In early March 2020, crude oil prices declined significantly in response to disruptions in worldwide oil demand due to the economic impacts of COVID-19 and an oversupply in the market. Market uncertainties have also impacted natural gas prices and demand. These trends, including a potential economic downturn, could have an adverse and material impact to companies in the oil and gas industry.
Companies are facing many challenges; forcing changes in business plans. Oilfield service companies are being squeezed on demand as well as prices. Bankruptcies are increasing and consolidations within the industry are expected. In light of the current environment, there are many accounting and financial reporting challenges for both public and private companies.
Lower prices may result in Proved Developed Producing (PDP) reserves becoming uneconomic. In order to qualify for inclusion as Proved Undeveloped (PUD) reserves, the company must have an approved plan to develop the reserves within 5 years.
In a period of delayed drilling, difficulty accessing capital and lower prices, many companies are not able to report potential PUD reserves. Lower prices, delayed drilling, idling of existing wells, and liquidity concerns all impact impairment considerations for proved and unproved oil and natural gas properties.
Successful Efforts – Proved Properties
Successful efforts companies will have a triggering event requiring an assessment of proved properties for recoverability under Financial Accounting Standards Board Accounting Standards Codification ASC 360. The properties are tested at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets, which is generally the field level.
Fair value assumptions used in the reserve report to determine fair value must use market-based assumptions (not company-specific). In some cases, the company-specific assumptions are consistent with those of a market participant, but this determination must be supported.
As a result, the fair value reserve report may be different from the company’s internal reserve report. In addition, the fair value assumptions should be consistent with other projections such as those used in determining the fair value of acquired properties and budgeting.
Full Cost – Proved Properties
Full cost companies are subject to the full cost ceiling test as prescribed in ASC 932 and SEC Regulation S-X, Rule 4-10. The ceiling is calculated at a country by country level based on projected cash flows for proved properties using the preceding first-day-of-the-month, 12-month average price assuming current economic conditions (LOE, capital costs) continue and a 10% discount rate.
As a reminder, hedges accounted for as cash flow hedges can be considered in the test; however, hedges not accounted for under cash flow hedge accounting (marked to market) cannot be included. As discussed earlier, the current economic conditions are causing a reduction in many cases of PDP and PUD reserves. As a result, even if the pricing used in the ceiling test is not significantly impacted, the reduction in reserves may result in a ceiling write-down.
Companies are required to assess unproved properties periodically (i.e., at least annually) to determine whether they have been impaired. The assessment of these properties is based mostly on qualitative factors such as intent to drill on the lease, results from other wells drilled in the area, and the remaining term on the lease if there is no intent to renew the lease.
Successful efforts companies record an impairment expense and an allowance within unproved properties, whereas full cost companies record the impairment through a reclassification to proved properties where the costs are subject to amortization.
Equipment and Other Long-Lived Asset Impairment
Companies must also determine if there are impairment indicators for long-lived assets such as frac fleets, drilling rigs, midstream assets, other equipment, buildings, or finite-lived intangible assets. Assuming there are triggers in the current environment, then the two-step assessment under ASC 360 is required. Note that if the assets meet the held-for-sale criteria, the order of impairment testing differs.
Many upstream companies hold inventories of drilling and lease operating supplies and equipment. These inventories are carried at the lower of cost or net realizable value. Under ASC 330, the allowance for impairment should be assessed to determine if the carrying value should be impaired considering current drilling and operating plans and dropping market values. Companies utilize software like CEPS to help manage these types of inventories.
Goodwill and Indefinite – Lived Asset Impairment
It is not as common in the upstream sector, but goodwill may have been recorded in prior acquisitions. If so, management should assess if there are indications that it is more likely than not that goodwill or an indefinite-lived intangible asset is impaired and if so, an interim impairment test is required under ASC 350.
Equity Method Investments
Many companies account for investments in upstream companies using the proportional consolidation method for joint ventures and certain qualifying equity method investments. For these investments, management should assess if there are indicators that the carrying amount of the investment might not be recoverable. If so, these investments are required to be reviewed for impairment under ASC 323.
There are many tax implications associated with the current environment. In addition, there are specific implications to companies that have received Paycheck Protection Program (PPP) loans under the CARE Act. This discussion is not all-inclusive but addresses some of the more common considerations under ASC 740.
Management should determine if the forecasted future taxable income in the carryback or carryforward period has changed, as this will impact the deferred tax valuation allowance. In addition, interim reporting requirements under ASC 740 should be carefully reviewed.
