Energy Insights Oil & Gas Revenue Recognition
Implications of new revenue recognition standard for oil and gas companies OIL AND GAS EXECUTIVES MAY HAVE HEARD that the new revenue recognition standard (ASC 606) will not require a substantial change in how they recognize revenue. While this is true, ASC 606 will fundamentally change how oil and gas companies think about, track, record and report revenue. Under previous revenue recognition guidance for oil and gas companies, production drove revenue. Under the new comprehensive model to be applied to all industries, performance obligations and the fulfillment of those obligations determine when revenue is recognized. ASC 606 also requires substantially different and more extensive qualitative and quantitative disclosures. Energy companies will need to modify or add systems to track and evaluate different types of information than they have historically tracked. As a result, implementation of the standard will be more time-consuming, complex and costly than many expect.
The five-step revenue recognition model All entities that hold contracts with customers must follow the following five-step model to recognize revenue: 1: Identify the contract with a customer A contract is a legally binding agreement between two parties to provide goods or services. To qualify as a contract under ASC 606, the agreement must meet certain criteria that were specifically written for the new standard.
2: Identify performance obligations in the contract Performance obligations are distinct and separate promises stipulated in the contract to help complete the transfer of the goods or services. Within one contract, there may be multiple performance obligations.
3: Determine the transaction price The transaction price is the agreed-upon cost to transfer the promised goods or services. The price may be fixed or variable.
4: Allocate the transaction price to the performance obligations in the contract The transaction price should be allocated to each stand-alone promise in the contract, and if the exact cost is unknown, it should be estimated.
5: Recognize revenue when (or as) the entity satisfies a performance obligation If the previous four steps have been completed accurately, the final step of recognizing revenue is straightforward — as the distinct performance obligations are met, the entity will recognize revenue as allocated in step four.
Energy Insights: Revenue Recognition Oil and gas examples Let’s look at a few examples of how transition to this new model may require additional documentation:
Production imbalances PRODUCTION IMBALANCES ARISE when owners in a commodity-sharing arrangement under a Joint Operating Agreement (JOA) sell more (“overlift”) or less (“underlift”) production volume than contractually allotted. In many instances, the JOA calls for settlement of imbalances at the end of the contract, which may be years in the future. Past guidance under ASC 932-10-S99-5 allowed revenue recognition and recording receivables for imbalances using either the sales method or the entitlements method. ASC 606, however, requires companies to use the sales method for all revenue recognition transactions. This means the volumes sold in a period are treated as revenues under the standard, but those volumes that were receivables by either the operator or non-operator would not result in an adjustment to revenue or the recording of a receivable for imbalances as part of the revenue recognition process. At least one position has been that under-producing assets would instead have an adjustment to their oil and gas reserves, but the Financial Reporting Executive Committee Issue #12-1 – Revenue Recognition of Sales of Oil and Gas merely states that FinREC believes the accounting treatment for the imbalances between what the producer sells and its proportionate working interest share falls outside the scope of FASB ASC 606. Entities with these types of imbalances should follow applicable guidance relating to the nature of the agreements that gave rise to the imbalance. Initial assessments were that this change in imbalance accounting could be significant; however, production imbalances are not common in the current age of automated production accounting systems, as these imbalances historically arose out of adjustments to production information in the paper age.
Joint operating agreements ALL PARTIES IN A JOA MUST DETERMINE what their roles are in the sales process — are they principals or agents? If an entity’s performance obligation is to provide goods or services directly to the customer, it would be considered a principal in the selling arrangement. If the obligation is to contract with another party to get those goods or services to the customer, the entity would be considered an agent. Once the parties make this determination, they will have a better idea of whether they should recognize revenue on a gross or net basis. In general, principals will record their revenue on the gross basis as long as they control the goods before they are transferred to the customer. Agents, on the other hand, often do not control the end product; therefore, they would record their agency service earnings revenue net of their costs.
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Energy Insights: Revenue Recognition Contract modifications
1. Disclosures about contracts with customers
BECAUSE THE PROCESS of recognizing revenue under ASC 606 begins with identifying contracts, entities must be able to determine when a modification to an existing contract would be accounted for as a separate contract. With blend-and-extend contract modifications, for example, executives must ask themselves:
Management must break out revenue into appropriate categories, which is a technique referred to as “disaggregation of revenue” (ASC 606-10-50-5). Each entity will be different and can choose the categories that make the most sense based on the types of contracts in place. For example, some entities may choose to report revenue by product line, type of contract or duration, where others may choose to report revenue by market or type of customer. Most upstream oil and gas companies will have three products (oil, gas and natural gas liquids) that are produced in one or more geographic areas and sold under contracts with limited variation in terms. To determine which categories to use, management should consider how revenue has been reported for other purposes, such as annual reports or investor presentations. Management can also consider how the financial performance of their operating segments has been evaluated in the past — this can give some clue as to which factors would be most relevant to the financial statement users. For those performing segment reporting, a reconciliation may be needed.
