S&P: Corporate governance and accounting affect credit quality

"Our analysis is based on fundamentals, and as we see new risks enter, whether it is accounting issues, governance, liquidity or trading triggers, we are not cast in concrete in how we do our business. We constantly evaluate better ways to improve upon our analysis," Ronald M. Barone, managing director of S&P's utilities, energy, and project finance group told clients during a September briefing in Houston.

He emphasizes that S&P is not an auditor and is not an investigative agency. "Our accounting initiative is not designed to undercover accounting fraud. It's essentially a tool to unravel accounting complexities in order to ensure that debt and cash flow measures are accurate. It's a tool to perform valid ratio comparisons across companies," he said.

S&P renders an opinion on the ability and willingness of a company to make timely payments of interest and principal. Rating changes as a result of S&P's enhanced analytic rigor are likely to be modest, Barone said.

"The combination of aggressive management culture and weak board oversight has the potential to constrain or impair credit quality. Alternatively, evidence of strong corporate governance helps to mitigate perceived risk and perhaps can add to ratings stability," he said.

Accounting analysis

S&P has added specialized resources for greater expertise and analytical discipline, he said. The ratings agency also is expanding coverage of accounting and governance data to include contact with a firm's auditors and board members, if necessary.

"Different accounting frameworks can give rise to huge apparent differences among companies that look identical in economic substance. The degree of aggressiveness or conservativeness in the application of accounting standards contributes to this. Recent accounting scandals and accounting rule changes underscore the need for greater scrutiny of accounting and financial reporting," Barone said.

S&P has increased the emphasis that it places on understanding companies' accounting characteristics. "We will comment upon implications of significant transactions and notable events, highlighting analytic adjustments that we perform in areas of potential concerns," he said.

For the oil and gas sector, this includes full cost accounting versus successful accounting efforts as well as accounting for impairments and volumetric production payment records, he said.

"If this is significant, we will make note of it, and we will comment on it in the report. Whether it has a huge impact or not, we also may let investors know that these things exist so that they can start keeping an eye on it as well," Barone said.

S&P created an accounting task force consisting of its chief accountant and 12 senior analysts. It also has instituted a formal internal training program for all of its analysts and requires them to use a detailed checklist as they go through the ratings process.

The ratings agency also created accounting working teams to help analysts address emerging accounting matters and to develop industry-specific accounting templates that facilitate peer comparison.

"Finally, S&P also has engaged large multinational accounting firms to provide accounting, taxation, and financial reporting advisory services, as needed, and a forensic accounting firm to provide proprietary financial reporting analysis," Barone said.

Forensic accounting involves the use of accounting, auditing, and investigative skills to go through financial statements.

Corporate governance

S&P is expanding its review of corporate governance. Some corporate failures during the last four years exhibited similar characteristics of aggressive management cultures and weak board oversight.

"Some of these characteristics have been predictive of credit quality deterioration and have acted as an early warning signal of potential future problems," Barone said. "In the oil and gas world, there are a few areas where governance issues have surfaced. I guess that the biggest item is proved reserves examination and disclosure, or rather the lack of it."

Royal Dutch/Shell Group announced in January its first of four reserves adjustments that ultimately lowered proved reserves by 24 percent, mainly through reclassification. Others, including El Paso Corp., Houston, also revised reserves estimates (OGJ Online, Mar. 22, 2004).

In addition to reserve estimates, S&P will monitor the level of a company's outstanding debt when evaluating corporate governance, he said.

Meanwhile, compliance with the Sarbanes-Oxley Act has proved to be costly for many small oil and gas companies. "It's actually keeping some firms from going public, and it also has had the reverse effect where some firms have gone private to avoid Sarbanes-Oxley compliance," he said.

The US Congress passed Sarbanes-Oxley in 2002 to deter corporate fraud in financial reporting, and oil and gas companies had to learn how to comply with the law (OGJ, Oct. 13, 2003, p. 23).

"Governance red flags always have been identified and discussed in our ratings process. The new approach provides a more clearly organized and structured review framework to analyzing governance risk factors. For companies whose ratings opinion would benefit from additional analysis, we are going to conduct a more detailed ratings assessment across several parameters."

One factor might not portend material difficulties, but a combination of factors could be symptomatic of a heightened risk profile, Barone said. A separate team of S&P governance specialists will work in close coordination with the rating analysts.

There are two types of governance analysis. The first is a corporate governance score of 1-10, with 10 indicating the highest standard of corporate governance. The score has a large equity focus, and it is compiled only when a company requests it.

"In other words, the board may want to know how it stacks up against others. The board wants an independent review of the company's policies and practices in the governance area," Barone said.

The second type of analysis involves governance assessments, which are done upon the request of S&P analysts who ask people from a corporation's governance group to come in and help them sort through any possible issues.

Enron example

Upon questioning, Barone is quick to point out that S&P's enhanced accounting and corporate governance analysis most likely would not have sounded alarm bells before the Enron debacle because that largely involved off-balance-sheet obligations.

"I don't think we could have stopped what ultimately occurred, but I think perhaps the rating might have been lower if we had had some of this additional rigor in place. I am not quite certain how much lower," he said.

S&P downgraded Enron to D+ on Nov. 28, 2001, and the former conglomerate filed for bankruptcy on Dec. 2, 2001.