New accounting rules in Canada are looser than before, making it harder for investors in oil and gas to understand their investments, and also more of a pain for Canadian companies to raise money in the United States.
That’s the conclusion I’ve come to after interviewing industry executives and national firm-accounting consultants in the oil patch.
“Find me a company in Canada that says we were able to raise more money at a better price with IFRS (International Financial Reporting Standards),” says Craig Nieboer, CFO at Canadian Energy Services (CEU-TSX). “Find me an investor who can now say I understand this company’s financials better because of IFRS.”
“They don’t exist.”
This year, for public companies, Canada dropped its GAAP accounting system—Generally Accepted Accounting Principles—in favour of the IFRS—International Financial Reporting Standards.
During my interviews, I found the main difference between the two is that IFRS allows greater leeway for management and boards to use their own judgement in how to present and explain company financials.
In an era where the core financial sector of the western world is under huge scrutiny for lending and accounting practises, I found this odd.
“There are now more choices, so consistency between companies is impaired,” says Nieboer. “For us, we have fewer lines in our statements so investors have to dig more in the notes and MD&A.”
“Has it improved better information to investors? At best no, and potentially it’s worse.”
Kevin Nielsen is a partner at Deloitte in Calgary, and works with a lot of energy companies. I asked him to explain the switch to IFRS, and how it impacts both investors and management teams in the Canadian oil patch.
“IFRS is more “principles” based and therefore more judgement is required (by management in how to produce their financials),” he said in a phone interview. “Previously, GAAP was more rules based. So as a result companies need to disclose in their financials more information on how their accounting policy choices are determined.
He said the new IFRS rules most benefit major international firms who operate in different countries and have different accounting practises.
For junior oil and gas companies in Calgary that have domestic assets, it obviously is not going to have the same benefit.
Stuart Symon, Chief Financial Officer at intermediate producer Angle Energy (NGL-TSX) in Calgary, says investors will have to do more digging to really understand a company with IFRS.
“You have to go to the notes in the financial statements to get the full story; read the disclosures. What’s happening behind the scenes? Is IFRS adding value to this equation? IFRS requires more disclosure that doesn’t necessarily provide incremental benefits for the reader.”
There are now more disclosures with IFRS. Management teams are trying to put the best information out there that’s the most relevant. But does the investor have time to read and understand it all? Or does all that information drive investors back to the basics – the management team, drilling results and reserve report?
The Canadian accounting standard setters decided to move to IFRS as the majority of the world is doing so — even though Canada’s largest trading partner and largest source of foreign capital, the U.S., still uses GAAP, and there are no indications that they are moving to IFRS anytime soon.
Most changes that IFRS makes to oil and gas accounting happens below the cash flow line. And being as most energy investors use cash flow as a primary valuation method, the IFRS changes should not have a major effect on corporate transactions, says Angle Energy’s Symon.
“We are not judged as much on earnings as we are on cash flow and recycle ratio. (Recycle ratio= field netback (profit) per barrel divided by finding cost per barrel–KS.) So how much will this change how investors look at junior oil and gas companies? If you have an earnings emphasis, IFRS will change things, but oil and gas valuations do not tend to be as influenced by earnings.”
Here are some of the main changes that Nielsen, Symon and Nieboer say investors will notice in the junior oil and gas accounting under IFRS vs. GAAP:
- More impairments, or writedowns—and more frequent impairments in IFRS. Asset values are obviously tied to commodity prices in this sector, so as prices move, the industry will not only see more writedowns, but lots of reversals in impairments. “A writedown used to be viewed as negative in the market as it was rare,” says Symon. “People are going to have to get more used to impairments and reversals giving rise to earnings volatility.” The intent is to carry assets on the financial statements at a more current or real time market valuation.
- For service companies, one of downsides of IFRS is you don’t get true gross margin anymore, says Nieboer, as non cash items like stock based compensation and amortization are included as cost of goods sold. “Gross margin is now artificially lower,” he says.
- Many more costs must be expensed, not capitalized, such as transaction costs when doing a deal, and even dry holes must be expensed, whereas before they could be capitalized. For the small junior producer, a couple misses can mean a very bad income statement.
- All of the above points means there will be more volatility in earnings. But few junior oil and gas companies have earnings.
No accounting system is a replacement for management integrity. But with fewer lines in the financial statements being replaced by more detailed notes—facts being replaced with explanations—investors will now more than ever be on their own trying to determine what’s being said, and what is not.