Adopting ASC 842? Key Considerations for Oil and Gas Entities

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1 Adopting ASC 842? Key Considerations for Oil and Gas Entities This ebook provides a focused discussion on how companies in the Oil and Gas Sector can prepare for compliance with new lease accounting regulation along with an overview of special considerations that are significant for Oil and Gas companies.

2 Overview of New Lease Accounting Standards In 2016, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) issued new standards for lease accounting: IFRS 16 and ASC 842, which must be implemented by Both IFRS 16 and ASC 842 are the result of a joint effort between the IASB and FASB to meet the objective of improved transparency, comparability, and financial reporting. These changes will impact virtually all companies, whether lessors or lessees. The primary purpose of the new standards is to address the fact that most operating leases are deemed off balance sheet financing arrangements and currently are only disclosed via a company s financial footnotes in the Commitments and Contingencies section. Therefore, for every identified lease, companies will be required to create a lease liability calculated as the present value of the future fixed payments and a corresponding ROU asset ( right-of-use asset). The ROU asset will be amortized over the life of the lease. Income statements will be impacted by the inclusion of straight-line lease expense items that contain an interest component along with the amortization of the asset over the life of the lease. ASC 842 does not apply to any of the following: Leases of intangible assets Leases of biological assets, including timber Leases of inventory Leases of assets under construction Leases to explore for, or use; minerals, oil, natural gas, and similar non-regenerative resources, including the intangible rights to explore for those natural resources and rights to use the land in which those natural resources are contained Copyright 2018 Nakisa Inc. 2

3 Significant changes for companies adopting ASC 842 include: All leases over an original term of 12 months will be capitalized on the balance sheet Companies will need to determine whether there are any embedded leases within contracts Each lease of an identified asset where a lessee is deemed to have control will have its own ROU asset and related lease liability (present value of future payments) For every lease, a separation of lease and non-lease components will have to be assessed and bifurcated. (Note: There is a practical expedient where companies may combine lease and non-lease components). In addition to the asset level accounting detail that will be required for each identified asset (there is a portfolio practical expedient), there are a significant number of new disclosures that will need to be divulged by companies. It is anticipated that lessees will be greatly affected by the new standard. The impact on their financial reporting, asset financing, contract and data management, IT systems, processes and controls are expected to be substantial. Many companies lease a vast number of small and/or big-ticket items, including IT and other equipment, cars, power plants, retail stores, cell towers, trains, and aircrafts. Issues Specific to the Energy Sector Oil and gas entities will need to change certain lease accounting practices when implementing the new standards, which could have far-reaching implications for their finances and operations. For example, determining which agreements fall within the scope of ASC 842 and IFRS 16, applying the definition of a lease, and allocating contract consideration to the lease and nonlease components of contracts will require extensive data collection, analysis, and informed judgements. Leases of oil and gas mineral rights or drilling rights are outside of the scope of ASC 842 and will continue to be accounted for under the guidance in ASC 932, Extractive Activities Oil and Gas. That includes the right to use the land that contains the mineral resources unless those rights include more than the right to explore for natural resources. However, this scope exception does not apply to leases of equipment used to explore for oil and gas. Copyright 2018 Nakisa Inc. 3

4 Given the equipment-intensive nature of oil and gas enterprises, further complicated by wide ranging geographically-dispersed operational environments and complex supplier relationships, energy sector entities face many challenges regarding implementation of new lease accounting standards. There is a wide range of arrangements that typically exist within the oil and gas industry which may fall within the scope of the new standards, such as: Service contracts including equipment used to deliver a service such as drill rigs, compressors, and tanks Shipping, freight, and other transportation arrangements, including railway infrastructure and harbor loading services contracts Use of gas pipelines and processing facilities Refining and storage arrangements There could also be other arrangements not specifically related to extractive activities such as rentals of vehicles, office space, computers, furniture, etc. For oil and gas entity lessees, the adoption of ASC 842 may require the recognition of significant assets and liabilities for leases that have traditionally not been recorded on the balance sheet. The reason for this is because of their extensive use of fixed assets under contracts that may qualify as leases under the new guidance. Agreements that oil and gas entities enter into are often customized and include services and other components critical to completing the contracts, especially in oilfield services arrangements. Copyright 2018 Nakisa Inc. 4

5 Embedded leases Operators tend to lease mineral rights and then hire service contractors to carry out the execution of the drilling campaign in various forms of contract agreements. While under current guidance, the accounting for operating leases is often like that for service contracts, this will no longer be the case under the new standard. The scoping of drilling contracts, oilfield services arrangements, etc., as either service or lease arrangements may determine whether they are reflected on or off the balance sheet under the new standard. Additionally, within service agreements, there may be embedded leases. For example, an operator hires a service provider to execute the operational portion on a drilling campaign. As part of that service contract, there may be an identified asset that the operator has control over. This assessment may potentially identify that there is a lease involved, which would require the accounting treatment outlined under ASC 842. This may result in the operator capitalizing the service contractor s equipment! Therefore, oil and gas entities need to assess many service and lease contracts to determine whether such agreements meet, or have components that meet, the new definition of a lease. Identifying and separating components of a contract and allocating consideration For contracts that contain the rights to use multiple assets but not land (e.g., a building and equipment, multiple pieces of equipment), the right to use each asset is considered a separate lease component if both of these conditions are met: the lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee, and the right of use is neither dependent on, nor highly interrelated with, the other right(s) to use the underlying assets in the contract. Oil and gas contracts that may contain a lease also may contain non-lease components for services provided by the supplier. Examples may include drilling arrangements, storage and transportation arrangements, and gathering agreements. Under ASC 842, there is a practical expedient that allows lessees to to make an accounting policy election (by class of underlying asset) to account for each separate lease component of a contract and its associated non-lease components as a single lease component. If this election is not made, lessees will need to use a standalone selling price to bifurcate the lease and non-lease components. Copyright 2018 Nakisa Inc. 5

