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Accounting Matters

Sigma Investment Counselors

January 14, 2016

Anyone that has actually waded through all of the footnotes that accompany public company financial statements should be aware that the accounting treatment for certain portions are complex and not as uniform as one might have thought.  In assessing an investment opportunity it is important to understand the ramifications of the applicable accounting standards and how they are treated by the company in question and its competitors.

Investors in the U.S. shale industry are about to see the effect of an accounting rule that they may not have been fully familiar with.

In 2009 the SEC allowed itself to be persuaded to adopt accounting provisions that permitted the fracking industry to claim reserves from wells that wouldn’t be drilled for years.  Inventories almost doubled and investors jumped in, enticed by the potential for these “reserves”.

But the new provisions included a potential offset.  They require that undrilled wells be profitable at a price determined by a SEC formula, and they must be drilled within five years.

The meter has been running and the five year window is about to run out.  New wells that could be drilled profitably at $95 a barrel, the SEC formula price for 2014, don’t pay currently.  Oil and gas prices are down and a substantial volume of shale drillers’ reserves will be removed from balance sheets, probably when companies file their 2015 financial statements.

Some of the wells may never be drilled, while others could return to inventories if prices rise.  It should be noted that the reserves in question won’t actually disappear, but will no longer be counted as an asset on the owner’s financial statements.

The foregoing represents only one example of the finer points of accounting.  Investors should be sure that they fully understand the implications of accounting in assessing the potential for prospective investments.  This may be an area where working with financial advisors could be rewarding.

Note:  The foregoing references recognized, acceptable accounting practices.  Fraudulent accounting, such as employed by Mr. Madoff, is another matter.

All comments and suggestions are welcome.

Walter J. Kirchberger, CFA®

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