The implementation and adoption of the new revenue recognition standard (ASC 606) is seen by many as the biggest shake-up in accounting in decades. The standard, issued as accounting standards update (ASU) 2014-09 by the Financial Accounting Standards Board and as international financial reporting standard (IFRS) 15 by the International Accounting Standards Board, converges the revenue recognition principles under the U.S. generally accepted accounting principles (GAAP) and IFRS as well as enhances the qualitative and quantitative revenue disclosures in financial statements.

For public companies, the standard is effective for annual reporting periods beginning after Dec. 15, 2017. For private companies, the standard is effective for annual reporting periods beginning after Dec. 15, 2018. The standard can impact the timing and the amount of revenue recognized and affect the way companies view and determine the value of oil and gas assets and operations.

As companies look to acquire oil and gas assets and businesses, they will need to conduct due diligence to properly understand the impact of the revenue recognition standard.

There are a few issues influencing accounting policy elections for E&P, midstream, oilfield service and refining sectors.

Upon adoption, management teams will need to exercise significant judgment in applying certain aspects of the standard which can impact the timing and presentation of revenues.

Companies within the industry have an opportunity to apply learnings from public company adoption processes, given their earlier timeline for implementation. The core principal behind the standard is to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. While the new standard prescribes a consistent model for application, the practical application requires judgment.

Many public oil and gas companies identified a few significant changes in revenue due to the new standard. Detailed due diligence was required for them to arrive at that conclusion.

Here are a few critical considerations for E&Ps, midstream, oilfield service and refining companies with respect to the adoption of the new revenue standard.

E&P and midstream

E&Ps and midstream companies often enter into gathering and processing arrangements, which can take many forms, such as percentage of proceeds, percentage of liquids, keep-whole and fee-based arrangements. The concept of control within the framework is key to identify when or if the transfer of the product occurs from the E&P to the midstream company. In certain contracts, control can be transferred at the wellhead, a common delivery point, the inlet of a plant or the tailgate of a plant, each of which results in various gross vs. net presentation considerations in both the E&P and midstream company financial statements. The application is based on the facts and circumstances of the underlying contract terms, but the control determination entails a level of judgment that can lead to variability in implementation across the industry.

For example, an E&P company enters into a gas processing and sales contract with a midstream company. The midstream company is paid a processing fee ($50) to process the gas. The midstream company also purchases the entire gas stream from the E&P for $500. The point at which control of the gas transfers from the E&P to the midstream company will determine the presentation of the processing fees for each company. If control of the gas stream passes at the inlet of the processing facility, the fee represents a reduction of the sales price. If control of the gas stream passes at the tailgate of the plant, the processing fee represents revenue to the midstream company and an expense to the E&P.

The timing of recognition also impacts midstream companies when it comes to tiered pricing contracts. In these scenarios, a company might sell its product at increasing prices during the contract period. For instance, suppose a midstream company provides the sale of its product of 1,000 units to a customer at $2, $4 and $6 per unit in contract years one, two and three, respectively. The company must determine whether the increase in price represents the standalone selling price in each of those years. If there is no expectation that the market price will increase for the product, the midstream company may have to blend the rate, which will create a timing difference between the revenue recognized and the actual cash flow received. In addition, when the timing of the cash payments differs from the transfer of goods or services, entities may need to evaluate the transaction for a potential financing component.

Similarly, midstream companies enter into contracts with minimum volume commitments that can also contain clawback provisions. In these contracts, the customer agrees to a take-or-pay type arrangement in which they agree to deliver a minimum amount of product for processing. To the extent there is a shortfall, a deficiency payment must be made. In certain cases, the customer has a clawback provision, or a right to offset future deliveries against previous deficiencies paid.

For example, company “A” enters into a contract with the midstream company for processing services and it agrees to deliver a minimum 12,000 units per year for two years at a processing fee of $1 per unit. To the extent company A has a shortfall, deficiency of $1 per unit is applied to each shortfall unit. However, company A also has the right to offset excess deliveries in year two against any year-one deficiencies.

