Energy companies: Q4 2021 accounting and reporting update
In this update, we highlight some of the more important 2021 fourth-quarter accounting, financial reporting, and regulatory developments that may impact energy companies. The content is not meant to be all-inclusive.
ASU 2021-09: Leases (Topic 842) – Discount Rate for Lessees That Are Not Public Business Entities provides entities that are not public business entities with additional flexibility when deciding whether to make the accounting policy election to use the risk-free rate as the discount rate when applying the guidance in ASC Topic 842. Originally, ASC Topic 842 allowed entities that are not public business entities to make an entity-wide policy election to use the risk-free rate as the discount rate when applying the guidance in ASC Topic 842. ASU 2021-09 allows an entity to make this accounting policy election by class of asset rather than at the entity-wide level. This means an entity could elect to use the risk-free rate for one class of assets (e.g., vehicles) while using its incremental borrowing rate for another class of assets (e.g., real estate). It’s expected this change will allow more entities to utilize the risk-free rate as the discount rate.
For entities that have not yet adopted ASC Topic 842, the guidance in ASU 2021-09 is effective when the requirements of the new lease standard are implemented. For entities that have already adopted ASC Topic 842, the guidance in ASU 2021-09 is effective for fiscal years beginning after Dec. 15, 2021, with earlier application permitted.
ASU 2021-08: Business Combinations (Topic 805) – Accounting for Contract Assets and Contract Liabilities from Contracts with Customers requires entities to recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with ASC Topic 606. This ASU creates an exception to the general principle that assets and liabilities acquired in a business combination should be recorded at fair value.
In general, the acquiree should account for the acquired revenue contracts as if it had originated the contracts. However, because the acquiree may be following a different accounting framework or applying different policies or judgments in evaluating contracts than the acquirer, the acquirer may not be able to solely rely on the acquiree’s carrying value of contract assets and contract liabilities and would instead need to review the acquiree’s analysis to evaluate the accuracy of the acquiree’s conclusions or perform their own analysis under ASC Topic 606.
This new guidance is effective for public business entities for years beginning after Dec. 15, 2022, and for all other entities for fiscal years beginning after Dec. 15, 2023. Early adoption is permitted. Entities should also be aware of the potential tax implications of adopting this new guidance. Depending on how the revenue contracts have been structured, changes in the amount of deferred revenue recorded as a result of a business combination could impact the amount of future taxable income post-acquisition. Given this, entities should consult with their tax advisors on the potential tax implications prior to adopting the new guidance.
ASU 2021-07: Compensation – Stock Compensation (Topic 718) – Determining the Current Price of an Underlying Share for Equity-Classified Share-Based Awards (a consensus of the Private Company Council) allows private companies that issue equity-classified share-based payment awards to elect, as a practical expedient, to determine the current price input in its valuation model by using a “reasonable application of a reasonable valuation method.” The ASU identifies the characteristics of the “reasonable application of a reasonable valuation method,” which are consistent with those in the Treasury Regulations for valuations made for income tax purposes. Accordingly, a valuation performed in accordance with the requirements of Treasury Regulation Section 409A would be acceptable under ASC Topic 718. The practical expedient is elected on a measurement-date-by-measurement-date basis; therefore, it must be applied to all share-based payment arrangements that have the same underlying share and measurement date. This update is effective for annual periods beginning after Dec. 15, 2021, with early application permitted.
High quality financial reporting in a complex environment
On Dec. 6, 2021, Paul Munter, the SEC’s acting chief accountant, was the keynote speaker at the AICPA and CIMA Conference on Current SEC and PCAOB Developments and issued a statement on the Office of the Chief Accountant’s (OCA) continued focus on high quality financial reporting in a complex environment. He discussed the roles of the preparer, auditor, and audit committee in ensuring high quality financial reporting and described the three elements necessary to support high quality financial reporting:
- High quality standard-setting
- High quality implementation and application of those standards
- High quality audits
Mr. Munter also highlighted the following rulemaking agenda items:
- Climate risk disclosures
- Trading prohibitions under the Holding Foreign Companies Accountable Act (HFCAA)
- Recovery of erroneously awarded compensation
Climate risk disclosures
“Given the dynamic nature of our capital markets, the total mix of information requested by investors continues to evolve to include new types of information, such as climate risk disclosures.” To this point, SEC Chair Gary Gensler has stated: “Occasionally, investors in our capital markets tell us that they … want something a little bit different. When it comes to climate risk disclosures, investors are raising their hands and asking regulators for more.” Chair Gensler has since directed the staff to develop a climate risk disclosure rule proposal, taking into account feedback received earlier this year.
