Oil and Gas Equipment & Services

Oil and Gas Equipment & Services Module 11: Adjusting Accounting Information Jeff Ritter

Agenda Review Module 8, 9, and 10 Adjustment A: Inventory Adjustment B: Operating Lease Adjustment C: Share Based Compensation

World’s Largest Oil Field Company

Review Module 8 • Primary Benefit of Abnormal Enterprise Growth Model • Less reliance on “continuing value” • Only 23.47% based on continuing value compared to 79.62% and 44.81% • Why is this a benefit? • Prefer shorter horizon because the farther we forecast into the future, the less confidence we have in our estimates.

Review Module 9 Sensitivity Analysis Market Value of HAL Enterprise: $48,795 Red = Sell Green = Buy

Module 10: Incorporating Additional Information “No longer limited to the information contained on the face of the financial statements”

Expanded Financial Statements Red=Eliminated from the financial statements and not included in calculations Green=Added to financial statements and included in calculations

Expanded Financial Statements Red=Eliminated from the financial statements or just shown as explanation and not included in calculations Green=Added to financial statements and included in calculations

Module 11: Adjusting Accounting information “Understand the effect of the accounting choices and whether adjustments are necessary ”

Effect of Accounting Method Choices on Valuation • Most accounting choices result in a shifting of income between periods • Life of a project depreciation examples • Past Accounting data used as a basis in forecasting • Income shifting or change in accounting method may cause a reduction in comparability which may lead forecasts of enterprise profitability that aren’t appropriate for the valuation.

Accounting Method Choices Accounting method choices may affect realized EPAT and NEA Adjustment A: Inventory Method Adjustment B: Operating Leases Adjustment D: Share Based Compensation

Adjustment A: Inventory Primarily uses average cost method just as the comparables within the industry. Information provided to separate the specific amount of LIFO vs Average Cost in the 10-K. “Some domestic manufacturing and field service finished products and parts inventories for drill bits, completion products, and bulk materials are recorded using the last-in, first-out method.” Halliburton 10-K

Adjustment A: Inventory “If the average cost method had been used, total inventories would have been $35 million higher than reported at December 31, 2013 and $41 million higher than reported at December 31, 2012.” Halliburton 10-K 2013

Recalculation of NEA, EPAT, EATO, EPM • Insignificant change in EATO (.0031) and EPM 7.971% to 7.958%

Accounting for the Adjustment Taxes payable: 35 X .37= $12.95 Tax expense: 6 X .37 = $2.22

Adjustment B: Operating Leases • Off balance sheet financing • Consequences of classifying a lease as operating: • Lease asset not reported on the balance sheet • EATO Higher because NEA is lower and revenues are unaffected • Lease liability is not reported on the balance sheet • Measure of financial leverage (such as the total liabilities to equity ratio) are improved. This results in better credit ratings, thus lower interest rates on borrowed funds. This doesn’t impact the valuation but the conversion of enterprise to equity value made in Module 9.

Adjustment B: Operating Leases • Consequences of classifying a lease as operating: • Without adjustment (capitalization of operating leases), return on NEA (RNEA) appears higher, which also improves the perceived quality of the company’s return on equity. • Rent expense reported for an operating lease is less than the depreciation and interest expense reported for a capital lease.

Adjustment B: Operating Leases Steps • Determine the discount rate • Compute the present value of future lease payments • Adjust the balance sheet to include the present value from step 2 as both a lease asset and lease liability. • Adjust the income statement to include depreciation and interest in lieu of rent expense

Adjustment B: Operating Leases 5.02% If the company is growing and continually adding assets financed with operating lease, the level of net income will continue to remain higher during the growth period. Step 1: No capital leases were discussed in the Halliburton 10-K to estimate the implied interest rate to use in capitalizing the operating leases. Long term weighted average interest rate from module 6.

