New directions for oil and gas companies: Restructuring options and accounting impacts
The operational and financial viability of many oil and gas companies and field service providers are being tested. Restructuring can bring operational efficiencies and address threats to liquidity. Here are key options and accounting impacts as organizations look to stay afloat and chart new directions.
Threats to oil and gas companies’ liquidity
Liquidity is, of course, critical to survival as upstream companies face severely volatile commodity prices, resulting in a rapid decline of production due to the prevalence and effects of shut-ins and lack of development activities. The constraint of shrinking operating cash flows and a lack of available financing resources is causing multiple rippling impacts to oil and gas companies.
Minimum volume or similar commitments are now at risk of not being fulfilled by producers, which creates risk for many midstream entities. Additionally, the slowdown of development activities by operators craters demand for service companies and creates downward pressure on margins as competition for the remaining work increases. Companies with significant leverage, many of which were already facing credit challenges in late 2019, are now faced with fewer options. Covenant violations, shrinking borrowing bases, mandatory repayments, forbearance agreements, and defaults are now realities. New capital is scarce, and many owners, including private equity groups, are consolidating their investees to gain efficiencies. Companies that were well hedged before are not immune to these prolonged challenges.
All of these factors are leading companies to reconsider their workforce needs, compensation, and commitments such as leases and service agreements, in an effort to control costs and preserve cash to weather the current storm and plan their path forward. While positive signs recently have emerged, including a slight commodity price rebound and increase in consumption and demand, businesses and investors are questioning the economic model, capital structure, future profitability, and plans for monetization. Many of these operational decisions driven by financial realities are often referred to as restructuring.
Restructuring to balance current realities with long-term financial goals
Restructuring requires an understanding of two things: first, the current reality and near- and long-term operational and financial goals, and second, the options for future opportunity and financial health. All options should be on the table as oil and gas companies look ahead. Some of the key options include:
- Reassessment of debt terms and relationships with current lenders.
- Reassessment of current credit markets, including other lenders.
- Exploring alternative financing venues, such as strategic partnerships, joint development arrangements, or mezzanine capital.
- Strategic divestitures.
Cost evaluations and margin analysis are another way to quickly identify improvements. Operations can be analyzed to determine opportunities for efficiencies in both cost and performance-integrated operational, financial, strategic, human capital, and technology services. Modeling and benchmarking help determine what products, services, customers, and locations are most efficient and what should be changed or eliminated. In some cases, reorganization through bankruptcy can provide the best option for preserving value.
Financial accounting impacts of restructuring
Restructuring may result in substantial impacts to the entity’s accounting given the breadth of these activities and transformations. Impacts can be as small as additional footnotes in disclosures and as large as revaluing the entire entity. Common financial accounting considerations related to restructuring include:
- Liquidity and the ability to continue as going concern
- Combination of entities under common control
- Trigger events and reassessment of recoverability of long-lived assets
- Asset sales, held for sale, and discontinued operations classification
- Reductions in workforce, termination benefits, and other exit costs
- Reorganizations and fresh-start accounting
- Liquidation and the liquidation basis of accounting.
Note that these and other factors also can have significant income tax ramifications, but these are beyond the scope of this analysis.
Assessing the debt situation
Liquidity challenges have a pervasive impact on both the operations and accounting of the entity. Substantial doubt about the entity’s ability to continue as a going concern is an all-too-common reality in today’s market that requires significant quantitative and qualitative analysis for the entire business. A large factor in this analysis is the entity’s debt situation. Current and prospective covenant violations, which if uncured generally lead to default, are a common trigger of substantial doubt. Borrowing base redeterminations in this environment can result in mandatory principal payments when the outstanding amount is greater than the redetermined amount. While covenant violations and borrowing base redeterminations bring the entity and the lender back to the table for discussions and renegotiations, these seldom go quickly and may take many turns before a mutually agreeable resolution is reached, if one is reached. Any time debt agreements are revised or amended, accounting complexities arise, since there is a need to determine if the change represents a modification, extinguishment, or a troubled debt restructuring. This generally accepted accounting principle (GAAP) determination impacts the treatment of the unamortized debt issuance costs, treatment of costs incurred during the debt amendment, measurement of the new carrying value of the debt, and financial statement disclosures.
