With the challenges the energy industry and midstream sector have endured over the past two years, no one wants to have to respond to more change—particularly due to non-energy specific accounting guidelines. But this is fair warning to begin preparing now: Current U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) revenue recognition guidelines will converge across all industries and capital markets starting in 2018.

The new U.S. guideline, Accounting Standards Codification Topic 606, goes into effect in 2018 and replaces all current industry-specific revenue guidance. As with all cross-industry solutions, there is a high risk of unintended consequences similar to Dodd-Frank and Sarbanes-Oxley compliance.

Gauging the impact

Each sector of the energy industry will be impacted differently with some contracts for goods and services considered in-scope and others out-of-scope. A key factor in determining whether a contract will be significantly impacted by Topic 606 in the midstream sector is the inclusion of a variable consideration component. For example, this could include an index such as West Texas Intermediate (WTI), Nymex gas price, or the Consumer Price Index (CPI). Or, it could include non-cash consideration, such as percent-ofproceeds (POP) and take-in-kind (TIK) processing agreements.

Since most midstream contracts have an index-based component to them, even if it’s merely an annual CPI escalator on a transaction feebased deal, it is likely most midstream contracts will be in-scope and will need to be evaluated for Topic 606 impacts.

Topic 606 may not change how much revenue an entity receives for the performance of a contract or the timing during which that revenue is recorded; however, the guidelines create a significant amount of compliance processes and reporting requirements that most likely do not exist in organizations today. Topic 606 will have significant impacts to a diverse set of corporate functions such as contract administration, accounting, financial reporting, information technology and planning. Entities should begin identifying the impacts that Topic 606 will have on their organizations, processes and systems today, in preparation for the reporting of 2016 and 2017 retrospective activity upon implementation, effective January 1, 2018.

Revenue recognition background

The FASB and the IASB initiated a joint effort to improve revenue reporting guidance to provide a framework for addressing issues, to improve comparability between industries and capital markets and to provide useful information for financial statements and disclosures. The guidance supersedes the previous Topic 605 requirements and previous industry-specific guidance.

Currently, GAAP revenue recognition standards vary by industry and may result in different accounting treatments for similar transactions across industries. The goal of principles- based accounting is to reduce the number of specific rules and, thus, may make the determination and consistency of accounting across industries more difficult.

The energy industry is vast and diverse from producers, processers, marketers, service providers, refiners, generators and many other roles. On the one hand, a universal guideline may simplify financial reporting for diversified energy companies. On the other hand, goods and services contracts are very different by sector and may create a “square peg for a round hole” feeling for accounting and finance organizations.

A standard that applies to everyone may not be appropriate for anyone.

New disclosure requirements

There are significant new qualitative and quantitative disclosure requirements regarding revenue timing, amounts and uncertainty coming with Topic 606. Entities must: • Segregate unique performance obligations in contracts and report against them; • Estimate revenue over the life of the contract by recognized period for impacted contracts at inception; • Report progress against the estimated revenue by period and record variances to an expense account for noncash consideration; • Explain variances to estimated revenue to auditors; and • May need to identify variance reasons such as differences in volume, price, term change, termination, component mix, etc.

Although revenue recognition guidelines are not new, the disclosure of the estimated life-of-contract value is new. While solutions are still being envisioned and tested, some key capabilities will be required for compliance. Key capabilities include:

• Contract management and performance obligation identification; • Obligation forecasted revenue calculation; • Invoicing—revenue systems/functions; • General ledger; • Reconciliation of forecasted revenue to actual revenue (output: adjusting general ledger entries); • Financial reporting; and • Performance monitoring and change management.

Midstream’s impact

The diversity of the midstream sector brings myriad different contract types depending on the services that a company provides. Topic 606 is interested in the variable nature of a contract’s price or revenue.

The commodities marketing division within midstream companies will most likely be impacted since its contracts often have index-based pricing and commodity exchange terms. The exchange of like products in different locations will most likely not need to be disclosed; however, the exchange of different products in the same or different locations may very well meet the FASB’s definition of variable consideration and, therefore, must be disclosed.

While most midstream companies have a high percentage of fee-based contracts, they may also have to be disclosed if there is a CPI escalator or adjustment to the rate based on commodity prices. With the drop in commodity prices over the past two years, producers have cut production and are facing economic hardships due to minimum volume commitment clauses within their midstream services agreements.

One technique used to restructure these minimum volume commitments has been for the midstream company to receive dedicated acreage from the producer in return for eliminating, or reducing, the volume commitment. Although restructured contracts may have reduced transaction fees, they may also include escalation and de-escalation terms based on the price of crude oil or natural gas. These contracts will most likely have to be disclosed under Topic 606 as there is significant variable consideration for the performance obligations.

POP and TIK

The two most interesting contracts that will be affected by Topic 606 are POP and TIK contracts. While there has been an effort to reduce these types of contracts in favor of fee-based terms, they are still quite common—and are likely to increase in frequency as commodity prices rebound in the future.

Both contracts have significant variability, both in volumes and product mixture. Over the life of a multi-year gathering and processing agreement, the processed volume levels and NGL component mixture can vary significantly. Variations can come from field production changes, technology improvements and geology.

So how is a company going to estimate its revenue for a multiyear gathering and processing agreement with the inevitable uncertainty of the volumes and products delivered?

Each contract will have to be reviewed by accountants educated on Topic 606 before the proper handling can be determined. Reporting entities must also prove to their auditors that they have reviewed all contracts, outlined how they concluded if a contract was required to be disclosed and share their ongoing, new or modified contract review processes.

