Ongoing market volatility and financing constraints has many oil and gas companies contemplating reorganization. Understanding the accounting recognition and financial reporting impacts of troubled debt restructurings, out-of-court reorganizations, and Chapter 7 and 11 bankruptcies is crucial when charting the path forward.
Decreased oil and gas demand forces difficult decisions
In addition to depressed commodity markets, stay-at-home orders throughout the world and a dejected summer travel season have slashed consumer demand, leaving leaders in the oil and gas industry with difficult decisions about the future of their companies and impacts to stakeholders and staff.
The lack of active capital investment in oil and gas companies, through public markets and private funds, may leave leaders limited financing options. Given the minimal drilling and completions in recent months as well as the impacts from recent shut-in production, companies with significant debt are now faced with even more leverage as a result of shrinking reserves from decreasing volumes, compounded by a drop-in pricing. These factors are leading to negotiations surrounding debt terms and covenant violations, mandatory repayments, and default. Considering the timing of the fall borrowing base redetermination season, these challenges are likely to only grow more problematic and widespread.
The upcoming November elections, at all levels, create an additional layer of uncertainty for the oil and gas industry as well as the overall energy sector. This uncertainty, combined with an increased focus on environmental, social, and governance performance, is forcing leaders and investors to further reanalyze and rechart their strategy for success.
Reorganizations are sometimes the solution for oil and gas companies
We have already seen numerous reorganizations and bankruptcies in recent months, with many more expected in the near term. That said, whether as a result of past strategy, financial and operational conservatism, or sheer luck through timing, many oil and gas companies are not in these dire circumstances, and they are able to tread water and retool while watching their peers and the market closely. However, as the constraints continue to challenge the industry, we may see an increasingly common outcome in the near term: reorganizations.
In many cases, companies, their investors, and major creditors have aligned interests in that they all seek solutions that will preserve their own capital. This aligned interest means out-of-court processes can be a viable option. These can minimize the time to emergence, save on costly in-court processes, and keep the company out of the headlines. While the result of out-of-court processes can be a complete sale through liquidation, it is not the only option. Other outcomes run the gamut: restructuring credit facilities, reducing principal payments, extending maturities, and modifying interest rates, fee structures, and covenants, in addition to further capital infusions from investors or converting outstanding debt balances to equity with increased lender governance roles.
If out-of-court processes are not possible or the impacted parties cannot reach an agreement, in-court processes are generally the next option. While a Chapter 7 process provides for liquidation of the specific assets with distribution of their proceeds to creditors, a Chapter 11 process often provides more value for most impacted parties given the current depressed commodity price environment and the long-term nature of oil and gas assets.
Either path, however, brings significant accounting consequences and financial reporting considerations for both publicly traded and privately held entities. (These events also have significant income tax and tax-related accounting and financial reporting ramifications, which are not addressed in this article.) Given the wide breadth of options that an out-of-court reorganization process affords, leaders need to consider the many potential accounting consequences.
Debt amendments may modify the accounting
When debt terms are modified or amended, the troubled debt restructuring and debt modification and extinguishment guidance should be analyzed to determine the impact of the modification or amendment on the carrying value of the debt, the unamortized debt issuance costs, as well as the costs associated with the amendment. The troubled debt restructuring guidance is required when the borrower is experiencing financial difficulty and the lender grants a concession. While this guidance may have been sitting on the back of the bookshelf for many borrowers in recent years, many out-of-court restructurings will qualify as troubled debt restructuring since borrowers are generally experiencing deterioration in creditworthiness, which is what has led them to this stage in the first place.
The troubled debt restructuring guidance is required when the borrower is experiencing financial difficulty and the lender grants a concession.
Due to the nature of these types of amendments, granting of concessions may also occur, since company-favorable amendments — maturity extensions, decreased principal payments or outstanding balances, or interest rate reductions, as examples — may result in decreased effective borrowing rates. The result of a troubled debt restructuring in which the future undiscounted cash flows are less than net carrying value of the original debt is the recognition of a gain, adjusted for any new fees incurred in conjunction with the debt modification or amendment.
