Earnings Management Study

Oil & Gas Industry

Abstract
This study mainly focused on the earnings management in oil and gas industry and we used Jones model to detect discretionary accruals in the subject companies. Specifically, we examined three oil and gas sample companies that have been required to restate their financial reports due to the oil reserve overestimation. After running the regression and comparing statistics with other oil and gas companies, we found that the sample companies do revise oil reserves to manipulate the DDA expenses, thus achieving their goals of earnings management. Some recommended auditing guidance to detect such manipulation were given at the end.

Introduction/Assumption
Earnings management, in accounting, is the act of intentionally influencing the process of financial reporting to obtain some private gain. Earnings management involves the manipulation of company earnings towards a pre-determined target. This target can be motivated by a preference for more stable earnings, in which case management is said to be carrying out income smoothing. Management may also overstate the income for personal interests. Other possible motivations for earnings management include the need to maintain the levels of certain accounting ratios due to debt covenants, boost earnings to beat analyst targets, or intentionally understate the earnings to get rid of the political pressure. Analysis of earnings management often focuses on management’s use of discretionary accruals. Such research requires a model that estimates the discretionary components of reported income.

In this paper, we studied three companies from three different components of the US oil & gas industry: (1) Stone Energy Corp from crude oil and natural gas production companies (SIC code 1311), Royal Dutch Petroleum from petroleum refining firms (SIC code 2911) and El Paso Corp from natural gas transmission (SIC code 4922). Crude oil and natural gas production firms specialize in exploration and production of crude oil and natural gas. They are mostly small independent firms and they sell their output on to the larger oil refining firms. While the larger petroleum refining firms (e.g. Exxon Mobil) do produce some crude oil, their operations differ in that they include a very significant part of down-stream processing (i.e. refining) and distribution to consumer markets.

The oil and gas industry is one of the largest and, most politically-sensitive industries in the United States. During 2007, the market capitalization of publicly-traded oil and gas companies reached a record $4.04 trillion. Prior research provided evidence that earnings management in gas an oil industry is closely related to the political costs. In other words, oil and gas companies tend to report higher abnormal DDA expense accruals, therefore understate earnings, in periods of higher oil prices (2006-2008) than in period of lower oil prices (2002-2005). Our sample companies’ financial restatements covered the years from 1999 to 2008, which experienced both the high price years and low price years. Therefore, when we did the research, we did consider the political costs as a factor that may affect earnings management in gas and oil industry. However, companies who performed mandated restatements due to earnings understatement is rare, instead, all three of the subject companies we studied had to restate financial statements due to earnings overstatements.

How they are able to do that is very tricky because oil and gas reserve do not present on assets directly, instead they are being required to be disclosed in the supplementary notes to financial statements. However, there is something called Depreciation, Depletion and Amortization (DD&A) expense, which is a significant period expense all those companies encounter, can easily be effected. DD&A expense is calculated as follows,

Oil and gas reserve is the denominator of the equation, meaning the higher the reserve, the lower the period DD&A expense therefore the earnings will be overstated.

Managerial discretion in using accruals has been studied extensively in prior research under the general assumption that mangers exercise discretion over reported accounting numbers due to different incentives (Dechow and Skinner, 2000). Healy and Wahlen (1999) state that “Earnings management occurs when managers use judgment in reporting and structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or influence contractual outcomes that depend on reported accounting numbers.” This definition of earnings management emphasizes the role of managerial intent to use discretion in reported earnings. The accounting literature identifies three broad motives for this behavior: capital markets motivations, contractual motivations, and regulatory motivations (Healy & Wahlen, 1999). The following paragraphs would discuss in details for each of the three companies and their restatements including a brief business background, the dates and statistical facts, legal actions taken and the result.

