In this update, we highlight some of the more impactful 2021 first quarter accounting, financial reporting, and regulatory developments that may impact energy companies. The content is not meant to be all-inclusive.
Accounting guidance issued in first quarter 2021
ASU 2021-03, Intangibles – Goodwill and Other (Topic 350): Accounting Alternative for Evaluating Triggering Events, introduces a new alternative for private companies to perform the goodwill impairment triggering event analysis as of the end of the reporting period, rather than as of the date a triggering event may have occurred. The new ASU clarifies that any interim or annual period where an entity issues U.S. GAAP-compliant financial information (as defined within ASC Topic 275) that includes goodwill, or any line item that could be impacted by goodwill impairment, is considered a reporting period. Based on this definition, companies that provide a GAAP-compliant statement of financial position and/or statement of operations to external users (e.g., lenders, regulators, or investors) more frequently than on an annual basis are considered to have interim reporting periods. Thus, these entities would need to assess if a triggering event has occurred at each interim or annual reporting date. The new guidance was effective for reporting periods beginning after Dec. 15, 2019.
ASU 2021-01, Reference Rate Reform (Topic 848): Scope, clarifies questions that had arisen regarding the types of contract modifications to which the optional practical expedients in ASC Topic 848 may be applied. The clarifications relate to the following areas of the reference rate reform guidance in ASC Topic 848 and were effective upon the issuance of the ASUs:
- Reference Rate Reform – Overall
- Contract Modifications
- Hedging – General
- Fair Value Hedges
- Cash Flow Hedges
Accounting guidance effective first quarter 2021: Public companies
The following standards are effective for public companies beginning with the first quarter of 2021:
ASU 2020-08, Codification Improvements to Subtopic 310-20 Receivables – Nonrefundable Fees and Other Costs, clarifies that an entity should reevaluate each reporting period whether a callable debt security is within the scope of paragraph 310-20-35-33. The standard is effective for fiscal years beginning after Dec. 15, 2020, for public business entities, and for fiscal years beginning after Dec. 15, 2021, for all other entities.
ASU 2020-01, Investments—Equity Securities (Topic 321), Investments—Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815): Clarifying the Interactions between Topic 321, Topic 323, and Topic 815, clarifies the interaction between the measurement alternative in Topic 321 for equity securities without a readily determinable fair value and the guidance in Topic 323 and Topic 815. The primary issue addressed in the ASU is clarification that an entity should consider observable transactions that require it to either apply or discontinue the equity method of accounting for the purposes of applying the measurement alternative in Topic 321 immediately before applying or upon discontinuing the equity method. The standard is effective for fiscal years beginning after Dec. 15, 2020, for public business entities, and for fiscal years beginning after Dec. 15, 2021, for all other entities.
ASU 2019-12, Income Taxes (Topic 740), Simplifying the Accounting for Income Taxes, simplifies the accounting for income taxes by removing the following exceptions from Topic 740 related to:
- Incremental approach for intraperiod tax allocation when there is a loss from continuing operations and income or a gain from other items.
- Recognition of a deferred tax liability for equity method investments when a foreign subsidiary becomes an equity method investment.
- Ability not to recognize a deferred tax liability for a foreign subsidiary when a foreign equity method investment becomes a subsidiary.
- General methodology for calculating income taxes in an interim period when a year-to-date loss exceeds the anticipated loss for the year.
The ASU also makes the following changes to the accounting for income taxes:
- Requires an entity to recognize a franchise tax (or similar tax) that is based partially on income as an income-based tax and account for any incremental amount incurred as a non-income-based tax.
- Requires an entity to evaluate when a step up in the tax basis of goodwill should be considered part of the business combination in which the book goodwill was originally recognized and when it should be considered a separate transaction.
- Specifies that an entity is not required to allocate the consolidated amount of current and deferred tax expense to a legal entity that is not subject to tax in its separate financial statements.
- Requires an entity to reflect the effect of an enacted change in tax law or rates in the annual effective tax rate computation in the interim period that includes the enactment date.
The standard is effective for public business entities for fiscal years beginning after Dec. 15, 2020. For all other entities, the standard is effective for fiscal years beginning after Dec. 15, 2021.
