Vicki Curtis, Jeremy Wei, Jordan Hill, Cody Rice
CICA Handbook (ACG-16)
Damage Awards and Earnings Management
in the Oil Industry (article)
A guideline on how to account for
exploration, development and production
activities for Canadian oil and gas companies
Two methods of accounting:
 Full cost
 Successful efforts
AcG 16 only considers application of full cost
Costs incurred to inquire a property
Property includes:
 Any interest representing the right to extract (e.g.
permit, license, agreement)
 Non-operating interests in properties operated by
others (e.g. royalty interests)
 Agreements with foreign governments/authorities in
which company serves as producer of underlying
 Note: Properties do not include agreements that
represent the right to purchase, rather than extract
Royal Dutch Shell spent $4.5 million in costs
for the right to purchase oil sands property
in Northern Alberta. Are they allowed to
As per AcG 16 p. 4...
▪ Properties do not include agreements that represent the
right to purchase, rather than extract
Costs incurred to obtain access to reserves
and to provide facilities for extraction
Costs include any depreciation or operating
costs of support equipment to:
 Gain access and prepare extraction
 Drill and equipment wells
 Acquire, construct and install production facilities
 Provide improved recovery systems
Costs incurred in identifying areas that may
contain oil and gas reserves
 Costs may be incurred before and after acquiring
property, and include:
Costs of geographical land studies
Costs of carrying and retaining unproved properties
Dry hole and bottom hole contributions
Costs of drilling and equipping exploratory wells
Estimated remaining quantities of oil and gas
that are anticipated to be recoverable
 There is a 50% probability amounts actually
recovered will exceed estimate
 Judgement based on available data
 Reserves are estimated using forecasted future
prices and costs
Estimated remaining reserves that are
anticipated with a high degree of certainty to
be recoverable
 Estimated 90% probability that actual extraction
exceeds estimate
Proved reserves can be further subdivided
 Proved developed reserves
 Proved undeveloped reserves
Proved developed reserves
 Reserve can be extracted with low expenditure to
Proved undeveloped reserves
 Reserve can be extracted with significant
expenditure to firm
BP has forecasted with an 95% probability
that their oil reserve in Venezuela will meet or
exceed production of $400 million.
What type of reserve is this?
A) Probable Reserve
B) Proved Reserve
Proved Reserve
 If the probability that extraction is greater than
90%, this meets the criteria of proved
All costs associated with exploration and
development activities should be capitalized
Internal Costs
 Should be limited to those than can be directly
identified with exploration and development
Costs of acquiring and evaluating unproved
reserves may be excluded from depletion and
depreciation (D and D), until reserve is
Costs include:
 Acquisition costs
 Costs of carrying unproved reserves
 Costs of drilling unproved reserves
 Asset retirement costs of unproved reserves
Costs of proved properties
Costs that have been subject to D and D
Costs of drilling a dry well
Exploration costs not related to unproved
properties already acquired
Impaired costs for unproved properties
May exclude certain costs for major
development projects subject to D and D,
until the earliest of:
 Property becomes capable of production
 Development activity ceases
 Impairment occurs
A property becomes impaired when:
 A dry hole has been drilled and the company has
no firm plans to continue drilling
 Negative geological and/or geographical data
 Insufficient time to produce with leased data
All exploratory dry holes are considered
impaired to the extent of the cost of the dry
Unproved property abandoned - carrying amount less
impairments subject to D&D, loss recognized if D&D
rate increases by 20% of more
Proved property exchanged - no gain or loss
Unproved property exchanged - carrying amount of
received = carrying amount of given up, immediately
test for impairment
Proved property distributed - calculate netbook
values according to par. 25, no gain or loss. If FMV <
NBV, recognize loss.
Unproved property distributed - test for impairment,
recognize loss if necessary
only applied to
 sales resulting in 20% or more change in the D&D
 sales of properties classified as held for sale at
 approved properties where costs not subject to
Net carrying amounts of other properties are
unknown under full cost accounting
Costs to be depleted and depreciated include:
 all capitalized costs, less accumulated D&D - other
than costs of unproved properties and major
 estimated future costs to develop proved reserves
- including asset retirement costs
For D&D purposes, estimated future development costs and
estimated proved reserves shall reflect the development method to
be adopted
 Calculated on a unit-of-production basis
 Computed by cost centre on the basis of units of proved reserves
 expressed in a common unit of measure such as a unit of energy or
unit of revenue
 In certain cases, processing plants and similar tangible assets may
be depreciated on a more appropriate basis - useful life
 Must be calculated each time financial statements are issued
 D&D determined on a consolidated basis for each cost centre
 NCI is calculated at the subsidiary level and is not changed even if
D&D changes upon consolidation.
