise” when the market realized that it had underestimated the impact of inflation. As the firms that adopted LIFO were presumably those most af- fected by inflation, the negative surprise reaction hit them hardest. In later years, however, the market learned from experience and the impact of inflation was more readily factored into earnings estimates. Although these studies shed some light on the market reaction to LIFO adoption, they still do not explain why some firms remain on FIFO. On the contrary, Biddle (1980) found

surprising the finding that many firms voluntarily paid tens of millions of dollars in additional income taxes by continuing to use FIFO rather than switching to LIFO. 9

Contracting Theory Approach

The contracting theories of accounting choice focus on this issue. Abdel-khalik (1985) exam- ined the bonus plan hypothesis and its implicit corollary that management-controlled firms, in which ownership is widely held, are more likely to use FIFO than owner-controlled firms. The rationale for this argument was that when management is more removed from ownership of the firm, then management compensation rather than the wealth of the firm becomes the primary motivator for manager actions. Thus, the LIFO-induced tax savings are less impor- tant to the management-controlled firm. Abdel-khalik found that manager-controlled FIFO firms had relatively higher income- based bonuses. On the other hand, there was no evidence that differences in compensation plans were related to the FIFO/LIFO choice. In explaining this (non)finding, Abdel-khalik hypothesized that either

1. firms switching to LIFO modify their compensation arrangements, or

2. as some executives have indicated to me, the FIFO-based income continues to be used in determining annual bonus. 10

Hunt (1985) examined the bonus plan and debt convenant hypotheses. His results did not support the bonus plan hypothesis. Contrary to expectations, he found that LIFO firms tended to be less owner-controlled. Hunt, however, did find support for the debt covenant hy- pothesis, especially with respect to the leverage and interest coverage ratios. His evidence also indicates a threshold level of dividend payout ratios above which firms are reluctant to use LIFO. Dopuch and Pincus (1988) examined the bonus plan, debt covenant, and taxation hy- potheses in one study and found that the taxation effect provided the best explanation for the LIFO/FIFO decision. They compared the holding gain that would have accrued to LIFO firms had they stayed on FIFO with the holding gain for firms that remained on FIFO.

7 Gary C. Biddle and William E. Ricks, “Analyst Forecast Errors and Stock Price Behavior Near the Earnings An- nouncement Dates of LIFO Adopters,” Journal of Accounting Research, Autumn 1988, pp. 169–194.

8 At that time, LIFO adoptions were unusual, and it took time for analysts to learn to estimate the impact. That they did learn is evidenced by the reduced earnings forecast errors for LIFO adopters in later years.

9 Gary C. Biddle, “Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory Policy,” Journal of Accounting Research, Supplement 1980, pp. 235–280. 10 A Rashad Abdel-khalik, “The Effect of LIFO-Switching and Firm Ownership on Executive’s Pay,” Journal of Ac- counting Research, Autumn 1985, pp. 427–447.

THE FIFO/LIFO CHOICE: EMPIRICAL STUDIES

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They found larger holding gains for LIFO firms, resulting in higher tax savings. In addi- tion, the holding gain grew as they approached the switch date. Dopuch and Pincus argued that this indicated

the long-term FIFO firms in our sample have not been forgoing significant tax savings, in

which case remaining on that method is certainly consistent with FIFO being an optimal tax choice, given other considerations. In contrast, long-term LIFO firms would have forgone sig-

Finally, using the long-term FIFO sample’s average holding gains as a

base, our change-firms’ average holding gains became significantly larger than the FIFO aver- age as they approached the year in which they switched, and this difference continued to grow subsequently. 11

nificant tax

Further, Dopuch and Pincus argued that financial analysts could have calculated the in- creased holding gains for the switch firms and thus anticipated the switch. Therefore, the in- conclusive findings of the market reaction studies could be a result of ignoring the “advance warning” market agents had regarding the switch. More recently, Jennings et al. (1992) supported this advance warning contention. They constructed a model that predicted which firms in the 1974 to 1975 period were more likely to adopt LIFO. The model accurately forecast adopting/nonadopting firms approximately two-thirds of the time. Furthermore, the prior probability of adoption affected the market re- action. The less likely candidates for adoption (according to the model) had more positive market reactions when they adopted LIFO. Similarly, firms that were originally viewed as likely candidates for adoption, but did not adopt, suffered negative market reaction when they failed to adopt LIFO. However, in summing up the research in this area, the editor of The Accounting Review stated

We continue to be relatively uninformed about these issues and know little about the real rea- sons that many firms do not switch to LIFO when it appears that they would benefit by positive tax savings. 12

11 Nicholas Dopuch and Morton Pincus, “Evidence of the Choice of Inventory Accounting Methods: LIFO Versus FIFO,” Journal of Accounting Research, Spring 1988, pp. 28–59. 12 Editor’s Comments, The Accounting Review, Vol. 67, No. 2, April 1992, p. 319.

Appendix 7-A

RESEARCH AND DEVELOPMENT AFFILIATES

INTRODUCTION

Because GAAP in the United States requires that all expenditures for research and develop- ment (R&D) be expensed, firms have looked for alternative methods of financing R&D that postpone the associated earnings charge. Alternate financing methods may also have the fol- lowing advantages:

Targeting investors who are attracted by the risk/reward characteristics of specific projects

Focusing management attention on specific projects by placing their development in a separate entity.

We discuss the two most common forms of these arrangements, R&D partnerships and de- velopment companies. The drug and biotechnology industries have been the most common users of these techniques, perhaps because R&D is focused on the development of discrete patentable products.

Appendix Objectives

1. Examine the motivation for the establishment of R&D arrangements.

2. Show the effect of R&D arrangements on the amounts and timing of research and de- velopment expense.

3. Show the effects of R&D arrangements on reported net income, stockholders’ equity, and financial ratios.

4. Compare the effects of R&D arrangements on companies using accounting methods that expense all R&D with those permitting capitalization.

RESEARCH AND DEVELOPMENT PARTNERSHIPS

An R&D partnership raises funds from investors. Those funds are then used to pay the com- pany for research. Any patents or products resulting from that research belong to the partner- ship, but the company can either purchase the partnership or license the product. Thus, the company controls the technology without reporting the expenses resulting from research costs, as the “revenue” from the partnership offsets the research expense. This arrangement has many of the attributes of an option; the firm has a call option on the patents or products developed for the partnership, with the purchase price being the exer- cise or strike price. Shevlin (1991) treats such limited partnerships (LPs) as an option and uses option pricing theory to value the LP:

The value of the LP call option to the R&D firm may be decomposed into the present value of the underlying project financed by the LP (an asset) less the present value of the payments to the limited partners if the firm exercises its option (liability). 1

1 Terry Shevlin, “The Valuation of R&D Firms with R&D Limited Partnerships,” The Accounting Review, Jan. 1991, pp. 1–21.

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RESEARCH AND DEVELOPMENT PARTNERSHIPS

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SFAS 68 (1982), Research and Development Arrangements, sets criteria to distinguish true transfers of risk from disguised borrowings. The following are indicators that there has not been a true transfer of risk:

1. The company has an obligation to the partnership (or investors) regardless of the out- come of the research. Such obligation may take the form of a guarantee of partner- ship debt or granting of a “put” option to the investors.

2. Conditions make it probable that the company will repay the funds raised by the part- nership. Such conditions include the company’s need to control the technology owned by the partnership or relationships between the company and the investors (e.g., top management invests in the partnership).

If there has not been a true transfer of risk, then the company is required to expense the ac- tual research costs and treat funds received from the partnership as borrowings. When the requirements of SFAS 68 are met, however, the company can recognize rev- enue from the partnership to offset R&D costs. The result is, in effect, a deferral of research cost until products are sold (and license fees paid) or the partnership is purchased. Such arrangements are disclosed in financial statement footnotes and analysts should be alert to their effects on reported income. In recent years, a new vehicle has largely superseded the R&D partnership: a separate development company that sells “callable common” shares to the public. The shares are often packaged with warrants of the (parent) company to make the resulting “units” more attrac- tive to investors. The new common shares are callable at prices that promise a high rate of return to investors if the venture is successful. These vehicles are similar to R&D partner- ships in their effects on the firm.

