Politics threatens the unsteady relationship between financial accounting and the reporting of oil and natural gas reserves. In the wake of unusually large reserves adjustments by Royal Dutch/Shell Group and others, a senior congressman normally unfriendly toward the oil and gas business has begun an investigation.
The potential thus grows for official overreaction to a problem easy to misconstrue. A letter last month from Rep. John Dingell (D-Mich.), ranking member of the House Energy and Commerce Committee, asks eight questions that show what oil and gas producers can expect. Dingell sent his inquiry to Energy Sec. Spencer Abraham; Patrick Henry Wood III, chairman of the Federal Energy Regulatory Commission; and Robert H. Hertz, chairman of the Financial Accounting Standards Board. Here, paraphrased and condensed, are Dingell's questions:
How did the Securities and Exchange Commission respond to its mandate under the Energy Policy and Conservation Act of 1975 to develop accounting practices for oil and gas producers?
What are the differences between successful efforts, full cost, and value accounting, and is the accounting-method issue being revisited in light of the recent reserves changes?
What guidance has SEC or FASB offered on the "reasonable certainty" standard for proved reserves?
How are reserves disclosures relevant to investors and national energy policy?
Is the SEC examining reserves disclosures across the industry, and if not, why not?
Was the SEC surprised by and staffed sufficiently to handle the reserves adjustments by Shell and others?
Why don't SEC and FASB require independent audits of reserves disclosures?
How do internal controls, and the responsibilities of managers and auditors for them, relate to these issues?
The congressmen's letter calls the recent reserves adjustments "scandals" and "debacles." It declares, "This turn of events is totally unacceptable and raises disturbing issues regarding the nation's energy reliability and security, the integrity of the energy and securities markets, and the protection of consumers and investors."
That's overstating things. Yes, a problem exists. No, it doesn't threaten national security or the integrity of markets. And it won't be solved by the prosecutorial posturing of politicians.
The problem is a conflict between financial accounting's need for precision and the uncertainty inherent in reserves numbers. Those numbers aren't measurements. They're estimates. They depend heavily on judgment and interpretation. They change considerably over time for reasons other than depletion.
Subjectivity and variability make estimated reserves volumes impossible to reconcile with dollars-and-cents financial statements. The SEC reached that conclusion in 1981 after a failed experiment with value-based reserves recognition accounting, its response to the congressional mandate about which Dingell asked. Under the accounting methods that survived the experiment—full cost and successful efforts—assets on balance sheets reflect historic development costs rather than direct valuations of reserves.
The reserves disclosures now drawing attention appear in company reports separate from balance sheets and income statements. They include a dollar value based on a calculation of future revenues generated by production from proved, developed reserves. But SEC carefully warns that this strictly defined value isn't predictive but rather a basis for comparison of companies.
Volumetric adjustments to proved reserves, which happen for many reasons, affect this SEC value but not necessarily companies' financial results. It's when a company reduces its reserves estimates enough to affect future profitability that volumes influence profits. In such a case—prescribed by SEC ceiling tests—the company lowers reported earnings by the estimated damage to future revenue.
Shell's four-step, 24% cut in reported reserves mainly shifted estimated hydrocarbon volumes into categories other than proved reserves. It required charges against 2001-03 earnings totaling $485 million. The mystery of how a company like Shell can make so large a mistake warrants the investigation that the SEC has begun. And careful initiatives to improve, or at least restore confidence in, reserves-disclosure practice deserve consideration.
What this issue doesn't need is the congressional inquisition Dingell's letter portends. A politically motivated overhaul of the reserves-reporting system would only confuse the inescapably uncertain. It would create fiction by pretending to impose precision where nature eludes measurement. There could be no greater disservice to investors. Yes, the current system is imperfect. But given the nature of reserves and the current state of technology, it may be nearly as good as it can be.