Cases Studies

1. Royal Dutch/Shell Group

Business overview
Royal Dutch group is created by the merger of Royal Dutch Petroleum and Shell Transport & Trading, in terms of revenue it is the largest company in the world and one of the six oil and gas " super-majors ". Shell is also one of the world’s most valuable companies. Shell is vertically integrated and is active in every area of the oil and gas industry, including exploration and production, refining, distribution and marketing, petrochemicals, power generation and trading. Restatement data
In January 2004, Securities and Exchange Commission had begun a formal investigation into the company's surprise restatement of its oil and natural gas reserves. Royal Dutch/Shell over reported its oil and gas reserves by 20% (or 3.9 billion barrels), Shell also overstated the standardized measure of future cash flows in this report by approximately $6.6 billion. It was revealed that bonus payments to top managers in previous years had been linked to the proven reserves base. This practice has been discontinued since then.
According to US Securities and Exchange Commission rules, a reserve must have "reasonable certainty" of being technically and commercially produced to be considered "proved." Shell admitted that a significant share of reserves previously booked as “proven” did not fulfill the requirements for proof under U.S. regulatory provisions.
Royal Dutch Shell group make five successive downgrades on oil reserve in 2004. 9th January 2004 First Reserves write-down 18th March 2004 Second Reserve write-down 19th April 2004 Third Reserves write-down 24th May 2004 Fourth Reserves write-down 1st November 2004 Fifth Reserve write-down

On January 9, 2004, Royal Dutch/Shell announced that it was writing down its “proved” oil and gas reserves by 20% (or 3.9 billion barrels), from 19.5 billion barrels to 15.6 billion barrels. The write-down: (a) cut the Company’s reserve life from 13.4 years to 10.6 years; (b) increased the Company’s worldwide 5-year average reserve replacement cost per barrel from $5.49 to $12.57 -- 128% greater than the industry average of $5.51; (c) increased Royal Dutch/Shell’s exploration and development costs to $7.90 per barrel -- well above the costs of its competitors; and (d) reduced Royal Dutch/Shell’s Appraised Net Worth by as much as 7.1%, or $9.6 billion. The restatement of proven reserves is related to Royal Dutch/Shell’s oil production in Australia and Nigeria.
On March 18, The Company also announced that it was further cutting its proved oil and natural gas reserves for 2002 by an additional 250 million barrels. This change raises the total amount of reserves improperly booked and filed with the SEC to 4.15 billion barrels. Royal Dutch/Shell also reduced its 2003 planned reserves by 220 million barrels, indicating that the Company would only replace 82% of depleted reserves for 2003, not the 98% announced in February 2004.
On April 19, 2004, Royal Dutch/Shell announced that it would cut down its energy reserve for third time. This third reserves reduction brought Royal Dutch/Shell’s total reserves to 4.35 billion barrels -- These most recent revisions brought the Company’s reserves replacement ratio for 2003 to around 60%, as of the end of 2003, and its reserves life to 10.2 years.
On May25, 2004, The Financial Times reported that Royal Dutch/Shell again restated its proved oil and gas reserves for the end of 2002 and disclosed that it will reduce earnings by a total of $402 million for the years 2001 to 2003.
On November 1, 2004, the Company took another “potentially significant” reserve write-down.

Car(-1,0) | -0.07028629 | (0,1) | -0.07119329 | (1,1) | -0.06596293 |

Following the January 9, 2004 announcement, Royal Dutch Petroleum share fell 7%
Securities analysts’ recommendations
Any reclassification of oil reserve into less certain categories is a serious concern for investors since reserves are an oil company's most valuable asset.
Credit rating agency actions
As a further consequence, Standard & Poor's downgraded Royal Dutch Shell Group’s AAA credit rating, which it had maintained for 14 years, to AA+. Moody’s Investor Service (“Moody’s”) placed its AAA rating of both Royal Dutch and Shell Transport under review for possible downgrade because the write-down had materially adverse effect on the individual companies’ reserves-to-debt ratios.

Legal and regulatory actions taken
Because of the reserve write-offs, Shell paid $151.5 million in U.S. and U.K. fines, dismissed three executives and lost its top-tier credit rating.