Assume company A delivers 10,000 units in year one and 14,000 in year two for processing. The midstream company would collect $12,000 in year one ($10,000 for units processed plus a $2,000 deficiency fee), but only record $10,000 in revenue. The midstream company would record deferred revenue for the $2,000 deficiency fee since the performance obligation related to those volumes was still unsatisfied upon receipt of the payment in year one. When applying the new revenue recognition standard, the concept of a breakage model (i.e., unexercised customer rights) is applied, and revenue could be recognized once it is clear there is a remote chance of the minimum volumes being achieved. Thus, entities may end up recognizing an amount of revenue attributable to breakage sooner than they could under the old standard.

Within the various gas purchase, gas sale, and gathering and processing arrangements, the variability of the contractual terms can potentially impact the timing and recognition of revenue. Additionally, as noted in the minimum volume contract, the timing of the revenue recognition does not always coincide with the receipt of cash. This is important to consider as part of the process of evaluating what cash is available for distribution or to identify potential cash flows for valuation decisions.

Oilfield service companies

Many public oilfield service companies also have had to rethink their recognition policies with the adoption of the new standard. For instance, an oilfield service company may manufacture a product for a customer that has no alternative use. The company must determine whether “point-in-time” vs “over time” recognition is appropriate. To be recognized as revenue over time, the oilfield service company will need a right to payment for completed performance at all times. Again, the facts and circumstances underlying the contract will impact the pattern of recognition.

Another consideration for oilfield service companies is the treatment of mobilization and demobilization costs (i.e., the cost to move equipment to and from an existing location to a specified well or pad site at the beginning and the end of a project). Companies need to determine whether the mobilization represents a fulfillment cost of the contract which would be capitalized and amortized or if it indicates a promise to deliver a service (a separate performance obligation). If the mobilization represents a fulfillment or setup cost, any upfront payments received from the customer for mobilization represent a contract liability (deferred revenue) and would be recognized over the service period.

In addition, demobilization revenue would need to be estimated at contract inception, included in the transaction price and recognized over the expected service period.

In contrast, if the mobilization is deemed to be a separate performance obligation or forms part of the overall performance obligation within the contract, revenue would be recognized when mobilization commences. Costs incurred for mobilization are generally considered to be direct costs incurred to enable the contractor to fulfill its obligations under the contract.

If the mobilization costs are not deemed to be a separate performance obligation or part of a performance obligation and the costs meet the capitalization criteria, they are capitalized and amortized using a method that is consistent with the pattern of transfer of goods or services to the customer.

Leadership judgment

Public downstream refining companies have had similar considerations as E&P and midstream companies with respect to variable consideration and pricing. The use of variable consideration (i.e., formula-based pricing) can present a challenge. Company leadership must exercise judgment regarding the transaction price in relation to the performance obligations; they will need to apply the constraint guidance within the standard.

Under the new standard, an estimate of variable consideration is only included in the transaction price to the extent that it is probable that subsequent changes in the estimate will not result in a “significant reversal” of revenue. This requires the company to take into account the likelihood and magnitude of a future reversal of revenue, and requires significant judgment from management, especially since the transaction price must be adjusted each period.

Incremental changes

While the adoption of the new revenue standard may not result in wholesale changes, it has highlighted the fact that corporate leadership needs to exercise sound judgment when reviewing contractual terms and conditions’ impact on revenue. This is particularly important for companies that are planning to grow through acquisitions.

As companies assess their growth trajectories, they may benefit from keeping the standard in mind as a key consideration and part of their due diligence process. For now, companies will likely need to be focused on gross revenue vs. net within financial statements and employ resources to adhere to the standard.

Paul L. Horak is a partner, audit and enterprise risk services, at Deloitte & Touche LLP in Houston and had more than 27 years of experience in audit and accounting services. Phillip Hilsher is an audit partner, energy and resources, and has more than 23 years of public accounting experience. Keith Waldrop is an audit senior manager with more than 11 years of client experience.

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