In this update, we highlight some of the more important 2020 second quarter accounting, financial reporting, and regulatory developments that may impact oil and gas companies. The content is not meant to be all-inclusive.
Accounting guidance issued in response to COVID-19 pandemic
In response to questions from stakeholders on accounting for lease modifications and concessions during the COVID-19 pandemic, the FASB staff issued FASB Staff Q&A - Topic 842 and Topic 840: Accounting for Lease Concessions Related to the Effects of the COVID-19 Pandemic. The main issues addressed in the Q&A document were:
- The FASB staff stated it would be acceptable for entities (both lessors and lessees) to make an accounting policy election to not apply lease modification accounting to lease concessions made as a result of the COVID-19 pandemic. Instead these entities would account for the concessions as though those rights and obligations were part of the original contract.
- The FASB staff stated the accounting policy election should be applied consistently for each class of lease; however, entities would be able to apply different accounting policy elections to different classes of leases. The FASB staff also clarified that entities would not be precluded from applying lease modification accounting to concessions related to the COVID-19 pandemic since the optional approach described above is an accounting policy election.
- The FASB staff provided the following two alternatives for accounting for deferrals of payments that do not result in a substantive change to the total consideration in the original contract:
- Account for the concession as if no changes were made to the lease contract. Under this approach, lessors would increase their receivable and lessees would increase their payable as the payments would have become due. However, the timing and pattern of income/expense recognition would remain the same as it was under the terms of the original contract.
- Account for the deferred payments as a variable lease payment.
The FASB staff issued FASB Staff Q&A – Topic 815: Cash Flow Hedge Accounting Affected by the Covid-19 Pandemic in response to stakeholder questions on how the postponement or cancellation of forecasted transactions due to COVID-19 should be treated when applying hedge accounting. The FASB staff clarified that when applying cash flow hedge accounting, entities would be able to apply the exception in paragraph ASC 815-30-40-4 for rare cases caused by extenuating circumstances outside the control of the entity. This means that if a forecasted transaction is delayed as a result of COVID-19 an entity would not automatically have to discontinue hedge accounting. Entities would still need to evaluate if the forecasted transactions are probable of occurring within a reasonable time period beyond the normal time period. This ASU benefits companies with shut-in production or other production declines applying cash flow hedge accounting.
The FASB staff also clarified that given the unprecedented nature of the pandemic, missed forecasts or forecasted transactions that result from COVID-19 would not call into question an entity’s ability to accurately predict forecasted transactions in the future. Entities will need to use judgment to determine whether or not COVID-19 is the reason for the missed forecasts or forecasted transactions.
AICPA issues guidance on accounting for Paycheck Protection Program loans
In June 2020, the AICPA issued Technical Q&A Section 3200.18 (“TQA 3200.18”) to provide guidance on accounting for forgivable loans received under the Paycheck Protection Program (PPP) provided for under the CARES Act and administered by the Small Business Administration (SBA). Questions on accounting for PPP loans had arisen as the loans are legally structured as debt instruments; however, many entities and financial statement users believe the loans are in substance a government grant since they are eligible for forgiveness. Given the unique nature of these loans, the AICPA’s TQA 3200.18 specifies that the following accounting models may be appropriate depending on the facts and circumstances.
- Debt model: Because the PPP loans are legally structured as debt, entities may always choose to account for them as debt instruments using the guidance in ASC 470. Under the debt model, the PPP loan would be accounted for as a financial liability based on the contractual terms. Entities would not be required to impute interest at market rates based on an exception in ASC 835-30 for loans where interest rates are prescribed by governmental agencies. Under the debt model, the PPP loan would continue to be recorded as a financial liability until it is either repaid, or the loan has been forgiven. If forgiven, the liability would be removed, and the entity would record a gain on debt extinguishment.
- Grant revenue guidance in ASC 958: The second option in TQA 3200.18 is to account for PPP loans following the guidance in ASC 958-605. While for-profit business entities are not in the scope of ASC 958-605, TQA 3200.18 states that businesses could apply this guidance by analogy based on the lack of authoritative guidance on accounting for government grants. Entities should only use this guidance if at the time of receiving the PPP loan the conditions for loan forgiveness are expected to be substantially met. Under this model, the PPP loan proceeds would be recorded as a deferred income liability and at the time the grant terms are substantially met, the proceeds would be reported as grant income. If conditions change after receipt of the PPP loan and the entity no longer expects the loan forgiveness terms will be substantially met, the PPP loan should be accounted for as debt.