2. El Paso Corp
Business Overview
El Paso Corporation was a provider of natural gas and related energy products and was one of North America's largest natural gas producers until its acquisition by Kinder Morgan in 2012. It was headquartered in Houston, Texas, United States. In October 2011, Kinder Morgan acquired El Paso Corp. in a $21.1 billion deal. For the year that ended December 31, 2011, El Paso Corporation had total revenues of almost $ 4,860 million and approximately 6,000 employees.
Restatement Data
On Feb. 17, El Paso lowered its natural gas and oil reserves by the equivalent of about 1.8 trillion cubic feet, a move that came after similar steps by the Royal Dutch/Shell Group and other oil companies, including Nexen Inc. of Canada. The El Paso Corporation announced that it would restate its earnings as it recalculates the effect of its decision last month to lower the estimates of its natural gas and oil reserves by 41 percent. El Paso also announced that revising its reserves would most to a $1 billion decline in the value of that oil and gas.
On May 3, 2004, El Paso announced that an independent investigation initiated by the Audit Committee of the board of directors determined that the downward revision to its natural gas and oil reserves that had been announced on February 17, 2004 would require a restatement of the financial statements for El Paso Corporation and its subsidiaries El Paso Production Holding Company and El Paso CGP Company for the periods from 1999 through 2003.
In September 30 2004, El Paso filed its 2003 Form 10-K with SEC. In that filing, El Paso indicated that it had restated their historical proved natural gas and oil reserve estimates, the financial information derived from those estimates, and financial information related to our historical accounting for certain hedges for the periods from 1999 through 2002, and for the first nine months of 2003.
The total cumulative impact of the restatement was a reduction of El Paso’s previously reported stockholders' equity as of September 30, 2003 of approximately $2.4 billion. Of this amount, approximately $1.7 billion related to the restatement of historical reserve estimates and approximately $0.7 billion related to the restatement of historical accounting for hedges. These restated amounts have been reflected only in this Annual Report on Form 10-K, and El Paso did not revise their historically filed reports for the impacts of the restatements.
Table below shows the effects of the adjustments on El Paso’s major financial statement items.

Accounting/Audit Firm
PricewaterhouseCoopers LLP, El Paso’s independent auditor, audited El Paso’s financial statements for fiscal years 1999-2003.
Stock Prices
El Paso’s stock trades on the NYSE under the ticker symbol EP. Shares of El Paso fell 17 cents on 17th February 2004, or 2.4 percent, to $6.93. They have fallen more than 21 percent since the company lowered its estimates on proven reserves. The trends in El Paso’s stock price around restatement announcement are shown in figure below.

Securities Analysts’ Recommendations
Lower reserves are just one challenge facing El Paso. The company and its subsidiaries are still recovering from unsuccessful forays into energy trading and the telecommunications business. In the third quarter 2003, El Paso lost $146 million, more than twice as much as it lost in the period a year earlier. Analysts said, to compensate for its financial difficulties, El Paso may have calculated its oil reserves using more optimistic assumptions than it might have otherwise. In that context, the possibility that El Paso may report larger losses is not unexpected. Analyst referring to El Paso, in their situation, it's prudent to delay their earnings, given all the moving parts they have.
Credit Rating Agency Actions
After El Paso's restatement announcement to lower its reserves, Standard & Poor's cut its rating of the company's debt to B-, six notches below investment grade.
Legal and Regulatory Actions Taken
The United States Securities and Exchange Commission filed a civil action against El Paso Corporation, its subsidiaries El Paso CGP Company LLC and El Paso Exploration & Production Co., and several former employees alleging that they inflated, or participated in the inflation of, the companies' proved natural gas and oil reserves in violation of the federal securities laws. Defendant consented to a judgment that permanently enjoin from future violations of these provisions and being ordered to pay a $235,000 civil penalty.