Accounting guidance effective for years ending Dec. 31, 2021: Private companies
The following standards are effective for private companies for annual reporting periods ending Dec. 31, 2021; however, private companies that prepare interim financial statements are not required to apply the new guidance until the first interim period in 2022. These standards were effective for public companies in 2020 and earlier periods:
ASU 2018-18, Collaborative Arrangements (Topic 808): Clarifying the Interaction between Topic 808 and Topic 606, addresses the diversity in practice that has arisen regarding when entities should apply the guidance in Topic 606 when entering into collaborative arrangements. The new guidance clarifies that collaborative arrangements may fall either wholly or partially within the scope of another topic (e.g., revenue recognition). A collaborative arrangement would fall within the scope of the revenue recognition standard when the entire transaction related to a distinct bundle of goods or service is with a customer. If the transactions related to the distinct bundle of goods or services include transactions with both customers and noncustomers, then the collaborative arrangement would not fall within the scope of Topic 606.
ASU 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities, simplifies the application of the Variable Interest Entity (VIE) guidance for entities under common control. The new guidance supersedes the existing Private Company Council (PCC) alternative for common control leasing arrangements and replaces it with an expanded private company alternative. The new alternative will allow a private company to not apply the VIE guidance to all legal entities under common control that meet certain criteria, rather than being limited to only leasing arrangements like the previous PCC alternative. The criteria for a private company to apply the new alternative are:
- The reporting entity (the entity preparing financial statements) and legal entity (the potential VIE) must be under common control.
- The reporting entity and legal entity are not under common control of a public business entity (PBE).
- The legal entity is not a PBE.
- The reporting entity does not have a controlling financial interest in the legal entity based on direct and indirect voting interests.
The ASU also changes the guidance for determining if a decision-making fee arrangement is a variable interest for entities under common control. Existing guidance requires entities to consider indirect interests held through related parties under common control as though it was a direct interest. The ASU changes this and requires entities to consider indirect interests held through related parties under common control on a proportional basis.
ASU 2018-15, Intangibles – Goodwill and Other – Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract, aligns the guidance for accounting for implementation costs in a cloud computing arrangement that is a service contract with the guidance for accounting for implementation costs of cloud computing arrangements accounted for as a software license. This guidance requires entities to capitalize eligible implementation costs for a cloud computing arrangement and amortize those costs over the term of the arrangement.
ASU 2018-14, Compensation – Retirement Benefits – Define Benefit Plans – General (Subtopic 715-20): Disclosure Framework – Changes to the Disclosure Requirements for Defined Benefit Plans, updates the disclosure requirements for defined benefit pension plans. The update makes the following changes to the disclosure requirements:
Disclosures removed from ASC Subtopic 715-20:
- The amounts in accumulated other comprehensive income expected to be recognized as components of net period pension costs over the next fiscal year.
- The amount and timing of plan assets expected to be returned to the employer.
- Disclosures related to the June 2001 amendments to the Japanese Welfare Pension Insurance Law.
- Related party disclosures about the amount of future and annual benefits covered by insurance and annuity contracts and significant transactions between the employer or related parties of the plan.
- Replace the reconciliation of the opening balances to the closing balances of plan assets measured on a recurring basis in Level 3 of the fair value hierarchy with disclosure of the amounts transferred into and out of Level 3 and purchases of Level 3 plan assets.
Disclosures added to ASC Subtopic 715-20:
- The weighted-average interest crediting rates for cash balance plans and other plans with promised interest crediting rates.
- An explanation of the reasons for significant gains and losses related to changes in the benefit obligation for the period.
ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, is intended to better align the requirements for hedge accounting with the risk management strategies used by entities, with the goal of allowing more risk management practices to qualify for hedge accounting. The ASU also updates how the earnings impact of hedging strategies is presented in the statement of operations by requiring the earnings impact to be included in the same line item in which the hedged items are reported.
Simplification to accounting for convertible instruments
ASU 2020-06, Debt – Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity, was issued to address the complexity associated with the accounting for convertible instruments, including application of the guidance on the derivatives scope exception for contracts in an entity’s own equity. The ASU introduces the following changes:
- Reduces the number of accounting models for convertible debt instruments and convertible preferred stock by eliminating the cash conversion and beneficial conversion feature models.
- Changes the settlement criterion that must be met for a contract to meet the “own equity” exception in ASC 815-40, which will result in fewer embedded features being separately recognized as derivatives when compared with current practice.
- For earnings-per-share (EPS) calculations, among other changes, the new guidance will require entities to presume share settlement when an instrument can be settled in cash or shares and require use of the if-converted method for convertible instruments.
- Provide an irrevocable election to apply the fair value option as of the date of adoption to liability-classified convertible securities that would be within the scope of ASC 825-10 as a result of adopting the ASU.
