Earnings quality of the successful efforts and full cost accounting methods in the oil and gas industry
Lugemwa, Michael Mayanja
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From time to time over the last decades, the issue of accounting for exploration and production activities has been politically charged and hotly debated in the US and internationally. While there have been numerous empirical studies on this issue, the question related to which accounting method – successful efforts (SE) or full cost (FC) – provides investors and other users with more informative numbers or superior earnings quality and thus should be recommended for use by all upstream oil and gas firms, is still unresolved. The main difference between the FC and SE historical cost accounting methods lies in the treatment of costs of unsuccessful exploration activities, where such costs are capitalised under the FC method and expensed under the SE method. The International Accounting Standards Board (IASB), Financial Accounting Standards Board (FASB) and the Securities Exchange Commission (SEC), are still undecided on which accounting method to mandate for use by all upstream oil and gas companies so that the global investment community can be served better. This thesis examines the earnings quality of two alternative accounting methods, SE and FC, used by upstream oil and gas firms in the US, with an aim of ascertaining which, if any, of the two methods provides superior earnings quality. Since there are different definitions of earnings quality, various measures of earnings quality have been used commonly in accounting research. However, in this study, seven measures of earnings quality are used to estimate the quality of earnings for SE and FC firms and form the hypotheses for the study. These include accruals quality, persistence, predictability, smoothness, value relevance, timeliness and conservatism. The study relied upon a longitudinal design to evaluate the issue of earnings quality of SE and FC firms, with the unit of analysis being at firm level, and the sample consisting of 84 US upstream oil and gas firms (43 SE firms and 41 FC firms), with data for the years 2007-2015. The required data for the empirical study were extracted from the firms’ financial statements, which were downloaded from the Osiris Financial Database. A comparative analysis approach was adapted in the data analysis and interpretation of the results, since this research sought to compare two alternative accounting methods. Microsoft Excel was used to compute the relevant research variables required for each earnings-quality measure and to generate graphs and tables, while the Statistical Package for the Social Sciences (SPSS) was used to generate the descriptive statistics, regression and correlation analysis, and performing hypothesis and significance tests, among others. The results of this thesis indicate that SE firms have higher earnings quality than FC firms, based on earnings predictability, persistence, smoothness, accruals quality and timeliness. In all these cases except for smoothness, the difference between the earnings quality for SE and FC firms was statistically significant. However, based on value relevance and conservatism, FC firms have superior earnings quality than SE firms, although the difference in the earnings quality was not statistically significant for most years studied. Overall, since the results are significant for four out of the seven hypotheses tested, this study concludes that the SE method of accounting provides earnings quality superior to the FC method. The contributions of this thesis are various, including, but not limited to addressing the ongoing debate about whether the SE or FC accounting method provides investors with numbers that are more informative or higher earnings quality. This thesis is extensive, as it looked at nine years of data of 84 firms and considered seven different measures of earnings quality that have been widely used in accounting research. Based on the literature consulted, it is also a much more recent study compared to previous research on this topic. Although this study was conducted on upstream oil and gas companies in the US, the results of the research are very relevant internationally, since most upstream oil and gas companies globally have adopted the accounting methods and practices used in the US. This study also provides an international comparison of the US GAAP with the UK GAAP and IFRS, specifically in accounting for extractive activities. Lastly, this study recommends that the IASB and the FASB undertake a joint project with the objective of the team coming up with a single method of accounting for the extractives industry.