If the creditors and borrower agree to an exchange of outstanding debt for equity interests and/or a transfer of assets, the borrower would compare the net carrying amount extinguished to the price of its reacquisition to determine the gain (or loss) on extinguishment. The reacquisition price of debt includes the fair value of equity issued and any assets transferred to the creditors. Determining the fair value may pose valuation challenges given the likely indications of distress. While significant, and most likely lengthy, negotiations will have taken place between the creditors and borrower to determine the value of the equity to be exchanged for a portion or all of the debt, the valuation considerations used in these negotiations may require adjustment in order to be consistent with the fair value concepts based on orderly transactions within Accounting Standards Codification (ASC) 820. While the fair value of the equity interests granted or assets transferred should be used to determine the reacquisition price of the debt, the fair value of the debt settled may be more evident than the fair value of the equity interests granted or assets transferred when there is a full settlement of the debt. However, if only a portion of the debt is settled, the fair value of the equity interests granted or assets transferred should be utilized to avoid having to allocate the value between the portion of the debt settled and portion still outstanding.
While the difference between the net carrying amount extinguished and the price of reacquisition will generally be a gain, the creditors’ relationship with the borrower should be analyzed to determine if it was, in essence, a capital transaction in which the amount would be recorded as a component of equity and not as a gain. All relevant pre- and post-extinguishment relationships, contracts, agreements, and other elements of control between the creditors and the borrower need to be considered in this analysis.
Chapter 7 and Chapter 11 bankruptcies also impact accounting
A Chapter 7 liquidation creates a wealth of accounting implications, including a likely change in the basis of reporting as the liquidation basis is required when the company has an approved plan for liquidation or when others have the authority to impose such plan, such as creditors forcing a sale, and the likelihood that the company will return from the plan is remote. ASC 205-30 utilizes recognition and measurement principles that reflect what an investor would be able to receive upon liquidation. While this may result in the use of a market participant based fair value, in a nonorderly and/or distressed environment, this may require the inclusion of additional and different considerations than those utilized in an orderly transaction. In subsequent periods, the value of all assets, including those previously not recorded, should be reassessed to reflect the impact of any changes in conditions or circumstances so that they continue to be recorded as of the reporting date based on the estimated amount of cash or other consideration that is expected to be collected upon settlement. Dissimilarly, in most cases, liabilities continue to be measured based on the applicable provisions throughout generally accepted accounting principles (GAAP), other than certain accruals for estimated disposal costs and expected income and expenses. While it can be expected given the nature of the liquidation process that certain liabilities will be relieved, wholly or partially, these liabilities should not be derecognized until there has been a legal release of the obligation.
Chapter 11 reorganizations similarly create another set of accounting considerations. ASC 852 is only applicable for entities that have filed petitions with the Bankruptcy Court, so entities that have not formally filed are not within that scope. Once the filing has occurred, while many aspects of financial accounting recognition and reporting remain unchanged and other provisions within GAAP are still applicable, entities must address several additional aspects of presentation and disclosure within the financial statements.
Emerging from bankruptcy and fresh-start accounting
Post emergence from bankruptcy, fresh-start accounting will be applicable when 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. In this case, the emerging entity will apply fresh-start accounting as a new entity with new controlling shareholders, which results in significant changes to the financial statements as a new entity is effectively created.
As you might expect, significant presentation and disclosure requirements accompany the fresh-start accounting model. The results of the reconstituted entity and the predecessor entity are segregated through the use of a vertical “black line” to segregate the activity from the two periods. Disclosure requirements include adjustments to the historical amounts of the specific assets and liabilities as well as the amount of debt forgiven. Since the reorganization value, which approximates the amount a willing buyer would pay for the assets of the company immediately after restructuring, is a key part of this accounting model, significant matters related to the determination of the reorganization value must be disclosed. These include the methods utilized for determining the value and the significant inputs utilized in those forecasts, models, as well as sensitivities to the various assumptions. Additional disclosures surrounding the background and facts associated with the bankruptcy and confirmed plan for re-emergence, as well as the terms and details associated with the ongoing stock, debt, and other liabilities, are also required.
Since the reorganization value, which approximates the amount a willing buyer would pay for the assets of the company immediately after restructuring, is a key part of this accounting model, significant matters related to the determination of the reorganization value must be disclosed.
Volatility and uncertainty create opportunity to rethink strategies
In the face of ongoing market volatility, many oil and gas companies continue to rethink their approaches and contemplate reorganizational strategies. As they do, it is critical to understand the accounting recognition and financial reporting impacts (as well as the numerous, significant income tax and related accounting consequences) as a key part of the process.
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