Analysis of Firms with R&D Affiliates

The impact of R&D affiliates on reported financial results is favorable as research costs are offset by “revenue” from the affiliate. Reported income would be lower if these costs were funded by borrowing (or from the firm’s own assets). Further, obtaining those funds would require additional debt or equity capital. R&D financing arrangements permit the company to conduct research without incurring debt or equity dilution, in addition to avoiding the effects of reporting the research costs as an expense. There is a cost to this capital, however. When the partnership is purchased or the callable common is called, a substantial cash payment or share issuance is required. Given the risk, investors in R&D affiliates require a high rate of return. The second cost factor is the impact when the affiliate is purchased. At that time, the purchase price must be written off as research costs. 2 The resulting write-off usually exceeds the amount of funds originally raised. But that write-off is delayed until the partnership is purchased. In effect, these arrangements permit the deferral of research costs, but with the penalty of a high interest factor (cost of capital).

R&D Affiliates Outside of the United States

In jurisdictions that do not require all R&D to be expensed, the incentives for alternative arrangements are weaker. Under IAS GAAP, as discussed in the chapter, research costs must be expensed but development costs are capitalized and amortized. Canada has similar re- quirements, as seen in the analysis of Biovail that follows. However, given the preeminence of the United States capital market, even non-U.S. firms may use these techniques to enhance their earnings reported under U.S. GAAP.

2 FASB Interpretation 4 (1975) provides that when an acquisition is accounted for under the purchase method of ac- counting, any portion of the purchase price allocated to R&D must be immediately expensed at the time of the ac- quisition. Chapter 14 contains more discussion of this issue.

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APPENDIX 7-A

RESEARCH AND DEVELOPMENT AFFILIATES

Example: Biovail

Biovail [BVF] is a Canadian pharmaceutical company. It used several R&D affiliates to fi- nance drug development in the 1990’s. We will focus on one such arrangement, Intelligent Polymers [INP], incorporated in Bermuda. In October 1997, there was an initial public offering of 3.7 million units at $20 per unit, resulting in net proceeds after expenses of approximately, $69.5 million. 3 Each unit con- sisted of:

One Intelligent Polymer common share

One warrant to purchase one Biovail share at $10 per share (adjusted for subsequent stock splits) from October 1, 1999 through September 30, 2002

Biovail recorded a credit to equity of $8.244 million to reflect the value of the warrants is- sued and an equal reduction of retained earnings to record the contribution to INP. The net result of the offering was that INP received $69.5 million of capital with no net effect on Biovail’s financial statements. At the time of the offering, the two companies entered into a series of agreements, in- cluding the following provisions:

1. INP agreed to spend the proceeds to develop seven possible products, paying BVF to conduct the required research.

2. INP would hold the rights to products developed but Biovail would have options to purchase those rights at predetermined terms.

3. Biovail had the option to purchase all shares of INP at the following prices:

$39.06 per share before October 1, 2000

$48.83 per share from October 1, 2000 through September 30, 2001

$61.04 per share from October 1, 2001 through September 30, 2002

The development agreement resulted in payments from INP to Biovail shown in the follow- ing table:

Years ended December 31

1998

1999

2000

Totals

Payments to Biovail Biovail’s related costs Biovail gross profit

$9.7

$33.0

$55.2

$97.9

(6.7)

(19.8)

(35.2)

(61.7)

$3.0

$13.2

$20.0

$36.2

Over the three-year period, INP paid Biovail approximately $98 million for research. If Biovail had conducted the research itself, the total cost would have been nearly $62 million. The effect of forming INP was to increase Biovail’s reported pretax earnings by the amount of the payments received. The significance of these amounts can be seen from Biovail’s rev- enues (Exhibit 7A-1), which rose from $111.6 million in 1998 to $309.2 million in 2000. In 1999, Biovail paid INP $25 million for the rights to one developed drug. On Septem- ber 29, 2000, Biovail exercised its option to purchase all INP shares, for a total price (includ- ing bank debt) of $204.9 million. The purchase resulted in a write-off of in-process research and development (IPRD) of $208.4 million. The write-off resulted in an operating loss for the year of $78 million. The IPRD was far above the actual research expenditures. However the creation of INP had the effect of delaying the recognition of these costs in Biovail’s fi- nancial statement. It also reduced Biovail’s risk; if the INP research had not been successful, Biovail would not have exercised its option. 4 We can see the cost of capital implicit in the creation of INP by examining the invest- ment from the investor point of view. Ignoring (for the moment) the Biovail warrants in-

3 All dollar amounts in this section are United States dollars even though Biovail is Canadian.

4 It is also possible that Biovail would have exercised its option even in the event of failure in order to maintain full control of its proprietary technology.

RESEARCH AND DEVELOPMENT PARTNERSHIPS

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cluded in the offering, investors bought INP shares for $20 each. The call prices shown above provide rates of return of 25% per annum. As Biovail shares rose substantially, trading above $45 per share in November 2000, the actual return (including the gain in the Biovail warrants) was even higher. Of course, investors took the risk that the INP research would not have produced marketable drugs. 5 In economic terms, the Intelligent Polymers capital came at a high price to Biovail. However, the risk reduction may have made the cost of capital acceptable relative to other sources of capital available at that time. The INP arrangement also resulted in postponed recognition of the research costs associated with the development of these drugs. As IPRD write-offs are often seen as “non-recurring” costs, it is uncertain how the financial markets value firms with such charges.

Comparison of Biovail Financial Statements: U.S. vs. Canadian GAAP

Under Canadian GAAP, IPRD and the acquisition cost of drug rights are capitalized and amortized over the useful life of the products. Both the $25 million paid to INP in 1999 and the cost of acquiring INP in 2000 resulted in asset recognition (rather than being expensed under U.S. GAAP). Biovail had written off more than $105 million of IPRD in 1999 from another R&D arrangement. The difference between the treatment of these transactions be- tween U.S. and Canadian GAAP can be seen in Exhibit 7A-1.

EXHIBIT 7A-1. BIOVAIL Financial Data under United States and Canadian GAAP All data in $US thousands, except per share

Years Ended December 31

1998

1999

2000

United States GAAP

Revenue Operating income (loss)* Net income (loss) Earnings per share (diluted)

 

$111,657

$172,464

$

309,170

45,303

(40,160)

(78,032)

41,577

(109,978)

(147,796)

0.38

(1.07)

(1.16)

Total assets Long-term obligations Convertible securities Common equity

$198,616

$467,179

$1,107,267

126,835

137,504

438,744

 

299,985

 

49,888

267,336

237,458

Common shares outstanding

99,444

124,392

131,461

*Includes IPRD charges

$105,700

$

208,400

Canadian GAAP

Revenue Operating income Net income Earnings per share (diluted)

$

98,836

$165,092

$

311,457

35,145

64,117

116,223

31,419

52,080

81,163

0.29

0.47

0.57

Total assets Long-term obligations Shareholders’ equity

$199,919

$635,137

$1,460,967

126,835

137,594

438,744

19,091

391,794

839,110

Common shares outstanding

99,444

124,392

131,461

Note: While the treatment of IPRD and the cost of acquired drugs are the principal differences between U.S. and Canadian GAAP, the data also reflect other differences. Source: Biovail 10-K, December 31, 2000

5 See footnote 4; for this reason, the risk may not have been excessive.

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APPENDIX 7-A

RESEARCH AND DEVELOPMENT AFFILIATES

The principal differences are:

1. Under Canadian GAAP, there is a progressive improvement in both operating and net income, as well as earnings per share. Under U.S. GAAP, the IPRD write-offs re- sult in operating and net losses for both 1999 and 2000.