He also mentioned that the FASB staff published an educational paper in March 2021 to provide investors, issuers, and others with an overview of the intersections between environmental matters, including climate change and existing U.S. GAAP requirements, and that the IASB staff issued similar educational materials in November 2020. Also, in September 2021, the staff in the Division of Corporation Finance (Corp Fin) published an illustrative letter containing sample comments that the Division may issue to companies regarding their climate-related disclosure or the absence of such disclosure. As stated in the sample comment letter, depending on the particular facts and circumstances, these disclosures may be required as part of a company’s description of business, legal proceedings, risk factors, and management’s discussion and analysis of financial condition and results of operations.
Mr. Munter noted that OCA actively monitors international developments on these topics. The IFRS Foundation, which is also responsible for governance and oversight of the IASB, announced in November 2021 the formation of the International Sustainability Standards Board (ISSB) to set IFRS sustainability disclosure standards.
Trading prohibitions under the HFCAA
The SEC adopted final rules on Dec. 2, 2021, to specify disclosure and submission requirements for affected issuers under HFCAA. The Act also requires a trading prohibition for an issuer’s securities if that issuer uses an audit firm that the PCAOB is unable to inspect or investigate completely for three consecutive years.
Recovery of erroneously awarded compensation
On Oct. 14, 2021, the SEC issued a release reopening the comment period for its 2015 proposed rules that would direct the national securities exchanges and national securities associations to establish listing standards that would require each issuer to develop and implement a policy providing for the recovery of incentive-based compensation received by current or former executive officers that was awarded based on financial information that required restatement and require disclosure of the issuer’s policy. Under the proposed rules, incentive-based compensation received by an executive officer during the three fiscal years preceding the date on which the issuer is required to prepare an accounting restatement to correct a material error would be subject to recovery, or “clawback.” The amount to be recovered is the incentive-based compensation that exceeds the amount the executive officer would have received had the incentive-based compensation been determined based on the restated financial statements.
Special purpose acquisition companies (SPACs)
On Dec. 9, 2021, SEC Chair Gary Gensler spoke at the Healthy Markets Association Conference where he shared his thoughts on the use of SPACs to go public. He expressed concerns that the investing public may not be getting like protections between traditional IPOs and SPACs. He noted that, “due to the various moving parts and SPACs’ two-step structure, I believe these vehicles may have additional conflicts inherent to their structure. There are conflicts between the investors who vote then cash out, and those who stay through the deal — what might be called ‘redeemers’ and ‘remainers.’ In order to reduce the potential for such information asymmetries, conflicts, and fraud, I’ve asked staff for proposals for the Commission’s consideration around how to better align the legal treatment of SPACs and their participants with the investor protections provided in other IPOs, with respect to disclosure, marketing practices, and gatekeeper obligations.”
He has asked staff to make recommendations about how investors might be better informed about the fees, projections, dilution, and conflicts that may exist during all stages of SPACs, and how investors can receive those disclosures at the time they are deciding whether to invest and to also consider clarifying disclosure obligations under existing rules.
Chair Gensler also expressed concerns about the marketing of SPACs and has asked staff to make recommendations around how to guard against what effectively may be improper conditioning of the SPAC target IPO market, which could include providing more complete information at the time that a SPAC target IPO is announced.
Chair Gensler expressed concerns about who is performing the role of gatekeepers, potentially including directors, officers, SPAC sponsors, financial advisors, and accountants. He noted that “there may be some who attempt to use SPACs as a way to arbitrage liability regimes. Many gatekeepers carry out functionally the same role as they would in a traditional IPO but may not be performing the due diligence that we’ve come to expect. Make no mistake: When it comes to liability, SPACs do not provide a ‘free pass’ for gatekeepers.”
He has asked staff for recommendations about how to better align incentives between gatekeepers and investors and how to address the status of gatekeepers’ liability obligations.
LIBOR transition: Key considerations for market participants
As a reminder, publication of the one-week and two-month USD LIBOR maturities and non-USD LIBOR maturities will cease immediately after Dec. 31, 2021, with the remaining USD LIBOR maturities ceasing immediately after June 30, 2023. In the United States, the preferred alternative rate is the Secured Overnight Financing Rate (SOFR), which is a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is based on directly observable U.S. Treasury-backed repurchase transactions.
On Dec. 7, 2021, SEC staff issued a statement addressing various aspects of the forthcoming LIBOR transition. The statement also addresses certain issues that companies should consider related to the LIBOR transition, such as: applicable disclosure obligations with respect to the transition away from LIBOR; the likely impact that the LIBOR transition will have on valuation measurements using LIBOR as an input, including those valuations determined by investment companies; and operational complexities that the LIBOR transition is likely to introduce, which may require significant IT system changes and those in operational processes.
