Shell’s Outside Auditors Got Warning on Reserves in 2002

The Wall Street Journal: Shell’s Outside Auditors Got Warning on Reserves in 2002

“The documents also suggest that some potential reserves problems at Shell were much more widely known and discussed — both internally and by external advisers — than the company has so far disclosed.”

By CHIP CUMMINS

Staff Reporter of THE WALL STREET JOURNAL

July 15, 2004; Page A3

LONDON — An internal Royal Dutch/Shell Group auditor alerted the company’s outside auditors to potential problems with energy-reserves bookings, including the possibility that the company’s bonus system may have encouraged the inflation of reserves, about two years before the petroleum giant disclosed it had massively overstated its holdings.

The warnings to affiliates of KPMG International and PricewaterhouseCoopers International Ltd., contained in Shell documents reviewed by The Wall Street Journal, provide the first look at the role played by outside accountants in the Shell reserves saga. The documents also suggest that some potential reserves problems at Shell were much more widely known and discussed — both internally and by external advisers — than the company has so far disclosed.

The role of outside accountants has been in the spotlight amid recent corporate scandals. But Shell’s reserves-accounting scandal raises new questions about the responsibility of independent auditors. Outside auditors aren’t required to sign off on reserves estimates. But reserves can have a material effect on a company’s bottom line, and auditors are required to satisfy themselves that there aren’t big problems with the reserves numbers.

It is unclear whether the internal warnings brought to the auditors qualified as an issue worth looking into at the time. Although the reports raised potential red flags, the documents said that any overstatements likely would be minimal.

A spokesman for KPMG in London said it stood by its auditing work for Shell, but referred all other questions about the work to Shell. A spokeswoman in London for PricewaterhouseCoopers referred all questions about the firm’s auditing work to Shell. A spokesman for Shell in London declined to comment on “leaked and unverifiable” documents. He said that the company is continuing to cooperate fully with authorities investigating the matter.

In January, Shell said it had massively overstated its reserves, and it has slashed its tally for 2002 by 23%. The overstatement shocked investors, drove down the share prices of Shell’s two parent companies and raised questions across the oil industry about accounting for reserves. Shell has said that some of its top executives and its independent directors, including current managers, weren’t provided enough information to make proper disclosures about the overstatement. An April 2004 internal report pinned blame largely on two top executives ousted in March, former Chairman Philip Watts and Walter van de Vijver, former head of Shell’s exploration and production division.

The newly revealed warnings, by then-top internal reserves auditor Anton Barendregt, said that only a small slice of Shell’s reserves were at risk of being overstated — about 1% of total Shell reserves for 2002, for example. But the warnings highlighted early on potentially serious systemic problems with Shell’s reserves reporting. The set of documents also indicates that problems were flagged repeatedly to a wider circle of senior executives and board members than previously disclosed.

The internal Shell documents containing the warnings were authenticated by three people familiar with the situation. In January 2002 and again in January 2003, Mr. Barendregt, who retired earlier this year, circulated an annual review of the previous year’s reserves tally to senior Shell executives and to the company’s outside auditors, the Dutch affiliate of KPMG and PricewaterhouseCoopers’s London affiliate. In those reviews, he warned that Shell’s guidelines for booking reserves might not comply with Securities and Exchange Commission guidelines in some cases.

At the same time, he raised questions about the integrity of Shell’s overall reserves-reporting system. In both January 2002 and January 2003, Mr. Barendregt prominently flagged that Shell’s bonus system may have encouraged the inflation of reserves bookings. Reserves additions figured into Shell’s “score card” bonus system, in which executives were awarded additional payouts when their business units achieved certain targets. Shell abolished reserves-related bonuses this year in the wake of the reserves scandal.

In his 2003 review, Mr. Barendregt dedicated a lengthy section to score cards. He indicated that senior managers in Shell’s exploration-and-production division, the business unit responsible for reserves bookings, rejected doing away with reserves-related bonuses. But, he wrote, “it is the auditor’s firmly held belief that the reserves-addition targets in these score cards present a potential threat to the integrity of the Group’s reserves estimates.”

His reports appear to have been distributed widely. Marked “confidential,” they were addressed to senior exploration-and-production executives, with copies sent to Shell’s outside auditors, KPMG and PricewaterhouseCoopers. The auditors received the reports, according to three people familiar with the situation.

It is unclear how KPMG and PricewaterhouseCoopers viewed the warnings. A KPMG letter to Shell internal auditors dated February 2002 referenced the January report but stated that it didn’t find reason to believe Shell’s reserves report that year was materially incorrect. It is unclear whether KPMG provided similar assurance in 2003 after reviewing Mr. Barendregt’s reports. It is also unclear whether PricewaterhouseCoopers responded to Mr. Barendregt’s reports.

Two investors have named Shell’s outside auditors in a broad lawsuit alleging that KPMG and PricewaterhouseCoopers should at least have known about reserves irregularities. PricewaterhouseCoopers has declined to comment on the suit, which was filed in a Middlesex County, N.J., state court, while KPMG has said it expects to defend itself.

Typically, reserves don’t directly affect the bottom line of most large oil companies in a significant way. But they do influence a company’s financial statements through calculations related to such factors as depreciation. For example, Shell reduced earnings by $106 million in 2003, to a net profit of $12.5 billion, as a result of its reserves overstatements.

Write to Chip Cummins at [email protected]