(Production/Reserves at beginning of period
adjusted for major changes in estimates
during the period) x Net book value at the
end of the period plus estimated future costs
to be incurred in developing proved
undeveloped reserves, net of estimated
salvage values
Section 3063 - Impairment of Long-Lived
 specifically excluded
Conducted at each annual balance sheet date
Recognize an impairment loss when the
carrying amount of a cost centre is not
recoverable and exceeds its fair value
 not recoverable if carrying amount > sum of
undiscounted cash flows
Prices and costs used
 estimates shall be reasonable in relation assumptions used in
developing other information
 based on the best information available to the enterprise
▪ quoted prices in futures market
▪ price forecasts
▪ adjusted for enterprise specific differences
 Incorporate contractual fixed prices, hedged transactions, and
government regulated prices
Future cash flows include only those resulting from development,
production, and sale of the cost centre reserves, not financing cash
 All proved reserves are included in future cash flows
 The cost of unproved reserves and of major development projects
excluded from D&D is included in future cash flows
all proved properties
all unproved properties
all major development projects
The amount by which the carrying amounts
of assets capitalized exceed the sum of:
 the fair value of proved and probable reserves and
 the cost of unproved properties not subject to
Fair value calculation
 expected present value due to uncertainty and
 assumptions market participants would use
Disposal of a subset of properties vs. entire
cost centre
Properties held for sale are classified
If following the full cost method, an enterprise
must disclose:
 interest and general and administrative costs
 costs excluded from D&D at balance sheet date
 method used in calculating D&D
 disclosures required by Section 3063 and 3475
 factors when planned principal operations in a
new cost centre have not commenced
 the disclosure requirements of measurement
uncertainty (Section 1508)
Steven C. Hall
William W. Stammerjohan
Purpose: hypothesis that managers make
accounting choices to reduce reported
earnings during litigation in which the firm is
a defendant and faces potentially major
damage awards
Evidence: manager often manipulate
accounting numbers to lower costs of the
Firms make income decreasing accruals
during periods in which they are defendants
in litigation with high potential damage
awards relative to other periods.
Firms under-report new reserves during
periods in which they are defendants in
litigation with high potential damage
awards relative to other periods.
Limited to the Oil industry
 Industry with potential for damage awards
substantially higher than the norm
 E.g. risks involved with transportation and
refining of oil
Omitted variables that are correlated with
 Reduce specification error
Management can manipulate earnings in a
variety of ways
Accruals can be separated into working
capital and non-working capital accruals
Criteria for Oil Firm:
 Sufficient data available to calculate:
▪ Change in sales
▪ Fixed assets
 Listed in Wall Street Journal
 One of the 20 largest oil firm, based on total assets
Accrual Equation:
Amoco - super-tanker wreck off the coast of
French Brittany
Diamond Shamrock - suit filed by Viet Nam
veterans who suffered illness
Exxon - super-tanker crashed into reef in
Occidental Petroleum - company dumped
21,000 tons of chemical wastes into the Love
Canal near Niagara Falls, NY
Shell Oil - Sued by U.S. Army for clean up
costs related to non-military chemical
Texaco - Pennzoil sued to block acquisition of
Getty Oil
Test/Litigation period lasts several years
Effect of the understatement on assets is
Damages is not a
significant predictor
No Control Firms:
 Possible that results are caused by inherent
differences between the 6 test firms
 Damages remains significant in non-working
capital accruals
Reserve Estimate
 Non-working capital component of accruals
▪ Calculated as a function of depreciation, depletion and
deferred taxes
 FASB 1975
 Damages remains significant when (Texaco &
Exxon) firm years are excluded
Consistent with hypothesis that defendants in
major litigation use non-working capital accruals
to decrease earnings during period of litigation
Estimates of reserves were under-reported
during the test period
No evidence of accounting manipulation in the
financial statement disclosures
Earnings are understated during major
Study examines only the oil industry
Future research required to examine effects
on other industries
Thank you for your attention!

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