2. Canadian GAAP assets exceed those under U.S. GAAP, reflecting the capitalization of drug acquisition costs.

3. Canadian GAAP equity exceeds that under U.S. GAAP, mainly due to the difference in net income.

The ratio effects of these differences are the subject of Problem 7A-1.

Conclusion

The Biovail—Intelligent Polymers example illustrates the effects of research and develop- ment arrangements on the financial statements of the sponsoring company. Such arrange- ment can have major impacts on the amount and timing of reported net income, as well as the balance sheet and cash flow statements. While ultimately, company valuation depends on research (and subsequent marketing) outcomes, the analyst should carefully consider the ef- fect of such arrangements on the financial statements of affected companies.

PROBLEMS

7A-1. [Ratio effects of differences in accounting for R&D arrangements].

A. Using the data in Exhibit 7A-1, calculate the following ratios for Biovail for 1998 through 2000 under both United States and Canadian GAAP:

(i)

Return on sales (net income margin)

(ii)

Return on equity

(iii)

Asset turnover

(iv)

Equity per common share

Note: use year-end amounts for balance sheet data.

B. Discuss the differences between both the level and trend of the ratios computed in part A.

C. The price of Biovail shares rose from less than $9 per share at the end of 1997 to nearly $39 per share at the end of December 2000. Discuss which set of ratios ap- pears to be reflected in the market performance of Biovail shares. Discuss any other factors that may have affected the price of Biovail shares during this time period.

D. State which of the two methods of accounting for IPRD (immediate write-off ver- sus capitalization and amortization) comes closest to recognition of the economic impact of the acquisition of drug rights. Justify your choice.

E. Discuss the limitations of the method chosen in part D.

F. Discuss whether the accounting for internal drug research expenditures should

differ from that for acquired drug rights. 7A-2. [Analysis of R&D Arrangements] In September 1997 ALZA (acquired by Johnson and Johnson in June, 2001) contributed $300 million to Crescendo Pharmaceuticals, a newly created company. ALZA formed Crescendo to help fund the development of new pharmaceutical products. Crescendo and ALZA entered into the following agree- ments:

1. Crescendo was required to spend virtually all of its available funds to fund the de- velopment (by ALZA) of seven possible new products.

PROBLEMS

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3. Crescendo granted ALZA options to license products developed, exercisable on a country-by-country basis after clearance from the Federal Drug Administration (FDA) or appropriate foreign regulatory body. ALZA also had the right to pur- chase Crescendo’s right to receive license fees. Both the license fee and the pur- chase price were based on predetermined formulas.

4. ALZA had the right to purchase all Crescendo shares until January 31, 2002 at a price equal to the greater of:

(i)

$100 million

(ii)

The market value of 1 million ALZA shares

(iii)

$325 million less all amounts paid to ALZA by Crescendo under the agree- ment, and

(iv)

A formula based on license fees paid to Crescendo by ALZA over the previ-

ous four calendar quarters. ALZA could purchase Crescendo shares for cash, ALZA shares, or a combination of the two. The option deadline would be extended if Crescendo had not yet expended all of its funds. On September 29, 1997, ALZA contributed $300 million to Crescendo, of which $247 was recorded as a “non-recurring” expense. Crescendo shares were distributed to ALZA’s shareholders and debenture holders as a dividend. Over the next three years, Crescendo made the following payments to ALZA:

Years Ended December 31

1998

1999

2000

Payments for research Technology fees Administrative service fees

$95.0

$90.5

$68.3

10.7

6.7

2.7

0.2

0.2

0.2

ALZA paid the following to Crescendo for three drugs that had been successfully developed:

Drug license fees

$2.4

$4.5

On November 13, 2000 ALZA paid $100 million to acquire all outstanding shares of Crescendo. $45.7 million of the purchase price was allocated to developed products as deferred product acquisition costs and $9.4 million was expensed as IPRD. Exhibit 7AP-1 contains financial data on ALZA for the three years ended Decem- ber 31, 2000. Use the data provided to answer the following questions.

A. Prepare income statements for ALZA for the years 1998 through 2000 assuming that the Crescendo transactions had not taken place.

B. Calculate the percentage change in each of the following from 1998 to 1999 and from 1999 to 2000, using reported data:

(i)

Revenues

(ii)

Expenses

(iii)

Operating income

(iv)

Pretax income

C. Calculate the percentage change in each of the following from 1998 to 1999 and from 1999 to 2000, using adjusted data from part A:

(i)

Revenues

(ii)

Expenses

(iii)

Operating income

(iv)

Pretax income

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APPENDIX 7-A

RESEARCH AND DEVELOPMENT AFFILIATES

EXHIBIT 7AP-1. ALZA CORP. Financial Data All data in $millions, except per share

Years Ended December 31

1998

1999

2000

Net sales Royalties, fees, and other Research and development Total revenues

$ 289.4

$ 448.0

 

$607.2

233.1

227.1

281.2

124.4

120.8

100.1

$ 646.9

$ 795.9

$

988.5

Costs of products shipped Research and development Selling and administrative Merger-related charges In-process R & D Total expenses

(125.7)

(158.4)

(180.2)

(182.8)

(183.6)

(190.8)

(141.9)

(259.0)

(349.4)

(45.7)

00000—

00000—

00.(12.4)

$ (450.4)

$ (646.7)

$ (732.8)

Operating income Interest and other income Interest expense Pretax income Income tax expense Net income*

196.5

149.2

255.7

26.4

41.6

59.0

00.(56.7)

00.(58.1)

00.(58.0)

$ 166.2

$ 132.7

$

256.7

00.(57.9)

00.(41.7)

00.(26.0)

$ 108.3

$

91.0

$

230.7

*before cumulative effect of accounting change

D. Calculate the effect of the adjustments in part A on each of the following for the three years ended December 31, 2000:

(i)

Revenues

(ii)

Expenses

(iii)

Operating income

(iv)

Operating margin

(v)

Pretax income

(vi)

Pretax margin

(vii)

Times interest earned

E. Describe the effect of the Crescendo transactions on each of the following, using the results of parts A through D:

(i)

ALZA’s reported growth rate for 1999 and 2000

(ii)

ALZA’s reported profitability for 1998–2000

(iii)

The volatility of ALZA’s profitability for 1998–2000

(iv)

ALZA’s reported return on equity for 1998–2000.

Hint: Consider the effect of the Crescendo transactions on ALZA’s equity.

F. Discuss the benefits and drawbacks to ALZA of the Crescendo transactions, using the results of parts A through E.

G. Considering the Crescendo transactions as a whole, justify the analytical adjust- ments in this problem.

Appendix 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

INTRODUCTION

The two acceptable accounting methods used for oil and gas exploration: the successful ef- forts method (SE) and full cost method (FC) 1 are illustrated in Exhibit 7-1. The choice be- tween these methods has significant effects on reported financial statements. These differences can be summarized as follows:

SE firms, by expensing dry hole costs, have lower carrying costs of oil and gas re- serves than FC firms.

SE firms have lower earnings than FC firms when exploration efforts are rising.

SE firms have lower cash from operations than FC firms (unless explicitly adjusted for, as in the case of Texaco).

APPENDIX OBJECTIVES

1. Examine the motivation for use of the successful efforts and full cost methods.

2. Describe the motivation and effects of changes between the two accounting methods.

3. Analyze the supplementary disclosures regarding oil and gas reserves, showing how they can be used to gain insight into the:

changes in reserve quantities over time.

cost of finding new reserves.

level and trend of present value of reserves, a proxy for the fair value of oil and gas reserves.

4. Show how to adjust present values for subsequent price changes.

5. Adjust stockholders’ equity and the debt-to-equity ratio for the difference between the carrying cost and present value of oil and gas reserves.

