ASC 842: Implementation considerations for the energy industry
The much-discussed new accounting model for leases, released in early 2016 by the Financial Accounting Standards Board (FASB) as Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), creates a significant change in the accounting for leases under accounting principles generally accepted in the United States of America (GAAP). Accounting Standards Codification Topic 842, the successor to the prior lease guidance, Topic 840, can have a substantial impact on the financial statements of entities that operate throughout the energy industry. The long-lived nature of assets common in the space, which are often developed or serviced utilizing a wide range of service providers, may require balance sheet recognition under Topic 842. Additionally, recent increases in acquisition and transactional activity by energy entities are creating additional arrangements that may potentially be within the scope of Topic 842.
As more fully described in Plante Moran’s July 2021 article, ASC 842: The impact of the new lease standard on lessees in the energy industry, Topic 842 generally requires the present value of the lease payments, as defined, to be presented on an entity’s balance sheet as both a right-of-use asset and lease liability for agreements that meet the definition of a lease. The lease definition within Topic 842 is short: “a contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. However, the far-reaching applicability for many agreements that entities operating within the energy industry commonly enter into, and the complexity and judgment required to determine such, can be both challenging and time-consuming.
As implementation of Topic 842 continues to be on the minds and to-do lists of accounting and finance teams, certain aspects of this Topic continue to create hurdles for implementation teams.
(The impacts of lessors’ accounting, as well as any income tax and tax-related accounting and financial reporting ramifications of Topic 842, are beyond the scope of this article.)
Measurement of the lease liability and right-of-use asset
While there are various scoping considerations, practical expedients, and policy elections that generally help simplify the process and complexity, Topic 842 can still result in a lengthy, complex implementation process.
This complexity can be attributed to the numerous, often judgmental, inputs to the right-of-use asset and lease liability measurement, including:
- Lease term, including contract inception date, evaluation of purchase options and penalties, and assessment of extension periods, which are “reasonably certain” to be exercised.
- Lease payments, including in substance fixed payments, variable payments dependent only upon a rate or index, expectations for exercising purchase options or termination penalties, and if nonlease components are excluded (if the relevant accounting policy election is utilized), the allocation of consideration to the lease and nonlease components.
- Discount rate, which is based on the rate implicit in the lease, only if such is known. If unknown, the incremental borrowing rate should be utilized, which is the rate of interest that the entity would be required to pay on a collateralized basis over a similar term, in a similar economic environment, which often requires the use of significant judgment and third-party data sources. For certain nonpublic entities, a policy election to utilize a risk-free rate is also available.
Related party implications
Entities operating within the energy industry often engage with other related entities in the normal course of business, and such arrangements are often the result of investor preferences or requirements driven largely by legal, tax, and financing considerations. While Topic 842’s predecessor focused on the “economic substance rather than legal form” regarding related party leases, Topic 842 requires leases between related parties, as defined, to be accounted for based on the basis of the legally enforceable terms and conditions of the lease, which generally results in the accompanying classification and accounting mirroring that of unrelated parties1. For entities that engage in related party arrangements, not only does the adoption of Topic 842 require a change in the accounting methodology from Topic 840, but it also requires reassessing the arrangement using the definition of a lease, as defined by Topic 842.
Also commonplace for many entities within the energy industry, whether deemed related parties or not, is the use of joint operations, such as an operator and nonoperator relationship for oil and gas entities. When such arrangements are present, this may result in complexity as to the determination of whether the arrangement “conveys the right to control” of the asset. The arrangement may meet the definition of a lease to the joint operations or one entity within the joint operations. Additionally, the joint operations arrangement may indicate that there is a sublease between the joint operations or parties to the joint operations, which can require significant analysis of the legally enforceable terms and conditions. Related party aspects of a joint operation may complicate this assessment surrounding “control.”
Pipelines are frequently used throughout the energy industry and determination of whether the pipeline arrangements meet the definition of a lease is often complex due to the integrated aspects of a pipeline system. Topic 842 recognizes that while a larger asset may not meet the definition of a lease, generally due to the “control” provisions, a physically distinct portion of a larger asset may meet such definition.
Challenges continue to arise during Topic 842’s implementation related to the determination of: the appropriate unit of account to apply this provision of Topic 842 and whether “the right to control the use” is present for a potentially physically distinct portion of such larger asset. Determination of the right to control includes both the right to obtain substantially all of the economic benefits as well as the right to direct the use of the identified asset. The latter often requires significant judgment for pipeline and related gathering and transportation agreements as the determination rests on asset-specific decision-making rights that “are relevant when they affect the economic benefits to be derived from use” and generally include the type of output from the asset, right to change the output, when the output is produced, and the quantity of the output.
