The Effect of Accounting for Oil and Gas Reserves on the Relation between Returns and Earnings

This study examines how the choice between successful efforts and full cost methods of accounting affects the value relevance of earnings for firms in the oil and gas industry. The strength of the relation (R2) between twelve month (annual) security returns and annual earnings levels is compared to assess differences in the value relevance of earnings. Focusing on earnings levels provides insight into how this accounting choice affects the usefulness of the entire set of earnings information rather than focusing solely on the information in unexpected earnings as has been the focus in prior earnings usefulness studies (i.e. earnings response coefficient analysis). The results suggest that the strength of the returns - earnings relation is significantly greater for full cost firms than for successful efforts firms in periods of declining oil prices and reduced exploration activity. This is consistent with the hypothesis that earnings generated by accounting methods that smooth income are more value relevant than earnings generated by other methods that generate more volatile earnings.