Revenue Recognition and Gas Balancing
Oil, gas and NGL revenues are recognized when production is sold to a purchaser at a fixed or determinable price, delivery has occurred, title has transferred and collectibility of the revenue is probable. Delivery occurs and title is transferred when production has been delivered to a pipeline or truck or a tanker lifting has occurred. Cash received relating to future production is deferred and recognized when all revenue recognition criteria are met. Taxes assessed by governmental authorities on oil, gas and NGL revenues are presented separately from such revenues as production taxes in the statement of operations.
Devon follows the sales method of accounting for gas production imbalances. The volumes of gas sold may differ from the volumes to which Devon is entitled based on its interests in the properties. These differences create imbalances that are recognized as a liability only when the estimated remaining reserves will not be sufficient to enable the underproduced owner to recoup its entitled share through production. The liability is priced based on current market prices. No receivables are recorded for those wells where Devon has taken less than its share of production unless all revenue recognition criteria are met. If an imbalance exists at the time the wells' reserves are depleted, settlements are made among the joint interest owners under a variety of arrangements.
Marketing and midstream revenues are recorded at the time products are sold or services are provided to third parties at a fixed or determinable price, delivery or performance has occurred, title has transferred and collectibility of the revenue is probable. Revenues and expenses attributable to Devon's gas and NGL purchase and processing contracts are reported on a gross basis when Devon takes title to the products and has risks and rewards of ownership. The gas purchased under these contracts is processed in Devon-owned plants.
Major Purchasers
During 2007, 2006 and 2005, no purchaser accounted for more than 10% of Devon's revenues from continuing operations.
Derivative Financial Instruments
The majority of Devon's derivative financial instruments consist of commodity financial instruments used to manage Devon's cash flow exposure to oil and gas price volatility. Devon has also entered into interest rate swaps to manage its exposure to interest rate volatility. The interest rate swaps mitigate either the cash flow effects of interest rate fluctuations on interest expense for variable-rate debt instruments, or the fair value effects of interest rate fluctuations on fixed-rate debt. Devon also has an embedded option derivative related to the fair value of its debentures exchangeable into shares of Chevron common stock.
All derivative financial instruments are recognized at their current fair value in the fair value of financial instruments caption on the balance sheet. Changes in the fair value of these derivative financial instruments are recorded in the statement of operations unless specific hedge accounting criteria are met. If such criteria are met for cash flow hedges, the effective portion of the change in the fair value is recorded directly to accumulated other comprehensive income, a component of stockholders' equity, until the hedged transaction occurs. The ineffective portion of the change in fair value is recorded in the statement of operations. If such criteria are met for fair value hedges, the change in the fair value is recorded in the statement of operations with an offsetting amount recorded for the change in fair value of the hedged item.
A derivative financial instrument qualifies for hedge accounting treatment if Devon designates the instrument as such on the date the derivative contract is entered into or the date of a business combination or other transaction that includes derivative contracts. Additionally, Devon must document the relationship between the hedging instrument and hedged item, as well as the risk-management objective and strategy for undertaking the instrument. Devon must also assess, both at the instrument's inception and on an ongoing basis, whether the derivative is highly effective in offsetting the change in cash flow of the hedged item.
During 2007 and 2006, Devon entered into and acquired certain commodity derivative instruments. For such instruments, Devon chose not to meet the necessary criteria to qualify these derivative instruments for hedge accounting treatment. Therefore, for the years ended December 31, 2007 and 2006, the changes in fair value related to these instruments were recorded to gas sales in the statements of operations. Such amounts recorded were a $25 million loss and a $37 million gain in 2007 and 2006, respectively
The following table presents the components of the 2007, 2006 and 2005 change in fair value of financial instruments presented in the accompanying statement of operations. Significant items are discussed in more detail following the table.
| 2007 | 2006 | 2005 | |||||||
|---|---|---|---|---|---|---|---|---|---|
| (In millions) | |||||||||
| Losses (gains) from: Option embedded in exchangeable debentures |
$ | 248 | 181 | 54 | |||||
| Chevron common stock | (281 | ) | — | — | |||||
| Interest rate swaps | (1 | ) | (3 | ) | (4 | ) | |||
| Non-qualifying commodity hedges | — | — | 39 | ||||||
| Ineffectiveness of commodity hedges | — | — | 5 | ||||||
| Total change in fair value of financial instruments | $ | (34 | ) | 178 | 94 | ||||
The change in the fair value of the embedded option relates to the debentures exchangeable into shares of Chevron common stock (see Note 4). These unrealized losses were caused primarily by increases in the price of Chevron's common stock.
As previously discussed in the Short-Term Investments and Other Marketable Securities section of Note 1, beginning in 2007, the change in fair value of the Chevron common stock owned by Devon is included in Devon's results of operations rather than accumulated other comprehensive income. The unrealized gain on this investment resulted from the increase in the price of Chevron's common stock.
In addition to the changes in fair value of Devon's interest rate swaps presented in the table above, settlements on these interest rate swaps increased interest expense by $4 million, $14 million and $10 million in 2007, 2006 and 2005, respectively.