The statement notes that registrants should carefully consider the “fallback language” (i.e., language intended to provide an alternative reference rate or otherwise address a permanent cessation of LIBOR) in existing agreements as well as new LIBOR-linked securities.
The statement noted, “It is important that companies keep investors informed about their progress toward LIBOR risk identification and mitigation, and the anticipated impact on the company, if material. A number of existing rules or regulations may require disclosure related to the expected discontinuation of LIBOR, including rules and regulations related to disclosure of risk factors, management’s discussion and analysis, board risk oversight, and financial statements. Issuers of registered asset-backed securities also should consider relevant disclosure requirements under Regulation AB, as well as appropriate disclosures regarding the potential impacts of the LIBOR transition on investors in those securities. To provide meaningful insight to investors about the status of their identification and mitigation efforts, including significant matters yet to be addressed, companies should consider providing detailed and specific disclosure, rather than general statements about the progress of the company’s transition efforts to date.”
Companies are encouraged to provide qualitative disclosures and, when material, quantitative disclosures. An example given was the notional value of contracts referencing LIBOR that extend past Dec. 31, 2021, or June 30, 2023, as applicable. Another example related to companies with material risk related to outstanding debt with inadequate fallback provisions. In these cases, a company should consider disclosing how much debt will be outstanding after the relevant cessation date and the steps the company is taking to address the situation, such as renegotiating contracts or refinancing the obligations. To the extent that a company has or is taking steps to identify and assess LIBOR exposure and mitigate material risks or potential impacts of the transition, the company should consider providing investors insight into what the company has done, what steps remain, and the timeline for further efforts.
The SEC noted that companies generally include disclosures about the LIBOR transition as part of risk factors, recent developments, MD&A, and/or quantitative and qualitative disclosures about market risk. The statement suggests that to the extent a company provides this disclosure in response to more than one disclosure requirement within a filing, consideration should be given to providing a cross-reference or otherwise summarizing or tying the information together, so an investor has a complete and clear view of the company’s plan for the discontinuation of LIBOR, the status of the company’s efforts, and the related risks and impacts. The staff expects disclosures to evolve over time as companies provide updates to reflect transition efforts and the broader market and regulatory landscape. Companies are encouraged to refer to the July 2019 Staff Statement as they prepare their disclosures to investors about the LIBOR transition and its potential impact on their businesses.
In December, the SEC issued Staff Accounting Bulletin (SAB) No. 120, which updates SAB Codification Topic 14, Share-Based Payment, and adds interpretive guidance for public companies to consider when entering into share-based payment transactions while in possession of material nonpublic information, including share-based payment transactions that are commonly referred to as being “spring-loaded.” This SAB provides additional guidance to companies estimating the fair value of share-based payment transactions in accordance with Topic 718 regarding the determination of the current price of the underlying share and the estimation of the expected volatility of the price of the underlying share for the expected term when the company is in possession of material nonpublic information.
In addition, SAB No. 120 also rescinds portions of SAB Codification Topic 14 and conforms other portions of it to make staff interpretive guidance consistent with the guidance in FASB ASC Topic 718.
SEC hot topics
Calendar-year companies should consider certain SEC concerns and suggestions when preparing 2021 annual financial statements and disclosures. At the 2021 AICPA and CIMA Conference on Current SEC and PCAOB Developments, SEC staff discussed matters related to accounting, financial reporting, and disclosures. A summary of some of the matters not discussed earlier, follows.
Unlike the prior year, this was not the dominant topic at this year’s conference. However, SEC staff did remind companies to consider 2020 CF Disclosure Guidance: Topic 9 and Topic 9A for disclosure considerations and guidance.
Environmental, social and governance (ESG)
ESG continued to be a hot topic with most speakers discussing this area. There is demand for a global set of ESG standards. In November 2021, the IASB announced the formation of the International Sustainability Standards Board (ISSB) to set IFRS sustainability disclosure standards. The SEC is moving toward its own standards, and it’s expected that new SEC proposed disclosure rules on climate risks will be issued in early 2022, including whether ESG disclosures should be included in SEC filings such as Form 10K.
The SEC has already issued principle-based human capital disclosure requirements and is expected to issue more prescriptive guidance.
In addition, the role of the auditors in sustainably reporting was discussed in several sessions. The Center for Audit Quality (CAQ) speaker stated that audit firms are well positioned to provide assurance over ESG information. This was also discussed by the ESG panel. Assurance guidance over ESG disclosures is expected to be issued as disclosure requirements are adopted.
