Impairment of oil and gas properties; is a ceiling test needed for successful efforts companies?

The accounting profession is devoting considerable attention to the financial reporting problems of the impairment of long-lived assets. Because of inconsistencies in practice and lack of authoritative guidance, in December 1990 the Financial Accounting Standards Board issued a Discussion Memorandum, Accounting for the Impairment of Long-Lived Assets and Identifiable Intangibles. In view of the profession's concerns about asset impairment, this is an appropriate time to focus on certain measurement, recognitiion and disclosure issues of asset impairment affecting a major sector of the economy--the oil and gas industry.

There has been considerable debate whether the full cost or the successful efforts method is the most appropriate accounting treatment for oil and gas companies. Simply stated, the full cost method capitalizes all exploration costs and allocates them over the life of all producing wells. Thus, dry holes are included in the cost of successful wells. The successful efforts method expensed the costs of unsuccessful wells as they are incurred and capitalizes only the costs of successful wells. The successful efforts method is considered more conservative because it results in an early writeoff of unsuccessful exploration costs. Both methods, however, are acceptable and widely used today.

This article does not debate which of the two methods is preferable but, rather, describes an inconsistency in the Securities and Exchange Commission requirements governing the reporting of impaired oil and gas properties. This inconsistency stems from the SEC's placing a ceiling on capitalized costs for full cost companies but not for successful efforts companies. This has made it difficult to assess the financial performance of some successful efforts companies, particularly reported net income and asset values. Further, the inconsistency has affected the behavior of some full cost companies in a way the SEC had not anticipated; numerous companies changed from the full cost to the successful efforts method apparently to avoid impairment write-downs.

FAST REPORTING REQUIREMENTS

One of the problems in accounting for oil and gas companies is the companies make large expenditures on oil and gas properties whose value is very volatile. Thus, significant changes in oil and gas prices can have a dramatic effect on the value of these properties and, in turn, on the value of the companies. The SEC's concern for informing investors about the current value of oil and gas reserves caused the FASB to issue Statement no. 69, Disclosures about Oil and Gas Producing Activities, in 1982.

Statement no. 69 requires several supplemental disclosures. These include capitalized costs relating to oil and gas producing properties and the discounted future net cash flows from proved oil and gas reserves, with an indication of changes in this value since the preceding year. In effect, application of this standard recognizes revenue when new proved reserves are found, rather than when they are sold.

Statement no. 69 is only for supplemental disclosure. The FASB does not require companies to write down the value of properties below cost based on the result of this disclosure. In theory, generally accepted accounting principles require that when an asset becomes impaired--when the historical carrying cost exceeds its appropriate measure of value--the asset should be written down. How to measure the value of an asset or group of assets appropriately is central to theh issue of impairment.

In its asset impairment DM, the FASB identifies five attributes that could be used to measure evidence of impairment. These are current cost, current market value, net realizable value, present value of future cash flows and the sum of future cash flows.

For some specific assets such as inventories, restructed loans and marketable equity securities, existing GAAP provides guidance on the measurement attribute to be used in determining the amount to which these assets should be written down. But GAAP is not clear about the attribute to use to determine the amounts to which long-lived assets should be written down.

When capitalized costs exceed the appropriate value of reserves, oil and gas companies should

* Select the appropriate measurement attribute to use in determining the amount to which capitalized costs should be written down.

* Decide whether (and how) the loss should be reported on the income statement.

* Determine whether subsequent increases in the carrying amount after the writeoff should be recornized by increasing the asset's book value.

FASB Statement no. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies, does require an impairment test of unproved reserves, with a required writeoff if current value is below historical cost. But no such requirement exists for proved oil and gas reserves. Statement no. 19 is not intended to change current practice by either requiring or prohibiting an impairment test for proved properties or wells, equipment and facilities that are part of the enterprise's oil and gas producing systems.

As long as new properties are discovered and oil and gas prices are rising, the supplementary disclosure requirements of Statement no. 69 are adequate. However, with significant price declines, the absence of a requirement for write-downs may result in a material distortion of net income and assets.

SEC REPORTING REQUIREMENTS

The FASB requires no write-down of proved reserves of oil and gas properties for either successful efforts or full cost companies when their carrying values have been impaired. The SEC, however, requires such a write-down for full cost companies. Specifically, SEC regulations SX 4-10 says unamortized capitalized costs (less certain adjustments) for each cost center must not exceed the cost ceiling, which is defined as the present value of future net revenues from estimated production of proved oil and gas reserves (plus certain adjustments).