- International Financial Reporting Standards (IFRS) government grant model: Business entities may also elect to account for PPP Loans by analogizing to the guidance in International Accounting Standard 20, Accounting for Government Grants and Disclosure of Government Assistance (“IAS 20”) if certain conditions are met. In order to apply the IAS 20 model, the borrower must be able to support from loan inception until ultimate forgiveness that it is probable the loan forgiveness criteria will be met. The term ‘probable’ is used consistently with other areas of U.S. Generally Accepted Accounting Principals (GAAP) and means an event is likely to occur (a high threshold). As long as it continues to be probable the entity will meet the forgiveness criteria, grant income is recognized on a systematic basis as the qualifying expenses are incurred. If the entity were no longer able to conclude it is probable that the forgiveness criteria will be met, then the entity should discontinue applying the IAS 20 model and account for the PPP loan as debt.
Regulatory update: COVID-19-related
SEC COVID-19 response
The SEC has taken numerous actions to address registrant, investor, and market COVID-19 concerns, which are accumulated and discussed at the SEC COVID-19 Response site. We discuss some of the more important guidance and actions in the second quarter below and encourage companies to monitor the SEC website for current communications.
SEC stresses continued importance of financial reporting in light of COVID-19
On June 23, 2020, SEC Chief Accountant Sagar Teotia published a statement regarding the importance of providing investors with high-quality financial information and summarizing the efforts of the Office of the Chief Accountant (OCA) in this regard. Some of the highlights of the statement follow.
- OCA issued a statement on April 3, 2020 regarding the importance of high-quality financial reporting in light of the significant impacts of COVID-19 that we discussed in our First Quarter newsletter. OCA’s April statement acknowledged many companies have been required to make significant judgments and estimates to address a variety of accounting and financial reporting matters. In the June statement, he noted that consistent with the April statement, OCA has “consistently not objected to well-reasoned judgments that entities have made, and we will continue to apply this perspective.” These significant judgments and estimates should be consistent with the company’s specific facts and circumstance and disclosed in a manner that is understandable and useful to investors.
- Public companies are required to maintain Disclosure Controls and Procedures (DCP) and Internal Control over Financial Reporting (ICFR), and management is required to evaluate the effectiveness of the company’s DCP as of the end of each fiscal quarter, and the effectiveness of its ICFR at the end of each fiscal year. Changes in financial reporting processes in response to the current environment may need to be disclosed in quarterly filings in the fiscal quarter in which it occurred (or fiscal year in the case of a foreign private issuer) if the change materially affects (or is reasonably likely to affect) ICFR.
- OCA is available for consultation on complex financial reporting issues resulting from COVID-19 or other emerging issues.
- Audit committees serve a vital role in the financial reporting system through their oversight of financial reporting, including ICFR and the external, independent audit process. OCA noted that “in these times of rapid change and increased uncertainty, the need for the oversight role that audit committees play is as critical as ever.”
Division of corporation finance issues additional disclosures guidance for COVID-19
On March 25, 2020, the Division of Corporation Finance (Corp Fin) issued CF Disclosures Guidance: Topic No. 9, Coronavirus (COVID-19), to provide its current views regarding disclosure and other securities law obligations that companies should consider with respect to COVID-19 and related business and market disruptions (we discussed in our First Quarter newsletter). On June 23, 2020, Corp Fin provided additional views regarding operations, liquidity, and capital resources disclosures in CF Disclosures Guidance: Topic No. 9A, Coronavirus (COVID-19) — Disclosure Considerations Regarding Operations, Liquidity, and Capital Resources.
Disclosures assessment: Operations, liquidity, and capital resources
Companies have undertaken and are generally in the process of making a diverse range of operational adjustments as well as a diverse and sometimes complex range of financing activities in response to the effects of COVID-19. The operational adjustments may have a material effect on a company that requires an obligation to disclose this information to investors. It is also important that companies provide robust and transparent disclosures about how they are dealing with short- and long-term liquidity and funding risks in the current economic environment, particularly to the extent efforts present new risks or uncertainties. Corp Fin observed companies making some of these disclosures in their earnings releases but encourages companies to evaluate whether any of the information should also be included in management discussion and analysis (MD&A).
The staff guidance provides a list (not all inclusive) of a broad range of questions for companies to consider with respect to their disclosure obligations:
- What are the material operational challenges that management and the Board of Directors are monitoring and evaluating? How and to what extent have you altered your operations, such as implementing health and safety policies for employees, contractors, and customers, to deal with these challenges, including challenges related to employees returning to the workplace? How are the changes impacting or reasonably likely to impact your financial condition and short- and long-term liquidity?