Any time debt agreements are revised or amended, accounting complexities arise, since there is a need to determine if the change represents a modification, extinguishment, or a troubled debt restructuring.
Combining multiple separate entities
Another type of restructuring transaction that’s increasingly used to address these financial challenges is the combination of multiple separate entities by a common owner or owners. These combinations can be creatively structured to combine the common owner’s assets into one entity to lower overhead burdens, consolidate credit facilities, and gain other organizational efficiencies. The accounting for these types of transactions can vary widely based on both the legal structure and the substance of the transaction, which is based on factors of pre- and post-transaction control and ownership. These factors influence whether the entity and the net assets transferred are measured by both the transferring entity and the receiving entity at fair value or at historical carrying value, as well as how the historic activity is reported in the receiving entity’s financial statements. Similarly, any changes to the entity’s organizational, managerial, and contractual structure or operating agreements may require a reassessment of consolidation accounting. This occurs under both the voting interest and variable interest models. Changes to the operating and similar or related agreements that impact the power to direct significant activities of the entity, including protective, participating, and kickout rights, whose equity is at risk and who is obligated to absorb losses, and who is the primary beneficiary, may result in a different conclusion on consolidation accounting. Changing conclusions may result, including deconsolidation, recognition of a noncontrolling interest, or the use of equity method accounting.
Trigger events may be present
Many of these events may trigger the need to evaluate the entity’s assets for recoverability since they may indicate that the assets might not be recoverable at the current carrying value. This results in the need to determine the appropriate grouping of the long-lived assets to test for recoverability as well as creation of estimates of future cash flows of those assets to test such recoverability. In times of significant uncertainty, or where there are multiple potential future scenarios, various appropriately weighted estimates of these entity-specific future cash flows may be necessary to evaluate whether these undiscounted cash flows are greater than the carrying value of the long-lived assets. If they are, additional analysis is then required, often utilizing fair value specialists to assist in the determination of market participant-based factors to determine the fair value of the long-lived assets. This is necessary since the impairment will be measured in the amount by which the carrying value exceeds the fair value.
While merger and acquisition activity has slowed recently, if an entity is considering a sale of an entity or its assets, the entity should consider whether the assets meet the requirements for held-for-sale classification. If they do, a different impairment model is utilized, which compares the carrying value of the assets to the fair value less costs associated with the sale. If the held-for-sale classification is met, or the assets have already been sold, the entity is also required to consider whether the transaction meets the requirements of discontinued operations. This in turn requires the entity to analyze whether the transaction represents a strategic shift that will have (or had) a major effect on the entity’s operations and financial results. If either the held-for-sale or discontinued operations requirements are met, the financial reporting requirements result in significant and pervasive changes to the entity’s financial statement presentation and footnote disclosures.
If an entity is considering a sale of an entity or its assets, the entity should consider whether the assets meet the requirements for held-for-sale classification.
Workforce reduction and termination benefits
As business leaders are making difficult decisions to close locations, consolidate assets, reassess profitability, and slow development activities, staffing levels and overhead costs are being put under the microscope, leading to workforce reductions. Any termination benefits provided by the entity must be assessed to determine if they should be accrued for immediately or recognized when paid. Several key factors influence this determination and include analysis as to:
- When the plan is committed to by management.
- When it is communicated to employees.
- Whether or not future services are required.
- Whether the amounts can be reasonably estimated.
- When the employee accepts the terms of the arrangement.
Similarly, as entities are consolidating locations or rethinking their office space footprint because the need for square footage has been drastically reduced, entities are renegotiating leases or breaking them altogether. When this occurs, entities must analyze whether a lease modification occurred to determine whether to accelerate expense recognition. This analysis is different depending on whether the entity is applying ASC 840 or the newer ASC 842. The presence of a sublease can also impact this analysis since whether or not the sublessee relieved the entity’s obligation to the landlord and is in essence a termination will impact the timing and pattern of expense recognition.