ESG reporting standards are expected to be issued fairly quickly so preparers are encouraged to gain an understanding of the company’s ESG information. Mr. Munter noted companies should consider the ownership of ESG date, related processes and controls over the preparation of ESG information, and what level of governance and oversight exists for the reporting processes and controls.
SEC staff noted the high volume of SPAC IPOs and that these transactions outnumbered traditional IPOs. Accounting for warrants and the related OCA April 2021 Statement was discussed, along with concerns over public company readiness by the target company as it relates to financial reporting, internal controls, and processes.
Speakers from OCA, Corp Fin, and Division of Enforcement addressed the importance of carefully assessing errors discovered after the issuance of financial statements when determining whether a potential restatement is to be reflected in the financial statements as a “Big R” or “little r.” In a “Big R” restatement, prior financial statements are restated, whereas in a “little r” restatement, the error is corrected in the current period financial statements by restating the prior-period information and the prior-period financial statements are not reissued. “Little r” as compared to “Big R” restatements have increased in recent years. SAB 99 provides guidance on the materiality assessment, including the requirement to assess both quantitative and qualitative factors. Mr. Munter noted that in cases where the error is quantitatively material, it’s rare that qualitative factors would be able to overcome the magnitude of the error and support a conclusion that a “little r” restatement is appropriate. He also noted that in cases where the error is quantitatively immaterial, qualitative factors should be carefully analyzed because in combination, the qualitative and quantitative factors could make the restatement a “Big R” restatement. This topic was discussed by many speakers and is a focus of the SEC.
The impact on internal control over financial reporting (ICRF) must also be considered. Of note is that even if a restatement is determined to be a “little r,” there could still be material weakness.
Non-GAAP measures and metrics
SEC staff discussed three issues that continue to be an issue. They were: prominence (where the measure is presented), mislabeling (such as using a term for the measure that’s similar to a GAAP term), and using metrics instead of non-GAAP measures (must ensure the metric is a non-GAAP measure).
Common OCA revenue consultation topics involved principal versus agent considerations, determination of performance obligations, and identification of the customer and consideration paid to a customer.
SEC staff continues to focus on segment reporting and how registrants apply the guidance in ASC Topic 280, Segment Reporting, and IFRS 8, Operating Segments, and they consider all publicly available information when reviewing segment information, including public filings as well as information available from a registrant’s earnings calls, website, and industry or analyst presentations. It was noted that the staff has observed companies presenting multiple measures of segment profit or loss in the notes to their financial statements, and they are likely to comment when that is the case. Staff also noted that the management approach is a fundamental concept in ASC Topic 280, and companies should carefully consider all information that the chief operating decision-maker (CODM) uses on a regular basis, including any changes to that information based on changes in the business.
Disaggregation of revenue and presentation of gross profit
SEC staff discussed that they continue to ask registrants for information supporting their conclusions on the appropriate presentation of revenue and cost of sales in the income statement and that they specifically focus on the proper disaggregation of revenue in accordance with Rule 5-03(b)(1) of Regulation S-X and the improper presentation of gross profit when depreciation and amortization have been excluded from cost of sales. Under SAB Topic 11.B, Depreciation and Depletion Excluded from Cost of Sales, depreciation and amortization may be excluded from cost of sales if the line item clearly discloses its exclusion, and the income statement does not include gross profit. If both cost of product and cost of service line items are presented, the staff expects the disclosure of depreciation and amortization related to each type of cost of revenue.
OCA has received a number of consultations related to digital asset-related transactions or business models. These questions include, among others, when digital assets represent an asset or liability of the registrant, determining the cost basis for digital assets, and revenue recognition considerations. SEC staff indicated that unless the digital assets are considered to be securities and subject to other accounting guidance, they most likely should be accounted for as intangible assets. Many investors and preparers are asking for guidance from the FASB and SEC to help in the accounting for these assets. There are existing accounting models to account for these digital assets; however, many investors would like a fair value model. The FASB received over 400 letters in the comment process during 2020 that proposed that these assets be recorded at fair value and may add a project to its technical agenda to address the accounting.
The conference included a cybersecurity panel that discussed best practices in reducing losses, including reputational, and the importance of board involvement. Panelists noted that this issue is a top agenda item for many boards with audit committees also involved specifically to ensure that the company’s internal controls are effective and that the required financial statement and filing disclosures are made.
Reference rate reform
See earlier discussion LIBOR Transition: Key considerations for market participants.