Disclosure considerations

The most significant takeaway from the new disclosure requirements is the needto estimate a contract’s value over its life at inception. It will be very difficult to estimate those obligations where the price is based on an index. Entities must determine if there is sufficient liquidity within the index to determine a reasonable and reliable price to be used for the estimate. This will be particularly difficult for NGL markets that do not have a forward market past 18 months. Midstream gathering and processing entities with POP agreements will need to work with their auditors on how best to disclose the value of these contracts.

After a contract’s net present value has been estimated, performance against that original estimate must be updated and reported quarterly. The integration of a forecast with the actual settled value of an obligation will be a new capability required of organizations. If organizations compare forecasts to actual values today, it’s not typically done at a contract level—let alone at the level of a unique obligation within a contract.

To make things even more complicated, yet more realistic, revisions to contracts will need to be carefully managed. Updating previously reported disclosures with a new baseline created by contract amendments needs to be clear and identifiable to auditors.

Organizational compliance

Planning, accounting, contract administration and IT groups will need to work together to define a solution to these new challenges. The solution will require process, governance and system changes to be compliant with Topic 606 disclosure requirements.

Most organizations have these capabilities, but rarely interact as much as needed to comply with Topic 606. Contract management systems typically represent document management solutions and do not break down a contract into its unique performance obligations. Contract management systems certainly do not forecast the full value of a contract over its life. While that might be a function of a financial planning and analysis organization, that information is not regularly compared to the actual invoices generated from the revenue systems.

Another challenge is created when the accounting and financial reporting groups must disclose the aggregate estimated enterprise revenue for in-scope contracts along with the cumulative performance of those contracts against the original estimate of revenues. The general ledger systems contain the actual performance but typically do no contain the original and current plan for past and future revenue expectations. All of these capabilities become significantly more complicated when contract revisions occur. It’s unnatural to have all of these internal groups interact at such a base level of detail and with such regular frequency. Software solutions most likely will need to solve the data, process and organizational integration challenges, but which software?

How to prepare

The 10-Q financial report for the first quarter of 2018 will be the first time entities must comply with Topic 606 guidelines. Don’t forget, though, that entities must report, retrospectively, disclosures for 2016 and 2017. In many ways, organizations are already behind in preparing for compliance. Most companies have only just started >understanding the impacts to their business and identifying solutions for the key capabilities they must have to remain in compliance.

Now is the time to start your analysis and planning. Most boards’ audit committees will require a compliance plan for their fall 2016 meetings. The bulk of solution implementations will be in 2017, so those costs should be accounted for in the 2017 budget process that is currently ongoing.

At Opportune, we recommended compliance approach includes the following activities:

• Assemble cross functional team and become educated on the guidelines; • Document current processes for key capabilities; • Identify common contract types and impacts of Topic 606; • Gather and analyze all contracts; • Define management and reporting solutions; • Define retrospective reporting solutions; • Evaluate and select software solutions; • Implement software solutions, integrations and reporting; and • Execute the transition to compliance.

Topic 842

There is one more thing to worry about: changes to lease accounting are coming.

If one big change wasn’t enough for the FASB, there is another accounting change, Accounting Standards Codification Topic 842—Leases (Topic 842), coming that affects the treatment of operating leases and may have a significant impact on a company’s balance sheet. When implemented on Jan. 1, 2019, almost all contracts meeting the definition of a lease—including operating leases—will be recognized on-balance sheet via a right of use asset and lease liability. The gross-up of the balance sheet and front-loaded expense recognition associated with finance-type leases can cause financial ratios such as EBITDA to increase, profit margins to decrease and debt-to-equity to increase. Loan covenants with debt-specific provisions could end up in default or in a more negative position.

How will lenders and investors respond to the degradation in these covenants and financial ratios when the underlying business did not change? The use of leases varies significantly among midstream companies. The challenge is, dependent upon contract specifics, Topic 842 could include transportation, storage, rights-of-way and gathering agreements as leases when, in most cases, they are not considered leases today.

Companies will need to spend time understanding the new definition of a lease and identifying where in their organization they have contracts that may have to be classified as a lease under Topic 842. The time required for this front-end diligence should not be underestimated.

The compliance dates and approach to assessing the impacts of the new lease accounting guideline are very similar to Topic 606. The FASB recognized these two initiatives would create similar policy, process and system changes for companies and therefore felt companies could gain efficiencies by addressing both Topic 606 and Topic 842 simultaneously. Both guidelines require similar capabilities such as centralized contract management, software solutions, audit compliance and financial reporting integration.

While this article is focused on Topic 606 and revenue recognition, it is important to mention Topic 842 because auditors, boards’ audit committees and ultimately the CEO and CFO will be asking this fall about how the companies’ compliance approach will ensure the revised reporting and disclosure requirements under Topic 606 and 842 can, and will, be achieved.

Responding now

The initial reaction many companies may have is “we are not affected.” Many times, after they hear that pricing terms involving indexes and consideration in the form of product will be affected, they change to a more cautionary stance. When the lease accounting changes are layered in, it’s clear that midstream companies will be affected by both Topic 606 and 842. The degree to which a company is affected can only be determined after conducting a detailed impact assessment involving technical accountants, tax advisors, and process and technology solution consultants.

Compliance is going to require the integration and collaboration of traditionally disconnected departments, processes and applications. While the first reporting period after the effective date is first-quarter 2018, the retrospective reporting requirement back to 2016 and 2017 means the clock is already ticking. If companies have not established a cross-functional team to start assessing the impacts on financial reporting from both a systems and process standpoint, they should start now because the necessary reporting changes and solutions are formidable, and daylight is burning.

Kurt King is a partner leading the midstream practice at Opportune, an energy management consulting firm.