Profits are the measure of financial return for company activities. In the FRS system, profits are expressed in terms of net income, operating income, and contribution to net income. The first term applies only to the consolidated company profits, and represents income after the provision for income tax expense. Operating income applies both to the segments and to the consolidated company and is the net of operating revenues and operating expenses. Excluded from this figure are such items as income taxes, and interest income and expense which are not allocated to the segments because they are "corporate level" items for FRS system purposes. (This is explained more fully in the Accounting Practices section of this appendix.) Contribution to net income is meant to be the equivalent of net income for individual segments. The term net income is not used for individual segments since several corporate level items are not allocated to the segment level.

"Cash flow from operations" is presented for the consolidated company and generally follows the indirect or reconciliation method of reporting cash flow from operations allowed by Statement of Financial Accounting Standards No. 95. The indirect method adjusts net income to remove the effects of changes in receivables, payables, and inventory during the year. The indirect method adjusts for the effects of depreciation, depletion, and amortization, gains or losses on disposition of property, plant, and equipment, and other items. "Cash flow from operations" represents the cash effects of producing and delivering the company's products and services. This presentation is useful in analyzing the ability to generate future positive cash flow, adequacy of cash flow in relation to current obligations, and the relationship of net income to cash flow.

Accumulated investment is expressed by (1) total assets, (2) net property, plant, and equipment (PP&E), (3) investments and advances to unconsolidated affiliates, and (4) net investment in place.

Total assets is used in the context of the consolidated company figures, and is the total of the left-hand, or asset side, of the balance sheet.

Net PP&E is frequently used as a measure of resources committed by an enterprise to an industry or segment. In the energy industry, net PP&E accounts for the bulk of the consolidated assets.

Investments and advances to unconsolidated affiliates is of interest because many energy companies extend

the range of their activities through subsidiaries of which they own less than 50 percent.

Finally, net investment in place is the total of: (1) net PP&E and (2) investments and advances to unconsolidated affiliates.

Annual new investment is the measure of newly committed resources during any given year. In the FRS system, this is expressed in terms of: (1) additions to PP&E; (2) current capitalized exploration and development (E&D) expenditures; (3) current expenditures on E&D; (4) additions to investment in unconsolidated affiliates; and (5) additions to net investment in place. The key words are: current, which means simply a current commitment of resources; and capitalized, which refers to expenditures which are classified as an addition to the PP&E account in the balance sheet rather than as an expense of the current year in the income statement. Being capitalized indicates that the expenditure benefits future years and will be amortized to expense in the years benefitted. Being expensed means the benefit is to the current year and, therefore, the item should be shown as an expense of generating that year's revenues. The capitalization concept is at the heart of the difference between the successful efforts versus full cost accounting methods (discussed in the Accounting Practices section of this appendix.). Therefore, in the FRS system, total expenditures that are both expensed and capitalized are used as a measure of activity in order to standardize the measurement of resources invested.

Foreign Reserve Interests

This category includes all three types of foreign reserves collected on the FRS form: (1) net ownership interest reserve; (2) proportionate interest in investee reserves and (3) foreign access reserves. These three foreign categories are added together for purposes of comparison with U.S. net working interest reserves because of the different nature of company interests in foreign production as compared to U.S. production.

Foreign petroleum reserve statistics are not strictly comparable to U.S. petroleum reserves because of the more complex and varying arrangements whereby U.S. companies obtain foreign crude oil. In addition, such arrangements have been known to be changed suddenly by those governments, thereby imposing degree of uncertainty about what a reporting company can describe as their equity reserves. Foreign reserve statistics may be used as an indicator of the rate and magnitude of industry activity, but the fact that their

Nontraceables and Eliminations

One of the objectives of the FRS system is to allow economic and financial analysis of the energy industry to be performed by function. These functions, referred to in the FRS system as segments, are presented as separate entities with their own income statements. They reflect sales and purchases not only to and from unaffiliated parties, but also to and from other segments. Because the segments are not separate entities, but are part of an integrated firm, two special classifications are defined which allow reconciliation of consolidated company figures with those of the segments.

The first is the nontraceable classification, which covers those items included in the consolidated financial statements but not allocated to the segments. The second is the eliminations classification, which prevents double counting of intersegment transactions when the segments are consolidated into total company figures.

The nontraceable classification captures assets, liabilities, revenues, and expense items, which cannot be attributed to the activities of a segment. In the FRS data, this classification reflects general overhead for the consolidated firm and financial activities which represent corporate level activities.

