Earnings Management Study
Oil & Gas Industry
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. ...view middle of the document...
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...