If adjusted unamortized costs capitalized within a cost center exceed the cost center ceiling, the excess is charged to expenses and separately disclosed during the period it occurs. Required writeoffs are not to be reinstated for any subsequent increase in the cost center ceiling. This requirement is called the "ceiling test" for full cost companies. In periods of declining oil prices, the effects on a company's reported net income can be quite severe.

The SEC requires no such test for successful efforts companies, believing successful efforts is the more conservative accounting method and thus a ceiling test is not needed. This may be true when oil and gas prices are relatively stable. However, the SEC did not anticipate the extraordinary 1986 decline in oil prices, motivating full cost companies to change accounting methods to avoid the ceiling test.

Because of this price deline, many successful efforts companies suffered significant impairment of asset values. These companies provided investors with financial statements showing the carrying values of oil and gas properties significantly exceeded present values, as measured by the supplemental discolsures requried under Statement no. 69. Consequently, their reported net incomes were substantially higher than if they had been required to write down their assets.

Recent studies by Professors Kevin Chen and Chi-Wen Jevons Lee of Tulane University show the lack of a ceiling test caused a number of full cost companies to switch to the successful efforts method in 1986 to avoid reporting the substantial losses required had they not changed.

The SEC believes an informal ceiling should be applied to the costs of proved properties. Under the policy, they compare capitalized costs with undiscounted future net cash flows. The SEC uses undiscounted cash flows rather than discounted (as required for full cost companies) because successful efforts companies are already using a more conservative accounting method. Thus, the ceiling test need not be as stringent as the test for full cost companies.

APPLICATIONS IN PRACTICE

The SEC's ceiling test means substantial asset write-downs for many full cost companies. Based on our research in preparing this article, similar write-downs would have been necessary for a number of successful efforts companies if they had been required to apply the ceiling test used by full cost companies.

Full cots companies. The Chen and Lee study of 66 full cost companies with write-downs in 1985 or 1986 shows the effect of these write-downs. In either or both years, the companies had write-downs ranging from $1.1 million to $388 million. Under SEC regulation SX 4-10, these companies were required to charge the write-downs against earnings for the period, reducing net income. The write-downs are permanent and assets cannot be written back up to cost even if oil prices rise. Adjustments must be made on a quarterly basis. Thus, if a write-down was taken at the end of the first quarter, with a subsequent price rise before yearend, the company still would not be allowed to recover any previously written-down amounts.

Successful efforts companies. As stated earlier, the SEC does not require successful efforts companies to apply a ceiling test, believing existint practices preclude any significant overstatement of assets or income. In addition, the SEC applies an informal test based on undiscounted cash flows. To test the validity of this position, we examined the financial statements of a number of successful efforts companies with fiscal years ending in 1986. The goal was to evaluate the extent an unreported impairment reporting problem may have existed for successful efforts companies in a period of delining oil and gas prices.

We rendomly selected 15 successful efforts companies from a list provided by the National Automated Accounting Research System, 5 of which had switched from the full cost to the successful efforts method during 1986.

Data for the 10 companies on a successful efforts basis for all of 1986 are shown in exhibit 1, above. Column 5 of the exhibit shows the potential magniture of asset impairment. It is not necessarily the amount of the required write-down if the companies had been subjected to the same ceiling test required of full cost companies. The estimated ceiling shown in column 4 was determined by adding the present value of future net cash flows (as reported under Statement no. 69) to the cost of unproved properties.

Several adjustments are necessary to arrive at the amount of asset impairment under SEC regulations for full cost companies. For example, capitalized costs must be reduced by related deferred income taxes, and the estimated ceiling must be increased by the cost of properties not being amortized, as well as the income tax effects of differences between the book and tax bases of the properties involved. These data were not available for this study. Based on exhibit 1 and applying a rule similar to that required for full cost companies, 9 of the 10 companies show impairment of oil and gas properties.

The amounts in column 2 are future undiscounted net cash inflows reported under Statement no. 69. Column 2 is the basis for the informal ceiling test the SEC applies to successful efforts companies. In this case, only three companies show asset impairment. One of these, Sunshine Mining, did write down its oil and gas properties.

Exhibit 2, below, is similar to exhibit 1 except it shows only companies that changed from the full cost to the successful efforts method during 1986. Even after changing, four of the five companies have significant impairment of oil and gas properties when capitalized costs are compared to the estimated ceiling.

Why did companies change? Those that did so said the reason was the successful efforts method was preferred by the FASB and management believed it to be more appropriate. However, exhibit 3, page 59, shows the most likely motivating factor--avoidance of a signifance write-down of oil and gas properties.

