There are four governance concerns that have special significance to the oil and gas industry: the illusion of precision in financial reporting, enterprise risk, executive compensation and succession planning. The illusion of precision in financial reporting. One of the most dangerous things permeating capital markets today is the implication or expectation of precision in financial reporting-what The Economist referred to as "the brittle illusion of exactitude." Pretending that the best prepared financial statements of complex companies present anything more than reasonable estimates or approximations of operating results and financial position can lead to disastrous decisions by management and investors. It is vitally important that directors not fall prey to this myth of accuracy. Because of accounting's dependence on estimates, real precision in financial results and projections is simply impossible to provide. Financial statements are inherently imprecise. Consequently, management teams, directors, and investors should not rely on precise determinations of earnings-or even worse, projected earnings-for close-call decisions. For example, directors should be skeptical of a capital expenditure decision based on a projected return only marginally higher than the company's calculation of cost of capital. Nor should one buy or sell a company's shares because reported results were 1% or 2% higher or lower than management's guidance or analysts' estimates-much less a penny a share. The gun just doesn't shoot that straight. Or as the 103rd American Assembly's report, "The Future of the Accounting Profession," states much more eloquently, "The truth of the matter is unpalatable to some, but unavoidable: no matter how carefully financial statements may be prepared and no matter how competent the auditors, neither the financial statistics nor the underlying transactions that create those figures are as 'hard and fast' as the public has presumed them to be." This illusion of precision is as pervasive as it is ridiculous. A recent Wall Street Journal article reported on the difficulties of accounting for pensions and other post-retirement benefits in the wake of Securities and Exchange Commission (SEC) announcements that they are looking into these practices. Accounting for these issues includes estimates of long-term, return-on-pension assets, selecting an appropriate discount rate, life expectations and estimates of future increases in healthcare costs-among other things. Using two companies as examples, The Wall Street Journal noted, "In 2002, [a company] assumed its pension assets would return 10%, while they actually lost 5.2%. On the other hand, in 2003 [another company] lowered its expected return to 9%, which produced expected returns of $6.4 billion, while the actual returns were $13.5 billion." Further on, it refers to a decision by one of the companies to lower its discount rate used in the pension calculation from 6.75% to 6%. The Journal reported, "The decline in the discount rate boosted the liabilities...by billions of dollars." And speaking of one company's assumption about the future inflation rate in health care costs, the Journal added that according to the company's filings, "a one percentage point increase will boost liabilities by $7.6 billion." So what, then, is the "right" or "accurate" or "true and fair" pension or post-retirement benefit expense for such a company? Let's be serious. The best that can be offered is a very rough estimate. Closer to home, the oil and gas industry's financial statements are incredibly dependent on a collection of estimates and approximations that are in no way precise. Would one buy or sell Shell Oil shares on the basis of its GAAP-based/SEC-based "proven reserves"-even appropriately applied? What are the oil deposits in the Kashagan Field that Shell removed from its "proven reserves" ultimately worth? How many barrels of energy will the company eventually sell from the field? What will happen to global demand for oil and gas? What will energy prices be in the future? What technology will be developed to enhance the efficiency of recovery? What alternative energy sources will emerge? Will environmentalists allow the construction of regasification plants in the United States? What political and security risks will be encountered and how will they be resolved? As everyone in the industry knows, any realistic determination of the value of Shell's Kashagan interests would have to include assumptions about the answer to these and other questions. Given all these imponderables, how accurate can that determination of value be? The corporate governance implication here is that directors must understand the directional and approximate nature of the financial information they receive and provide to their investors. They must not be deceived by the "brittle illusion of exactitude" and must seek the broadest input and ultimately look to the fundamental success factors for the business when facing critical decisions. Directors also have a responsibility to encourage management and investors to focus on the fundamentals of the business and the industry, rather than marginal changes in rough approximations of operating results such as earnings per share. Many people are responsible for this "brittle illusion of exactitude" that misleads the investing public. Financial management in companies and the accounting and auditing profession have oversold their product-whether intentionally or not-and they have paid a price for their zeal. The SEC-unintentionally I'm sure-has reinforced this illusion with unrealistic approaches to materiality, such as Staff Accounting Bulletin 99 and the discussions around it. Recently, The New York Times published a story about a settlement of an enforcement action against one of the Big 4 accounting firms. There were some amazing comments about the materiality of the amounts in question. An assistant regional director of enforcement with the SEC said that the standard is "what is important to investors." One might ask how this is known before the fact? The story continues that "for several years, the SEC has tried to make clear that such a criteria (for traditional materiality concepts) is not enough when a miss of even a penny a share in expected quarterly earning can cause a company's share price to plunge." This is correct. It reflects the SEC's position articulated prior of the release of Staff Accounting Bulletin 99-and it is an impossible standard to meet. Modern financial statements are a collection of sophisticated estimates, approximations, and guesses-particularly in the oil and gas industry. And the SEC does not protect investors when it implies otherwise-whether by requiring relatively small restatements or through public declarations about accuracy within a penny per