3. Stone Energy Corp
Business Overview
Stone Energy Corporation is an independent oil and natural gas exploration and production company headquartered in Lafayette, Louisiana, currently has a market cap of 2.4 billion dollars as of 2014.
Restatement
On October 6, 2005 Stone Energy announced to the public that it had to adjust previously overestimated natural gas reserve. The overestimation was about 171 billion cubic feet which accounts for one-fifth of its total reserve in that time. On the announcement date, Stone’s stock price plunged by more than 14% as the graph displayed.

On November 8, two months after its downward revision of natural gas reserve, Stone energy expressed that their historical financial statements has to be restated to fairly reflect their operation in result of the adjustment. Financial statements for the period from 2001 to 2004 and first six months of 2005 will be required for restatements. Eventually the earnings of those effected periods were adjusted downward. Class action against Stone Energy was filled.

Interestingly enough, the audit committee played a very crucial role in the whole event, mostly positive. The committee first initiated a reserve revision and hired a third party firm to look into the matter, including the estimation procedures. After the independent submitted their report to audit committee, the committee exerted pressure on the management, in result of that, the CEO resigned and another senior manager stepped down from the position. In addition to that, audit committee and the board of directors of the company enforced the following guidance were made to mend the weakness described in independent report:

Legal or Regulatory Actions Taken (i) improved training regarding SEC guidelines (ii) revisions of documentation procedures and controls (iii) the continued use of one or more independent third party engineering firms (iv) the formation of a specific reserves committee of the board of directors to review the reserve booking process (v) appointment of a reservoir engineer as Vice President, Reserves

We can see the DDA expense account is very different in reserve overstated year and normal years, and also the discretionary accruals in portion of assets:

| 2004 (Reserve Overstated) | 2005 (Reserve Overstated) | 2006 | 2007 | DD&A Expense($) | 210861( Expense Understated) | 241426(Expense Understated) | 320696 | 302739 |

The reserve overstated year had rather obvious lower DDA expense and therefore, higher income. And they both agree with year 2004 and 2005 Stone made efforts to boost the earnings.

Empirical Results and Analysis

Our Jones Model statistical results support our claim that all those three companies we studied did in fact boost their earnings through discretionary accruals. Even though El Paso in 2001 had negative discretionary accruals, we believe it is due to statistical limitation in the model.

The three companies had very similar practices during those restated years. They all boosted earnings through overstatement of oil and gas reserves therefore, the DD&A expense are understated. So how they are able to manipulate such an important estimation is an interesting question since oil and gas reserve is usually the most crucial assets a company can hold on to. SEC and GAAP requires gas and oil companies to properly disclose the proved reserves, however the definition is no clear cut. Regulators left reserve estimation in grey area.

SEC/GAAP:
“Proved oil and gas reserves are those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible–from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations.”

Well, many vocabularies in this definition are up to human judgment. For example, who defines reasonable certainty? It must be those who have the expertise. Those companies usually use internal engineer or hire third party engineering companies to come up with estimation. Since those companies are paying, they definitely have influence on the estimation.

Proposed auditing guideline with example
An audit of the reserves information pertaining to an entity generally should include a review of (i) The policies, procedures, controls, documentation, and guidelines of such entity with respect to the estimation, review, and approval of its reserves information; (ii) The qualifications and independence of reserves estimators internally employed by such entity; (iii) Ratios of such entity’s reserves to annual production for, respectively, oil, gas, and natural gas liquids; (iv) Historical reserves and revision trends with respect to the oil and gas properties and interests of such entity; (v) Historical change of depreciation, depletion and amortization expense; (vi) The ranking by size of properties or groups of properties with respect to estimates of reserves or the future net revenue from such reserves; (vii) The percentages of reserves estimation method; (viii) The significant changes occurring in such Entity’s reserves, other than from production, during the year with respect to which the audit is being prepared.
These procedures can help auditors test whether there is a potential accounting manipulation on oil and gas reserve. Take the example of company’s historical change of depreciation, depletion and amortization expense. If the oil price was high, then the company had the motive to mark down the earnings by increasing DDA expense, which will be resulted from lower reserve estimation. If the oil price was low, then the company would most likely to tune up the earnings by decreasing DDA expense, which is resulted from the overestimated reserve. By using this principle found from our research samples, we could detect whether another oil and gas company could make so like accounting tricks to manage earnings.
ConocoPhillips
In 2008, U.S economy was deep in recession. For oil and gas companies, they suffered from low oil price $47 per barrel in comparison to $147 not so long before that time. Under this background, oil and gas companies have the motivation to make their earning look better than real. Based on our proposed procedures, we assumed that companies could mark up their oil reserve to achieve this goal. To reflect this information in the financial statement, the DDA expense will be understated. Then the earnings for the company can be improved or boosted.

