Texas Supreme Court Rejects Expert’s Reliability

In the case of Kerr-McGee Corp., et al v. Jimmy Helton, et al, in the Supreme Court of Texas (02-0356), the expert’s testimony on calculating damages was excluded for reasons linked to Daubert and the test of reliability. The principal issue was whether the expert witness’s testimony had a reliable foundation to support damages in a claim that Kerr-McGee did not protect against natural-gas drainage.

In this case, Helton sued Kerr-McGee, claiming the company should have prudently drilled a third offset well to tap into a large gas reservoir discovered on adjacent property. Two wells the company did drill failed to produce gas in paying quantities. At the trial, Helton’s expert, a petroleum engineer, testified that a hypothetical third well drilled at a certain location would have produced as much as $2.4 million in royalties. The expert testified that he based his calculations in part on certain assumptions and not on actual data.

The trial court denied Kerr-McGee’s motion to strike the expert’s testimony, offered after the expert finished testifying and awarded Helton royalty damages of more than $860,000. The court of appeals rejected Kerr-McGee’s reliability and legal sufficiency challenges and affirmed. The Texas Supreme Court held that the expert’s testimony on calculating damages was unreliable and therefore no evidence; reversing and rendering.

To our reading, the court criticized the expert's lack of nexus between existing well data and the hypothetical well that should have been drilled. In other words, the methodology lacked explanation of how to get from what was known to what was not known but was instead expert opinion. Specifically, saying one well would have produced like other wells in the area was not sufficient without addressing how the wells differed and the effect these differences would have had on the hypothetical well. For example, no specific analysis appeared to have been made as to formation thickness, well bore conditions, permeability, porosity and structure elevation differences.

Without knowing how the expert used data from existing wells and other data to reach his conclusions, the reliability of his analysis could not be determined. There was simply too great an analytical gap between the data and the expert’s conclusions for the conclusions to be reliable. Apparently, had the expert explained through accepted methodologies the basis for his opinions, the court would not have reached its result; the concern was not with the correctness of the conclusions but the reliability of the methodology.

The AICPA’s Professional Ethics Executive Committee has deferred until December 31, 2004 the effective date of the new requirement to document in writing the understanding established with the client regarding nonattest services (e.g., bookkeeping, tax consulting, internal audit services, etc.). This extension is intended to provide members with additional time to update their firm policies and procedures and further educate firm personnel. Attest services include audits, reviews, agreed-upon procedures and many other engagements where a practitioner expresses a conclusion about the reliability of a written assertion that is the responsibility of another party, such as management.

Interpretation 101-3 established three general requirements for performing nonattest services. First, the member should not perform management functions or make management decisions for the attest client. Second, the client must agree to perform the following functions in connection with the engagement to perform nonattest services: make all management decisions and perform all management functions; designate a competent employee, preferably within senior management, to oversee the services; evaluate the adequacy and results of the services; and establish and maintain internal controls, including monitoring ongoing activities.

According to the Interpretation, "In cases where the client is unable or unwilling to assume these responsibilities (for example, the client does not have an individual with the necessary competence to oversee the nonattest services provided, or is unwilling to perform such functions due to lack of time or desire), the member’s provisions of these services would impair independence." The Interpretation appears to us to place a duty upon the CPA to satisfy herself that management is capable of making the decisions required and are willing to do so; this is an interesting area of inquiry because attest services are largely based upon the premise management is responsible for the assertions made in the financial statements. Incompetent management could not be presumed responsible for such.

Finally, before performing attest services, the member should establish and document in writing his or her understanding with the client (board of directors, audit committee or management as a appropriate in the circumstances) regarding the following: objectives of the engagement; services to be performed; client’s acceptance of its responsibilities; member’s responsibilities and any limitations of the engagement.

The American Institute of Certified Public Accountants (AICPA) recently published Consulting Services Special Report 03-1 (SR 03-1). SR 03-1 does not set new standards, but summarizes how traditional professional standards apply to a CPA’s performance of litigation services. SR 03-1 describes the application of rules contained in the AICPA Code of Professional Conduct as well as the application of AICPA Statement of Standards on Consulting Services No. 1.

As set forth in greater detail in SR 03-1, the AICPA Code of Professional Conduct and Bylaws that have specific applicability to the practice of litigation services include: Integrity and Objectivity, General Standards, Compliance with Standards, Confidential Client Information, Contingent Fees and Acts Discreditable.

Please contact Jesse Daves or Jeff Compton if you have a question or would like a copy of these standards which, while the AICPA is a voluntary organization, are generally part of the compulsory Rules of Professional Conduct of the Texas State Board of Public Accountancy and consequently required of the Texas-licensed CPA. The violation of these standards subjects the CPA to enforcement action by the State Board.

According to the 2003 Annual Review of Financial Reporting Matters, a report by Huron Consulting Group that analyzes the leading causes and trends in financial restatements filed with the U.S. Securities and Exchange Commission, 323 public companies that changed their previously released financial statements due to accounting errors in 2003, a slight decline compared to 330 restatement filings identified in 2002 and up from 270 in 2001. "As we have observed in prior years, problems applying accounting rules, human and system errors and fraudulent behavior are the three primary causes for accounting errors," said Joseph J. Floyd, chief operating officer for Huron’s Financial and Economic Consulting practice.

Errors in accounting reserves and contingencies was the leading cause of restatements in 2003. This category includes accounting errors related to accounts receivable, inventory reserves, restructuring reserves, accruals and other loss contingencies. Restatements attributable to this category experienced a greater increase in 2003 than any other accounting issue. Reserves and contingencies may be among the most judgmental accounts in a company’s financial statements as they are subject to an estimation process. These restatements, however, do not simply reflect changes in estimates, but rather reflect flawed judgments due to the oversight or misuses of facts, fraud or misapplication of Generally Accepted Accounting Principles (GAAP).

The number of 2003 restatements by companies with annual revenues under $100 million rose to 158 or 49% of all restatements filed during the year. The percentage of restatements filed by companies with annual revenues greater than $1 billion decreased slightly in 2003 from 22 percent in 2002 to 20 percent in 2003.

If you would like to unsubscribe or would like to provide the name and email address of someone you believe might also benefit from receiving this newsletter, simply reply to this email and let us know.

If you would like to read more about us and the work we have done, please see www.jacompton.com.