Question

Date: September 20, 2016

Presented here is Exxon Corporation’s comments on RRA in its 1979 10-K:

The following information departs significantly from prior reporting of historical information and attempts
to portray 1978, 1979 and future activities of Exxon in oil and gas producing in a highly arbitrary fashion.
Therefore, Exxon believes it should warn that the remaining data set forth in this section, for reasons
further explained here, are not to be interpreted as necessarily representing current profitability or
amounts which Exxon will receive, or costs which will be incurred, or the way oil and gas will be produced
from the respective reserves. The arbitrary 10 percent discount rate used in the determination of the
present value of estimated future net revenues represents neither a cost of capital nor a borrowing rate,
and, additionally, does not necessarily reflect political risks. Actual future selling prices and related costs,
development costs, production schedules, reserves and their classifications, and other matters may differ
significantly from the data portrayed or assumed. The requirement to publish such information regarding
future activities is part of the SEC’s attempted development of a new method of accounting for oil and
gas producing activities called “Reserve Recognition Accounting” (RRA). RRA would depart significantly
from historical accounting practices. Exxon has taken exception to the SEC’s proposal and has indicated
the following major concerns with the concept of RRA: Financial reporting for the oil and gas producing
segment of the oil industry would include forecasts of future production rates and future investments in
an estimation of potential cash flows. Such reporting would be completely different from the historical
cost reporting of the remainder of the oil industry and of all other industries. The difficulties and
uncertainties of estimating the volumes of oil and gas reserves and their production rates appear not to
have been appropriately considered, making comparability between companies, and segments thereof,
very difficult at best. Quantification of reserves is far from a precise science. A variety of methods and
techniques are used to estimate reserves and the answers obtained are subject to wide fluctuations
because they are dependent on judgmental interpretations of geologic and reservoir data. The same is
true of estimates of future production schedules. While, in management’s judgment, the quantities
reported herein are reasonable, there is no methodology or certification process in place now, or likely to
be in place in the near future, which would permit independent verification of such volumes and rates.

The Regulations prescribe that future net revenues be determined by applying December 31, 1979, prices
and costs to the projected production schedules for Exxon’s net proved oil and gas reserves as of
December 31, 1979,. The reserves exclude probable reserves as well as reserves in the Canadian
Athabasca Oil Sands. In Exxon’s opinion, applying these arbitrary assumptions to the estimated future
production schedule for the various categories of reserves can only lead to financial reporting which is
more likely to mislead than inform. In addition to these general areas of concern, the following cautions
should be noted when reviewing the information: Care should be exercised when comparing the “Net
Revenues from Producing Oil and Gas in 1978 and 1979” with “Future Net Revenues.” The 1978 and 1979
information, in accordance with the Regulations, was determined by subtracting only Production (Lifting)
Costs from the gross revenues. Future Net Revenues, in accordance with the Regulations, were
determined by subtracting both Development Costs and Production (Lifting) Costs from the gross
revenues. Care should also be exercised when using the net revenue data for 1978, 1979 and the future
since all applicable costs have not been deducted from gross revenue. The Regulations make no provision
for deducting exploration expenses, amortization of acquisition costs (bonus payments), depreciation of
capitalized production investments, purchase costs of royalty oil and gas, income taxes, or other payments
to governments. The “Future Net Revenues” and the present value of such revenues, as computed under
the Regulations, present neither a true “future value” nor “present value” for the reasons mentioned
above in addition to the effect of excluding income taxes from the calculation. In view of Exxon’s concern
that the absence of this considerable, and in some cases major, cost from the calculation would cause the
information to be seriously misunderstood and misleading, particularly in the case of some foreign
operations, the undiscounted and present value information presented here is shown on both a beforetax
and after-tax basis.

Required: Evaluate the merits of Exxon’s criticism of RRA.

Answer 1

Merits of Exxon's Criticism of RRA:-

1) First of all, Exxon is crystal clear in its disclaimer to the users of financial statement that the information presented here is arbitrary and not to be considered as the final figures.

2) Exxon made it clear that using the  assumptions to the estimated future production schedule for the various categories of reserves can only lead to financial reporting which is more likely to mislead than inform.

3) Exxon noted that “Net Revenues From Producing Oil and Gas in 1978 and 1979” with “Future Net Revenues.” The 1978 and 1979 information, in accordance with the Regulations, was determined by subtracting only Production (Lifting) Costs from the gross revenues. Future Net Revenues, in accordance with the Regulations, were determined by subtracting both Development Costs and Production (Lifting) Costs from the gross revenues. Care should also be exercised when using the net revenue data for 1978, 1979 and the future since all applicable costs have not been deducted from gross revenue. Since, all applicable costs are not deducted from the gross revenue, the information will be likely to mislead the users and will not give proper information to the users.

4) The future net revenues and present value of such revenue does not present true value of any of the item because the Regulations make no provision for deducting exploration expenses, amortization of acquisition costs (bonus payments), depreciation of capitalized production investments, purchase costs of royalty oil and gas, income taxes, or other payments to governments.

5) Because of the above concerns, the same would cause the information to be seriously misunderstood and misleading, particularly in the case of some foreign operations, the undiscounted and present value information presented here is shown on both a before-tax and after-tax basis.