While the financial transactions may play a key role in the firm's ability to do business, such transactions are not allocated to activities in an individual segment. The cash, corporate investments, interest income, and interest expense are examples of this. The

accompanying example illustrates a nontraceable item, interest expense of $20, and the $10 corresponding tax effect (see "FRS Segment Tax Allocation Rules" in this appendix for further explanation).

The need for the eliminations classification arises when the product of one segment is sold to a second segment, which in turn sells the product again. In the accompanying example, $80 of crude oil is sold by the U.S. production segment to the refining/marketing segment. The refining/marketing segment records $80 of purchases of crude oil and, after processing, reflects sales of $160 of refined product. If the segment figures were simply added to arrive at the consolidated total, the consolidated sales figure of $240 ($80+ $160) would be too high because of double counting. Thus, the eliminations classification subtracts $80 of sales and $80 of costs, leaving consolidated sales of $160, the appropriate measure of the firm's consolidated transactions. The nontraceables and eliminations classifications are treated as if they are segments for purposes of aggregating segment data to the consolidated level.

FRS Income Taxes

FRS Segment Tax Allocation Rules. In the FRS system, the tax allocated to each segment reflects a prorata share of consolidated income taxes. Where the consolidated company reports income and pays a tax, but an individual segment incurs a loss, the segment with a loss reflects a tax benefit. This treatment is an FRS rule whose purpose is to reflect, at the segment

level, the effect of the segment's operations on the consolidated income taxes. The tax benefit reflected at the segment level is limited to the extent it offsets taxes in other segments on a consolidated basis.

In comparing an FRS company's segment to a specialized (nonintegrated) company in the same line of business, one must consider the effect of the above described rule. The current tax effect may be different, since a specialized company cannot report tax benefits for operating losses incurred in that year. It must carry the loss forward, or backward, against profits of other years, while a segment of an otherwise profitable consolidated firm can show a tax benefit by FRS conventions since a segment's loss can offset profits in other segments on a consolidated basis.

FRS Reporting Companies, Segments, and Tax Paying Entities. FRS reporting companies and their segments differ from the entities which actually pay income taxes. The FRS system reports energy activities on a consolidated company basis, disaggregated into various energy lines of business. Accordingly, income tax expense, current and deferred, is reflected on a lineof-business basis. However, under the tax laws, taxes are not necessarily based upon FRS reporting company consolidated earnings of the FRS line-of-business segments.

The tax-paying entities of an FRS reporting company are its subsidiaries. Some are incorporated in the United States and some in foreign countries, and each may operate in the United States, foreign countries, or both. Income tax expense in the FRS system consists of both. U.S. and foreign income taxes incurred by these subsidiaries. Taxes reflected by the consolidated company and each individual segment are allocated from taxes paid and deferred by the actual tax-paying entities.

Under U.S. tax law, U.S. income taxes are not required to be paid by foreign corporations on their foreign operations. Only income of foreign corporations earned in the United States or paid into the United States as dividends to a U.S. parent corporation (owner) are taxed by the United States. Foreign and U.S. earnings of U.S. corporations, including divisions and branch operations, are taxed by the United States. All income subject to U.S. tax, whether the entity is a foreign or U.S. corporation, is given the benefit of the foreign income tax credit (up to the statutory rate) to avoid double taxation. Each U.S. incorporated subsidiary of a U.S. corporation elects either to be included in a consolidated U.S. tax return or to file a separate return, depending on which election is most likely to minimize

the aggregate U.S. and foreign taxes. In the FRS system corporate organization and relationships are not purely a function of line-of-business financial reporting. This fact requires that allocations be made of taxes incurred so that they can be classified according to the FRS segment format. These allocations are required when a subsidiary is involved in both U.S. and foreign operations and/or in more than one line of energy business. For example, the FRS system has separate segments for the foreign and U.S. petroleum production business, and for the foreign and U.S. refining/marketing business. Therefore, if an FRS reporting company has a foreign subsidiary involved in both petroleum production and refining/marketing of petroleum, a disaggregation of that subsidiary's activities, including income taxes, must be performed.

The disaggregation is further complicated by the existence of nontraceable items such as interest expense, interest income, minority interest and foreign currency gains and losses. The nontraceable column must be treated as a separate segment in making the tax allocation. Therefore, the nontraceable columns should generate U.S. and foreign income tax benefits.

