| | Management
assessed internal control over financial reporting of the Company and its subsidiary
as of December 31, 2005. The Company’s management conducted its assessment in
accordance with the Internal Control — Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (“COSO”): Upon
completion of the Company’s Sarbanes-Oxley compliance assessment, management identified
the following material weaknesses. Hedging We
completed a review of our documentation practices underlying our derivative positions
in 2004 and 2005 and determined that we lacked sufficient contemporaneous documentation
and did not timely designate our derivative positions at inception as cash flow
hedges as required by Statement of Financial Accounting Standards (“SFAS”) No.
133, “Accounting for Derivative Instruments and Hedging Activities” to account
for these positions as cash flow hedges. Under cash flow hedge accounting, the
after-tax change in the fair value of the open derivative positions (“fair value
change”) is reported as Other Comprehensive Income in the equity section of the
balance sheet. Alternatively, if the derivative does not qualify as a cash flow
hedge, mark-tomarket accounting requires that the fair value change be reported
in earnings. This error came to management’s attention during the preparation
of our Consolidated Financial Statements for the year ended December 31, 2005
which ultimately resulted in a restatement of our financial statements for 2004
as well as the first three quarterly periods in 2005. In
the process of restating our financials to account for our derivatives on a mark-to-market
basis, we discovered certain computational errors in the fair value of the Company’s
derivatives that was previously reported in other comprehensive income in 2004
and 2005. These errors resulted from the information we had relied upon to establish
oil and gas prices used in connection with determining the fair value of the derivatives.
For all the periods covered by our consolidated financial statements, we used
a third-party website source to obtain New York Mercantile (“NYMEX”) oil and gas
prices and then used those prices to determine the fair value of the derivatives.
However, we determined in the course of our evaluation that the use of Houston
Ship Channel prices was instead required for this purpose which matched the index
used within our derivative agreements, furthermore we also determined that the
information from the third party provider was not entirely reliable. As a result
of the restatement relating to our change in the treatment of our derivatives,
we no longer report the change in fair value of our derivatives in other comprehensive
income but now record them as a change to earnings. Nevertheless, in marking these
derivatives to market, the gains and losses reflected in other income and expense
have been based upon corrected amounts that were not based upon the information
from the third party provider. These items constituted a material weakness in
our internal controls as of December 31, 2005. Additional information relating
to these items is included in Note 3 to the Company’s consolidated financial statements.
Year-end Close Process and Other Controls In
the fourth quarter of 2005, we hired a manager of financial reporting, filling
the prior vacancy described in our Annual Report on Form 10-K for the year ended
December 31, 2004. This manager of financial reporting subsequently left the Company
late in the fourth quarter of 2005, creating a new vacancy. Our manager of accounting
left the Company in November 2005. In February 2006, our controller and our director
of financial planning and analysis also both left the company. We attempted to
fill these vacancies, but were not able to do so as quickly as we would have liked.
We subsequently hired a new controller and manager of accounting in March 2006,
near the end of our year-end closing process. We have also hired a new manager
of financial reporting, who is expected to join the Company in April 2006. The
accounting and financial staff vacancies described above occurred during the year-end
close process. While these vacancies were partially remedied by reliance upon
independent financial reporting consultants for review of critical accounting
areas and disclosures and material nonstandard transactions, these absences, combined
with our complex manual, review intensive accounting system, placed greater burdens
of detailed reviews on our remaining middle and upper-level accounting professionals,
which in turn compromised the level of their qualitative review of the elements
of the year end close, financial statements and disclosures. These review procedures
are an important component of our controls surrounding the closing process and
in financial reporting. As a result, we believe that these vacancies resulted
in inadequate staffing, supervision and financial reporting expertise in our accounting
and financial areas, which constituted a material weakness in our internal control
over financial reporting as of December 31, 2005. These deficiencies ultimately
affect the accuracy of our financial statement reporting and disclosures. Accordingly,
in connection with the audit of our 2005 financial results, Pannell Kerr Forster
of Texas, P.C. (“PKF”), our independent registered public accounting firm, detected
a number of errors and/or omissions that were an indication that the aforementioned
material weaknesses were present at December 31, 2005, increasing the likelihood
to more than remote that a material misstatement of the Company’s annual or interim
financial statements will not be prevented or detected. The most notable of these
errors included (1) our accounting for our derivatives as cash flow hedges rather
than on a mark-to-market basis, (2) corrections for certain computational errors
in the fair value of the Company’s derivatives previously reported in other comprehensive
income in 2004 and 2005, (3) errors related to our capital expenditures accrual,
(4) errors in the evaluation of our | |
