Topic: Applying Accounting Standards

(A5.1) What is Halliburton management trying to achieve through decisions with respect to financial reporting for long-term projects?

(A5.2) What accounting standards must Halliburton consider when making its decisions?

(A5.3) Did Halliburton management meet its financial reporting objectives?

(A5.4) What knowledge, estimates, or assumptions did Halliburton accountants (and management) use in making decisions? Were their decisions appropriate?

Halliburton: Accounting for Cost Overruns and Recoveries CASE: A-187 DATE: 05/18/07 Brian Tayan prepared this case under the supervision of Professor Maureen McNichols as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 2007 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: [email protected] or write: Case Writing Office, Stanford Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –– electronic, mechanical, photocopying, recording, or otherwise –– without the permission of the Stanford Graduate School of Business. HALLIBURTON COMPANY: ACCOUNTING FOR COST OVERRUNS AND RECOVERIES INTRODUCTION In July 2002, a legal watchdog group, Judicial Watch, announced that it was suing Halliburton Company for overstating revenues during the period 1998 to 2001. The group’s contention was that Halliburton used fraudulent accounting practices to boost revenues and hide a deteriorating financial position from investors. Specifically, the lawsuit centered around the way the company recognized claims recoveries on long-term construction projects. Prior to 1998, the company’s policy was to book cost overrun expenses as soon as they occurred, but not to book claims recoveries as revenue until the repayment amount was agreed to with the client. In 1998, the company changed policies to begin estimating future recoveries and recognizing them in the same period that overrun expenses were realized. The company, which had been suffering from a recent slowdown in business and large litigation losses from asbestos lawsuits, claimed that its accounting practices were permitted under generally accepted accounting principals (GAAP). Judicial Watch, however, claimed the accounting policy inflated revenues over the four-year period by as much as $534 million. Vice President Dick Cheney, who served as CEO of the company when the accounting change was made, was named as a defendant in the lawsuit. Given the recent slew of accounting scandals in the press and public debate over corporate responsibility, many parties took a strong interest in the Halliburton case. The Securities and Exchange Commission launched its own probe, stating that Cheney was “not immune.” This document is authorized for use only by Jennifer Robinson in ACCT-6140-1,Current Trends Acct Standards.2020 Summer Sem 05/04-08/23-PT2 at Laureate Education - Walden University, 2020. Halliburton: Accounting for Cost Overruns (A) A-187 p. 2 OIL & GAS INDUSTRY Oil Supply Chain Oil and natural gas are the most heavily used energy sources for industrial production. By 2002, worldwide demand for oil was approximately 76 million barrels per day with 25 percent of demand coming from the United States. The supply of oil currently exists in natural reserves. Total worldwide reserves were estimated to be 1.03 trillion barrels. Of those reserves, 79 percent existed in OPEC countries1. Oil production was largely managed by state-run companies, whose revenues were a major source of income for local economies. These companies managed exploration and production on their lands or just offshore. Another set of large publicly owned companies managed the refining, marketing, and distribution process. The largest of these companies were Exxon Mobil, Royal Dutch/Shell Group, BP, Total Fina Elf, and Chevron Texaco—often called the “supermajor” oil companies. These companies also explored for new oil, frequently in offshore locations. The North Sea was one of the most promising locations for new oil exploration. Oil producing companies, both state-owned and publicly held, often contracted out much of the drilling process to equipment and oilfield service providers. These companies built oilrigs and drilling equipment, as well as provided services to help with production. Much of the construction work was contracted under long-term agreements. Because the process of oil location and production had so many steps, each of which required specific expertise, the oilfield equipment and services industry had several subsectors where specialty companies had carved out individual niches. Throughout much of its history, the industry had been highly fragmented. More recently, however, a handful of companies brought together a suite of construction and drilling services to form total-service providers. The largest three of these companies were Baker Hughes, Schlumberger, and Halliburton. The amount of revenue these companies earned depended directly on the amount of money the oil producers invested in exploration and production. Oil producers generally cut back on capital investments when demand for oil was weak because of an economic slowdown or when the price of oil was low from overproduction. OPEC had agreed to an acceptable range of oil prices between $22 and $28 per barrel, with a target price of $25 per barrel. However, prices had frequently fallen outside of this range, with low prices causing large losses throughout the oil industry and high prices leading to sharp increases in investment to expand production capacity. In 2002, global capital spending on exploration and production was expected to be $100 billion. 1 The Organization of the Petroleum Exporting Countries (OPEC) was founded in 1960 to regulate the production of oil in the Middle East. Member nations, who are heavily reliant upon revenues from oil production, decided that regulation of supply was necessary for price stability and, in turn, stability for their national economies. Membership has since expanded beyond Middle Eastern nations, and by 2002 included Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. This document is authorized for use only by Jennifer Robinson in ACCT-6140-1,Current Trends Acct Standards.2020 Summer Sem 05/04-08/23-PT2 at Laureate Education - Walden University, 2020. Halliburton: Accounting for Cost Overruns (A) A-187 p. 3 HALLIBURTON COMPANY Halliburton Company was one of the largest oilfield equipment and service companies in the world. The company was divided into two main divisions: Engineering & Construction and Energy Services Group. The Engineering & Construction Group provided both onshore and offshore equipment and technology for oil production. The Energy Services Group provided a wide range of products and services, including exploration services, contract drilling, drill systems and drill fluids, well recovery services, logging and data collection, onshore and offshore production facilities, and planning (Exhibits 1 and 2). Company History In 1920, Erle Halliburton founded the Halliburton Oil Well Cementing Company to provide well cementing services. With a reputation for high quality service and the continuous invention and patenting of new processes, Halliburton’s business steadily expanded, serving clients in the oil- rich lands of the southern United States. Two trends in the 1930s greatly increased the demand for oil and oilfield services: automobile production and domestic oil heating. The company also began providing drill equipment for barges in offshore oil production. In the 1940s, Halliburton increased its service offering to include data collection, drill fluids, and various well recovery services. In the 1950s, the company added more sophisticated logging services and wall cleaning services. In 1957, Erle Halliburton died, after 28 years as president of the company. The company’s growth continued after Erle Halliburton’s death. With the purchase of Brown & Roots in 1962, Halliburton was able to greatly increase its construction business, which became the company’s growth engine throughout the next two decades. After 1973, the year of the Arab oil embargo, business for the oil industry as a whole surged as oil producers searched for new reserves outside the Middle East. By the 1980s, however, the industry had built up excess production capacity, and construction revenues plunged. To shore up revenues and profits, the company increased its service offerings by acquiring dozens of specialty service providers. In 1995, Dick Cheney, former U.S. defense secretary, became CEO. For the first years under Cheney’s management, revenues and profits increased as oil producers resumed capital spending. In 1997, Halliburton purchased a major oilfield equipment manufacturer, Dresser Industries, which led to a near-doubling of Halliburton’s revenues. The next year, the company’s revenues hit an all-time high of $17.4 billion. In 2000, Cheney resigned as CEO when he was named vice presidential running mate to George W. Bush. Halliburton Today Since 1998, however, the company has faced numerous business challenges. First, after a surge in oilfield spending by the supermajors in 1996 and 1997, capital investments were greatly scaled back in the latter part of 1998 following the Asian economic crisis. Halliburton, which had net income of $454 million in 1997, recorded a loss of $15 million the next year.2 The 2 Current financial statements for Halliburton that include 1997 results on a historical basis report pro forma net income of $772 million. This figure includes net income from Dresser as if the two companies had operated together throughout 1997. Prior to the merger