- How is your overall liquidity position and outlook evolving? To the extent COVID-19 is adversely impacting your revenues, consider whether such impacts are material to your sources and uses of funds, as well as the materiality of any assumptions you make about the magnitude and duration of COVID-19’s impact on your revenues. Are any decreases in cash flow from operations having a material impact on your liquidity position and outlook?
- Have you accessed revolving lines of credit or raised capital in the public or private markets to address your liquidity needs? Are your disclosures regarding these actions and any unused liquidity sources providing investors with a complete discussion of your financial condition and liquidity?
- Have COVID-19-related impacts affected your ability to access your traditional funding sources on the same or reasonably similar terms as were available to you in recent periods? Have you provided additional collateral, guarantees, or equity to obtain funding? Have there been material changes in your cost of capital? How has a change, or a potential change, to your credit rating impacted your ability to access funding? Do your financing arrangements contain terms that limit your ability to obtain additional funding? If so, is the uncertainty of additional funding reasonably likely to result in your liquidity decreasing in a way that would result in you being unable to maintain current operations?
- Are you at material risk of not meeting covenants in your credit and other agreements?
- If you include metrics, such as cash burn rate or daily cash use in your disclosures, are you providing a clear definition of the metric and explaining how management uses the metric in managing or monitoring liquidity? Are there estimates or assumptions underlying such metrics that the disclosure of which is necessary for the metric not to be misleading?
- Have you reduced your capital expenditures, and if so, how? Have you reduced or suspended share repurchase programs or dividend payments? Have you ceased any material business operations or disposed of a material asset or line of business? Have you materially reduced or increased your human capital resource expenditures? Are any of these measures temporary in nature, and if so, how long do you expect to maintain them? What factors will you consider in deciding to extend or curtail these measures? What is the short- and long-term impact of these reductions on your ability to generate revenues and meet existing and future financial obligations?
- Are you able to timely service your debt and other obligations? Have you taken advantage of available payment deferrals, forbearance periods, or other concessions? What are those concessions, and how long will they last? Do you foresee any liquidity challenges once those accommodations end?
- Have you altered terms with your customers, such as extended payment terms or refund periods, and if so, how have those actions materially affected your financial condition or liquidity? Did you provide concessions or modify terms of arrangements as a landlord or lender that will have a material impact? Have you modified other contractual arrangements in response to COVID-19 in such a way that the revised terms may materially impact your financial condition, liquidity, and capital resources?
- Are you relying on supplier finance programs, otherwise referred to as supply chain financing, structured trade payables, reverse factoring, or vendor financing, to manage your cash flow? Have these arrangements had a material impact on your balance sheet, statement of cash flows, or short- and long-term liquidity and if so, how? What are the material terms of the arrangements? Did you or any of your subsidiaries provide guarantees related to these programs? Do you face a material risk if a party to the arrangement terminates it? What amounts payable at the end of the period relate to these arrangements, and what portion of these amounts has an intermediary already settled for you?
- Have you assessed the impact material events that occurred after the end of the reporting period, but before the financial statements were issued, have had or are reasonably likely to have on your liquidity and capital resources and considered whether disclosure of subsequent events in the financial statements and known trends or uncertainties in MD&A is required?
Government assistance: The Coronavirus Aid, Relief, and Economic Security Act (CARES Act)
Companies receiving federal assistance under the CARES Act should consider the short- and long-term impact of that assistance on their financial condition, results of operations, liquidity, and capital resources, as well as the related disclosures and critical accounting estimates and assumptions. The staff guidance provides a list of questions for companies to consider with respect to their disclosure obligations:
- How does a loan impact your financial condition, liquidity, and capital resources? What are the material terms and conditions of any assistance you received, and do you anticipate being able to comply with them? Do those terms and conditions limit your ability to seek other sources of financing or affect your cost of capital? Do you reasonably expect restrictions, such as maintaining certain employment levels, to have a material impact on your revenues or income from continuing operations or to cause a material change in the relationship between costs and revenues? Once any such restrictions lapse, do you expect to change your operations in a material way?
- Are you taking advantage of any recent tax relief, and if so, how does that relief impact your short- and long-term liquidity? Do you expect a material tax refund for prior periods?
- Does the assistance involve new material accounting estimates or judgments that should be disclosed or materially change a prior critical accounting estimate? What accounting estimates were made, such as the probability a loan will be forgiven, and what uncertainties are involved in applying the related accounting guidance?
