As you are likely aware, the FASB’s sweeping new rules replace all existing guidance, industry-based and otherwise, including oil and gas-specific guidance. Revenue will now be recognized based on the transfer of control of goods or services to a customer in the amount of the consideration the entity expects to be entitled to receive. In other words, revenue should be recognized when a customer has the ability to direct the use of and obtain substantially all of the benefit from the goods or services provided. This concept may change the amount of revenue recognized, as well as the timing of recognition. Gone are the concepts of risks and rewards, fixed and determinable amounts, and industry-specific norms. In addition, robust quantitative and qualitative disclosures are required.
While new disclosures will affect all oil and gas companies in some way, those with midstream or field service operations will potentially experience greater financial statement impacts. For all companies, the exact impact will vary based on the nature and complexity of contracts. Management must understand the new guidance and consider what it means in regards to their own contracts, revenue streams, performance obligations, and payment terms.
Available resources and expectations
There are many resources to assist companies with their implementation efforts. These include the FASB’s original guidance, as amended, as well as many published interpretations. In addition, the Transition Resource Group (TRG), formed to review implementation issues, issued numerous whitepapers addressing specific concerns. The AICPA formed 16 industry task forces to help develop a new Accounting Guide on Revenue Recognition that will provide helpful hints and illustrative examples for how to apply the new revenue standard. The task force for oil and gas entities has released various working drafts addressing specific industry issues. Management should consider the TRG and AICPA white papers in implementing ASC 606.
Private companies also have the benefit of reviewing public company filings (calendar-year companies adopted as of January 1, 2018) for disclosures regarding the method chosen for adoption, the financial statement adoption impact, changes in revenue recognition policies, and additional disclosures required under ASC 606. It is important to note that not all public company disclosures are required for private companies. SEC comments on 2018 filings will provide additional implementation and application insights for private companies.
Importantly, public company management teams have indicated that the implementation effort, including the initial scoping of contracts, assessment, quantification of adoption impact, and preparation of disclosures, took much more time and resources than initially budgeted. This same experience should be expected of private company implementation resources needs.
A review of first-quarter 2018 public oil and gas company filings shows that most companies used the modified retrospective adoption method. Under this method, the adoption impact, if any, is reflected in beginning retained earnings as of January 1, 2018. Companies must disclose what the 2018 financial statements would have looked like if still following the old guidance (ASC 605). The public filings offer insights into whether there was an adoption impact affecting net income as well as the post-adoption impact on financial statement line items.
Assessment under the new guidance is applied at the contract level. The first step in implementation is to inventory all contracts and then apply appropriate scoping considering the type of commodity, nature of the contract, and whether contracts are homogenous. Then, the specific contracts selected can be reviewed to determine if the criteria under ASC 606 will change the accounting and/or disclosures. When reviewing public company filings to aid in implementation efforts, it is important to remember that individual contract terms dictate the accounting. As a result, there is not a “general” rule for application, and management should perform its own analyses to support its conclusions.
Key takeaways from revenue recognition implementation
Takeaways from first-quarter 2018 public filings include the following (as discussed above, specific revenue contract information is essential to form conclusions) for upstream companies, midstream companies, and oilfield service companies.
Upstream companies for the most part reported an immaterial or no-adoption impact to beginning retained earnings (i.e., net income impact) as of January 1, 2018. Many gas producers, however, did report changes in classification of revenues and expenses in the statement of operations for the quarter ended March 31, 2018. Under the new guidance, fees and costs incurred under pipeline gathering, transportation and gas processing agreements prior to control transfer are recognized as transportation and processing expenses. Fees and costs incurred after control transfer are recognized as a reduction to revenue. It is critical that management analyze these types of contracts to determine when control transfers under the new criteria.
The new rules change the principal versus agent criteria, requiring contracts with midstream processors/gatherers to be reassessed. In many cases, companies have changed the conclusion reached under ASC 605 on whether the midstream company or the third-party end user is considered to be the “customer.”
Under some natural gas processing contracts, producers may deliver natural gas to a midstream company at the wellhead or the inlet of the midstream processing company's system to be gathered and processed. The midstream company remits proceeds to the producer for the resulting sales of natural gas liquids (NGLs) and residue gas. For those contracts where the producer concludes the midstream processing entity is the producer's agent and the third-party end user is its customer (generally fixed-fee agreements), the producer recognizes revenue on a gross basis, with transportation and processing expenses presented as an operating expense in the statement of operations. Alternatively, for those contracts where the producer concludes the midstream processing entity is its customer, as it controls the product (generally percentage of proceeds agreements), the producer recognizes natural gas and NGL revenues based on the net amount of the proceeds received from the midstream processing company.
In other cases, producers may conclude that they are the principal under ASC 606 for natural gas processing contracts when they have the ability to take-in-kind the NGLs and residue gas at the tailgate of the processing plant and market the products. In these situations, the producer delivers the NGLs and gas to a third-party purchaser. As principal, revenue is recognized on a gross basis.
Additionally, companies using the entitlements method to account for sales of natural gas under ASC 605 disclosed a change to the sales method, but the impact was not material to the financial statements.
Many midstream companies reported an adoption impact to beginning retained earnings. The assessment for midstream companies is more difficult than for upstream companies and more often results in material changes in the timing and/or amounts of revenue recognition. Some relief was gained through discussion with the FASB following the original issuance of ASC 606 related to estimating and accounting for noncash consideration (i.e., contracts payable in product).
Many midstream companies reported changes related to accounting for producer reimbursement payments for costs to construct connections to gathering systems. Under ASC 605, these reimbursements were recorded as a reduction to the property whereas under ASC 606, these reimbursements are recorded as deferred revenue which is then amortized over the expected contractual term.
Another common change relates to accounting for the timing of revenue recognized for producer deficiency payments received under firm transportation minimum volume commitment contracts for which the producer can ship the unused volumes later (if there is capacity) for a specified time period. Under ASC 605, these payments were recorded as deferred revenue and recognized upon resolution of all contingencies. Under ASC 606, these payments are still recorded as deferred revenue but they are recorded in revenue based on management’s estimate of the likelihood that the volumes can be shipped or forfeited each reporting period.
As discussed in the upstream takeaways, midstream companies must also analyze contracts to determine if they are the principal or agent. This conclusion drives the amount and timing of revenue recognition.
Oilfield service companies
Oilfield service companies reported both material and immaterial adoption impacts to beginning retained earnings depending on their specific revenue streams and contracts. These companies many times have service contracts with lease components as well as payments that may vary. Revenue policy disclosures discuss management estimates and judgments related to variable consideration, interaction with lease accounting guidance, and timing of revenue recognition.
The good news is that private companies are not required to adopt the new guidance in quarterly 2019 financial statements (i.e., reporting to banks and investors) and have until the 2019 year-end financial statements to complete implementation. The bad news is that the implementation process will likely take longer and require more resources than management teams may anticipate.
Even if management concludes that there is no material change upon adoption, the subsequent accounting may be different (i.e., determining when control passes, classifying costs/expenses, and assessing timing of revenue recognition). Also, disclosures regarding the nature, timing, and uncertainty of revenue and cash flows are much more robust than existing disclosure requirements. Information needs to be accumulated and tracked to support the disclosure requirements. Many management teams have found that disclosure development efforts are very challenging. If you have any questions, please give us a call.