Leases and your financial statements: Change is coming for private oil and gas companies

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

Consistent with legacy generally accepted accounting principles (GAAP), the recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee primarily depends on its classification as a finance or operating lease. Capital leases, called “financing” leases under the new standard, are also no longer subject to bright-line tests.

However, the new rules can impact accounting for contracts that aren’t legally labeled a “lease,” or that also contain service elements.

The accounting mechanics by lessors remain similar to legacy accounting. However, changes in the definition of a lease as well as other accounting rules discussed later in the article 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 aren’t legally labeled 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 legacy 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:

1. “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

2. “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 new 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.

Determining whether the customer directs the use of the asset may be difficult to assess.

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 judgment.

Lease and nonlease components

A contract may also have both lease and nonlease 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 nonlease accounting guidance. The different components would be separated, and the consideration allocated based on relative stand-alone price, which is often unavailable. In recognition of the difficulty in accounting for these situations, the Financial Accounting Standard Board (FASB) allows a lessee to make an accounting policy election to account for all contract components under the lease guidance. The FASB also allows a lessor to make a similar accounting policy election to not separate nonlease components from the associated lease component, under certain defined circumstances.

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

Under legacy accounting, many oil and gas companies account for all components together because the accounting results are substantially 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 are now required to carefully review joint operation 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 judgment 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 using one of two available methods of adoption. The first method allows for the guidance to be applied to all leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The second method allows for the guidance to only be applied to leases that have commenced as of the beginning of the period of adoption, with no adjustments to any prior comparative periods.

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 legacy lease guidance. In these cases, the contracts may be required to be assessed under the new guidance upon adoption.

Both adoption methods provide for certain practical expedients. One that is highly applicable to the oil and gas industry allows a company to not have to reconsider its accounting for existing or expired land easements, if they were not previously accounted for as leases under legacy lease guidance. Rights-of-way contracts held by oil and gas companies were often entered into several years prior to adoption. This practical expedient provides significant relief for existing contracts that were not accounted for as leases under legacy 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 result in recognition 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.

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.

As noted earlier, it is expected that the effective adoption date for the guidance will be deferred to 2021 for private companies. While this may provide an additional year for adoption of the new guidance, given the depth of this guidance, it is not recommended to defer beginning or completion of the assessment of the new guidance.

The new lease rules 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 COPAS ACCOUNTS in Spring 2018. It was updated in October 2019.