Motivations for Accounting Choice

The differential effects on financial statements demonstrated in Exhibit 7-1 as well as the il- lustration in Box 7-1 help explain why some firms prefer the SE method and others the FC method. Empirical evidence as to these preferences is provided in Box 7B-1. Small firms generally prefer the FC method; large firms tend to be indifferent. For larger firms, with relatively stable exploration budgets and relatively constant success ratios (pro- ductive to total expenditures) across a “portfolio” of exploration projects, the year-to-year variability of dry hole expense is low. Amortization of past expenditures is large, reflecting a large reserve base. As a result, the difference between the two methods is small. Additionally, larger oil companies are often diversified into the refining and distribution segments of the oil business. Income from these sources dampens the variability of exploration

1 Both methods are described on pages 244–246.

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APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

BOX 7B-1 SE Versus FC Choice of Methods: Empirical Evidence

A number of research studies* have examined characteristics of

firms using SE versus FC accounting. Malmquist (1990) tested the relationship between the following characteristics and firm choice.

1. Size

The larger the firm, the less likely it will choose FC for several reasons. First, large firms prefer income-reducing alternatives such as SE to avoid earning “windfall profits,” especially when

prices are rising, given the political sensitivity of energy prices. Second, large firms have more drilling activities occurring si- multaneously, creating a portfolio effect and thereby decreasing income variability. Third, in addition to the risks associated with exploration, oil companies are subject to the risks associated with marketing and refining. The larger the proportion of the firm’s activities in marketing and refining, the lower the impact

of SE because its effect is limited to the income associated with

exploration. As large firms tend to be more diversified, they have less incentive to opt for FC.

Using sales as a proxy for size (political costs) and the ratio

of exploration costs to market value as well as the ratio of pro-

duction costs to market value to measure the various aspects re- lated to size, Malmquist found them all to be significant in explaining the accounting choice. Higher sales and a larger pro- portion of production costs made the firm more likely to choose SE. Conversely, the larger the exploration cost proportion, the more likely the firm was to choose FC.

2. Difficulty of Raising Capital in the Equity and Debt Markets

SE companies report lower assets than FC companies. There- fore, securities underwriters may be hesitant (or find it diffi- cult) to sell the securities of firms having low or negative net book value (equity) levels. Borrowing may also be more diffi- cult for firms with high and variable debt/equity ratios. More- over, for debt already in existence, there is a higher probability

of technical violation of debt/equity-related debt covenants. Malmquist’s study confirmed that firms with higher debt/eq- uity ratios are less likely to choose SE.

3. Management Compensation Contracts

Earnings-based management compensation contracts are af- fected by the choice of accounting method. Opportunistic man- agers may choose full costing to increase the level of their compensation and decrease its variability. Malmquist notes “there are strong disincentives and limits placed on such behav- ior by the managerial labor market.” No apparent relationship between the choice of accounting method and the presence of an earnings-based compensation contract was observed. These results are consistent with some (but not all) of Deakin’s (1989) findings. Analyzing firms that lobbied for FC and the reasons given by those firms for lobbying, Deakin found that, on average, they had characteristics consistent with the stated reasons. The reasons given by the firms were:

1. The expected impact on cost of capital and access to capital markets

2. The potential of the proposed elimination of the FC method to affect accounting income-based management incentive con- tracts

3. The perceived effect on future drilling activity

4. The effect of rate regulation

To some extent, generalizing from Deakin’s sample of com- panies, which lobbied for a particular accounting method, to the general population of firms, is fraught with danger as the sample may be biased. Taking the time and effort to lobby can be an in- dication that these firms are the ones most likely to be affected by the choice. Thus, Deakin’s finding that the presence of man- agement incentive contracts was associated with firms that lob- bied for FC in contrast to Malmquist, who did not find such a relationship, may reflect their different samples.

*See, for example, Steven Lilien and Victor Pastena, “Determinants of Intra-Method Choice in the Oil and Gas Industry,” Journal of Accounting and Economics, 1982, pp. 145–170 and Edward B. Deakin III, “An Analysis of Differences Between Non-Major Oil Firms Using Successful Efforts and Full Cost Methods,” The Accounting Review, Oct. 1979, pp. 722–734. Edward B. Deakin III, “Rational Economic Behavior and Lobbying on Accounting Issues: Evidence from the Oil and Gas Industry,” The Accounting Review, Jan. 1989, pp. 137–151. The last reason applied primarily to regulated companies that were required by rate-making authorities to use FC accounting procedures.

income. Large oil companies tend to use the SE method as well because it is perceived to be more conservative. 2 For smaller companies, however, the differential impact of these two accounting meth- ods can be considerable. Year-to-year variations in spending and success ratios mean that dry hole expense can vary greatly. Under SE accounting, this variability is transmitted directly to the income statement. Further, smaller companies (especially if growing rapidly) have small reserve bases and low amortization of past capitalized costs. Dry hole costs from current drilling activities often exceed the amortization of the capitalized costs of past drilling.

2 A more detailed analysis of the financial reporting effects of SE versus FC on firms under different environments is provided by Sunder (1976).

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

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Smaller companies are also less diversified as they concentrate on exploration. Widely fluc- tuating patterns of earnings growth are considered a drawback for firms attempting to obtain external (equity or debt) financing. This problem is further exacerbated because, under suc- cessful efforts, the balance sheet shows lower assets and equity, thus hurting reported sol- vency ratios. As a result, smaller companies tend to use the FC method of accounting.

Changing Accounting Methods

The FC method has one drawback, however. When the price of oil causes the value of the re- serves to fall below book value, the SEC requires that companies using the FC method write down properties whose carrying cost exceeds the present value of future cash flows of the

proved reserves attributable to that property. 3 Companies using the SE method are required

to use the less stringent measure of undiscounted future cash flows. 4 In the 1980s, when

the price of oil fell drastically, some companies that had previously chosen FC accounting

(presumably to report higher income) were forced to take large write-offs, reducing reported income. One method of avoiding such large write-offs was to change reporting methods from FC

to

SE, reducing the carrying amount of reserves. The change to or from the FC method is one

of

those cases where retroactive adjustment for accounting changes is mandatory; all prior

years presented must be restated and the cumulative effect reported as an adjustment to the beginning retained earnings. Note that this does not change the value of the reserves; it only changes the carrying amount on the balance sheet. Sonat changed its accounting method sev- eral times, reflecting changing industry conditions (see Problem 7B-1). Adoption of the SE method of accounting requires the expensing of capitalized dry hole costs, lowering reported income. On the other hand, the amortization of previously capital- ized costs is also reduced, increasing reported earnings. The balance between increased ex- pensing of current year expenditures and reduced amortization of past expenditures determines the net effect on earnings for any given year. What is the effect of the accounting change on cash flow? There is no effect on actual cash flow as the change to the successful efforts method merely reallocates cash flows for fi-

nancial reporting purposes. (For income tax purposes, oil and gas companies expense the maximum allowable; the accounting change has no impact on tax return income.) However, components of reported cash flows may be affected by the accounting change. Lower reported capital expenditures are offset over time by lower reported operating cash flows. Once again, we see how the classification of cash flow components is affected by ac- counting choice.

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

A major drawback of both accounting methods is the lack of correspondence between the re-

ported cost of a producing oil or gas field and its economic value. Although this is true of vir- tually all fixed assets, it is especially true of oil- and gas-producing assets because, even at the time of drilling, there may be little relationship between the expenditures and results. An expenditure of millions of dollars can result in a dry hole. Alternatively, a small expenditure can result in a discovery of oil or gas worth many times its cost. Neither method provides truly relevant data as to the value of reserves. This shortcom- ing is addressed by the disclosure requirements of SFAS 69 (1982), which requires extensive information about the results of operations for oil and gas activities and disclosure of a stan- dardized measure of proved oil and gas reserves. Additional summary disclosures of these activities by equity method investees and minority interests are also required.

