In the oil and gas industry, uncertainty comes with the territory. Estimates of reserves and future prices and costs, valuation of unproved properties, and other calculations affecting a company's financial picture are often moving targets. Yet, in the post-Enron era, pressure continues to build for companies to "get their numbers right"-or, in the absence of "precision," to have a sound process for arriving at the numbers reported in their SEC filings and other financial disclosures. As guardians of shareholder interests, corporate boards and their audit committees have a principal role to play in meeting the heightened expectations for integrity and transparency that are so highly valued in today's corporate-governance environment. For all industries, the dramatic increase in the number of restatements during the past five years-punctuated by a 28% spike in 2004 and an expected two-fold increase in 2005-points to the powerful, and often competing, pressures affecting financial reporting today. Companies face the increasing complexity of accounting standards, management's drive to "make its numbers," and the demand by investors and regulators for integrity and transparency in financial statements. Given the complex mix of physical and financial facts and assumptions that drive financial reporting in the industry, these pressures often can have a greater impact on oil and gas companies than on businesses in other industries. According to Audit Analytics, E&P companies (as defined by those engaged in oil and gas drilling, field exploration and field services) filed a modest number of restatements in 2003 and 2004-just five and three restatements, respectively. The figure jumped dramatically in 2005, however, to 40. Of those, many involved depreciation, depletion or amortization errors, as well as financial derivatives or hedging accounting (FAS 133) issues. Estimates can involve significant subjectivity and judgment-and slight changes in calculations can have a dramatic effect on financial reports. Perhaps the most prevalent-and challenging-of these estimates are those related to reserves and derivatives. Poll results The opportunities for misstatement of financial information-whether unintentional or by design-are considerable. Companies must consider issues such as FASB 123 (accounting for share-based payment), continuing changes in accounting principles (such as the new proposed rules on business combinations) and numerous treatment alternatives under GAAP. Ensuring that the critical accounting judgments and estimates applied by management present a fair and accurate picture of the company's assets, liabilities and overall financials presents audit committees with significant challenges. Effective oversight requires, among other things: understanding key financial reporting processes, getting the right information on a timely basis, posing incisive questions to management and auditors, and setting clear expectations for transparency and quality. Many directors and audit-committee members today are fairly confident they understand management's accounting and the processes behind it; yet, a significant number may not be so confident. Based on recent surveys by KPMG's Audit Committee Institute (ACI) of directors and audit-committee members, many of those polled said they lack sufficient understanding of critical accounting policies, judgments and estimates to effectively oversee the company's financial statements and disclosures. During roundtable discussions conducted in 34 cities in the Southwest and around the U.S. during this past November and December, directors, audit-committee members and C-level executives were polled on various aspects of their oversight of financial statements and disclosures. The survey findings included the following: • A majority of roundtable participants said they were "very satisfied" (43%) or "somewhat satisfied" (41%) that the company's financial disclosures, including management's discussion and analysis (MD&A), present a clear and accurate picture of the company's finances. (Some 14% indicated that their disclosures "need improvement.") • Nearly 90% of participants said management at the company is "not likely" to inappropriately modify accounting judgments and estimates; yet, 47% believe that management at other companies is "somewhat likely" to do so. (Three percent thought that management at all companies is "very likely" to inappropriately modify judgments and estimates.) • While most participants said their audit committees are "somewhat actively engaged" (49%) or "very actively engaged" (34%) in discussing and understanding management's critical accounting policies, judgments and estimates, 14% said their audit committees are "not actively engaged." • Thirty-eight percent were "very satisfied" with the external auditor's communications regarding its consideration of the company's critical accounting policies, judgments and estimates, with an equal number "somewhat satisfied" and 22% "not satisfied." • Participants believe the greatest pressures on management to inappropriately modify accounting judgments and estimates stem from analysts' earnings estimates and forecasts (40%), incentive compensation targets (20%), and unrealistic plans and budgets (16%). When asked informally to what they attribute the increase in restatements, directors and board members at the Fall 2005 roundtables cited the complexities of accounting issues as the primary reason, with errors and earnings management being contributing factors. Others pointed to an increased focus on technical accounting "accuracy" by auditors and regulators in the current "rules-based" environment as another underlying pressure. Oversight of disclosures Under Sarbanes-Oxley (section 204) the external auditor is required to review with the audit committee all critical accounting policies and practices used by the issuer, GAAP alternative treatments discussed with management, the ramification of each treatment, and the treatment preferred by the audit firm. In