In light of the current environment — reduced demand as a direct result of the COVID-19 pandemic, lower oil prices, price decreases for service companies, limited financing options, reduced M&A activity, increased number of restructurings and bankruptcies — there are many year-end accounting and financial reporting challenges for both public and private oil and gas companies.
Management and governance committees should consider that many of these potential implications may require companies to make significant judgments and estimates, which can be challenging in an environment of uncertainty as discussed in more depth in a previous article.
Below is an overview of some — not all — of the more common areas that may require additional consideration.
Asset impairment
Asset impairment is one of the common accounting issues companies may face as a result of the economic consequences of the COVID-19 outbreak. U.S. GAAP requires different impairment models depending on the type of asset being evaluated. Some of the more common types of assets that may require evaluation for impairment include:
- Receivables
- Marketable equity securities without a readily determinable fair value
- Debt securities
- Equity method investments
- Inventory
- Goodwill
- Indefinite-lived intangible assets
- Oil and gas properties, proved and unproved
- Other property, plant, and equipment such as frac fleets, drilling rigs, midstream assets, other equipment, buildings, and finite-lived intangible assets
- Deferred income taxes
- Contract assets
For each of the asset classes above, companies will need to carefully review the relevant impairment guidance to determine when and how an impairment test should be applied. While some asset classes require an annual impairment test, others are only performed when there is a triggering event. Even those asset classes that only require an annual impairment test may require interim tests when triggering events are present.
Lower prices, delayed drilling, idling of existing production, and liquidity concerns all impact impairment considerations for proved and unproved oil and gas properties. Also, differences in impairment models for successful efforts and full cost companies add additional complexity.
Estimates of reserves
Lower prices may result in PDP reserves becoming uneconomic or they may not qualify for inclusion if the company does not have an approved plan to develop the reserves within 5 years. In a period of delayed drilling, difficulty accessing capital and lower prices, many companies are losing PUD reserves.
Debt determinations, modifications, and loan covenants
As part of the borrowing base redetermination process or upon the default under covenant requirements, credit agreements may be amended. There are differences in accounting for revolving lines of credit and term debt. In these situations, management should first determine whether the amendment on term debt meets the definition of a troubled debt restructuring (TDR) if the lender granted a concession and the company was experiencing financial difficulties. If the amendment is not a TDR, for term debt, management should then assess the amended debt terms to determine if the amendment should be accounted for as a debt modification or extinguishment.
Management should also consider if there are cross default clauses in other contractual agreements that may be triggered under a default in the credit agreement.
Hedging
There are several considerations in the current environment of falling commodity prices and interest rates. Counterparty credit risk should be assessed both for its impact on the fair value of the instrument as well as collectability concerns if the hedge is in an asset position to the company.
Many companies with asset hedge positions have monetized certain asset positions to generate liquidity and fund required debt repayments or operations. There are accounting implications for hedges accounted for under cash flow hedge accounting, as well as tax implications for all hedges of realizing the gains (especially during a period of limited drilling deductions). Management should also consider the income statement presentation of realized and unrealized gains and losses and possible tax consequences for noncash exchanges of commodity derivatives.
In some interest rate hedges, lenders, as counterparties, are offering “blend and extend” restructuring amendments for swaps whereby the swap’s term is extended, and the negative fair value of the original swap is rolled into the amended swap. There may be accounting implications for both swaps accounted for as cash flow hedges and economic hedges not accounted for under hedge accounting.
Lease concessions
Lease concessions (excluding mineral leases) are common in this environment and may result in accounting treatment as a lease modification under ASC 840 and ASC 842, if the concessions are beyond the enforceable rights and obligations in the lease contract. The FASB issued a FASB Q&A on accounting for lease concessions related to COVID-19 that provides a reasonable approach in accounting for these lease concessions.
Paycheck Protection Program loans
Many companies have received loans under the Paycheck Protection Program (PPP), provided for under the CARES Act and administered by the Small Business Administration (SBA). Questions on the accounting for PPP loans have arisen, as the loans are legally structured as debt instruments but may be forgivable under certain circumstances. If there is an expectation that a PPP loan will be forgiven, GAAP may allow for the arrangement to be accounted for as an in-substance government grant rather than as a debt obligation. Depending on when a notice of forgiveness is received from the SBA, companies may need to account for a PPP loan at the end of their fiscal year without having definitive evidence that the loan will be forgiven. There are different accounting models that may be applicable depending on an entity’s situation, and judgment will be needed to determine the proper accounting. For additional insights into the different models for accounting for PPP loans, please see Paycheck Protection Program loans accounting: What are the options?
Income taxes
There are many tax implications associated with the current environment. Some examples include:
- Assessing whether the forecasted future taxable income in the carryback or carryforward period has changed.
- Revisiting management’s indefinite reinvestment assertion related to foreign earnings.
- Determining tax consequences related to debt forgiveness and possible Section 382 limitations upon the issuance of additional equity.
- Assessing possible tax consequences for noncash exchanges of commodity derivatives and other hedge related issues.
In addition, there are specific implications if companies have received PPP loans under the CARES Act.
Going concern
Management is required to evaluate at each reporting period whether there is substantial doubt about the company’s ability to continue as a going concern within one year after the financial statements are issued or available to be issued. The significant uncertainty in the industry related to commodity or service pricing, production or service levels, and debt covenant compliance creates difficulties not typically encountered when applying the going-concern guidance. The significant uncertainty about future cash flows will often require management to prepare multiple cash flow projections that reflect different assumptions about when and how multiple possible scenarios may play out.
If management concludes that there is substantial doubt, the next step is consideration of management’s plans intended to mitigate the adverse conditions or events identified in the initial assessment. When assessing management’s plans, events should only be considered to the extent that it is both probable the plans will be effectively implemented and that they will mitigate the conditions or events that raise substantial doubt.
Other considerations
There are many other potential accounting and reporting considerations in the current environment, such as modifications to stock and unit awards, employee terminations, exit activities, insurance recoveries, effects on contracts and commitments including revenue and leases, accounts receivable allowances, challenges in fair value measurements, and loss contingencies.
Conclusion
Challenges facing the industry — and the related accounting and reporting considerations — will require management to make complex and difficult judgments and assessments. We recommend that companies start to inventory potential issues early in order to allow adequate time to prepare year-end financial statements and reporting packages.