Company’s ability to continue as a going concern
Management should consider whether conditions and events, taken as a whole, raise substantial doubt about the company’s ability to meet its obligations as they become due within one year after the issuance of the financial statements. There are required financial statement disclosures when there is substantial doubt about a company’s ability to continue as a going concern or in cases where the substantial doubt is alleviated by management’s plans. Companies should also consider the following questions regarding the MD&A disclosure:
- Are there conditions and events that give rise to substantial doubt about the company’s ability to continue as a going concern? For example, have you defaulted on outstanding obligations? Have you faced labor challenges or a work stoppage?
- What are your plans to address these challenges? Have you implemented any portion of those plans?
Companies may have changes to their processes and internal controls as they adapt to the new conditions necessitated by COVID-19, such as working remote, personnel losses, and other constraints. These changes may require disclosure in the Forms 10-K and 10-Q. Management and audit committees should consider the disclosure requirements related to the establishment of new controls, redesigning of controls and processes.
Center for Audit Quality (CAQ) COVID-19 resources
The CAQ has developed a resource page to help auditors, management, and audit committees understand the impact of the COVID-19 on financial reporting and oversight. We discuss some of the publications in the second quarter below and encourage companies to monitor the CAQ website for current resources.
COVID-19 resource: Key auditor and audit committee considerations
In April 2020, the CAQ issued a publication with key considerations for upcoming filings. We discussed the publication in our First Quarter newsletter. Accounting and financial reporting implications of COVID-19 may require companies to make significant judgments and estimates, which can be challenging in an environment of uncertainty. The publication contains questions on certain accounts and disclosures for management, auditors, and audit committees to consider.
COVID-19 considerations for non-GAAP financial measures and performance metrics
In April 2020, the CAQ issued a publication to provide a high-level overview of SEC requirements and guidance around non-GAAP reporting and the potential impact of COVID-19 on that reporting. The CAQ conducted a series of roundtables and noted that companies may use non-GAAP financial measures to describe the impact of COVID-19 in their quarterly and annual reporting and company management, audit committees, and investors find non-GAAP financial measures and performance metrics to be useful when they are calculated and presented consistently, transparently disclosed, and comparable to measures disclosed by other companies. Companies may adjust or tailor the non-GAAP financial measures and performance metrics they typically present because of COVID-19-related factors. It is important that transparent disclosure of how the metrics are calculated and why management finds these metrics meaningful be included in filings to help investors understand the effects of COVID-19 on a particular company.
Corp Fin provided guidance on non-GAAP financial measures and performance metrics used to describe the impact of COVID-19 in CF Disclosures Guidance: Topic No. 9, Coronavirus (COVID-19). In January 2020, the SEC provided guidance on the disclosure of key performance indicators (KPIs) and metrics in MD&A.
The CAQ publication summarizes SEC guidance related to non-GAAP financial measures, performance metrics, and the key components of the Topic No. 9 guidance related to COVID-19 and discusses the important responsibility that the audit committee has to oversee the financial reporting process and the external auditors. This resource is helpful for management as well.
The audit committee can act as a bridge between management and investors by:
- Assessing management’s reasons for presenting non-GAAP financial measures and performance metrics;
- Considering the sufficiency of management’s related disclosures; and
- Evaluating whether the measures present a fair and balanced view of the company’s performance.
The audit committee may consider the following when evaluating non-GAAP financial measures and performance metrics being presented to communicate the effects of COVID-19:
- Putting itself in the shoes of investors when evaluating if the non-GAAP financial measures, performance metrics, and related disclosure will help investors understand how management and the audit committee are evaluating the business.
- Discussing with management how the company made changes to the non-GAAP financial measures and performance metrics the company typically presents to communicate the effects of COVID-19, including the rationale and any related disclosure for those changes.
- Asking management how they have considered compliance with the SEC’s rules and guidance when reporting non-GAAP financial measures and performance metrics that reflect adjustments for COVID-19.
- Asking the external auditors what their responsibilities are for non-GAAP financial measures and performance metrics, and whether that responsibility is different depending on where the non-GAAP financial measures or performance metrics are presented.
Goodwill impairment considerations in the COVID-19 environment
In June 2020, the CAQ published a resource intended to provide a high-level overview of management’s accounting requirements and auditor considerations for testing goodwill impairment in the COVID-19 environment. This resource is useful in considering the impact COVID-19 may have on certain aspects of accounting for goodwill impairment, such as triggering event identification and reporting unit carrying value and fair value calculations, as well as internal control considerations.