addition, New York Stock Exchange (NYSE) listing standards (Sec. 303A.07(c)) require the audit committee to review major issues and changes regarding accounting principles and financial-statement presentations as well as analyses prepared by management or independent auditors regarding significant issues and judgments made in connection with the presentation of financial statements, including the effects of alternative GAAP methods on the financial statements. To effectively address their oversight responsibilities, audit committees should have a sufficient understanding of: • The processes used by management to make and modify critical accounting decisions, particularly when they materially affect the financial statements, • The pressures that may encourage management to engage in earnings management, particularly compensation-related incentives, • The various earnings-management "opportunities" and potential GAAP "loopholes," and • "Red flags" that may indicate earnings-management activities. The committee also should be comfortable that management has the skills, knowledge and experience to apply critical accounting policies appropriately, but audit committee oversight should not be based solely on management's input. The views of the external auditor and internal audit as well as relevant regulatory bodies, industry organizations and independent experts are essential to help the audit committee achieve a balanced, objective and contextual picture of the company's financial statements. The focus on "earnings management"-characterized by former SEC chairman Arthur Levitt (in his now-famous "Numbers Game" speech in 1998) as practices by which "earnings reports reflect the desires of management rather than the underlying financial performance of the company"-has intensified greatly with the wave of corporate-governance reforms. Audit committees are increasingly focused on understanding the pressures that can lead to earnings management. To be sure, management may not start out with the intent of managing earnings inappropriately. But in response to internal and external pressures, management may gradually move from legitimate motives to areas of gray, to illegitimate practices. Identifying and preventing this movement toward inappropriately managed earnings-often referred to as the "treadmill effect"-depends on the diligence, vigilance and probing questions of the audit committee. Up at night? Once considered a technical formality, management's discussion and analysis (MD&A) and financial-statement footnotes are now viewed by regulators and investors alike as critical to providing a complete picture of the company's true financial condition. Indeed, the numbers alone don't always tell the full story, and technical accuracy often does not equate with transparency. MD&A is designed to provide a narrative of the company's financial statements, enhance overall financial disclosure and provide the context within which financial information may be analyzed. It also should provide information about the quality and potential variability of the company's earnings and cash flow to help investors determine whether past performance is indicative of future performance. Ultimately, a thorough and accurate MD&A should enable readers to examine and understand a company's financial performance "through the eyes of management." Working with management, auditors and the disclosure committee (if one exists), the audit committee can help ensure that MD&A and other disclosures provide a clear, accurate and understandable explanation of critical accounting issues and risks underlying the company's financial condition. In addition to asking incisive questions about management's choice of accounting policies and judgments and estimates, the audit committee should: • Insist on having sufficient time to review all SEC filings and disclosures, including earnings releases and other information that is released publicly, • Consider the consistency of assertions in MD&A and the financial statement, • Request sufficient disclosure-related analysis from management, versus a regurgitation of the financial statement, • Ask to be informed about SEC and other regulatory communications received by the company, • Consider the clarity of the disclosure language, e.g. whether it is written concisely, in plain English and in a way that most investors can understand, and • Consider the appropriateness of assumptions as well as the "economics" of critical accounting decisions and their materiality. Active engagement The expectation of investors and regulators for quality, accuracy and transparency demands that audit committees be actively engaged with management and auditors in the financial-reporting process. This is particularly vital to effective oversight of financial reporting by oil and gas companies, given the complexity-and prevalence-of significant judgments and estimates in the industry. Regular, in-depth discussions with management and auditors about the key processes and data used to generate oil and gas reserves estimates, account for derivatives and arrive at other critical estimates and judgments driving the financial statements can help provide the audit committee with a fuller understanding of management's numbers and the basis for them. Broadly, the audit committee should also monitor the "tone at the top" and encourage management to focus on quality financial reporting and long-term financial performance, versus short-term earnings and stock price. By taking sufficient time to discuss these critical accounting issues with management and auditors and setting clear expectations with regard to financial reporting integrity, audit committees can more effectively exercise their oversight responsibilities and help ensure confidence in the company's financial statements and disclosures. Bill Kimble is KPMG's national sector leader, energy and natural resources. The views and opinions expressed here are those of the author.

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