3 The comparison of the carrying value of reserves with their present value is sometimes referred to as the ceiling test.

4 See David B. Pariser and Pierre L. Titard, “Impairment of Oil and Gas Properties,” Journal of Accountancy, Dec. 1991, pp. 52–62.

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APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

Disclosure of Physical Reserve Quantities

GAS DISCLOSURES Disclosure of Physical Reserve Quantities Texaco’s 1999 financial statements (included in the

Texaco’s 1999 financial statements (included in the website and CD that accompany the text) contain a section entitled, “Supplemental Oil and Gas Information.” Table I provides data on the physical quantities of Texaco’s proved oil and gas reserves, including:

1. Separate disclosure of oil and gas reserves

2. Separate disclosure by geographic area

3. Separate disclosure of the reserves of equity affiliates 5

4. Reconciliation of the year-to-year change in proved reserves

5. Disclosure of proved developed reserves

These data describe the company’s physical reserves at each balance sheet date. The first two features listed help the user understand the nature of the reserves. For example, oil reserves in the United States have different economic characteristics than gas reserves in Africa. Sep- arate disclosure of the reserves of equity method affiliates aids the evaluation of the invest- ment in such companies. The reconciliation is one of the most significant features as it enables us to understand how estimated reserves change from year to year as a result of:

1. Production, which reduces reserves

2. Discoveries, which increase reserves

3. Purchases and sales of reserves

4. Revisions of estimates

5. Price changes, which can make reserves economically feasible to produce, or not 6

Each of these disclosures provides useful data because physical quantities can be related to cash flows. For example, the cost of finding reserves can be derived by comparing explo- ration expenditures with reserves discovered. This is considered an important measure of management ability. Revisions, as noted by Clinch and Magliolo (1992), 7 are important indicators of the “quality” of management estimates. Companies reporting predominantly downward revi- sions are viewed with some skepticism, reflecting the apparent overoptimism of past esti- mates. Investors prefer positive surprises, that is, upward revisions of estimated reserves. Texaco’s disclosures show that worldwide oil reserves increased over the three-year pe- riod, from 2,704 million barrels at December 31, 1996 to 3,480 million barrels at December 31, 1999. Most of the increase was in the United States and “Other East” geographic areas. Gas reserves also rose, with the United States and “Other East” (the largest percentage in- crease) again accounting for the gain.

5 See Chapter 13 for a discussion of the equity method.

6 For example, in 1985, Atlantic Richfield removed 8.3 trillion cubic feet (trillion billion MCF) of natural gas re- serves located in northern Alaska from its estimate of proved reserves, reducing its domestic gas reserves by more than 50%. The company explained that this change was prompted by a review of economic factors, especially the significant drop in oil and gas prices in that year. In its 1999 10-K, the company stated that:

Signifi-

cant technical uncertainties and existing market conditions still preclude gas from such potential projects being included in ARCO’s reserves.

ARCO is actively evaluating various technical options for commercializing North Slope

7 Clinch and Magliolo argue that the value-relevance (informativeness) of the SFAS 69 data depends on the reliabil- ity investors attach to it. As data are subject to constant revision, reliability suffers. They found that although the market did not find reserve data to be value-relevant, production data were found to be informative. Production data, they argue, are more objective as they reflect actual actions taken by management rather than just estimates. Further, they found, for the subset of firms whose quantity estimates appeared more reliable (less revision of estimates), that proved reserve data were also value-relevant. (Greg Clinch and Joseph Magliolo, “Market Perceptions of Reserve Disclosures Under SFAS No. 69,” The Accounting Review, Oct. 1992, pp. 843–861.)

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

W25

The reconciliations give us additional insights regarding the reserve increases:

Revisions have generally been positive. 8

Improved recovery estimates also consistently made positive contributions to esti- mated reserve quantities. These gains may reflect newer technologies that permit higher recovery from existing oil and gas wells.

Texaco purchased oil reserves in the U.S. in 1997 (Monterey Resources) and gas re- serves in the “Other East” in 1998 and 1999.

Discoveries and extensions, however, were below production levels in all three years for oil and all but 1997 for gas

The data can also be used to measure the reserve life (end-of-year reserves divided by pro- duction) of Texaco’s reserves, by type and geographic segment. The computations below in- dicate that Texaco’s reserve lives increased over the period as U.S. oil production and worldwide gas production failed to increase with reserves. Reserve lives in the United States are higher that in other areas for oil, but lower for gas.

Reserve Lives in Years

United States

Worldwide

 

1997

1998

1999

1997

1998

1999

Oil reserves

1,767

1,824

1,782

3,267

3,573

3,480

Production

157

144

144

317

351

336

Ratio

11.25

12.67

12.38

10.31

10.18

10.36

Gas reserves

4,022

4,105

4,205

6,242

6,517

8.108

Production

643

633

550

839

879

786

Ratio

6.26

6.48

7.65

7.44

7.41

10.32

Data from Table I; oil in millions of barrels, gas in billions of cubic feet

Disclosure of Capitalized Costs

Table IV reports the balance sheet carrying cost of the disclosed reserves and Table V the current year costs incurred. When reviewing Table IV (Capitalized Costs), note that:

Capitalized costs depend on the accounting method followed: Companies using the FC method will capitalize more exploration cost than companies employing the SE method. Notice that the capitalized costs of equity affiliates are disclosed separately, just as their reserve quantities are disclosed separately.

Costs are net of accumulated depreciation, amortization, and valuation allowances; different accounting choices in these areas will affect the net carrying cost.

Costs of unproved properties and support facilities are separately disclosed.

Capitalized costs are aggregated for oil and gas, unlike reserve quantities.

These data give analysts a balance sheet cost to match against the physical reserves with all oil and gas reserves combined into one measure, usually termed barrel of oil equivalent (BOE). Quantities (of oil and gas reserves disclosed in Table I) can be combined into units of

8 There is a typographic error in the 1999 gas reserve change data. The worldwide revisions should be 915 and the total changes 1,591; the negative signs are in error.

W26

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

BOE based on either energy equivalence (1 barrel of oil 6 MCF of gas) 9 or the basis of rel- ative price. 10 Once this has been done, the balance sheet cost per BOE can be computed. At December 31, 1999, the calculation for Texaco’s reserves is (in millions of barrels):

No. of BOE No. of Barrels of Oil BOE Equivalent of Gas Reserves

3,480 8,108 BCF (billion cubic feet)

6

3,480 1,351 4,831

The capitalized cost per BOE is

BOE $13,038

$

4,831

$2.70

Note that part of the capitalized cost represents outflows for unproved properties (for which no reserves have yet been estimated) and for support facilities. This calculation, therefore, overstates the capitalized cost per BOE. With two years of data, we can look at the trend of capitalized cost per BOE as well as variations by geographic area:

Capitalized Cost per BOE Equivalent

December 31

United States

Europe

Other East

Equity

Worldwide

 

1998

Oil reserves Gas reserves BOE Capitalized costs Costs per BOE

1,824

419

598

684

3,573

4,105

964

477

151

6,517

2,508

580

678

709

4,659

$8,086

$1,436

$1,278

$1,072

$12,190

3.22

2.48

1.89

1.51

2.62

 

1999

Oil reserves Gas reserves BOE Capitalized costs Costs per BOE

1,782

427

670

546

3,480

4,205

962

1,866

134

8,108

2,483

587

981

568

4,831

$7,933

$1,459

$2,056

$1,178

$13,038

3.20

2.48

2.10

2.07

2.70

Data from Tables I and IV. Oil reserves and BOE in millions of barrels, gas reserves in billion cubic feet, capitalized costs in $millions

This table indicates that Texaco’s unit carrying costs are below even the cyclical low points of recent oil prices (approximately $10 per barrel). Low capitalized costs are ex- pected, given the use of successful efforts accounting. These amounts represent the costs that Texaco must amortize as oil and gas reserves are produced; low capitalized costs equate to low amortization and higher operating earnings. Low capitalized costs also indicate that the risk of impairment write-downs is minimal.