Companies with foreign earnings face additional considerations related to their indefinite reinvestment assertion and the potential impact under ASC 740 on the deferred tax accounts. Management should ensure that the company can continue to assert its intent and ability to indefinitely reinvest foreign earnings if their operations in such countries have been affected by current market conditions.
If management had any questions they should be sure they are checking with their tax and accounting professionals.
Debt Redeterminations, Modifications, and Loan Covenants
Many companies are experiencing reduced borrowing bases upon redetermination, which can impact the classification of debt and the required write-off of a portion of any debt issuance costs as a result of the decrease in borrowing capacity in a revolving debt agreement. Also, there may be negative liquidity implications from the related inability to maintain the current drilling budget and PUD support as well as going concern projections and assessment.
As part of the redetermination process or upon the default under covenant requirements, the credit agreement may be amended.
In these situations, management should first determine whether the amendment meets the definition of a troubled debt restructuring (TDR) if the lender granted a concession and the company was experiencing financial difficulties. If the amendment is not a TDR, management should then assess the amended debt terms to determine if the amendment should be accounted for as a debt modification or extinguishment under ASC 470.
Companies typically enter into derivatives to protect against commodity price volatility, interest rate increase and foreign currency fluctuations. The hedges may be accounted for under hedge accounting, typically as cash flow hedges, or non-hedge accounting where the derivative is marked to market in earnings.
There are several considerations in the current environment of falling commodity prices and interest rates. Counterparty credit risk should be assessed in the current environment both for its impact on the fair value of the instrument as well as collectability concerns if the hedge is in an asset position to the company. Some other specific considerations for commodity and interest rate derivatives include:
Many credit agreements require a certain level of production to be hedged and failure to maintain the required coverage can result in a debt covenant violation. As discussed earlier, covenant violations may result in the waiver being amended in the debt agreement.
Under the ISDA agreements, there may be acceleration or cross default provisions that can be triggered if there are defaults under other agreements. This can even be the case if the counterparty is also the lender under a debt agreement. Careful review of the ISDA provisions should be performed to ensure that the derivative will not be forced to terminate.
Companies with asset hedge positions may decide to terminate certain positions to generate liquidity and fund required debt repayments or operations. There are accounting implications for hedges accounted for under cash flow hedge accounting as unrealized amounts must remain in Other Comprehensive Income and be reclassified to earnings as the underling production is sold.
Interest Rate Derivatives
Many credit agreements require a certain level of interest payments to be hedged, and, if not, companies may have entered into hedges to protect interest rate volatility in variable rate loans. As interest rates have fallen, companies have recorded liabilities for receiving variable/pay fixed rate interest rate hedges.
In some cases, lenders as counterparties are offering “blend and extend” restructuring amendments for swaps whereby the swap’s term is extended, and the negative fair value of the original swap is rolled into the amended swap. This strategy is intended to lower the fixed swap payments in the short term as well as provide interest rate protection for a longer period.
Lease concessions are common in this environment and may result in accounting treatment as a lease modification under ASC 840 and ASC 842 if the concessions are beyond the enforceable rights and obligations in the lease contract. The FASB issued a recent FASB Q&A on accounting for lease concessions related to COVID-19 that provides a reasonable approach in accounting for these lease concessions.
Management is required to assess whether there is substantial doubt about the company’s ability to continue as a going concern within one year after the financial statements are issued or available to be issued (Assessment Period) considering all the facts and circumstances that exist as of the date the financial statements are issued (or available to be issued) under FASB ASC 205-40.
Obligations should be considered in the broadest sense and include all liabilities that are or will become due and payable within the Assessment Period. This includes debt obligations that are due on demand based on their contractual terms, or that will become callable due to provisions in the debt agreement, such as a failure to meet restrictive covenants as discussed earlier, which requires management to consider debt maturities and covenant compliance for periods after the balance sheet date.
The significant uncertainty in the industry related to commodity or service pricing, production or service levels, and debt covenant compliance, creates difficulties not typically encountered when applying the going concern guidance. The uncertainty about future cash flows, will often require management to prepare multiple cash flow projections that reflect different assumptions about when and how multiple possible scenarios may play out.
If management concludes there is substantial doubt, the next step is consideration of management’s plans intended to mitigate the adverse conditions or events identified in the initial assessment. When assessing management’s plans, events should only be considered to the extent that it is both probable the plans will be effectively implemented and that they will mitigate the conditions or events that raise substantial doubt within the Assessment Period.
These are unprecedented times for the industry and will require us to make complex and challenging judgments and assessments to ensure compliant, reliable and informative accounting and financial reporting.
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