- The new guidance will also enhance transparency by making improvements to the disclosures for convertible instruments.
The guidance in the ASU is effective for SEC filers (except smaller reporting companies) for fiscal years beginning after Dec. 15, 2021, including interim periods within those years. For all other entities, the new guidance is effective for fiscal years beginning after Dec. 15, 2023, including interim periods within those years. Early application is permitted for fiscal years beginning after Dec. 15, 2020, including interim periods within those years. The new guidance must be adopted as of the beginning of an entity’s annual fiscal year.
The new guidance can be implemented (1) on a modified retrospective basis to financial instruments outstanding as of the beginning of the fiscal year of adoption, with the cumulative effect of adoption recognized as an adjustment to the opening balance of retained earnings; or (2) on a retrospective basis to financial instruments outstanding as of the beginning of the first comparative reporting period in accordance with the guidance in ASC 250. Under the retrospective method, EPS for all prior periods should be restated, whereas under the modified retrospective method, EPS amounts are not restated.
Special purpose acquisition companies
The increase in special purpose acquisition companies (SPACs) and the related acquisition transactions, has garnered more attention from regulators. The SEC recently issued two reminders of existing rules and how they impact SPACs. The SEC’s concern focuses on SPAC acquisition targets being ready to be issuers following the SPAC acquisition transaction.
Select issues pertaining to SPACs
The SEC issued this staff statement addressing certain accounting, financial reporting, and governance issues that should be carefully considered before a private operating company undertakes a business combination with a SPAC. The statement provides detail on the following three topics:
- Shell company restrictions — As shell companies, SPACs are subject to certain limitations that should be considered by the SPAC and the private companies engaging in business combinations with them before undertaking such a transaction.
- Books and records and internal controls requirements — These requirements apply to SPACs before the business combination and generally also apply to the combined company after the business combination. It’s important for a SPAC and the private operating company to consider these requirements when planning for a business combination because the private operating company may not have prior experience in these matters.
- Initial listing standards of National Securities Exchanges — If the SPAC is listed on a National Securities Exchange, such as the New York Stock Exchange LLC or the NASDAQ Stock Market LLC, in order to remain listed after the merger, the combined company must satisfy quantitative and qualitative initial listing standards, which include certain corporate governance requirements. The combined company should consider how it will maintain a listing throughout and after the merger.
Financial reporting and auditing considerations of companies merging with SPACs
Acting chief accountant, Paul Munter, made the following public statement about the reporting and auditing considerations related to SPAC transactions. He noted that the merger of a SPAC and target company often raises complex financial reporting and governance issues. Some of the unique risks and challenges of a private company entering the public markets through a merger with a SPAC include considerations related to:
- Market and timing
- Financial reporting
- Internal controls
- Corporate governance and audit committee
Excerpts from his statement follow:
Market and timing considerations
While a SPAC generally has 18-24 months to identify and complete a merger with a target company or liquidate and return proceeds to shareholders, once a target company is identified, the merger can occur within just a few months, triggering a number of related regulatory reporting and listing requirements. It is, therefore, essential that target companies have a comprehensive plan in place to address the resulting demands of becoming a public company on an accelerated timeline. SPAC initial filings and de-SPAC merger filings are potentially subject to review by the SEC staff, and companies may receive comment letters in a similar fashion to a traditional IPO.
A target company should also evaluate the status of various functions, including people, processes, and technology, that will need to be in place to meet SEC filing, audit, tax, governance, and investor relations needs post-merger. It is essential for the combined public company to have a capable, experienced management team that understands what the reporting and internal control requirements and expectations are of a public company and can effectively execute the company’s comprehensive plan on an accelerated basis.
Financial reporting considerations
The combined public company should have personnel and processes in place to produce high quality financial reporting that is in compliance with all SEC rules and regulations. Among other considerations, the combined public company should have finance and accounting professionals with sufficient knowledge of the relevant reporting requirements, including the applicable accounting requirements, and the appropriate staffing to meet deadlines for required current and periodic reports.