9 Natural gas is measured in MCF (thousand cubic feet). 10 In recent years, in the United States, gas has usually sold at a lower relative price than its energy equivalent would suggest. The relationship changes over time. In 2000, natural gas prices rose more rapidly than oil prices. While some analysts combine oil and gas reserves based on relative price, such calculations may require frequent revision.

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

W27

The geographic differences are revealing. Capitalized costs per BOE are signicantly lower in the Other East segment and for Texacos equity afliate (also Other East). Higher nding costs in the United States and Europe have driven exploration efforts for companies such as Texaco increasingly to areas with lower costs. These data also reect historical costs, well below the cost of nding new reserves. The capitalized cost per BOE, moreover, is only a crude means of comparing the cost of reserves for different companies. It reects both the accounting method used and the efciencyin nding oil (the nding cost per BOE). Companies that use the SE method and have low nd- ing costs have a low capitalized cost per BOE. Companies using the FC method or recording higher nding costs have higher capitalized cost per BOE. The capitalized cost per BOE can also be compared with the market value of oil and gas reserves, as revealed by market transactions. If the capitalized cost is higher than transaction prices, this indicates that the balance sheet amount is overstated; if transaction prices are higher, the reverse is true. However, using the capitalized cost per BOE is, at best, only an approximation of the value of reserves. It is decient because it fails to recognize the following factors:

1.

Reserves in different geographic markets vary in value.

2.

Oil reserves have different values from natural gas reserves of equivalent energy content.

3.

The cost of producing reserves (bringing them to the surface) may vary with location.

4.

A

barrel of oil produced today is more valuable (assuming constant pricing) than one

produced in ve years because of the time value of money.

5.

Tax rates vary by jurisdiction and, within jurisdictions, may vary by location and type of resource.

For these reasons, the aggregation of all reserves by physical quantities does not capture the market value of reserves. Fortunately, better data are available.

Analysis of Finding Costs

Table V, Costs Incurred,reports Texacos exploration costs. This table includes all expen- ditures, regardless of whether they are capitalized or expensed, making the data comparable among companies with different accounting methods. These expenditures can be compared with reserves found to compute the actual per unit finding cost. Although annual nding costs are volatile, over longer time periods they mea- sure managements prociency in discovering reserves. Texacos 1999 nding cost was $4.37 per BOE, 11 well above both the carrying cost of reserves and the nding costs over the ve-year period ending in 1999. Finding costs can be compared by geographic area and over time, although we have not done so here.

Disclosure of Present Value Data

Table II, Standardized Measure,reports the estimated future cash ows of the specic re- serves owned by the rm. The following elements are presented:

1. Future cash inflows. Based on a year-by-year schedule of planned unit production, multiplied by current price levels, that is, future gross revenues based on current

prices. Companies are not permitted to assume price changes, unless provided for by

a rm contract, which may then be incorporated in the computation. These calcula-

tions use proved developed reserves only.

2. Future production costs. Also based on current prices. Production costs include all expenditures required to bring the oil or gas to market.

11 Reported in Table V of Texacos 1999 Supplemental Oil and Gas Information.

W28

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

3. Future development costs. Include the cost at current price levels of additional wells and other production facilities that may be required to produce the reserves.

4. Future income tax expense. The estimated tax liabilities assuming that the forecast cash ows actually take place.

The net of these amounts, net future cash ows before discount, is a forecast of net cash ows from existing oil and gas reserves. These data must also be adjusted to reect the time value of money by discounting to present value. SFAS 69 requires that all rms use a dis- count rate of 10%. The objective is comparability; the correctdiscount rate will vary over time and, perhaps, from rm to rm. The result is a net present value of the after-tax 12 cash ows expected from the rms re- serves. Note that these data are provided separately for reserves in different geographic areas, but with oil and gas combined. Companies providing these data routinely state that the standardized measure is not market value and suggest that the data have limited usefulness. Nonetheless, the data are widely used in the analysis of companies with oil and gas reserves and, in practice, are a useful approxima- tion of market value. Despite some limitations, the data are far more representative of market values than the cost shown on the balance sheet, regardless of the accounting method used. 13

Using Present Value Disclosures

How can the data be used? One simple adjustment is to replace the capitalized cost of re- serves with the net present value (standardized measure). This is one step in preparing a cur- rent value balance sheet (see Chapter 17) or computing adjusted net worth. Before making this adjustment, the following issues should be considered:

1. Have prices changed since the balance sheet date? If so, the present value data must be adjusted to current prices, for example, a 10% increase in oil prices increases fu- ture cash ows by 10%. (Because oil and gas prices do not always move together, use a weighted-average based on the composition of reserves.)

2. Costs may also be adjusted. Although hard data are difcult to come by, industry sources can provide a rough guide as to changes in production and development costs.

3. Do economic or other factors suggest a need for assumptions of future price changes? Some analysts construct their own price scenarios and make their own computations of future cash ows.

4. Is 10% the right discount rate? The discount rate is a function of the general level of interest rates and the relative riskiness of the rms reserves. Adjustments may be re- quired. A higher discount rate, of course, reduces the net present value calculation; a lower rate increases the present value.

5. Should pretax or after-tax net present values be used? The answer depends on the tax status of the rm and purpose of the analysis. 14 In a liquidation analysis, for example,

12 Texaco deducts tax payments from net cash ows (both undiscounted) and then discounts the after-tax cash ows. We can estimate the discounted income taxes by using the ratio of the discounted pretax cash ows to the undis- counted cash ows. (This assumes a constant tax rate.) Some rms deduct the present value of tax payments from the net present value of pretax cash ows. The re- sult is the same, but this latter case permits more accurate calculation of the pretax net present value. 13 Surprisingly, early empirical studies did not seem to bear this out. Harris and Ohlson (1987) and Shaw and Wier (1993), for example, found that SFAS 69 disclosures had weak explanatory power for stock prices and that book value measures outperformed the standardized present value measure. More recently, however, Boone (2002) demonstrated that the valuation models used in the previous studies were misspecied and, for the valuation model used in his study, the present value measure exhibited signicantly more explanatory power than the historical cost measure. 14 Disclosures for rms with signicant reserves outside of North America and Europe frequently show very high income tax rates for these reserves. These high rates reect the fact that royalties in many countries are a percentage of the gross value of the oil or gas produced. Accounting for these royalties as income taxes obtained better income tax treatment in the United States. This suggests that net present value data for such reserves should always be used on an after-tax basis. Texacos Other Eastclearly ts the category just described, with an estimated tax rate of 64% in 1999 [$7,665/($7,665 $4,323)].

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

W29

when all cash ows are evaluated on a pretax basis, pretax present values would be used for consistency.

Example: Texaco

To illustrate, we use the data provided by Texaco and the following assumptions:

1. No change in prices or costs

2. A 10% discount rate

3. Pretax net present values for U.S. reserves but after-tax present values for foreign re- serves. 15 The data provided can be used to adjust Texacos equity at December 31, 1998 and 1999, for the difference between the present value of its oil and gas re- serves and the carrying amount:

Years Ended December 31

Standardized Measure

1998

1999

United States*

$

4,879

$15,604

Europe

1,382

4,990

Other areas**

$ (1,116

$23,909

Total

$ 9,375

$26,502

Carrying amount

$12,190

$13,038

Excess

$ (2,815)

$13,464

Reported equity

$11,833

$12,042

Adjusted equity

$ 9,018

$25,506

% change

24%

112%

Total debt

$ 7,291

$ 7,647

Debt-to-equity ratio

Reported

0.62

0.64

Adjusted

0.81

0.30

*Using United States 1999 as an example, $15,604 was calculated as the net present value ($11,352) plus the estimated present value of in- come tax payments ($4,252). The later is estimated by applying the ratio, ($11,352/$22,168) ($8,304) and assuming a constant rate. **Sum of Other West, Other East, and Afliate (after-tax) present values.

