Accounting for the impairment of long-lived assets: Evidence from the petroleum industry☆
Introduction
Under U.S. GAAP, oil companies may use either of two oil and gas accounting methods, full cost or successful efforts. Under successful efforts, only those exploration costs relating to successful wells are recorded as assets. All exploration costs for unsuccessful wells, or ‘dry holes,’ are expensed. By contrast, exploration costs relating to both dry and successful wells are capitalized under full cost. However, although full-cost firms may record dry holes as assets, the Securities and Exchange Commission (SEC) requires them to conduct a quarterly impairment test, known as the ‘ceiling test,’ on their capitalized oil and gas assets. This test requires firms to permanently write down capitalized costs of oil and gas assets to the extent that these assets’ net capitalized costs exceed the full-cost ceiling. This ceiling is an estimate of the present value of net cash flows from expected future production, under the assumption that current (end-of-quarter) oil and gas prices will prevail indefinitely. In effect, this ceiling test functions as a ‘lower of cost or market’ test.
The precipitous decline in oil and gas prices in the mid-1980s sparked a protracted debate between full-cost oil and gas producers and the SEC about the application of the full-cost ceiling test, particularly the use of quarter-end price as the basis for determining asset values. The debate continues today. In 1991, 26 full-cost companies, with the support of five of the Big Six accounting firms, urgently requested a temporary waiver of the use of quarter-end prices in calculating the full-cost ceiling. The SEC denied the request. In a 1994 Coopers and Lybrand/Institute of Petroleum Accounting Survey of Accounting Practices in the Oil and Gas Industry, the four ‘most needed’ accounting rule changes included three modifications to the full-cost ceiling test.1 The full-cost ceiling test was discussed at the Fall 1997 meeting of the Council of Petroleum Accountants Societies: several participants indicated that the ceiling test continues to be an important issue for their firms and that their firms had taken full-cost ceiling test write-downs in recent years. Evidence of the value relevance of full-cost ceiling test write-downs provided by the empirical analyses in this paper is central to this continuing debate between the oil and gas industry and the SEC.
We investigate the relation between security returns and asset write-downs due to the application of the ceiling test for a sample of 78 full-cost firms that recorded a total of 148 ceiling test write-downs over the fiscal years 1984–1987. We choose this period because it includes the largest decline in oil and gas prices since the SEC mandated the application of the full-cost ceiling test in 1978. Prior to the fall in oil and gas prices in the mid-1980s, the market values of these firms had generally been considerably greater than their book values. However, our results show that if the write-downs had not been taken in late 1985 and early 1986 when oil prices dropped, the average book value would have been greater than the average market value. Thus, the write-downs aligned book values and share market values. Nonetheless, the asymmetry in the ceiling test, requiring write-downs but not allowing subsequent write-ups when oil and gas prices rebound, is evident from the divergence of the firms’ share prices and book values after 1986.
We find that the write-down amounts have statistically significant incremental explanatory power over pre-write-down earnings for returns of the quarter in which the write-down is recorded (the ‘write-down quarter’). That is, the stock market reflects some of the decline in asset values in the fiscal period in which the write-down is recorded. The correlation between write-down amounts and returns of the quarter preceding the write-down period is also significant. Moreover, this correlation is greater than the correlation between write-down amounts and contemporaneous returns.
In short, our evidence suggests that the write-downs tended to be reported after the associated decline in share prices, suggesting that the market already knew at least some of the information implicit in the write-down amounts.2 This evidence is inconsistent with the oil and gas producers’ concern that taking the write-downs would have an ‘unrealistic and harmful’ effect on equity values. Further, the insistence by the SEC that firms record the write-downs on their balance sheets resulted in book values which, at the time, better reflected market values.
Full-cost ceiling test write-downs are a classic example of conservatism in accounting as discussed in Basu (1997). A write-down must be recorded when the net capitalized cost of the oil and gas assets exceeds the full-cost ceiling, but if the book value of these assets is less than the ceiling test amount, write-ups are not permitted and the higher value will not be reflected in the financial statements until the benefits accrue from future oil and gas sales. That is, bad news is recorded quickly while good news is recorded over a longer period. Basu (1997) uses negative returns as a proxy for net bad news. Not surprisingly, we find that a high proportion of the returns in the quarter that the write-down is recorded are negative. Consistent with Basu (1997), the correlations between write-down amounts and contemporaneous and lagged returns are always higher when we remove observations with positive contemporaneous returns.