Accounting impacts of bankruptcy
If bankruptcy is the only feasible strategy to preserve value, entering the Chapter 11 petition process has significant accounting impacts. While many aspects of recognition and reporting remain unchanged, liabilities are segregated into pre- and post-petition categories, and the pre-petition liabilities are further segregated into amounts subject to compromise and amounts not subject to compromise, which are generally secured amounts. Those subject to compromise are generally reported at the expected allowed claims amount, which is the amount allowed by the Bankruptcy Court as a claim, even if it’s expected that the obligation will be settled at a lower amount later in the process. The statement of operations and statement of cash flows continue with the same presentation as prior to filing of the petition. However, any costs, such as professional fees and provisions for losses, directly related to the reorganization are presented separately as reorganization items.
Once the entity emerges from bankruptcy, if the reorganization value of the assets is less than the total of all post-petition liabilities and allowed claims, and if the holders of the voting shares prior to confirmation receive less than 50% control of the emerging entity, the emerging entity will apply fresh-start accounting as a new entity with new controlling shareholders. The reorganization value, which is determined as a part of the court-approved plan of emergence from bankruptcy, is viewed as the value of the reconstituted entity.
Fresh-start accounting and financial statement impacts
If fresh-start accounting is applicable, there are significant impacts to the financial statements. First, all assets and liabilities of the emerged entity are valued based on the reorganization value and using the fair value concepts within ASC 820 and recognition concepts within ASC 805, which may result in recognition of previously unrecognized intangible assets, such as favorable contractual terms or goodwill. Next, the disclosure of the activity prior to emergence and post-emergence results in the identification and presentation of discrete predecessor and successor activity through the use of a vertical “blackline” to separate the activity, as the pre-emergence entity and post-emergence entity are effectively two separate entities. As can be expected, there are significant disclosure requirements that go along with this accounting to disclose the background, facts, and terms associated with the bankruptcy.
Lastly, if there are no other valuable avenues left, a full liquidation is often contemplated, voluntarily or involuntarily, such as Chapter 7 bankruptcy or lender actions. While entities generally account for activity in their GAAP financial statements on the basis of a going concern, when these activities are present, the liquidation basis of accounting is often applicable. To meet these requirements, the entity must have an approved plan for liquidation or, when others have the authority to impose such a plan, the likelihood that the entity will return is remote. While historic cost and fair value concepts are prevalent throughout the majority of GAAP, and fair value concepts are based on orderly transactions, the liquidation basis requires the use of recognition and measurement principles to reflect what an investor may be able to receive, which are often present in a nonorderly and distressed environment. Entities often consult with a fair value specialist during this process to determine the liquidation-basis values.
While historic cost and fair value concepts are prevalent throughout the majority of GAAP, and fair value concepts are based on orderly transactions, the liquidation basis requires the use of recognition and measurement principles.
Additionally, depreciation of assets ceases, and assets are adjusted to this expected settlement value, while the value of liabilities are generally not adjusted until legally settled unless impacted by timing-based factors. At the time of determination that the liquidation basis applies to the entity, the entity must accrue for any expected disposal costs as well as income and costs that are reasonably expected to occur and incur, so that the resulting financial statements reflect the total value an investor may expect to receive for the net assets of the entity as of that point in time.
Navigating decisions and improving operational efficiencies
Outside advisors can help lead companies through the options and decisions leaders must make as they reshape their companies. An advisor who specializes in restructuring and transformations can provide an unbiased perspective to the company and its management as well as bring ample experience in navigating the challenges. They can also bring new technologies to the table to increase operational efficiencies and processes. They provide guidance to the owners and management team who want solutions that take their reputational and legacy concerns into account in addition to financial and operational issues. An accounting advisor can help navigate the various accounting impacts — and numerous near- and long-term tax outcomes — of decisions made in response to economic slowdowns and related challenges, and help companies chart a new direction.
As the industry continues to reel from market uncertainties and commodity pricing volatility, identifying, implementing, and capitalizing on the ever-changing options for restructuring will only become more crucial to the short- and long-term viability of oil and gas companies.
If you have any questions, please give our energy team a call.