Going concern: Management and auditor responsibilities
In April 2020, the CAQ published a resource to provide a high-level overview of management’s accounting requirements under U.S. GAAP and a public company auditor’s requirement under PCAOB auditing standards related to going concern. As a result of the COVID-19 pandemic and the resulting economic uncertainty, several companies may face challenges that could impact their ability to continue operating as a going concern. Those challenges may include, among others, work stoppages, restrictions and/or regulations, supply chain disruptions, decreased commodity pricing, shut-in production, and reduced demand. To determine the effect of these challenges on the business, management may need to invest significant effort to prepare supportable future cash flow projections for the next 12 months that will be utilized in going concern evaluations. This may result in increased judgments by management and corresponding increases in skepticism from auditors with respect to going concern evaluations. In this environment, it becomes even more critical that management, the auditors and those relying on the financial statements have a clear understanding of each party’s responsibilities as it relates to going concern with respect to both the interim and annual financial statements.
Regulatory update: Other
Amendments to financial disclosures about acquired and disposed businesses
In May 2020, the SEC adopted amendments to the required financial disclosures about acquired and disposed businesses. The amendments will be effective on Jan. 1, 2021, but early voluntary compliance is permitted.
The amendments to the rules and forms are intended to assist registrants in making more meaningful determinations of whether a subsidiary or an acquired or disposed business is significant and improve the financial disclosure requirements applicable to acquisitions and dispositions of businesses.
When a registrant acquires a significant business, other than a real estate operation, Rule 3-05 of Regulation S-X generally requires a registrant to provide separate audited annual and unaudited interim pre-acquisition financial statements of that business. The number of years of financial information that must be provided depends on the relative significance of the acquisition to the registrant. Three separate tests defined in Rule 1.02(w) are used to compute “significance:” the investment test, the asset test, and the income test. The relative significance of the acquisition or disposition then determines the period of the required historical and pro forma financial statements.
Article 11 of Regulation S-X also requires registrants to file unaudited pro forma financial information relating to the acquisition or disposition. Pro forma financial information typically includes a pro forma balance sheet and pro forma income statements based on the historical financial statements of the registrant and the acquired or disposed business, including adjustments to show how the acquisition or disposition might have affected those financial statements.
The final amendments will, among other things:
- Update the significance tests in Rule 1-02(w), Securities Act Rule 405, and Exchange Act Rule 12b-2 by:
- revising the investment test to compare the registrant’s investments in and advances to the acquired or disposed business to the registrant’s aggregate worldwide market value if available;
- revising the income test by adding a revenue component;
- expanding the use of pro forma financial information in measuring significance; and
- conforming, to the extent applicable, the significance threshold and tests for disposed businesses to those used for acquired businesses;
- Modify and enhance the required disclosure for the aggregate effect of acquisitions for which financial statements are not required or are not yet required by eliminating historical financial statements for insignificant businesses and expanding the pro forma financial information to depict the aggregate effect in all material respects;
- Require the financial statements of the acquired business to cover no more than the two most recent fiscal years;
- Permit disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity;
- Permit the use of, or reconciliation to, International Financial Reporting Standards as issued by the International Accounting Standards Board in certain circumstances;
- No longer require separate acquired business financial statements once the business has been included in the registrant’s post-acquisition financial statements for nine months (if exceed 20% but does not exceed 40% significance) or a complete fiscal year (if exceed 40% significance), depending on significance.;
- Align Rule 3-14 with Rule 3-05 where no unique industry considerations exist;
- Clarify the application of Rule 3-14 regarding:
- the determination of significance;
- the need for interim income statements;
- special provisions for blind pool offerings; and
- the scope of the rule’s requirements;
- Amend the pro forma financial information requirements to improve the content and relevance of such information. The revised pro forma adjustment criteria will provide for:
- “Transaction Accounting Adjustments” reflecting only the application of required accounting to the transaction;
- “Autonomous Entity Adjustments” reflecting the operations and financial position of the registrant as an autonomous entity if the registrant was previously part of another entity; and
- optional “Management’s Adjustments” depicting synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given if, in management’s opinion, such adjustments would enhance an understanding of the pro forma effects of the transaction and certain conditions related to the basis and the form of presentation are met;
- Make corresponding changes to the smaller reporting company requirements in Article 8 of Regulation S-X, which will also apply to issuers relying on Regulation A;
- Amend the definition of “significant subsidiary” to provide a definition that is specifically tailored for investment companies; and
- Add new Rule 6-11 and amend Form N-14 to cover financial reporting for fund acquisitions by investment companies and business development companies.
If you have any questions, please give our oil and gas team a call.