The next section describes the full-cost ceiling test, summarizes the major issues in the debate over the ceiling test, and compares the full-cost ceiling test with the asset impairment test under Statement of Accounting Standards (SFAS) No. 121. Section 3 outlines the sample selection procedure and Section 4 presents descriptive statistics for our sample of write-downs. In Section 5, we provide a comparative analysis of the time-series of oil and gas prices, the oil and gas firms’ share prices, and their book values during our sample period. 6 Empirical analyses of full-cost ceiling test write-downs, 7 Test results present the research design and the empirical results, respectively. The last section summarizes the findings of the study and discusses the extent to which they provide new evidence relevant to the debate between the oil and gas industry and the SEC.
Section snippets
The full-cost ceiling test
According to Regulation SX 4-10, for each cost center (defined as a country), capitalized costs, less accumulated amortization and related deferred income taxes, shall not exceed the cost center ceiling.3
Data and sample selection
A sample of full-cost firms is obtained from the Arthur Andersen Survey (1989): Oil and Gas Reserve Disclosures. The firms’ annual reports or Form 10-Ks are examined to determine if and when the firms took ceiling test write-downs during the 1984–1987 test period. The write-down amounts and the quarters of the write-downs are identified by examining quarterly reports and Form 10-Qs for the firms’ write-down years. This results in a sample of 95 firms and 199 write-downs. Availability of the
Description of write-down activity
The first write-down in the sample period, equal to 3.7% of pre-write-down total assets, is recorded in April 1984. Write-downs are observed over the entire period with concentrations in December 1985 when there are 33 write-downs recorded, March 1986 with 21 write-downs, June 1986 with 20, and December 1986 with 17 write-downs. Thirty-four of the 78 sample firms have only one write-down over the four-year period, 24 have two write-downs, 14 have three write-downs, four have four, one have
Oil and gas prices, market values and book values of oil and gas firms
This section provides a descriptive analysis of the trends in oil and gas prices, the oil and gas firms’ share prices, and their book values around the sample period. Fig. 1 plots the market price of oil, the market price of gas, the median price per share of the firms in our sample, the median book value per share, and the median ‘adjusted book value’ (adjusted by adding back the amount of the ceiling test write-down). In order to facilitate comparison, share price and book value data are
Overview of timing issues
Our empirical analyses focus on the fiscal quarter in which the write-down is recorded. We examine the association between the write-down amount and: (1) contemporaneous returns, and (2) returns of the period preceding the write-down (lagged returns).
We first test for a relation between the ceiling test write-down and contemporaneous returns to determine whether including the ceiling test write-down amount in earnings results in a number that provides a better summary of the information that
Results of non-parametric analyses
The results for the analyses of the partial rank correlations between returns (contemporaneous and lagged) and the write-down amounts, conditional on earnings (contemporaneous and lagged) are summarized in Table 2. For the entire sample of 148 write-down observations, the partial correlation (A) between the write-down amounts and contemporaneous returns conditional on contemporaneous earnings is −0.157 and significant at the 0.05 level.15
Conclusions
We show that the mandatory full-cost ceiling test write-downs of assets of oil and gas firms provide value-relevant adjustments to the earnings of those firms. Specifically, the empirical analyses consistently indicate that write-downs are correlated with contemporaneous returns. However, the correlation between write-downs and lagged returns is significant and it is greater than the correlation between write-downs and contemporaneous returns. Analyses of the time-series of the oil and gas
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We thank S.P. Kothari (the editor), Dan Collins (the referee) and workshop participants at the following universities for their helpful comments: Alabama, Baruch College, Carnegie Mellon, Chicago, Iowa, Indiana, MIT, Melbourne, Monash, New South Wales, Pennsylvania and Pennsylvania State. We are grateful for the technical advice provided by Dennis Jennings and Larry Schumann from PriceWaterhouseCoopers LLP. We thank R. Carter Hill for several helpful discussions about econometric issues associated with the analyses of the data. We gratefully acknowledge financial support from the KPMG Peat Marwick Foundation.