During 2005, Devon had a number of commodity derivative instruments that qualified for hedge accounting treatment as described above. During 2005, certain of these derivatives ceased to qualify for hedge accounting treatment. In the third quarter of 2005, certain oil derivatives ceased to qualify for hedge accounting primarily as a result of deferred production caused by hurricanes in the Gulf of Mexico. Because these contracts no longer qualified for hedge accounting, Devon recognized $39 million in losses as change in fair value of derivative financial instruments in the accompanying 2005 statement of operations.
In addition to the changes in fair value of non-qualifying commodity hedges presented in the table above, Devon also recognized in 2005 a $55 million loss related to certain oil hedges that no longer qualified for hedge accounting due to the effect of the 2005 property divestiture program. These commodity instruments related to 5,000 barrels per day of U.S. oil production and 3,000 barrels per day of Canadian oil production from properties that were sold as part of Devon's divestiture program. This loss is presented in other income in the 2005 statement of operations.
The following table presents the balances of Devon's accumulated net gain (loss) on cash flow hedges included in accumulated other comprehensive income (in millions).
| December 31, 2004 | $ | (286 | ) |
| December 31, 2005 | $ | 3 | |
| December 31, 2006 | $ | 1 | |
| December 31, 2007 | $ | — |
By using derivative financial instruments to hedge exposures to changes in commodity prices and interest rates, Devon exposes itself to credit risk and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. To mitigate this risk, the hedging instruments are placed with counterparties that Devon believes are minimal credit risks. It is Devon's policy to enter into derivative contracts only with investment grade rated counterparties deemed by management to be competent and competitive market makers.
Market risk is the change in the value of a derivative financial instrument that results from a change in commodity prices, interest rates or other relevant underlyings. The market risk associated with commodity price and interest rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken. The oil and gas reference prices upon which the commodity hedging instruments are based reflect various market indices that have a high degree of historical correlation with actual prices received by Devon. Devon does not hold or issue derivative financial instruments for speculative trading purposes.
Stock Options
Effective January 1, 2006, Devon adopted Statement of Financial Accounting Standard No. 123(R), Share-Based Payment, ("SFAS No. 123(R)"), using the modified prospective transition method. SFAS No. 123(R) requires equity-classified, share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant and to be expensed over the applicable vesting period. Under the modified prospective transition method, share-based awards granted or modified on or after January 1, 2006, are recognized in compensation expense over the applicable vesting period. Also, any previously granted awards that were not fully vested as of January 1, 2006 are recognized as compensation expense over the remaining vesting period. No retroactive or cumulative effect adjustments were required upon Devon's adoption of SFAS No. 123(R).
Prior to adopting SFAS No. 123(R), Devon accounted for its fixed-plan employee stock options using the intrinsic-value based method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, ("APB No. 25") and related interpretations. This method required compensation expense to be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.
Had the fair value provisions of SFAS No. 123(R) been applied in 2005, Devon's 2005 net earnings and net earnings per share would have differed from the amounts actually reported as shown in the following table (in millions, except per share amounts).
| Net earnings available to common stockholders, as reported | $ | 2,920 | |
| Add share-based employee compensation expense included in reported net earnings, net of related tax expense |
18 | ||
| Deduct total share-based employee compensation expense determined under fair value based method for all awards (see Note 9), net of related tax expense |
(44 | ) | |
| Net earnings available to common stockholders, pro forma | $ | 2,894 | |
| Net earnings per share available to common stockholders: As reported: Basic |
$ | 6.38 | |
| Diluted | $ | 6.26 | |
| Pro forma: Basic |
$ | 6.32 | |
| Diluted | $ | 6.21 |
Prior to the adoption of SFAS No. 123(R), Devon presented all tax benefits of deductions resulting from the exercise of stock options as operating cash inflows in the statement of cash flows. SFAS No. 123(R) requires the cash inflows resulting from tax deductions in excess of the compensation expense recognized for those stock options ("excess tax benefits") to be classified as financing cash inflows. As required by SFAS No. 123(R), Devon recognized $44 million and $36 million of excess tax benefits as financing cash inflows for 2007 and 2006, respectively. In 2005, excess tax benefits of $44 million were classified as operating cash inflows.
Income Taxes
Devon is subject to current income taxes assessed by the federal and various state jurisdictions in the United States and by other foreign jurisdictions. In addition, Devon accounts for deferred income taxes related to these jurisdictions using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases. Deferred tax assets are also recognized for the future tax benefits attributable to the expected utilization of existing tax net operating loss carryforwards and other types of carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
At December 31, 2007, undistributed earnings of foreign subsidiaries included in continuing operations were determined to be permanently reinvested. Therefore, no U.S. deferred income taxes were provided on such amounts at December 31, 2007. If it becomes apparent that some or all of the undistributed earnings will be distributed, Devon would then record taxes on those earnings.
In June 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109. Interpretation No. 48 prescribes a threshold for recognizing the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination by a taxing authority. Recognized tax positions are initially and subsequently measured as the largest amount of tax benefit that is more likely than not of being realized upon ultimate settlement with a taxing authority. Liabilities for unrecognized tax benefits related to such tax positions are included in other long-term liabilities unless the tax position is expected to be settled within the upcoming year, in which case the liabilities are included in accrued expenses and other current liabilities. Interest and penalties related to unrecognized tax benefits are included in income tax expense.