Deferred Taxes

The Financial Accounting Standards Board (FASB) began working on a project to reexamine the generally accepted accounting procedure for income taxes in September 1982. Accounting Principles Board Opinion 11 ("APB 11"), issued in 1967, faced criticism and concerns about the inconsistencies in its amendments and interpretations. In addition, problems created by new tax depreciation methods and changes in accounting for income taxes in other countries were making APB 11 outdated. In 1988, the FASB issued Statement of Financial Accounting Standards No. 96 "Accounting for Income Taxes" ("SFAS 96") to address the increased complexity and significance of deferred taxes in the balance sheet. However, because of its complex scheduling process and conservative tax asset provisions, SFAS 96 soon became a source of controversy among businesses, CPA firms, professional organizations, and industry trade groups. In response to the criticism, the FASB deferred the required implementation date of SFAS 96 three times (SFAS 100, 103, and 108), and began developing a new standard which would not only address criticism of APB Opinion 11, but also the controversy surrounding SFAS 96. The new standard, SFAS 109, "Accounting for Income Taxes," became effective for periods beginning after December 15, 1992.

The objective of accounting for income taxes is the recognition and presentation in the financial statements of:

• Taxes currently payable or refundable

• Deferred tax assets and liabilities for the future tax consequences of events that have been recognized in the financial statements or tax returns.

Deferred taxes reflect the future tax consequences of events already recognized in either the financial statements or tax returns. SFAS 109 uses the balance sheet approach, also referred to as the liability method, to determine deferred taxes. This method, first introduced in SFAS 96, differs from APB 11, which used the income statement approach. SFAS 109 also requires a deferred tax asset to be recognized for deductible temporary differences and operating loss and tax credit carryforwards using the applicable tax

rate.

The income statement approach recognizes deferred taxes on the temporary timing differences between the pretax accounting income and taxable income each year. Temporary timing differences are those differences between accounting and taxable income which will ultimately reverse. For example, intangible drilling costs for a successful well are expensed when paid for tax purposes, but capitalized and depreciated for accounting purposes. If we assume intangible drilling costs of $100,000 on one well was the only timing difference, and this cost was depreciated $20,000 per year for accounting purposes, there would be an $80,000 temporary timing difference in year one, as taxable income would be less than accounting income. This timing difference would reverse $20,000 each year as the intangible drilling cost is depreciated for accounting purposes with no deduction for tax purposes. At the end of the fifth year, the timing difference would be completely reversed.

The liability approach recognizes deferred taxes on the temporary differences between the financial and tax bases of assets and liabilities. Both the deferred tax liability and the deferred tax asset must be measured using the applicable tax rate. The applicable tax rate is the enacted tax rate to be applied to the last dollar of taxable income for the year when the liability is expected to be settled or the assets recovered. A single flat tax rate may be used for companies for which graduated rates are not a significant factor. A deferred tax asset is recognized for existing alternative minimum tax credit carryforwards for tax purposes. When computing deferred tax assets and/or liabilities, if there

is a change in the tax rate or tax law, the deferred tax assets and/or liabilities should be adjusted in the period that includes the enactment date. To the extent deferred tax balances are adjusted for the effects of such changes, income tax expense or benefit from continuing operations is charged or credited. Using the example from the preceding paragraph, the financial statement basis of the intangible drilling cost in year one would be $80,000 ($100,000 less $20,000 depreciation), while there would be no basis for tax purposes as the costs were totally deducted. Deferred taxes would be provided for the $80,000 difference using enacted tax rates. Deferred taxes would be adjusted each year until the difference between the financial accounting and tax bases was fully eliminated at the end of year five.

Once deferred tax assets and liabilities relating to the future tax consequences of temporary differences and carryforwards have been measured, the deferred tax provision or benefit is based on the net change in a deferred tax balance during the year. The income tax expense or benefit for the period is derived from the total tax currently payable or refundable and the deferred tax expense or benefit.

As stated earlier, SFAS 109 became effective for fiscal years beginning after December 15, 1992. There were two transition options available when adopting SFAS 109: prospective or retroactive application. A company could elect to restate the financial statements for any number of consecutive prior years (retroactive application) or report a cumulative effect adjustment below "income from continuing operations" (prospective application).

For 1993, all twenty-five FRS companies have reported taxes in accordance with SFAS 109. For 1992, seventeen FRS reporting companies had adopted the provisions of SFAS 109, which resulted in a net $163 million benefit to their 1992 reported earnings. The remaining eight FRS reporting companies adopted SFAS 109 in the first quarter of 1993, and they have reported a $671 million benefit to 1993 reported earnings. Of the eight companies which had not adopted SFAS 109 in 1992, five reported under APB 11 and three reported in accordance with SFAS 96.

Corporate Acquisitions

Under FRS reporting rules, no acquisitions are accounted for under the pooling of interest method. This is because, under the pooling method, the financial statements do not reflect such transactions as new investment, since the historical financial statements are