Adjustment B: Operating Leases Total includes 2014 to Thereafter

Adjustment B: Operating Leases Step 2: * Adjust NEA upward by $820: Included in Enterprise Assets (PP&E) *Assuming payments continue at 2018 amount

Adjustment B: Operating Leases Step 3 $820 • Adjust NEA upward by $820: Included in Enterprise Assets (PP&E) • Financing Liabilities increased $820 as a result of the implied borrowing • Current portion : $241 = $282-$820*.0502 • Long term portion: $579 = $820-$241

Adjustment B: Operating Leases Weighted Average Interest Rate $820 5.02% $41 Operating Lease Payment Interest Expense $287 $246 $41 Remove the $287 from SG&A with the classifications above Interest Expense PV Depreciation Expense

Adjustment B: Operating Leases • EPAT Increase: (287-246)*(1-.37)= $26 • Remove $287 rent of expense from EPAT and add $246 of depreciation expense • Step 4: • Capitalizing operating leases affects EPAT via the addition of depreciation and the removal of operating lease payments which were typically accounted for as a rent expense • Assume principal payment is equal to the omitted depreciation

Adjustment C: Special Purpose Entity I did not identify any disclosures that indicate any details regarding special purpose entity • Allows companies to structure projects or transactions with a number of financial advantages. • Cost of debt capital: Reduce business risk and bankruptcy risk

Adjustment D: Share Based Compensation • “Measuring the liability that is created over time and the realization of the additional expense at exercise…” • Employee stock options (ESO) • Compensate employees and to better align the interests of employees and shareholders. • Why do we need to adjust for share based compensation? • Differing degree to which companies utilize stock options creates lack of comparability • Goal of adjustment

Process to capture the ESO Liability Compute the value of options exercisable at beginning of year using beginning of year share price Compute the value of options exercisable at beginning of year using end of the year share price Estimate the value of ESOs exercised during the current year using an estimate of the average share price over the year. Estimate the value of ESOs cancelled during the current year an estimate of the average share price over the year price Compute the value of options exercisable at the end of the year using end of the year share price Compute an estimate of additional share based compensation from information computed in the prior steps Adjust NFL, CSE, EPAT, and FEAT using information computed

Note 11 2013 2012

$35.71 Jan 1, 2013: $35.71 Dec 31, 2013: $50.75

Step 1 Compute the value of options exercisable at beginning of year using beginning of year share price • This is beginning (prior year) ESO overhang, the liability for share-based compensation, which is part of NFL we need to recognize

Step 2 • Compute the value of options exercisable at beginning of year using end of the year share price • This an as-if amount that allows us to determine the change in the beginning liability that would be caused by the change in market prices. This change is an element of FEAT.

Step 3 • Estimate the value of ESOs exercised during the current year using an estimate of the average share price over the year. • Disclosures in the financial statements provide the average exercise price which we compare to average share price to estimate the value of ESOs exercised We could refine this if we know when the ESOs were exercised

Step 4 • Estimate the value of ESOs cancelled during the current year an estimate of the average share price over the year price • Similar to ESOs exercised, disclosures in the financial statements provide the average exercise price which we compare to the average share price to estimate the value of ESOs cancelled

Step 5 • Compute the value of options exercisable at the end of the year using end of the year share price • This is ending (current year) ESO overhang which is a part of NFL we need to recognize

Step 6 • Compute an estimate of additional share based compensation from information computed in the prior steps • The computation of additional compensation using the results of prior steps 5. Value of options exercisable at end of year -2. Value of options exercisable at beginning of year at end of year prices +3. Value of exercisable options +4. Value of cancelled options =6. Share based compensation Effect of change in exercisable options Effect of exercising and cancellation

Step 7 Adjust NFL, CSE, EPAT, and FEAT using information computed (B) (A) (A): Expense due to change in market price (B): Expense due to exercise and cancellation

Conclusions/Issues Restricted stock: Search for disclosures within the 10-K to determine if adjustments are required Additional discussion with group members regarding other accounting methods within our 10-K’s that may require adjustment Information obtained in this module and the prior module will be used for “full-information” forecasting in the next module. We must consider the accounting quality and whether adjustments are necessary

Any Questions?

Oil and Gas Equipment & Services