This adjustment more than doubles Texacos equity at December 31, 1999; for 1998 the adjustment reduces equity by 24% because of low oil and gas prices on that date. The adjustment sharply reduces Texacos debt-to-equity ratio in 1999. Varying the discount rate or making assumptions about changes in prices or costs would also lead to different adjustments. The adjustment of net worth is not an end in itself, but one step in the analysis of a rm. Although equity after adjustment is not a precise measure of the market value of Texacos net assets, it is a better measure than the historical cost of those assets. Chapter 17 discusses the usefulness of equity adjustments in greater detail.

Adjustments for Subsequent Price Changes

In 2000, natural gas prices rose sharply from the year-end 1999 levels. As a result the De- cember 31, 1999 present value data no longer reected the economic value of Texacos re- serves. Exhibit 7B-1 shows the assumptions and calculations required to adjust the 1999 standardized value of U.S. reserves for subsequent price changes.

15 See footnote 14.

W30

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

EXHIBIT 7B-1. TEXACO—UNITED STATES Adjustments to Present Values for Subsequent Price Changes Amounts in $ millions except for reserve quantities (oil in millions of barrels, gas in billions of cubic feet)

A. Future Cash Inows

 

Quantity

Unit Price

Cash Flows

December 31, 1999 Crude oil and natural gas liquids Natural gas

1,361

$25.60

$34,842

3,388

2.33

$47,894

 

$42,736

December 31, 2000 Estimated

Crude oil and natural gas liquids Natural gas

1,361

$26.80

$36,475

3,388

9.77

$33,101

 

$69,576

 

B. Standardized Measure

 

Reported

Adjusted

Explanation

Future cash inows Future production costs Future development costs Pretax net cash ow Future income tax expense Net future cash ows Discount (10% rate) Standardized measure

$ 45,281

$ 69,576

Part A

(10,956)

(12,052)

20% higher

$1(3,853)

$1(4,238)

20% higher

$ 30,472

$ 53,286

$1(8,304)

$(14,521)

Same rate

$ 22,168

$ 38,765

$(10,816)

$(18,914)

Same rate

$ 11,352

$ 19,851

C. Discussion

The objective is to recompute the standardized measure using price changes at a later period. In part A, we estimate the future cash ows associated with Texacos U.S. reserves, using reserve quantities from Table I of the 1999 supplementary data and prices obtained from the futures market at December 31, 1999. Our computed future cash ows of $42.7 billion is nearly 6% below the $45.3 billion shown in Table II. The difference must be due to different prices as the standardized measure must use proved reserves. We estimate future cash ows at December 31, 2000 using the same reserve quantities but with prices at December 31, 2000. These calculations produce future cash ows of $69.6 billion, 63% higher than the December 31, 1999 level. In part B, we adjust each component of the standardized measure to estimated levels at December 31, 2000. The future cash inows come from part A. We assume 20% increases in both future produc- tion costs and future development costs, on the assumption that the cost of drilling equipment and ser- vices rises with higher oil and gas prices. We assume the same tax rate (27.25%). We also assume the same production time pattern so that the % discount is unchanged. These calculations produce a 75% increase in the standardized measure for U.S. oil and gas reserves, to $19.8 billion. The actual standard- ized value (see Exhibit 7BP-1) at December 31, 2000 was just under $18 billion. The major reason for the difference was that reserves declined during 2000, reducing future cash ows to the following amounts:

December 31, 2000 Actual

Quantity

Unit Price

Cash Flows

Crude oil and natural gas liquids Natural gas

1,202

$ 26.80

$ 32,214

3,299

9.77

$332,231

 

$ 64,445

Lower reserves reduces future cash ows and, therefore, lowers the standardized value.

PROBLEMS

W31

Changes in Present Values

Table III is a reconciliation of changes in the standardized measure, akin to the reconcili- ation of reserve quantities. But these data are richer as they include the impact of such factors as:

Changes in prices and costs

Accretion of discount (the passage of time reduces the discount period)

Expenditures that reduce future required cash ows

Changes in estimates

Purchases and sales of reserves

Effect of production

The standardized measure of Texacos oil and gas reserves declined by nearly one-third in 1997 and more than half in 1998, but soared to a higher level at December 31, 1999. The rec- onciliation provides the following insights:

1. Changing prices and costs were the major factor accounting for the sharp decline in the standardized measure in 1997 and 1998 and its recovery in 1999. Over the three-year period, the price effect was slightly negative.

2. Texacos quantity revisions were positive each year, suggesting that the companys estimates have been conservative.

3. Timing effects were negative each year, suggesting that Texacos production rate was below previous forecasts. 16

Summary and Conclusion While the supplemental oil and gas data mandated by SFAS 69 must be used with care, they provide considerable useful information regarding the firms exploratory activities and the value of its reserves. These data are far more comparable among firms than reported financial data as most are unaffected by account- ing methods.

PROBLEMS

7B-1. [Changes between full cost and successful efforts methods] Sonat [SNT], a diversied energy company, announced the following accounting change when it reported its re- sults for the third quarter of 1998:

Sonat Exploration Company [Sonat subsidiary] changed from successful efforts to full cost accounting because its future capital spending will be focused signicantly more on explo-

ration activity than in the past. Full cost accounting, which amortizes rather than expenses dry-hole exploration and other related costs, provides a more appropriate method of match- ing revenues and expenses. Exploration activity has increased from 6 percent of 1995 capi- tal spending, or $27 million, to an estimated 33 percent of 1998 capital spending, or approximately $175 million The adoption of the full cost method is expected to increase 1998 and 1999 normalized earnings from levels that would have been reported under successful efforts accounting and, more important, will reduce earnings volatility from quarter-to-quarter and year-to-year

going

panys cash ow from operations.

all previous charges related to the

were reversed, which significantly raised

impairment of Sonat Explorations assets

the book value of those properties as well as Sonats stockholdersequity. The full cost method, however, requires quarterly ceiling tests 17 to insure that the carrying value of as-

sets on the balance sheet is not

The end result of the full cost conversion

The change to full cost accounting will not materially affect the com-

Sonat has restated all prior period statements

16 Postponing production reduces the net present value by increasing the discount factor. 17 Authorsnote: see footnote 3 to this appendix and the related text.

W32

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

is that both the book value of Sonat Explorations properties and Sonats stockholdersequity are at higher levels than if it had continued with the successful efforts method of accounting. 18

Note 2 to Sonats annual report for the year ended December 31, 1998 reports the fol- lowing effects of the accounting change and restatement of prior periods:

Effect on

1996

1997

1998

Net income ($thousands) Earnings per share, fully diluted

18,006

130,584

(258,351)

.16

1.17

(2.35)

The 1998 income statement reports ceiling test charges of $1,035,178 thousand. Re- tained earnings at January 1, 1996 were increased by $199,196 thousand for the ac- counting change.

A. Explain each of the following benets from the accounting change stated in the Sonat press release:

(i)

Increased normalized earnings

(ii)

Reduced earnings volatility

(iii)

Higher book value of exploration properties

(iv)

Higher stockholdersequity

B. Compute the effect of the accounting change on Sonats stockholdersequity at December 31, 1998.

C. Describe the effect of the accounting change on each of the following Sonat ratios for 1998:

change on each of the following Sonat ratios for 1998: (i) Debt-to-equity ratio (ii) Asset turnover

(i)

Debt-to-equity ratio

(ii)

Asset turnover

(iii)

Book value per share

D. Explain why the accounting change was not expected to materially affect Sonats cash from operations.

E. Given your answers to parts A through D, evaluate Sonats decision to change ac- counting method.

F. The accounting change took place during a period of declining energy prices. De- scribe the risk of making the accounting change and illustrate that risk using the data provided.

