potential effect of the FASB's proposed concepts statement on cash flow measurements on the oil and gas company, The

Petroleum Accounting and Financial Management Journal, Summer 1998 by Nichols, Linda

In June of 1997, the Financial Accounting Standards Board (FASB) issued a proposed Statement of Financial Accounting Concepts entitled Using Cash Flow Information in Accounting Measurements. Issuance of the proposed concepts statement is a very significant event, especially considering that the FASB has not issued a concepts statement since 1985. Between 1978 and 1985 the FASB issued six concepts statements which were intended to guide the Board in developing sound accounting principles by establishing objectives, qualitative characteristics, and other concepts that would guide the resolution of recognition and measurement issues in financial reporting. Issuance of a proposed concepts statement involving measurement issues twelve years after the last concepts statement indicates that the FASB is now ready to consider nontraditional measurement methods. One of the measurement methods discussed in the proposed concepts statement could have a very significant impact on the oil and gas industry if implemented. In the proposal, the FASB introduces the concept of "expected cash flows". In developing that concept the Board recognized that accounting applications of present value which typically use a single set of most likely estimated cash flows, a single interest rate, and a single timing scenario may be deficient. The Board felt that the expected cash flow approach could be used instead of the traditional approach in many circumstances involving cash flow projections. A projected application of the expected cash flow approach is in the valuation of derivative instruments. An application specific to the oil and gas industry may be in the present value calculations necessary for SFAS No. 69 disclosures. Another instance could be in the application of SFAS No.121 dealing with asset impairment. SFAS No. 69 Disclosures

SFAS No. 69 requires publicly traded companies with significant oil and gas producing activities to disclose the net quantities of their interest in proved reserves of crude oil and natural gas along with value-based information about those reserves. The value-based information includes the disclosure of a standardized measure of discounted future net cash flows relating to proved oil and gas reserves. In computing this measure, a single set of what is considered the most likely future net cash flows and the most likely timing of those cash flows is utilized. Future cash inflows are based on estimated year-end prices, as are future development and production costs. Future net cash flow is found by subtracting future production and development costs and future income tax from future cash inflows. The net cash flows are then discounted at an annual rate of ten percent. Projecting future net cash flows from proved reserves is extremely difficult, as is assuming a single most likely set of estimated cash flows and a single timing scenario for those cash flows. Reserves estimates are imprecise and subjective, and differing estimates of proved reserves are often associated with the same fields. One prior study analyzed the differences between the estimates of proved reserves prepared by two or more reserves estimators using a common database. This was accomplished by comparing estimates of the same reserves by companies for commonly owned properties. The findings indicated that in 66 percent of the cases, the estimates of the companies were not within 25 percent of each other; in 42 percent of the cases they differed by more than 50 percent; and in 21 percent of the cases the reserves estimates differed by more than 100 percent (Porter, 1980). Even once estimates are made, they will inevitably change as additional data becomes available. Furthermore, even if the estimate of total expected production does not change, the projected timing of that production will most likely change as production decline rates are revised and/or secondary and tertiary recovery plans are implemented.

The Board stated in the exposure draft that the traditional approach to present value calculation is inadequate for complex measurement computations. A case in point is the present value disclosure requirements of SFAS No. 69. If the proposed concepts statement is adopted, the FASB will then have the theoretical basis needed to change the procedures used in computing the present value disclosures required by SFAS No. 69. For example, instead of using a single most likely production schedule to project cash flows, multiple possible production schedules with assigned probabilities could be obtained from petroleum engineers. Because petroleum engineers normally consider a range of possible production from fields, these schedules would not be difficult to create. The following example reflects Great Finds, Inc.'s calculations regarding Field A. The calculations are prepared for SFAS No. 69's required disclosures: Assume that Great Find used the above production schedule because the petroleum engineers estimated that this schedule of production had a 60% chance of actually occurring. However, even though the engineers estimate that the total remaining production from the field will be 120,000 barrels, they recognize that two other production timing schedules are possible, in addition to the schedule presented above. They estimate that the first additional scenario has a 25% probability of occurrence, and the second additional scenario has a 15% probability of occurrence. If the expected cash flow technique were applied in this situation, all three production scenarios would be considered. To continue with the above example, assume that the following production schedule and related cash flow projections have a 25% probability of occurrence: In addition, assume that the following production schedule has a 15% probability of occurrence: Using the expected cash flows approach, each schedule would be taken into consideration with its related probability level as shown below: In the above example, the present value of future cash flows for Field A is included in the disclosure schedules at $1,502,308 when using the current single best cash flow schedule approach. Alternately, when the expected cash flow technique is applied, the future cash flows for field A is included in the disclosure schedules at $1,510,531. Any new rules requiring the expected cash flow technique to be used for SFAS No. 69 disclosure purposes should include disclosure requirements regarding assumptions used in the cash flow projections.