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Gas and Oil industry is one of the sectors which promise a great deal of benefit. It is also evaluated as a complex sector which blends of diversified transactions. Consequently, as its complicated nature, such a number of uncontrollable events are the result of this kind of industry. Following is the short overview of Chevron Corporation which illustrates that there are some potentially risks in assessing this entity’s financial health.
This paper provides the identification of inherent risks associating with the multinational energy giant as Chevron during its audit assessment. Particularly, this report will reflect the innate risks which impact to five key transaction cycles: Sales and collection, acquisition and payment, payroll and personnel, inventory and warehousing, capital acquisition and repayment. If many minor misstatements remain undiscovered in these cycles, the combined total could be significant (Arens, 2010). From this, analyzing these risks is also drawn as well as some recommendations are suggested with regard to mitigate related risks.
This paper is based on knowledge about gas and oil sector, resources from academic materials, financial magazines and newspaper, analytical articles.
Chevron is a giant American multinational energy entity based in San Ramon, California. It is one of the world biggest oil company with roughly 62,000 employees in 180 countries. Every aspect of oil and gas industry is optimized in Chevron business. They can be listed as explorationandproduction;refining, marketing and transport; chemicals manufacturing and sales; andpower generation. In short, its spreading operation is concluded within three main key businesses: upstream, downstream and alternative energy. These substantial business activities bring net income of $ 19.2 billion on sales and other revenues of $ 200.5 billion to Chevron Group in 2014.
Figure 1 shows revenues are made of nearly half from USA and over half from international. This reflects the fact that aggregate revenue is recognized from various countries which have different policies and standards. Thus, the level and frequent of interpretation and adjustment of reporting from subsidiaries and affiliates to the parent company is quite significant.
According to prior year’s audit, Chevron is audited with unqualified opinion by Independent Registered Public Accountant Firm (Annual Report, 2014). Nevertheless, it can be clearly seen that when big entity as Chevron operates, there obviously daily complex transactions and events would maintain the inherent risks in recording. It requires a well and thorough analysis as well as strategic testing plan to assure that all the transactions to be shown in a true and fair view.
As Ernst & Young has stated in Revised proposal for revenue from contracts with customers “There are many complex contracts in oil and gas industry and diversity currently exists in how these are accounted for”. Therefore, it is not too exaggerated to say that revenue recognition is the most risky area for auditing in Sale and Collection cycle approach. Chevron records revenue by entitlement method which means that revenue reflects each owner’s contractual share of production regardless that who actually made the sale and invoiced the volume (Chevron annual report, 2014). The imbalance between the actual sale and entitlement will be made up in a particular time and adjusted at the end by adjusting revenue or adjusting cost of sales (Accounting standard ASU 2014-09, IFRS 15). Therefore, it causes the fact that there is potential issue as at any given time, the amount of oil or gas actually sold by each owner may differ from its working interest percentage (Earns & Young, 2012). This issue can be seen in the historical case of Chevron vs Belco Petroleum Corporation (1985). Although this case helped Chevron increased its inflow by reserving its working interest.
In addition, in service contract the benefit is raised with partners will be not counted as revenue. However, it still lacks specific guidance from IFRS in determining counterparty or customer.
All above factors reflect that there bears hidden risks in recording revenue. Especially, gas and oil industry maintains the high level of diverse interpretation for revenue.
Some analysts suggest that spending on Research and Development is a way for oil and gas companies to sustain in their core businesses (Ed Crooks, 2014). It could be reasonable for Chevron to maximize their spending on R&D to increase productivity. Accordingly, it raises an important aspect in recording these costs in appropriate way.
According to Property, Plant and Equipment (PPE) accounting Policy (IASB ED6), all costs for development wells, related plant and equipment, proved mineral interests in crude oil and natural gas properties, and related asset retirement obligation (ARO) assets are capitalized. Costs also are capitalized for exploratory wells that have found crude oil and natural gas reserves. From that, it means that evaluation of costs to determine whether they are assets or expenses is quite crucial to reflect the accurate report of asset.
However, these reserves just base on the estimation of future production as long as the quantity of reserves justify its assessment with reasonable certainty of producible future (US Geological Survey and SPE Prospective Resources). Therefore, it could not deny the fact that this fact can impact to the assets and expenses accounts. This can be an inherent risk in acquisition an payment cycle as a result of estimation.
This is especially necessary for Chevron as PPE is a dominant portion of total assets, occupying 68.9% (Figure 2). Hence, it is obvious that if there is any misstatements in identify the cost of R&D, it will highly effect to the total assets recognition.
