In a new standard issued in February, the Financial Accounting Standards Board made significant changes to the way assets and liabilities arising from leases must be reported. The new standard, ASC 842, provides an update on how lessees must account for these items on their balance sheets.
Lessees are now required to recognize lease assets and lease liabilities on their balance sheet and to disclose both qualitative and quantitative information about these lease transactions. This includes information such as variable lease payments and options to renew and terminate leases. For oil and gas companies, this may result in significantly more assets and liabilities being recorded on the balance sheet than in the past.
"Virtually all lease assets and liabilities must be recognized on the balance sheet."
Lessees will need to use their judgment when applying the definition of a lease and allocating consideration between lease and non-lease components of their contracts. While some identified assets, such as land or buildings, are easy to recognize, others may be less clear. For example, depending on the conditions specified in the lease, storage tanks or caverns or transportation or drilling services, may qualify as identified assets.
Leases covering oil and gas mineral rights or drilling rights, and the right to explore the land containing these minerals for other natural resources, will be considered outside the scope of ASC 842 and will not be effected by this update. These leases should be accounted for following the guidelines spelled out in ASC 932. This exemption does not apply to the leasing of oil and gas equipment used to explore for oil and gas.
Once all assets and leases are identified, businesses will need to correctly classify their leases. For companies reporting assets and liabilities they lease, these items will be need to be qualified as either operating or finance leases. The classification of the lease will remain critical as it determines how and when a lessee and a lessor recognize lease expense and income, and, therefore, how these items are recorded.
Classifying a lease
In determining whether a lease will be classified as a finance lease or an operating lease, companies will follow similar guidelines to those FASB currently uses for capital leases and operating leases. Like capital leases, a finance lease will generally have a front-loaded expense recognition pattern. Operating lease expenses will still be generally recognized on a straight-line basis.
The classification of a lease must occur at the lease commencement. In order to qualify as a financing lease, the lease must meet the following conditions:
- The lease involves a transfer of ownership of the asset to the lessee by the end of the lease term.
- The lease grants the lessee the option to purchase the asset and the lessee is reasonably certain to do so.
- The lease runs for the majority of the remaining economic life of the asset and the lease did not commence at or near the end of the asset's economic life.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already included in the lease payments equals or exceeds the fair value of the asset.
- The asset is of such a specialized nature that it will have no other value to the lessor at the end of the lease.
If the lease does not meet any of the above criteria, it is classified as an operating lease.
For lessors, much of the standard will remain the same. Lessors should continue to classify their leases as operating, direct financing or sales-type. However, the qualifications for sales-type and direct financing leases have been updated, as have the related accounting procedures. The new guidance also eliminates real estate-specific provisions that were used before the update.
Updating internal procedures
According to FASB, the new standard update will greatly affect the oil and gas sector, and lessees specifically, as they will be required to record virtually all lease-related assets and liabilities. This will require revisions of internal reporting procedures, and will likely change how the balance sheet appears to investors and others who review the company's financial records.
Oil and gas companies will need to begin implementing the updated standard by ensuring their inventory of leases is accurate and complete. This may require extensive review, as leases may be embedded in other contracts for goods or services. Companies will need to identify all their leases and measure lease-related assets. Additionally, each existing lease will need to be evaluated to account for lease and non-lease components, in order to identify information necessary for disclosure.
"The update may require extensive review, as leases may be embedded in other goods or services contracts."
This can present a unique challenge for oil and gas entities as contracts often contain non-lease components for services provided by the supplier. This may include drilling, storage and transportation arrangements, which often include services that are not classified as leases, such as service contracts. In these instances, the standalone value of the non-lease components must be determined, which can be difficult if no market value is known for each individual component.
Identifying lease and non-lease components has not been a common practice to date as the accounting treatment for both has often been the same. However, because most leases will need to be recognized on the lessee's balance sheets under ASC 842, lessees will need to develop more thorough methods for identifying both lease and non-lease components of contracts for recording.
In addition to changes to internal reporting practices, the addition of new items to the balance sheet may impact other aspects of the company's operations. This may include arrangements with lenders, accounting of income for state taxes and general operating decisions, such as determining whether to lease or purchase an asset.
The new FASB standard will go into effect for public companies after December 15, 2018. For private companies, the standard is effective for fiscal years beginning after December 15, 2019.
Oil and gas companies needing additional guidance in creating a transitional procedure for implementing ASC 842 should contact the accounting professional in LaPorte's Energy Industry Group.