March 2020
Find out what private companies can do now to prepare for the new leases standard (ASC 842) slated to go into effect next year.
By Kristin Floyd Newton
In November 2019, the Financial Accounting Standards Board (FASB) delayed the effective date of the new leases standard (ASC 842) for private companies by one year, making the standard effective date for annual reporting periods beginning January 1, 2021. The delay was a direct reflection of the FASB’s belief that private companies needed an additional year to learn from the public company adoption process to properly implement the new leases standard and the numerous technical challenges that public companies faced to comply with the new leases standard by the public company effective date.
But, does the deferral of the effective date really mean that private companies can wait another year to begin the implementation process?
The overwhelming feedback from public energy companies is that the implementation process required significantly more time, effort and resources than initially expected. Thus, it’s imperative that private energy companies capitalize on the extra year that the FASB provided for adoption by beginning the planning and implementation process now.
Overview of the New Leases Standard
The FASB issued the new leases standard in 2016 to provide financial statement users with more information about a company’s leasing activities. Under the new leases standard, a lessee is required to recognize all leases, including operating leases, with a term greater than one year on-balance sheet.
Lease classification criteria to determine whether a lease represents an operating lease or a finance lease are largely consistent with legacy guidance under ASC 840. However, under the new leases standard, lease classification doesn’t determine whether a lease is presented on a company’s balance sheet.
The new leases standard became effective for public companies for quarterly reporting periods beginning on January 1, 2019. As previously mentioned, private companies were originally required to comply as of annual reporting periods beginning January 1, 2020. However, the FASB subsequently deferred the private company effective date by one year, with compliance now required for annual reporting periods beginning January 1, 2021.
Implementation Challenges in the Energy Industry
Considering the public energy company adoption process, there are three key challenges that private companies are likely to face during the implementation process:
- Development of a complete population of lease contracts
- Technical application challenges and
- Resource constraints
Development of a Complete Population of Lease Contracts
One of the biggest challenges that public energy companies faced through the implementation process was developing a complete population of at-risk lease contracts. This challenge is further magnified for companies that currently have decentralized ownership of the lease execution and management process, which is common in the energy space.
"It’s imperative that private energy companies capitalize on the extra year that the FASB provided for adoption by beginning the planning and implementation process now."
In addition, given that service contracts and operating leases were treated similarly under legacy lease accounting guidance (ASC 840), private companies may not currently have sufficient processes in place to appropriately distinguish between those contract structures and track existing and new operating leases. As such, in developing a complete population of lease contracts, it’s imperative that private companies perform procedures to elevate existing lease contracts and review at-risk service contracts that may include in-substance leased assets.
Technical Application Challenges
In connection with the adoption of the new leases standard, there are several new technical energy issues that require management judgement and analysis, as summarized below:
- Determination of the lease term for evergreen contracts: In the energy industry, it’s common for certain rental contracts to be structured with a fixed minimum term of one year or less that becomes evergreen (that is, month-to-month or well-to-well) upon expiration of the minimum term. For example, compressor rentals and drilling rig daywork arrangements are often structured in this manner. For these contracts, management will be required to evaluate whether an estimate of the evergreen renewal periods that may be exercised should be included in the lease term. This determination should be based on historical usage for that asset class, drilling plans and production forecasts, termination and/or demobilization penalties and other relevant factors. Given the initial terms for these contracts may be short term as defined under the new leases standard (that is, one year or less), this analysis can directly impact whether certain of these leased assets are required to be presented on a company’s balance sheet.
- Midstream service contracts: Under the new leases standard, private companies must review midstream service contracts to ensure that the arrangements don’t represent an in-substance lease of the underlying midstream assets (for example, a transportation pipeline or gathering system). Indicators that a midstream service contract may represent a lease include:
◊ Producer utilization of substantially all (that is, 90% or more) of the underlying midstream asset’s capacity, or
◊ A single producer customer for a midstream asset. Private energy companies should work with their commercial and marketing teams to identify midstream contracts that may be at risk of qualifying as a lease upon adoption of the new leases standard.
In many cases, evaluation of these issues requires detailed review procedures on an individual contract by individual contract basis. Thus, beginning the process of understanding contract structures that are currently in place in the near-term will help set private companies up for a more efficient implementation.
Resource Constraints
The implementation process will likely take longer than initially expected and there’s a significant manual component to the data extraction and lease contract analysis processes. Given capital constraints and volatility in the current energy market, we expect public and private operators alike to increase focus on optimizing operational cost structures and overhead, which could lead to further resource constraints in business departments that are critical to the overall leases implementation process.
"Beginning the process of understanding contract structures that are currently in place in the near-term will help set private companies up for a more efficient implementation."
Thus, starting the implementation process early affords private companies increased flexibility in allocating constrained resources to key steps of the implementation to ensure compliance by the effective date.
Where to Start
Based on hindsight from the public company adoption process, one of the more critical components of a successful transition to the new leases standard is employing a cross-functional approach to a company’s implementation. This is of particular importance for energy companies with decentralized ownership of the lease execution and management process. As such, the first step in a private company’s implementation process should be the creation of an integrated cross-functional lease team that includes all departments that have the authority to execute material at-risk contracts (for example, accounting, legal, commercial, operations and IT departments).
From here, private companies should begin the process of developing a complete population of contracts that are at-risk of representing a lease under the new leases standard, starting with those contracts that a company currently accounts for as a capital or operating lease under legacy lease accounting guidance. This can be one of the most time consuming and resource intensive implementation tasks, so now is the time to start!
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Kristin Floyd Newton is a Director in Opportune’s Complex Financial Reporting practice based in Dallas. Kristin has worked on a variety of projects, including revenue recognition and lease accounting implementations, transaction advisory services and other technical accounting research projects. Prior to joining Opportune, Kristin worked at the FASB and served as a member of the team leading the FASB’s revenue recognition efforts. Kristin received her undergraduate degree and Masters in Accounting from Texas A&M University and she is a Certified Public Accountant licensed in the State of Texas.