• Has there been a change in the scope of the project? • Have additional goods or services been promised? • If so, does the additional consideration reflect the price I would charge for these goods or services if this were a standalone contract? If the answer to these questions is “yes,” then the modification represents a new contract, and the company should walk through the five-step revenue recognition process for the modification as if it were a separate contract.
Take-or-pay arrangements TAKE-OR-PAY ARRANGEMENTS ARISE when customers agree to purchase a certain volume of product whether they end up accepting delivery or not. This may result in customers paying for product that they never receive. Walking through the five-step process of ASC 606, oil and gas companies would generally recognize revenue from goods over the entire duration of the contract — in other words, as they complete their performance obligations to the customer. Depending on the contract, this revenue may be recognized equitably over time, or it may be recognized as the product is delivered. Under ASC 606, when it comes to undelivered goods in take-or-pay arrangements, oil and gas companies may only recognize revenue when the likelihood of the customer accepting delivery is considered remote. While the approach to thinking about these arrangements will change, it is expected that the accounting will largely remain the same in practice. However, companies should be sensitive to specific contract language that may change the timing of revenue recognition from current practices.
Potential impact of new disclosure requirements
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Disclosures are nothing new to companies that follow GAAP or IFRS, but because ASC 606 is principles-based, executives may not be used to the different qualitative and quantitative disclosures required. These new disclosures are intended to clear up any uncertainty in financial statements regarding the company’s contracts with its customers. We have categorized the new disclosure requirements into four main types: (1) contracts with customers, (2) contract balances, (3) performance obligations and (4) judgments that were made while interpreting the guidance.
2. Disclosures about contract balances Upon implementation of ASC 606, management must disclose both qualitative and quantitative information about their contracts, including: • The progress of contracts, such as the balances of contract liabilities, assets and receivables (ASC 606-1050-8) • How the timing of fulfilling contract obligations compares to the timing of payments received and how both of these factor into how assets or liabilities are reported (ASC 606-10-50-9) • Any significant changes in how contract balances are being determined, such as changes in how management measures progress, whether there was a contract modification, or whether there was a change in transaction price on a particular job (ASC 606-10-50-10) • If a contract asset becomes impaired (ASC 606-10-5010) • If a contract asset becomes a receivable, and why the right to consideration has suddenly become unrestricted (ASC 606-10-50-10)
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Energy Insights: Revenue Recognition 3. Disclosures about performance obligations Performance obligations, or promises to perform a certain task, must be included in the contract itself, and more detail about these performance obligations will need to be included in the disclosures section of financial statements. These disclosures include: • Information about when performance obligations will be fulfilled (upon delivery, upon completion, as services are rendered or ratably over time) • Payment information, such as when payment comes due, how the required payment compares to the completion of performance obligations, whether payment is variable or fixed, etc. • Additional information to fully comprehend when a performance obligation will be considered complete • How returns, refunds or warranties will affect the completion of performance obligations • What revenue has been recognized in the current reporting period from performance obligations that were at least partially satisfied in the prior period, and why this revenue is now being recognized • How the entity determines the transaction price allocated to the incomplete performance obligations and the expected time remaining to fulfill those obligations • What assumptions were made when determining the transaction price or when to measure the completion of performance obligations when warranties or refund options exist
4. Disclosures about significant judgments that were made when interpreting the guidance Much of the new revenue recognition guidance can be interpreted in multiple ways. Over time, oil and gas entities may decide to change how they report on their contracts with customers to improve the accuracy of their reports. Changing assumptions and judgments is an acceptable practice, but these changes must be disclosed so that amounts reported can be comparable between years. These assumptions will affect when performance obligations are satisfied (and therefore revenue recognition itself), so being clear about assumptions is important. In most instances, additional data will need to be collected to meet these disclosure requirements, which might also require changes in the processes and systems companies have in place. Additional monitoring and recordkeeping will also be required.
What’s next? The new revenue recognition standard will require oil and gas companies to make substantial changes in some internal processes to accommodate new requirements for recognizing and reporting revenue. To ensure new processes reflect the new requirements, we recommend that financial executives become intimately familiar with the five-step process. In addition, taking the time to draft disclosures in advance can help clarify questions that could derail the process later. Weaver’s Risk Advisory Services team can help you examine and update your processes and offer guidance throughout your implementation of the new standard.
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CONTACT US Jody Allred, CPA, CITP, CISA, CGMA Partner Risk Advisory Services jody.allred@weaver.com 817.882.7750 Weaver’s oil and gas services group is deeply familiar with the issues oil and gas companies around the world face, including uncertain credit markets, increasing industry legislation and tax reform, regulatory and environmental oversight, data security and other areas of potential risk. We work closely with our clients to customize services that fit their existing staff structure and operations. Some of the services we provide include: • • • • • • • • • • • • • • •
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