Abstract
This study examines the effect of the firm's level of financial risk on management's preference for full-cost or successful-efforts accounting in the oil and gas industry. Agency theory predicts that firms with increasing levels of financial risk have an incentive to switch to an accounting method which tends to increase net tangible assets and which creates more stable earnings in order to avoid technical default on loan covenants. Therefore, it is expected that successful-efforts firms with increasing levels of financial risk will tend to switch to use the full-cost accounting method. Past studies have used leverage as a surrogate for financial risk, but it is argued in this study that leverage is not necessarily a good surrogate in the oil and gas industry. Instead, a variable, debt beta, is developed which represents a market assessment of financial risk. An informationally efficient market considers other factors besides leverage in assessing financial risk, and these factors are reflected in the debt beta. The empirical results indicate that firms switching to the full-cost accounting method experience an increase in financial risk prior to the change, while firms changing to the successful-efforts method have stable financial risk. Unlike previous studies that used leverage variables as surrogates for financial risk level of full-cost firms is greater than that of successful-efforts firms. Nor can it be generally concluded that the financial risk level of nonchange firms change over time. More importantly, the results of this study indicate that the debt beta does not always behave in the same manner as leverage variables. These results provide evidence that leverage may not be a good surrogate for financial risk in the oil and gas industry.
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