TIP OF THE MONTH
	Are you really ready for Sarbanes-Oxley? During a time of increased scrutiny of financial information and the introduction of the Sarbanes-Oxley Act (SOA), directors and management of companies have become significantly more involved in understanding and challenging existing financial reporting practices and processes. Considering the pervasive effect that reserve quantities have on financial information reported by exploration and production companies and its use as a measure of success, it is expected that the directors and management will also become more involved in the reserve reporting process. Under Section 404 of the SOA, companies will be required to assess the effectiveness of internal controls related to financial reporting and provide a report to that effect. The independent auditor will be required to attest to and report on management’s assertion of effectiveness. Companies should be examining the reserve reporting processes as part of their compliance with the requirements of Section 404. Since the determination of reserve volumes is critical to financial reporting in an oil and gas company, the internal controls surrounding the reserves evaluation process should be given substantive attention. To comply with the requirements of Section 404, reserve engineers will need to be directly involved in the process of documenting controls surrounding the reserves evaluation process. Reserve engineers, along with financial management personnel, will need to: Consider what controls are in place to ensure the inputs used in the reserve evaluation process are complete and accurate, Compare these controls to an appropriate internal control framework, Ensure that the company uses appropriate reserve definitions as provided by the SEC, Evaluate information technology risks inherent in the process, Consider the appropriateness and adequacy of duty segregation and management review, and Conduct appropriate tests of control, design, and operating effectiveness to support management’s assessment of internal control. The expectations of audit committee members have increased significantly over the last several years. More time is being spent at the director level discussing and scrutinizing companies’ accounting policies and practices. As a result, the checks and balances in the audit process have been positively reinforced and a greater sense of accountability is shared between the directors, management, and the independent auditor. Considering that reserves are the most significant economic resource an exploration and development company has and that the disclosures made in public filings may offer important predictive value in evaluating a company’s performance, it is expected that director and management involvement in the reserves evaluation process will increase. Reserve information will need the same kind of attention that financial information is given. Directors may consider establishing a “reserve committee” and how it may mirror audit committee mandates. By drawing an analogy to an audit committee, a reserve committee would: Meet regularly with senior technical management of the company and external reserve evaluators Understand the reserve estimation process and areas where: Key judgments and estimates have been made Disagreements with or between management occurred Difficulties in the process existed Consider the internal controls surrounding the preparation of reserve estimates Review and discuss reserves disclosures and presentation in the company’s SEC filings Consider the independence of external reserve evaluators This analogy is not intended to be prescriptive; however, directors and management of exploration and production companies will ultimately need to satisfy themselves that appropriate diligence has been applied in the reserve reporting process and that they understand where key judgments should not be viewed as a “black box” domain of technical personnel. My concern is that the financial auditors are very aware of what happened to Arthur Anderson, and with Sarbanes-Oxley as an excuse, may come out looking for reasons to find companies not in compliance this coming year-end. Public companies should give serious consideration about upcoming financial audits and year-end reserve reporting and make every effort to implement immediately some or all of the above mentioned practices to improve the likelihood of being found in compliance. Back to September 2004 Newsletter
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