As land use is crucial to many entities operating throughout the energy industry, the use of easements, or right of ways, are prevalent. In addition to determining whether these agreements contain a lease, the sheer size of the population of easements can be complex. Thankfully, there are numerous scope exceptions and practical expedients that provide relief in accounting for these.
Leases to “explore for or use minerals, oil, natural gas, and similar non-regenerative resources … includes the intangible rights to explore for those natural resources and the rights to use the land in which the natural resources are contained” are explicitly excluded from Topic 842. However, as many entities have components that can be described as doing more than just “explore for” those natural resources, such as midstream and other transportation components, consideration should be given to whether rights of easements include “more than the right to explore for natural resources,” which may not be explicitly excluded from Topic 842.
One of the multiple practical expedients available at the adoption date of Topic 842 allows an entity, for leases that commenced before the effective date of Topic 842, to not reassess whether any expired or existing contracts are or contain leases. However, this practical expedient doesn’t allow for grandfathering of prior, incorrect accounting on Topic 840. Another practical expedient available allows an entity to not reassess whether existing or expired land easements that were previously not accounted for under Topic 840 contain a lease.
Even with consideration of the scoping aspects of Topic 842 and these helpful practical expedients, the assessment of easements common within the energy industry, which frequently include unique characteristics such as air rights and underground access rights, is still challenging. The ongoing accounting may be difficult as any new or modified easements would require reassessment of the applicability of Topic 842 as the practical expedients are only available at the adoption date.
In addition to determining the impact of Topic 842 on the implementation date, the Topic will continue to add complexity to an entity’s accounting and finance operation.
Modifications to processes and internal controls to appropriately capture the new complexities created by Topic 842 will need to be tested and implemented, including those related to identification of new arrangements that potentially contain a lease and modifications of current arrangements. These modifications may be especially prevalent in entities that operate with a disaggregated environment, either due to having remote operations and field offices or a primarily hybrid or remote environment accounting and finance team. Other processes and internal controls will need to be appropriately implemented to capture the preparation and review of the potential additional accounting entries created by Topic 842.
While entities have recently focused on the implementation of Topic 842 to prepare for year-end financial reporting, the voluminous Topic 842 disclosure requirements may also modify processes and internal controls. The quantification of “short-term lease cost” and “variable lease cost” continues to create a challenge for entities although they aren’t generally included in the initial right-of-use asset and lease liability determination. As a result, the quantification may result in significant additional time and effort to determine not only which arrangements contain leases within the scope of Topic 842 but also contain these types of costs, as well as tracking, quantifying, and aggregating these costs for financial statement footnote disclosure.
Topic 842 also creates other accounting implications. In addition to creating a new asset, the right-of-use asset, which is subject to the impairment guidance, Topic 842 creates additional assets and liabilities to be potentially accounted for under Topic 805. Under Topic 842’s predecessor, an asset or liability was generally only recognized under Topic 805 by a lessee when favorable terms, relative to the market at the acquisition date, were assumed or there were leasehold improvements. Under Topic 842, acquired leases are now accounted for in accordance with Topic 842, which can result in the recognition of right-of-use assets and lease liabilities, in addition to the accounting for any leasehold improvements acquired.
Additionally, many entities that operate within the energy industry have been significantly impacted over the past few years by the change to the definition of a “business” by Topic 805 via ASU 2017-01 - Clarifying the Definition of a Business. ASU 2017-01 created a “practical screen” that requires when substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, as defined, the transaction is accounted for as an asset acquisition, which follows a significantly differing accounting model than a business combination. As the fair value of the gross assets includes right-of-use assets associated with leases accounted for under Topic 842, but not the lease liabilities, the inclusion of right-of-use assets for lessees may result in a different conclusion to the “practical screen” than if it was performed using Topic 842’s predecessor.
Challenges are created throughout the implementation process as well as the ongoing, future accounting now required by Topic 842. Due to those created by the sheer size of potential lease populations for which the necessary analysis is to be performed as well as the necessity to update processes and internal controls, both of which may result in significant implementation timelines as well as ongoing accounting investments, resources constraints continue to occur. This challenge is amplified in the current environment of overall labor and talent constraints. Additional difficulties may include information and software solutions as the data used necessitates ongoing tracking, quantifying, and recording for the additional accounting entries and financial statement footnote disclosures as well as creating and maintaining an appropriate documentation trail.