6 Joint Operating Agreements Oil and gas entities often enter into joint operating agreements (JOAs), in which two or more parties (i.e., operators and non-operators) collaboratively explore for, and develop, oil or natural gas properties using the experience and resources of each party. These agreements often require the use of leased equipment. Questions have arisen regarding the lease assessment requirements under the new standard for parties to JOAs. Typically, in JOAs there is one operator, and this is the entity that will most likely have to capitalize the lease on its balance sheet as that is the entity that is signing the agreement with the service provider for use of its equipment. Once the accounting assessment has determined that the operator controls the identified asset, a secondary assessment may be done to assess whether there are any sub-leases between the operator and the non-operators, and therefore the same accounting assessment that the operator performed may also be performed by the non-operators to assert whether control exists or not. Intra/Intercompany movements Oil and gas operators are in the business of leasing oil and gas properties and drilling in various locations. As part of the accounting, they need to be able to track and account for the respective operating costs, as the drilling rig moves and drills from location to location. The need to accurately account for these costs is essential for accurate accounting. The impact of the new leasing standard is such that, as an operator identifies that there is a lease resulting from the contract between the operator and the drilling contractor, that cost may potentially be capitalized on the operator s balance sheet, creating a lease liability and a corresponding ROU asset. It is therefore critical to be able to move that ROU asset from location to location and possibly from company code to company code as the drilling campaign is executed. Copyright 2018 Nakisa Inc. 6

7 Use-Case Example: Who Controls the Asset? Under ASC 842, an arrangement is a lease (or contains a lease) if an underlying asset is explicitly or implicitly identified and use of the asset is controlled by the customer. Case study: A producer ( the Customer ) enters into a contract with the owner ( the Supplier ) of a drilling rig for the exclusive use of the drilling rig, which is specified in the contract. The Supplier does not have the legal right to substitute the drilling rig specified in the contract (except due to malfunction or maintenance issues). The Customer makes all of the operating decisions and has the final say regarding where the rig will be used, when it will be used, and the parameters under which it will be operated (i.e., the drilling rig is not subject to a joint operating agreement). The Supplier provides highly skilled personnel to operate the rig and execute the Customer s drill plan. The Supplier provides technical input into the drill plan instructions and advises on the safe operation of the rig but does not have the right to determine the drill plan instructions. Question: Does the arrangement contain a lease of the drilling rig? Answer: If the operator controls the asset, then most likely Yes. Next Steps: Get Started Now The new leasing standard requires companies to capitalize most operating leases when they meet the the following requirements: There is an identified asset and the lessee has control over the asset for the duration of the lease term. It is clear that companies within the oil and gas industry will be significantly impacted due to the industry s heavy use of capital equipment, and therefore starting the project early and involving key stakeholders will be critical to the success of the project and the timeliness of compliance with ASC 842. The first step on the path toward compliance and improved lease administration is to get all leases into a single centralized repository. This may seem like a giant step, especially for oil and gas entities with extensive lease portfolios and complex arrangements, but it is vitally necessary before any other real change can take place - and it doesn t have to be as difficult as you might imagine. Copyright 2018 Nakisa Inc. 7

8 Lease Administration by Nakisa is designed from the ground up to provide a single, unified repository for all relevant lease information. The solution addresses the full lease lifecycle from data abstraction and lease determination, to event management and termination. In most organizations, the accounting teams are responsible for driving data collection. However, accounting managers aren t necessarily aware of the fields required to be compliant with the new lease accounting standards. To help mitigate this issue, Nakisa provides a data dictionary, outlining all of the fields in Lease Administration by Nakisa. Before the effective date, organizations will need to bring all of their lease contracts into their chosen software solution. Lease Administration by Nakisa offers a tool to mass upload data and help streamline the initial data upload process. The mass upload tool supports extensible data collection formats in order to capture custom attributes depending on your business processes. The input mechanism also supports mass data importing from multiple contract sources for rapid and complete data capture. Since the new leasing standards-setting process began, Bramasol has been at the forefront of addressing the key issues to help our customers get ready for both IFRS 16 and ASC 842. They have developed a disciplined Lease Administration Solution Engagement Roadmap (LASER) that brings together all compliance requirements, stakeholder needs and work-stream processes within a unified and disciplined implementation process. Copyright 2018 Nakisa Inc. 8