Some of the areas that may involve significant judgment include, but are not limited to:
- Determination of whether financial statements should be prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) or alternatively may be prepared in accordance with International Financial Reporting Standards (e.g., if the combined public company will be eligible to report on forms applicable to foreign private issuers);
- Public company disclosure requirements, including issues related to the identification of the predecessor entity, the form and content of financial statements, and the preparation of pro-forma financial information;
- Identification of the entity in the merger that should be treated as the acquirer for accounting purposes, including variable interest entity considerations, and whether the transaction is a business combination or reverse recapitalization;
- Accounting for earn-out or compensation arrangements and complex financial instruments;
- Application of GAAP for public business entities (e.g., earnings per share, segment disclosures, and expanded disclosure requirements for certain topics such as fair value measurements and postretirement benefit arrangements) and the related reversal of any previously-elected Private Company Council accounting alternatives available to private companies; and
- Determination of the effective dates of recent accounting standards (e.g., leases and current expected credit losses), with certain public companies eligible to adopt those standards on a timeline that is generally more aligned with the effective dates applicable to private companies; the evaluation of, and preparation for, any potential acceleration of adoption of those standards if the company’s status changes; and the required disclosure of the impact those standards will have when adopted.
The Division of Corporation Finance also has guidance available on financial reporting and disclosure topics, including SPAC transactions.
Internal control considerations
Public companies are generally required to maintain internal control over financial reporting (ICFR) and disclosure controls and procedures (DCP). It is important for target companies to understand the ICFR and DCP requirements and have a plan in place for the combined public company to comply with those requirements on a timely basis.
Corporate governance and audit committee considerations
Corporate board oversight is essential prior to, during, and after the de-SPAC merger. It is important for boards to have a clear understanding of board members’ roles, responsibilities, and fiduciary duties, and for management to understand its responsibilities for communicating and interacting with the board. The composition of the board is crucial, particularly in the post-merger publicly-traded company, as generally a portion of the board members must be independent from the organization and board members should possess the right level of experience and be prepared for key committee assignments, including on the audit committee (as applicable). The audit committee plays a vital role, including through auditor selection, a shared responsibility for compliance with auditor independence rules, and oversight of financial reporting, ICFR, and the external audit process.
Clear and candid communications between the audit committee, auditor, and management are important for setting expectations and proactively engaging as reporting, control, or audit issues arise during and after the merger process.
The target company’s annual financial statements should be audited in accordance with the Public Company Accounting Oversight Board (PCAOB) standards by a public accounting firm registered with the PCAOB and compliant with both PCAOB and SEC independence requirements. Given that historical audits of the target company were likely performed under American Institute of Certified Public Accountants (AICPA) audit and independence standards, this may add additional time and complexity to the audit process.
SEC announces enforcement task force focused on climate and ESG issues
In March 2021, the SEC announced the creation of a Climate and ESG Task Force in the Division of Enforcement. The initial focus of the task force will be to identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules. The task force will also analyze disclosure and compliance issues relating to investment advisors’ and funds’ ESG strategies and work closely with other SEC divisions and offices, including the Divisions of Corporation Finance, Investment Management, and Examinations.
Acting SEC Chair Allison Herren Lee, stated that the Division of Corporation Finance will enhance its focus on climate-related disclosure in public company filings. “The Commission in 2010 provided guidance to public companies regarding existing disclosure requirements as they apply to climate change matters. As part of its enhanced focus in this area, the staff will review the extent to which public companies address the topics identified in the 2010 guidance, assess compliance with disclosure obligations under the federal securities laws, engage with public companies on these issues, and absorb critical lessons on how the market is currently managing climate-related risks. The staff will use insights from this work to begin updating the 2010 guidance to take into account developments in the last decade.” She also noted that, “investors are considering climate-related issues when making their investment decisions. It is our responsibility to ensure that they have access to material information when planning for their financial future. Ensuring compliance with the rules on the books and updating existing guidance are immediate steps the agency can take on the path to developing a more comprehensive framework that produces consistent, comparable, and reliable climate-related disclosures.”
New ESG reporting and attestation roadmap
In February 2021, the Center for Audit Quality (CAQ) and the Association of International Certified Professional Accountants (the Association) released a new roadmap, ESG Reporting and Attestation: A Roadmap for Practitioners, to provide audit practitioners with a blueprint to support companies in achieving their environmental, social, and governance (ESG) reporting goals. The roadmap also examines the history and evolution of ESG reporting, the latest developments driving toward ESG’s inclusion in SEC filings, and current practices of disclosure and attestation over ESG information disclosed in SEC filings.
The roadmap will also be of interest to management and audit committees as they address ESG disclosures.
ESG reporting has historically taken place outside of SEC submissions; however, there are increasing calls for public companies to incorporate ESG information, including the impact of climate change and diversity and inclusion metrics, into SEC submissions such as proxy statements, annual reports, and quarterly reports. Also, many market stakeholders see the value of having some or all reported ESG information subject to external attestation by an independent auditor.
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