share. To make matters worse, the FASB is moving steadily toward comprehensive "fair value" accounting. That means by definition that even more of reported amounts will be sophisticated estimates or approximations. Unless this movement is accompanied by a general public understanding of the directional accuracy of reported information, this will guarantee a continuation of the cycle of investor disillusionment as financial statements, auditors, and company management and directors fail to live up to an impossible expectation of precision. Enterprise risk. This is a topic receiving a lot of attention from boards of directors as it becomes clear that many corporate failures have occurred from risks not normally addressed by the traditional risk-management functions within businesses. Management and boards have responded by attempting to identify all of the potential risks faced by an enterprise and managing those risks-usually through a combination of centralized and individual business unit responsibilities. My sense is that the industry does a pretty good job of deciding how it manages the risks it identifies. The real challenge is in recognizing all the risks it faces. Surely, oil and gas must be the riskiest industry in the world-country risk, litigation, geological, operational, financial, trading, reputation, safety, environmental, economic, political, security, weather, and the list goes on and on. A special concern is extended enterprise risks-the risks incurred through relationships with other organizations. This is not an industry that should ever feel comfortable about risk. But directors of an oil and gas company should regularly satisfy themselves that the company has in place a reasonable system to identify and manage the risks it faces-including extended enterprise risks-and must periodically assess the effectiveness of the system. Excessive executive compensation has been one of the biggest criticisms faced by boards of directors in the wake of recent business scandals. In fact, the whole outcry about expensing stock options may be just another way of protesting what many view as out-of-control executive compensation. Directors are being held responsible-and rightly so. These problems may become particularly acute in the oil and gas industry. Many of the largest companies on earth are in this industry. It is not surprising that some of the largest and most complex businesses in the world also have extremely well-compensated management teams. That alone would not draw much fire. But many of these companies must do business in parts of the world that are not very popular right now with Americans. And while that may not be a rational reaction, it is part of the problem. Finally, many of the businesses in the industry will be extraordinarily profitable in 2004 and 2005 in large part because of very high prices, ultimately paid by consumers as energy costs. This profitability is reflected in unusual run-ups in share prices. Hence, many "performance based" compensation plans will produce extraordinary compensation for executives this year. And this compensation will be viewed by critics as unusual and undeserved profiteering, capitalizing on the hardships of fellow citizens. Unfair? Untrue? Of course, but don't count on that to produce sympathy. What does a board of directors do? They face Solomon's challenge of being fair to everyone. Successful leadership and management of huge, complex, risky enterprises should be appropriately rewarded. But the spike in energy prices is not really a function of management and leadership, so some judgment and moderation must be employed. The first suggestion would be to kill all the trivial perks. They comprise 1% of the value and 80% of the headaches in executive compensation. Other emerging trends are clear. Stock options are declining as a percentage of executive pay. Restricted stock with some performance criteria for vesting seems to be increasing in popularity. Good old cash-in base salaries and bonuses-seems to be making a comeback. Big severance packages and post-retirement perks are almost radioactive. Many employment contracts are being renegotiated or eliminated altogether. Working together, boards and management can arrive at answers that are fair for everyone, but the process needs to be active right now, and both managers and directors need to address this as a serious issue. Otherwise the industry could be "demonized," and what began as a reasonable correction of some abusive behavior by a few, could become a popular persecution of all. Succession planning. This is a governance concern that applies to all industries, but is particularly important in oil and gas because of the size and complexity of companies and the difficulty of successfully transplanting a chief executive from another industry. A prudent succession planning process must be deep and wide. It must anticipate that some of the best candidates will be attracted away to other organizations at exactly the worst possible time. It must anticipate that some candidates will not develop as anticipated. All of this requires a deep bench, a management team willing to work hard at development, and a board willing to invest the necessary time in getting to know the potential players. Management and directors must constantly reassess the quality of the pipeline and be willing to recruit outside for high-potential talent at every level if necessary. And the board should have a contingency plan for immediate replacement of an incapacitated CEO or key executive. The board should also have written authorization for access to hospital information if an executive is ill or injured. The Boy Scout motto-be prepared-is great advice where succession planning is concerned. "The best of times" certainly describes the oil and gas industry at this moment. Earnings and cash flow are amazing. And yet high prices and the essential nature of oil and gas make the industry a target for political and terrorist attacks. Directors and management have special responsibilities in times like these to act prudently. Being careful not to imply precision that doesn't exist in financial statements, providing superior systems to identify and manage enterprise risk, determining reasonable and appropriate executive compensation, and giving serious attention to succession planning constitute big steps toward assuring that the best of times don't turn into the worst. M James E. Copeland Jr. retired as chief executive officer of Deloitte Touche Tohmatsu in 2003. He currently serves on the boards of ConocoPhillips, Coca-Cola Enterprises and Equifax, and is a senior fellow for corporate governance with the U.S. Chamber of Commerce and a global scholar at Georgia State University's Robinson School of Business.

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