Copyright © 2009 by Pearson Education Canada 10S - 1 Chapter 10 Supplement Wolfson (1985) Study of Oil and Gas Limited Partnerships

Copyright © 2009 by Pearson Education Canada 10S Empirical Evidence of Incentive Problems and Their Mitigation in Oil and Gas Tax Shelter Programs Mark A. Wolfson (1985) An application of agency theory

Copyright © 2009 by Pearson Education Canada 10S - 3 The Question to be Addressed In a multi-period context, can market forces (i.e., reputation effects) eliminate shirking? –If so, no need to motivate managers by means of incentive contracts

Copyright © 2009 by Pearson Education Canada 10S - 4 Tax-Advantaged Limited Partnerships to Drill for Oil and Gas (U.S.) Principal: the limited partner, who invests and receives advantageous tax treatment Agent: the general partner/manager –Conducts drilling and on basis of drilling results decides whether or not to complete the well

Copyright © 2009 by Pearson Education Canada 10S - 5 Two Types of Drilling Exploratory –Riskiest (low probability of high payoff) Developmental –Least risky (high probability of low payoff)

Copyright © 2009 by Pearson Education Canada 10S - 6 An Incentive Contract A common sharing rule (contract) –Tangible drilling costs: must be capitalized for tax purposes –Intangible drilling costs: immediately tax deductible –Agent (manager) pays tangible costs –Principal (limited partner, investor) pays intangible costs –Let revenue from well be R –Manager gets, e.g.,.40R –Investor gets.60R

Copyright © 2009 by Pearson Education Canada 10S - 7 Information Asymmetry Manager knows expected R, investor does not This leads to incentive problems of moral hazard and possible shirking by manager –Noncompletion problem (manager shirks by not completing well)

Copyright © 2009 by Pearson Education Canada 10S - 8 The Noncompletion Problem (Well is Drilled But Not Yet Completed) A model of revenue from well: –E(R) = K(D + C) D: drilling costs. Paid by investor C: completion costs. To be paid by manager K: manager’s skill (e.g., K = 2) –Manager generates $2 in revenue for each dollar spent Manager knows E(R) and C, investor does not »Continued

Copyright © 2009 by Pearson Education Canada 10S - 9 The Noncompletion Problem (continued) From standpoint of society (and investor) –Complete well if R ≥ KC, since D is sunk From standpoint of manager –Complete well if.40R > KC Thus manager may not complete well (i.e., may shirk) when completion is in best interests of principal and society NB: Noncompletion problem greater for development wells

Copyright © 2009 by Pearson Education Canada 10S - 10 Controlling the Noncompletion Problem Direct monitoring of manager drilling effort and results (too costly) Manager establishes a reputation (multi-period) to convince principal that he/she will not shirk

Copyright © 2009 by Pearson Education Canada 10S - 11 Testing For Reputation Effects For each general partner (manager) in the sample of limited partnerships: –Expected return rating (ERR) A measure of a manager’s reputation, based on past performance Analogous to past income statements –Net return rating (NRR) Expected oil and gas finding rate. A measure of the cost to “buy in” to the manager’s partnership. Lower NRR implies higher cost to buy in, since limited partners (investors) then get lower expected return NRR analogous to a managerial labour market (i.e., measures the manager’s worth) »Continued

Copyright © 2009 by Pearson Education Canada 10S - 12 Testing For Reputation Effects (continued) Is higher reputation associated with higher cost to buy in? –Yes: Wolfson reports statistically significant evidence that higher reputation (higher ERR) associated with higher cost to buy in (lower NRR) –It appears investors are willing to accept a lower expected return the higher the manager’s reputation Conclude: reputation reduces the non- completion problem of manager shirking »Continued

Copyright © 2009 by Pearson Education Canada 10S - 13 Testing For Reputation Effects (continued) Does reputation eliminate the noncompletion problem? –No: Wolfson reports higher NRR for development wells –Development wells Average NRR for his sample = –Exploratory wells Average NRR for his sample = Thus lower price to buy into development wells »Continued

Copyright © 2009 by Pearson Education Canada 10S - 14 Testing For Reputation Effects (continued) Wells more subject to the noncompletion problem (development wells) are priced lower by investors than wells less subject to the noncompletion problem (exploratory wells) If reputation completely eliminated the noncompletion problem, the prices would be the same

Copyright © 2009 by Pearson Education Canada 10S - 15 Conclusion to Testing For Reputation Effects Conclude: reputation effects do not completely eliminate the need for an incentive contract Managerial labour market works, but not fully well

Copyright © 2009 by Pearson Education Canada 10S - 16 Implications for Accountants 2 roles for accounting information –Market forces of reputation reduce but do not eliminate manager shirking Thus compensation contracts and performance measures such as net income still needed –Net income should be informative about manager effort i.e., the ability of market forces to motivate effort is improved as accountants reduce ability of managers to shirk through higher quality reporting –Both roles benefit society