The importance of exhibit 3 is the increase in actual reported net income and earnings per share as a result of the change. Generally, such a change reduces net income because a company must expense considerable amounts of previously capitalized costs. For the five companies in exhibit 3, net income went up because the change in accounting methods eliminated the SEC requirement to write off impaired assets. Three of the five companies reported the amount of the writeoff they avoided by making the change.

ACCOUNTING AND FINANCIAL

REPORTING IMPLICATIONS

One of the tenets of financial reporting described in the FASB's conceptual framework is to provide investors with useful, relevant, comparable and unbiased information. The lack of a prescribed ceiling test for successful efforts companies has frequently

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biased management's choice of an accounting method in periods of declining oil prices. The result has been numerous accounting method changes for the apparent purpose of avoiding massive write-downs to show higher net income. This reduces the neutrality of accounting information and distorts reported results. Consequently, if investors are making capital allocation decisions based on these data, their decisions are influenced more by a company's choice of accounting methods than its competitive performance.

Before the 1990 Persian Gulf crisis, it would have been easy to say the reporting inconsistencies described above were the result of aberrations in the world oil price markets of 1985 and 1986--when the price of crude oil declined from $27 to $13 per barrel--and not likely to happen again in the foreseeable future. It even might have been possible to conclude no action was required. However, fluctuations in crude oil prices during 1990 raised concerns about the future availability of crude oil and the volatility of oil prices.

The composite price of crude oil was about $12 per barrel in January 1990, $15 in June, $33 in October and $26 in December. This was followed by a further decline to $19 per barrel in early 1991 as the Persian Gulf crisis subsided. Thus, the volatility of oil prices creates an economic environment in which oil and gas companies might issue financial statements whose relevance and reliability might be questioned. Action must be taken now to ensure financial statements will be useful to decision makers in the future.

ALTERNATIVES TO CONSIDER

In keeping with the measurement, recognition and disclosure issues described in the

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FASB DM on asset impairment, there are several alternatives we believe the profession may want to consider relative to the oil and gas industry.

Disclosure in management's discussion and analysis (MD&A). AT a minimum, successful efforts companies could be required to conduct a ceiling test and report impairments in the MD&A section of form 10-K and the annual report. Although this is a weak solution, it's better than current requirements.

Disclosure in notes. Companies could be required to conduct a ceiling test and report impairments in the notes to the finacial statements. This has an advantage over an MD&A disclosure; it makes the impairment discussion part of the formal financial statements, giving the disclosure added weight. As an integral part of the statements, the notes are subject to audit by independent auditors. This alternative does not, however, address the reporting inconsistency between full cost and successful efforts companies.

Write-down of impaired assets. Successful efforts companies could be required to conduct a ceiling test and write down assets in a manner similar to full cost companies. This would enhance the consistency in impairment reporting and provide financial statement users with information to assess the performance of oil and gas companies, regardless of the accounting method used. It would likely reduce the number of companies changing accounting methods merely to increase their net income in a falling market.

Write-down with a valuation allowance. Here, a ceiling test could be applied and a write-down of impaired assets required, as with full cost companies. However, under SEC regulations SX 4-10, write-downs are permanent. This proposal would allow companies (both full cost and successful efforts) to set up a valuation allowance and recognize impairment losses and recoveries stemming from market value fluctuations beyond the control of individual companies. If oil and gas companies are required to make significant write-downs when prices are falling, it can be argued they should be allowed to recognize recovery up to carrying value when prices are increasing.

Use of a valuation allowance instead of a permanent write-down still would require a charge against the income statement in the year of impairment, as currently required by the SEC for full cost companies, but would allow recovery in subsequent years, contrary to currrent SEC regulations. Investors would be served by timely reporting of impairment losses, yet companies woudl be able to recognize future recoveries. In addition, since full cost companies would be able to use the valuation allowance approach, they would be less motivated to switch accountign methods to improve current net income, since they would know future net income would rise with increased oil prices.

EVALUATING ALTERNATIVES

The study clearly shows significant differences in reporting impairments of oil and gas properties between full cost and successful efforts companies. In view of the increased interest in asset impairment, this is an appropriate time for the profession to evaluate altenatives to improve asset impairment reporting in the oil and gas industry. The issues discussed here are closely related to the measurement, recognition and disclosure issues the FASB is considering in its DM.

DAVID B. PARISER, CPA, PhD, is associate professor of accounting, College of Business and Economics, West Virginia University, Morgantown. He is a member of the American Institute of CPAs, the Institute of Management Accountants, the American Accounting Association and the West Virginia Society of CPAs. PIERRE L. TITRAD, CPA, PhD, is professor of accounting and business legal studies, University of Alabama, Huntsville. He is a member of the AICPA, the IMA, the AAA and the Society of Louisiana CPAs.