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Change is Coming – Leases and Your Financial Statements

March 23, 2018 | Diane Kirk

Diane Kirk | Audit Director

Diane has more than 23 years of public accounting experience and serves public and private companies with an emphasis in the natural resources industry. She has extensive expertise with oil and gas issues, commodity...

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Overview

The accounting lease rules as we know them change drastically in 2019 for public companies and 2020 for private companies. The change will provide a more faithful representation of the rights and obligations arising from lease transactions.

Long viewed as a vehicle for off-balance sheet financing, most operating leases with terms greater than one year will be reflected on the lessee balance sheet through a “Right to Use Asset” and a corresponding “Lease Liability.” The asset will be amortized over the lease term and the lease liability will be reduced by contractual payments and increased by the associated interest accretion. The income statement presentation for operating leases will be basically unchanged with both the amortization and interest expense included in the caption “Lease Expense.”

Consistent with current GAAP, the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee will primarily depend on its classification as a finance or operating lease. Capital leases, called “financing” leases under the new standard, will also no longer be subject to bright line tests.

The accounting mechanics by lessors will remain similar to current accounting. However, changes in the definition of a lease as well as other accounting rules discussed later in “Other Accounting Rule Changes” may impact lessor accounting under the new rules.

Initially, management may think about the accounting of lease agreements for field offices, trucks, equipment and corporate office space. However, the new rules can impact accounting for contracts that are not legally labelled a “lease,” or that also contain service elements. Application of the rules to specific oil and gas transactions, which can be very complex due to individual contract terms, is beyond the scope of this article. Consistent with current guidance, leases of mineral rights and drilling rights are scoped out of lease accounting.

Determining if the Transaction Contains a Lease

The new definition of a lease focuses on the concept of control - similar to the new revenue standard. In order to meet the definition of a lease, the following two criteria must be met:
  • “Identified Asset” – Asset must be identified:
    • Can be implicit or explicit in contract
    • Must be physically distinct and can be a distinct portion of a larger asset
    • Supplier cannot have a substantive substitution right
  • “Control” – Customer must have both of the following rights:
    • To obtain substantially all the economic benefits from use of the asset
    • To direct how and for what purpose the asset is used
Applying the above two criteria may not be easy and the Control criterion may result in more contracts including a lease. The guidance clarifies that a well connection or a dedicated pipeline segment that connects to a larger pipeline may meet the Identified Asset criterion even if the larger pipeline also serves other customers. In the case of well connections or pipeline segments, the parties must determine if the producer customer also meets the Control criterion through its ability to direct when or whether the asset is used to transport production.

In a natural gas processing contract, the parties must determine if the producer customer meets the Control criterion – does it obtain substantially all of the output and have the ability to direct the use of the processing facility?

Determining whether the customer directs the use of the asset may be difficult to assess. For example, a contract between a drilling company and a producer customer in excess of one year may involve supplying a drilling rig as well as operating the rig. The parties must assess if the customer makes the decisions that most significantly impact the economic benefits derived from the drilling rig during the contract term. This assessment can be very complex and requires significant judgement.

Lease and Non-Lease Components

A contract may also have both lease and non-lease components. This requires careful analysis of the contract terms to determine the appropriate guidance. An example would be a gathering contract where the producer customer determines that the lateral connecting the wells to the larger pipeline meets the definition of a lease as discussed above (i.e., it is a distinct portion of the pipeline and the customer controls decisions affecting the economics). The producer customer also receives other services under the contract, such as compression and transportation. In this example, there are contractual components that should be accounted for under both lease and non-lease accounting guidance. The different components would be separated and the consideration allocated based on relative standalone price, which is often unavailable. In recognition of the difficulty in accounting for these situations, the FASB allows a lessee to make an accounting policy to account for all contract components under the lease guidance. As of the date of this article, there is no such option for lessors; however, the FASB is considering providing a similar accounting policy option, so stay tuned for further developments.

Other examples of contracts with multiple components include drilling, storage, transportation and gas gathering arrangements.

Under current accounting, many oil and gas companies account for all components together because the accounting results are the same for the operating lease and service components. Upon adoption of the new rules, these contracts must be assessed because the lease component (or the entire contract if the policy election is made) will be recognized on the balance sheet.

Joint Operations

Operators and nonoperators will be required to carefully review joint operations contracts to develop and produce properties. This may prove difficult as the concept of control and the identification of the contracted party (operator or joint operation) will require judgement and thorough understanding of the contracts.

Other Accounting Rule Changes

The new rules also impact other areas, including:
  • Lease modifications
  • Sale leasebacks
  • Related party leases
  • Producer involvement in asset construction
  • Elimination of real estate - specific lease guidance

Transition Considerations

Lessees (for finance and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The approach does not require any transition accounting for leases that expired before the earliest comparative period presented and provides for certain other practical expedients. The FASB is considering a proposal to allow companies the option to apply the guidance as of the beginning of the latest comparative period presented in the financial statements. For example, a public calendar year-end company adopting as of January 1, 2018 and presenting two year financial statements (2018 and 2019) would have to adopt as of January 1, 2018. The proposed relief would allow the company to elect instead to adopt as of January 1, 2019 which would simplify the transition.

The guidance allows companies the option of not reassessing expired or existing contracts upon adoption to determine if the contract contains a lease. However, as discussed earlier, since the accounting for operating leases and service components is currently similar, many companies have failed to fully assess contracts under existing lease guidance. In these cases, the contracts may be required to be assessed under the new guidance upon adoption.

The FASB recently issued an amendment that provides an optional practical expedient for adoption. If elected, a company would not have to reconsider its accounting for existing or expired land easements, if they were not previously accounted for as leases under current lease guidance. Rights-of-way contracts held by oil and gas companies were often entered into several years prior to adoption. This amendment provides significant relief for existing contracts that were not accounted for as leases under current lease guidance. However, contracts entered into or modified post-adoption must be assessed under the new lease rules.

Other Implications

There are many steps management should take immediately to ensure a smooth transition. Management and the governance committee should ensure the adoption implementation process is well planned, staffed and that appropriate personnel outside of accounting are involved. Companies should begin (if not already) their assessment by taking an inventory of all lease contracts at all locations. Depending on the number of geographic locations as well as decentralized management and complexity of contracts, this process can take much longer than expected. Many companies are finding that the initial inventory of lease agreements and then the assessment under the new guidance is much more intensive than originally anticipated. In addition, as discussed earlier, other contracts may also contain a “lease” component requiring assessment.

Almost all leases will be recorded on the balance sheet increasing assets and liabilities. Contracts and agreements with balance sheet related covenant requirements should be reviewed to determine if amendments should be considered and negotiated. Communication efforts should be well prepared and proactive to ensure that any impacted covenants or other financial metrics can be timely addressed. Budgeting and forecasting, compensation plans and key performance indicators may also change. Many companies are not prepared to explain the significant liabilities added to their balance sheets with lenders, potential investors and suppliers. Systems and controls should also be evaluated and revised as necessary.

Conclusion

The new lease rules will impact all oil and gas companies and should be addressed as soon as possible. As Benjamin Franklin wisely observed: “You may delay, but time will not, and lost time is never found again.”

This article was originally published in the spring 2018 edition of the Council of Petroleum Accountants Societies (COPAS) Accounts newsletter.

With nearly 150 upstream, midstream, downstream, and field services oil and gas clients and comprehensive accounting, audit, tax, technology, and business consulting services, EKS&H is uniquely positions to assist oil and gas organizations with changing revenue recognition guidelines. To learn more, please contact Diane Kirk at dkirk@eksh.com, or call us today at 303-740-9400.
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