In our research for U.S GAAP based oil and gas companies, the industry trend was an overall increase in DD&A expense from 2004 to 2012. But for ConocoPhillips, the company showed a DDA expense downward tendency which is the opposite of the industry trend. Therefore, our team chose this company as the targeted firm to study whether additional procedures can be useful to predict its future restatement.
The first step, as we did in the beginning is to find oil reserve historical changes for ConocoPhillips. Then we compared its DDA expense through 2004-2013 to understand the trend. We did a vertical analysis by comparing the reserve replacement ratio of the company from year to year to further confirm the company could manage its earnings through manipulate reserve accounts. Related figures are showed below. Illustration of DDA Expense

Illustration of ConocoPhillips Financial Information

| 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | DDA | 3485 | 3798 | 4253 | 7,284 | 8,298 | 9,295 | 9,021 | 9,060 | 6,827 | 6,580 | Net income | 4593 | 8107 | 13529 | 15,550 | 11,891 | -16,998 | 4,492 | 11,417 | 12,502 | 8,498 | Reserve replacement | 106 | 206 | 230 | 192 | 159 | 85 | 141 | 138 | 112 | 142 |

Illustration of ConocoPhillips Reserve Replacement ratio

The empirical results showed that ConocoPhillips suffered a loss in the year of 2008, since that they had higher reserve estimation also a higher Reserve Replacement Ratio, also the DD&A expense started go down because of higher reserve ratios in spite of its industry counterparts all had growing DD&A expense.

From that we conclude, it might be possible that ConocoPhillips would experience a future financial statement restatement due to reserve overstatement. The assumption would be that ConocoPhillips is having bad operations starting from 2008, but to make it look good they started to inflate reserve estimation to boost the earnings.

Conclusion
The sample of our study includes the majority of the firms in the oil and gas producing, refining and transmission industries with available data during fiscal years from 2000 to 2006. And the assumption made was that energy companies would manage earnings through oil and gas reserves manipulation.However, we were unable to find any companies that were being required to restate the financials for underestimating its reserves. We believed it was due to the conservatism of U.S GAAP. SEC would rather see a company to underestimate its reserve than overestimate. And for the three cases we studied, Royal Dutch, El Paso and Stone Energy, our empirical results supported that they all had positive discretionary incomes that the management intended to use as a boost for earnings. The technique was rather simple, overestimate the reserve so DD&A ,which is a main component of period cost for such an industry, would go down, thus the net income will be positively impacted. There certainly are weaknesses in U.S GAAP in terms of dealing with oil and gas reserve disclosures. The reason being it’s a highly complicated estimation. Situation would only improve if regulators and auditors could work together in continuous efforts to achieve a more reliable and convincing estimating and reporting process.

Bibliography:

“El Paso Expects A Restatement Of Earnings.” The New York Times. The New York Times Company. 11 March. 2004. Web. 5 May. 2014.
U.S. Securities and Exchange Commission. El Paso Corporation: 10-K. 30 Sept. 2004. Washington, D.C., Web. 5 May. 2014.
U.S. Securities and Exchange Commission. Southern District of Texas. Houston Division. SEC Settles Securities Fraud Case With El Paso Corporation, Its Subsidiaries, and Several Former Employees. 11 July. 2008. Web. 5 May. 2014.