9 Working with dozens of clients Bramasol has also developed a purpose-built Data Abstraction and Migration methodology that includes machine learning, OCR, and data quality assurance steps. The goal is to provide companies with a complete end-to-end service to get them compliant quickly while setting up a foundation for long-term success. By combining Bramasol s Data Abstraction Services with the LASER methodology, companies have a comprehensive process for compliance that is efficient, effective, and meets the scrutiny of auditors. Comply, Optimize, Transform All companies, including those in the energy sector, need to leverage the process of changing their lease management methodologies. This will allow them to gain better visibility into their lease portfolios, streamline the process of lease management and reduce overall costs. Bramasol s holistic approach assures Compliance with the new leasing standards while also providing a structured solution for Optimization of all lease administration, portfolio management, and related business processes, while laying an integrated end-to-end foundation for the Transformation of overall end-to-end business systems including interface to your ERP systems. To start with, you need help to comply. Bramasol works with your team to ensure compliance and disclosure reporting mandates are achieved. Once you are compliant, Bramasol can help you optimize the Nakisa software, ERP integration, and other business systems to gain better results, faster, and more effectively. Many companies then choose to leverage the regulatory-driven change process to also transform their overall methodologies and related processes for leasing and asset procurement. This can include integration of worldclass procurement applications and streamlining of procure-to-pay processes, including applications like Ariba, Coupa etc. As a recognized industry innovator in transformative Office of the CFO solutions and the clear leader in helping companies implement recent major changes to Revenue Recognition standards, Bramasol is leading the way to create and deploy strategic and tactical solutions for ASC 842 and IFRS 16 lease accounting changes. For companies in the energy sector, Bramasol provides highly tailored implementation expertise, technical accounting support, and understanding of specific industry needs. Comply Optimize Transform Copyright 2018 Nakisa Inc. 9

10 About Bramasol, Inc. Bramasol is the leader in SAP Leasing, Revenue Recognition and Office of the CFO Solutions Bramasol is the Leasing leader and a recognized SAP Leasing services partner for companies seeking to comply with and benefit from the new Leasing standards. Our SAP-certified experts, partnering with SAP and Nakisa, have lead the way in education and enablement of the new Leasing standards. Even before the announcement of the new IFRS 16 and ASC 842 standards, Bramasol was working to educate companies on the coming changes and how to leverage the existing Revenue Recognition work to help with compliance. Our industry leading experience and focus on Office of the CFO solutions, enables our customers to ramp up quickly and evaluate the options to not only comply with the standards, but transform finance during the process. Bramasol is also the Revenue Recognition leader and a recognized SAP Revenue Recognition services partner for companies seeking to comply with and benefit from the new Rev Rec standards. Our SAP-certified experts, partnering with SAP, assisted in the majority of SAP Revenue Accounting and Reporting Ramp-Up projects. Driving successful workshops, Proofs of Concept, and implementation projects throughout the U.S., Bramasol is the go-to partner with the experience and expertise for companies wanting to leverage SAP Revenue Accounting and Reporting to comply with ASC-606 and IFRS 15. Currently, Bramasol is performing implementations and Proofs of Concept/Pilots for additional clients; proving that Bramasol is a go-to partner with experience and expertise for companies wanting to utilize SAP Revenue Accounting and Reporting to be compliant with the Financial Accounting Standards Board (FASB) current US Generally Accepted Accounting Principles (GAAP) revenue recognition standard or the newly announced ASC-606 and International Financial Reporting Standards (IFRS) 15 addressing the Revenue From Contracts with Customers. Whether you are looking for a SaaS, hosted or on-premise solution, Bramasol has worked with over 150 clients to solve business challenges using SAP solutions including SAP Business Suite, SAP Business All-in-One, SAP Business Intelligence solutions, SAP Business ByDesign, the SAP HANA platform and mobile solutions. If you are looking to build a platform for growth or just be Rev Rec Ready, contact us and we can help. Contact Information: United States Headquarters Bramasol, Inc Freedom Circle, Suite 620 Santa Clara, CA Toll Free (866) Phone +1 (408) Fax (408) info@bramasol.com Copyright 2018 Nakisa Inc. 10

11 About Nakisa Nakisa Inc., a recognized leader of data management and visualization solutions for SAP, helps customers better manage, track and validate their lease-related data to reduce spending, improve efficiency and ensure compliance to upcoming regulatory changes. SAP Lease Administration by Nakisa provides visibility into a corporate portfolio of leased assets allowing SAP customers to optimize the management of their global assets while supporting accounting processes for more efficient cost controlling and regulatory compliance. It also enables customers to prepare for the upcoming changes to lease accounting standards as defined by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). Nakisa continually collaborates with SAP to co-develop integrated solutions that extend the value of SAP customers existing investments. An SAP partner since 2007, Nakisa has over 3.4 million users in 700 enterprises across 24 industries worldwide. SAP sells, tests, and supports SAP Lease Administration by Nakisa. Contact Information: Nakisa Inc. 733 Cathcart Montreal, Quebec Canada, H3B 1M6 Phone: +1 (514) info@nakisa.com Copyright 2018 Nakisa Inc. 11