G. Sonat had changed from the full cost method to successful efforts in 1991, a pre- vious period of energy price declines. Describe the effect of that fact on your view of the 1998 accounting change.

7B-2. [Analysis of Supplementary Oil and Gas Data] Exhibit 7BP-1 contains the supple- mental oil and gas data from Texacos 2000 annual report. Use this exhibit, and the data for 1999 and prior years from Texacos 1999 annual report, to answer the follow- ing questions.

A. Compute Texacos reserve lives in years for 2000, for both oil and gas:

(i)

In the United States

(ii)

Worldwide

B. Discuss whether production trends mirror the reserve trends over the four years ended December 31, 2000.

C. Compute Texacos capitalized cost per BOE for 2000:

(i)

In the United States

(ii)

Worldwide

18 Sonat press release, October 22, 1998.

PROBLEMS

EXHIBIT 7BP-1. TEXACO 2000 Supplemental Oil And Gas Information

W33

Note: These disclosures omit text and tables that duplicate the 1999 disclosures.

Table INet Proved Reserves Net Proved Reserves of Crude Oil and Natural Gas Liquids (millions of barrels)

 

Consolidated Subsidiaries

 

Equity

 

Afliate

Afliate

 

United

Other

Other

Other

Other

World-

States

West

Europe

East

Total

West

East

Total

wide

As of December 31, 1999* Discoveries & extensions Improved recovery Revisions Net purchases (sales) Production

1,782

55

427

670

2,934

546

546

3,480

39

21

9

69

374

374

443

25

39

64

14

14

78

(21)

9

30

18

37

37

55

(135)

(52)

(44)

(231)

——

(231)

(130)

(3)

(44)

(78)

(255)

(52)

(52)

(307)

Total changes

(222)

(55)

(58)

(335)

374

(1)

373

38

Developed reserves

1,202

219

559

1,980

282

282

2,262

Undeveloped reserves

358

150

111

619

374

263

637

1,256

As of December 31, 2000*

1,560

369

670

2,599

374

545

919

3,518

*Includes net proved NGL reserves As of December 31, 1998 As of December 31, 1999 As of December 31, 2000

250

68

22

340

6

6

346

250

74

134

458

1

1

459

219

67

162

448

1

1

449

Net Proved Reserves of Natural Gas (billions of cubic feet)

 
 

Consolidated Subsidiaries

 

Equity

 

Afliate

Afliate

 

United

Other

Other

Other

Other

World-

States

West

Europe

East

Total

West

East

Total

wide

As of December 31, 1999 Discoveries & extensions Improved recovery Revisions Net purchases (sales) Production

4,205

941

962

1,866

7,974

134

134

8,108

585

——

585

33

4

37

622

5

——

5

——

5

121

12

43

164

340

8

8

348

8

(58)

(11)

(61)

——

(61)

(494)

(95)

(81)

(36)

(706)

(24)

(24)

(730)

Total changes

225

(141)

(49)

128

163

33

(12)

21

184

Developed reserves

3,299

738

573

977

5,587

121

121

5,708

Undeveloped reserves

1,131

62

340

1,017

2,550

33

1

34

2,584

As of December 31, 2000

4,430

800)*

913

1,994

8,137)*

33

122

155

8,292)*

*Additionally, there are approximately 302 BCF of natural gas in Other West which will be available from production during the period 20052016 under a long-term purchase associated with a service agreement.

W34

EXHIBIT 7BP-1 (continued)

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

The following chart summarizes our experience in nding new quantities of oil and gas to replace our production. Our reserve replace- ment performance is calculated by dividing our reserve additions by our production. Our additions relate to new discoveries, existing re- serve extensions, improved recoveries, and revisions to previous reserve estimates. The chart excludes oil and gas quantities from purchases and sales.

 

Worldwide

United States

International

 

Year 2000

172%

76%

267%

Year 1999

111%

99%

124%

Year 1998

166%

144%

191%

3-year average

150%

109%

192%

5-year average

146%

108%

189%

Table IIStandardized Measure

Consolidated Subsidiaries

 
 

United

Other

Other

(Millions of Dollars)

States

West

Europe

East

Total

As of December 31, 2000 Future cash inows from sale of oil & gas, and service fee revenue Future production costs Future development costs Future income tax expense

 

$ 67,115

$ 1,559

$ 10,549

$ 15,512

$ 94,735

(13,107)

(252)

(2,074)

(2,768)

(18,201)

(3,588)

(30)

(1,244)

(1,280)

(6,142)

(17,024)

(612)

(2,238)

(6,681)

(26,555)

Net future cash ows before discount 10% discount for timing of future cash ows

33,396

665

4,993

4,783

43,837

(15,407)

(259)

(1,778)

(2,239)

(19,683)

Standardized measure of discounted future net cash ows

$ 17,989

$ 406

$ 3,215

$ 2,544

$ 24,154

 

Equity

 

Afliate

Afliate

Other

Other

World-

(Millions of Dollars)

West

East

Total

wide

As of December 31, 2000 Future cash inows from sale of oil & gas, and service fee revenue Future production costs Future development costs Future income tax expense

 

$ 3,917

$ 7,873

$ 11,790

$ 106,525

(273)

(2,853)

(3,126)

(21,327)

(406)

(694)

(1,100)

(7,242)

(1,101)

(2,189)

(3,290)

(29,845)

Net future cash ows before discount 10% discount for timing of future cash ows

2,137

2,137

4,274

48,111

(1,431)

(809)

(2,240)

(21,923)

Standardized measure of discounted future net cash ows

$ 706

$ 1,328

$ 2,034

$ 26,188

PROBLEMS

EXHIBIT 7BP-1 (continued)

W35

Table IIIChanges in the Standardized Measure

Worldwide Including Equity in Afliates

(Millions of Dollars)

2000

1999

1998

Standardized measure beginning of year Sales of minerals-in-place

 

$ 18,710

$ 5,487

$ 12,057

 

(3,990)

(352)

(160)

 

14,720

5,135

11,897

Changes in ongoing oil and gas operations:

Sales and transfers of produced oil and gas, net of production costs during the period Net changes in prices, production, and development costs Discoveries and extensions and improved recovery, less related costs Development costs incurred during the period Timing of production and other changes Revisions of previous quantity estimates Purchases of minerals-in-place Accretion of discount Net change in discounted future income taxes

 
 

(7,345)

(4,276)

(3,129)

11,389

22,036

(11,205)

4,543

1,821

728

2,043

1,598

1,770

670

(517)

(1,170)

668

301

852

901

895

48

3,120

881

1,916

(4,521)

(9,164)

3,780

Standardized measureend of year

$ 26,188

$ 18,710

$ 5,487

Table IVCapitalized Costs

Consolidated Subsidiaries

 

Equity

 

Afliate

Afliate

 

United

Other

Other

Other

Other

World-

(Millions of Dollars)

States

West

Europe

East

Total

West*

East

Total

wide

As of December 31, 2000 Proved properties Unproved properties Support equipment and facilities

$18,213

$137

$3,295

$3,699

$25,344

$

66

$1,370

$1,436

$26,780

1,026

98

58

655

1,837

68

265

333

2,170

257

81

28

135

501

42

906

948

1,449

Gross capitalized costs Accumulated depreciation, depletion, and amortization

19,496

316

3,381

4,489

27,682

176

2,541

2,717

30,399

(12,084)

(92)

(1,821)

(1,508)

(15,505)

(1)

(1,349)

(1,350)

(16,855)

Net capitalized costs

$ 7,412

$224

$1,560

$2,981

$12,177

$175

$1,192

$1,367

$13,544