Accounting method choice and market valuation in the extractive industries

Abstract

For more than 40 years, oil and gas companies have been able to choose between two competing methods for accounting for exploration activities. The implication is that two otherwise identical companies can report substantially different earnings depending on chosen method. This situation, where oil and gas company managers have discretion to choose between different accounting methods, has transpired because of intense lobbyism towards accounting standard setters by oil and gas companies in favour of one of the methods. The existence of two accounting methods is concerning since investors will struggle to uncover the true underlying performance of oil and gas companies. We conjecture that investors will resort to operating cash flows to evaluate oil company financial performance since cash flows are less affected by managers’ discretion than earnings are. In this study, we investigate the relevance to investors of earnings versus cash flow for oil and gas companies. Our results show that cash flow measures, but not earnings, are significantly associated with oil company returns. These findings suggest that the financial markets lack confidence in oil company earnings, irrespective of accounting method used, and investors therefore prefer cash flows as measures of underlying financial performance.

Keywords:

• full cost vs. successful efforts
• oil company valuation
• oil and gas exploration
• cash flows
• earnings
• profitability
• shareholder returns
• oil price
• gas prices

Public Interest Statement

Oil and gas companies’ financial report represent a very important source of information about the financial performance of these companies. However, evaluating the profitability of oil companies is quite challenging, especially so since two otherwise identical companies will report different profits depending on choice of accounting method. In particular, for more than 40 years oil companies have been allowed to choose between two competing methods for accounting for exploration activities. In this paper, we conjecture that this choice between competing accounting methods will confuse investors.

We test our hypothesis by examining the impact on market valuation of financial performance measures. We find that there is a closer association between market valuation and cash flows, than with accounting earnings. We find that cash flows outperform earnings independent of accounting method choice. Our research therefore suggest that when the quality of accounting information is adversely affected by accounting method heterogeneity, investors will turn to cash flow measures to evaluate financial performance in the oil and gas sector.

Acknowledgements

The author would like to thank the participants at the IAEE conference in Rome 2017, as well as an anonymous reviewer, for constructive suggestions which have improved the quality of the paper.

Notes

1. Pre-discovery costs include property acquisition and carrying costs, geological and geophysical exploration costs and exploratory drilling costs.

2. As cited in DeFond and Hung (2003).

3. Extracted from Department of Justice response to the SEC dated 27 February 1978. Published in the Federal Register (43 F.R. 878), 4 January 1978 (as cited in Collins, Rozeff, & Dhaliwal, 1981).

4. Studies examining the impact of the association between financial ratios and valuation multiples did not find a significant relation (Osmundsen, Asche, Misund, & Mohn, 2006; Osmundsen, Mohn, Misund, & Asche, 2007).

5. Total shareholder returns include both capital gains and dividend yields.

6. The reserves class that is used in the calculation of reserves NPV is proved reserves. The reader should be aware that this definition of oil and gas reserves excludes other classes such as probable and possible reserves (see e.g. Bentley & Bentley, 2015; Misund & Osmundsen, 2015; Speirs, McGlade, & Slade, 2015).

7. Asche and Misund (2016) suggest using fixed effects model for capturing the effects on valuation from variables not included in the models. Examples of such effects might be related to size (Osmundsen et al., 2006), geographical location of oil and gas reserves (Kretzschmar & Kirchner, 2009) and exploration activity (Misund, Mohn & Sikveland, 2017).

8. We thank an anonymous reviewer for this suggestion.

9. We also test some alternative variables that Bryant (2003) used in her study, e.g. the asymmetric net income variables. However, in our data-set we found very high correlations (>0.700) and chose not to include these variables in order to avoid multicollineratity issues.

Additional information

Notes on contributors

Bård Misund

Bård Misund is an associate professor of Accounting and Finance at UiS Business School at the University of Stavanger. He has more than 10 years of industry experience from commodities companies. Before joining academia, he worked as an economic analyst, and later as an advisor to the Norwegian oil and gas company Statoil ASA.

His research covers several fields including accounting, finance and economics, mostly covering topics related to commodity markets. Misund’s research interests include commodity price behaviour, volatility transmission, the relationship between spot and futures prices, price formation in spot and futures markets, determinants of commodity firm stock returns, financial statement analysis and valuation of oil and gas firms. He has published more than 20 papers in international peer-reviewed journals in economics, finance and accounting.