Next, the second event would properly impact to the payment cycle with the issue of tax income payment. Recently, there are some evidences to state that Chevron Group used a complex web of payment to gain tax-free interest on inter-company loans from Delaware — known as a US tax haven. It has been able to borrow about $2.5 billion at a low 1.2%, but claimed at 9%. Therefore, Chevron can dodge $258 million in Australia taxes (Taxpayers Australia Limited, 2014). It can be a reasonable doubt when the effect income tax rate from international operation in 2014 declines as double as its 2013 (Figure 3). Chevron may be liable for a $322 million payback including penalties if it executed this illegal action. Therefore, payment cycle will be effected when cash and expenses accounts are changed.
Chevron’s executive compensation program consists of four elements: Base Pay, Short-Term Incentives, Long-Term Incentives and Benefits (IAS 24). These factors consist of two portions: fixed compensation (base salary and benefits) versus variable compensation (short-term and long-term incentive grants). As Mae Lon Ding, president of Anaheim-based Personnel Systems Associates said "What is good about the current compensation plan at Chevron is when the stockholders do well, the CEO does well also," which tracks executive pay. However, the variable compensation can lead to a fraud since this can rely on many assumption and judgment to determine. There was a issue in 2012, although the chief executive officer – John Watson ‘s bonus was cut, he still received compensation of 30% more than previous year. This fact raises a concern whether the board was findings way to make it up with stock options and grants while salaries and bonus were moderated (Corey Rosen, 2012). If this is true, even though the salaries are seen to be decrease when the company runs not well but in fact they can get more with the stock options. Figure 4 shows that the top executive compensations went up by 14.02 % (Morningstar, 2014) even though the net income and revenues declined approximately 10.2%, and 8.9% respectively in 2014 (figure 5).
It can be seen that inventory occupied 15.4% of all current assets according to Chevron annual report 2014. Therefore, the error in inventory records will show the wrong reflection of current assets. Chevron’s inventories comprise cruel oil and petroleum products; chemicals; materials, supplies and other which is accumulated from multiple locations. Hence, there is a potential trend of inherent risk as the physical stocktaking procedures in all subsidiaries are impossible.
Furthermore, Chevron still applies Last-in-First-out inventory method while LIFO has been strongly opposed in the financial community and not allowed by IFRS, except for U.S. GAAP. This method can be use as a “tax loophole”. Shackelford and Sheulin (2001) have documented the tax motivated effect of LIFO. LIFO will increase the cost by applying the most current cost, thus total revenue will be lower comparing with the other methods. In addition to this, inventories of Chevron are made up from many international subsidiaries which do not used LIFO method. Therefore, it requires a conversion to LIFO when it reports in the consolidated statement. Accordingly, it needs adjustment to inventories as figure 6. Inherent risk is generally considered to be higher where a high degree of adjustment is involved.
Properly combining and disclosing transactions between subsidiaries in different countries have become increasingly complex and therefore more difficult to record properly (Arens, 2010). Chevron Corporation is not an exceptional case with its equity method. Investments in and advances to affiliates which Chevron has interest of roughly 20%-50% use equity method (Chevron, 2014). It is explained that with equity method, the balance-sheet value of the investment changes according to the net income (the profit) of the "owned" company (Cam Merritt, 2015).
Therefore, it requires a frequent adjustment according to the changes in profits of subsidiaries and affiliates (IAS 27). As a rule of thumb, where there is a higher level of adjustment, there is a higher chance of misstatement. It is especially true for Chevron while it has subsidiaries over 180 countries. In addition to this, this inherent risk is increasing when the investment‘s gain or loss from other countries convert to its functional currency. This fact can be reflected via Figure 7
All the above issues confirm that there are always inherent risks in every transaction if the company does not have a good internal control. This can lead to the material fraudulent financial reporting and misappropriation of assets and direct-effects illegal acts. The results of recent fraud survey indicate that about half of typical frauds are detected by internal control. Therefore, an entity should design and implement an adequate internal control to prevent or detect instances of fraud by encouraging an efficient and effective use of its resources, personnel.
The accurate information can be reached as ethical and moral attitude from the top management to the employees. Every individual has to obey the policies, procedures which are set by the company. Obviously, these policies have to be in accordance with the applicable laws and regulations such Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The healthy control environment is built by transparent communication, interaction between layers of employees. The responsibility of maintaining the honest and accuracy of the inputs and processing transaction belongs to every member of the organization. However, the management’s ethical value plays an important role in motivating the awareness of employees about following the code of conduct. Internal auditing is also a course of action to make the internal control more effective.
There are some control activities which are suggested in order to mitigate the impact of those above identified risks: Adequate separation of duties, Proper authorization of transactions and activities: Adequate document and records, Physical control over assets and records, Independent checks on performance.(Arens, 2010).
Figure 7: Financial Adjustments