This article discusses the new financial route taken by Southwest Airlines in June. Southwest managers announced increase in quarterly dividend and share buyback program to boost shareholder returns. Southwest also plan to purchase larger 737 Max jets from Boeing compared to previous purchase of smaller version. These larger jets will help southwest fulfill increase in demand and decrease operating expenses. These proposed changes will affect all three section of cash flow statement.

Southwest is the No. 4 U.S. airline by traffic that has generated 39 years of positive net income by providing superior services to customers. This achievement becomes more impressive when we consider that U.S. airlines industry had decade of bankruptcies and consolidation. Southwest announced to quadruple quarterly dividend and increase its share buyback authorization by 50%. Southwest plans to repurchase $1.5 billion shares under an accelerated repurchase program. These programs send a clear message to shareholder about strong financial health and cash position of the company. Share repurchase programs indicate that company believes market is undervaluing their security and they can take advantage of undervaluation. This program will also help them to increase their earnings per share. Similar strategy was followed in 2011 by Southwest as we have seen in the case study.

Southwest Airline also announced the purchase of first larger 737 Max, which will be delivered in 2017. This new purchase and delivery schedule will help southwest to trim $200 million a year from it’s aircraft capital commitments. Increase in demand for southwest services has been cited for the purchase of these new larger jets. These new large jets have higher passenger and cargo capacity per flight that would help them increase revenue and decrease cost. Purchase of new airlines sends strong future growth signals to shareholder.

Southwest and delta are the only two U.S. airlines that pay dividends and have share buyback program. Southwest strong consistent cash generation from its operating activity has enabled them to invest into new bigger jets and plan share buybacks to increase shareholder value.

Article Source: http://online.wsj.com/news/articles/SB10001424127887324767004578485132305205650

Article Source: https://blogs.baruch.cuny.edu/acc9110fall2013/

An article written by Rick Wayman that was published in the online Forbes Journal in October 2010, advocates that cash flow from operations is a better metric of a company’s financial condition. Wayman states that, “Operating cash flow is the lifeblood of a company and the most important barometer that investors have (Wayman, 2010).”

Typically, prospecting investors regardless of financial proficiency would scrutinize the net income being generated by a company. It is presumed as the straightforward determinant of a company’s efficiency and profitability. It generally provides sufficient perspective on determining if the company is making profits in an adequate scale.  Although net income is an important determinant of company’s viability, there are many other factors investors’ take into consideration in weighing their investment decisions.

The article provides two main reasons why Operating Cash Flow is far superior that Net Income for investor assessment:

1. Cash flow is harder to manipulate under GAAP than net income
2. “Cash is king” and a company that does not generate cash over the long term is on its deathbed.

Wayman also takes into consideration that operating cash flows is often confused for EBITDA (earnings before interest taxes, depreciation, and amortization), which is actually the company’s earnings before the effects of financing and investing decisions. Moreover, it fails to include the variations in the company’s working capital.

When investors rely on net income evaluations, they usually attach assessments with EPS (Earnings per share), which have some drawbacks.  Wayman contends that a company can rely in EPS alone for a narrow time. More often than not, the company will need cash to pay its liabilities from suppliers and loans from bank institutions. Despite warnings that can be attained from reviewing the operating cash flows, investors continue to be engrossed with EPS signals.

The article also contends that net income from accrual accounting sometimes become overvalued and appears more significant than operating cash flows. Wayman states that there are various occasions when cash from legitimate sales can get confined on the balance sheet; and the two most common reasons are (1) customers delay payment, hence higher receivables, (2) inventory levels rise because of low sales performance or sales returns.

Lastly, Wayman identifies the prevalence of earnings manipulation in accrual accounting. For instance, managers may overstate net income in the income statement to earn more bonuses. There are other ways to manipulate the income statement to appear more attractive to investors. In contrast, operating cash flow statement will expose such management ploys. According to Wayman, when net income is more than operating cash flows, there is something wrong with the cash cycle which can be a long-term or short-term dilemma.

In general, for the reasons stated above, investors will find it more advantageous to evaluate the operating cash flows of a company.

George Hamelos 12/10/13
Prof. Friday-Davis Accounting Blog ACC 9110
“Examining Preferences in Cash Flow Statement Format”
Article Link: http://www.nysscpa.org/cpajournal/2004/1004/essentials/p58.htm
An article written by Tantatape Brahmasrene, C. David Strupeck, and Donna Whittena, which was published in the Online CPA Journal in October of 2004 examines user preferences in determining Cash Flow Statement Format. As indicated in the article, the FASB mandated that businesses issue a statement of cash flows as opposed to a statement of changes in financial position. In issuing a statement of cash flows companies can decide between two methods, the indirect method and the direct method. The direct method is called as such because in calculating the cash associated with operating activities, inflows and outflows of cash can be directly linked to a company’s cash T-account. The indirect method calculates cash provided by operating activities by starting with net income and adjusting this amount for differences between the cash basis and accrual basis methods of accounting (Pratt, 2011). While the FASB has encouraged companies to use the direct method of cash flows, it has not made this a requirement and as such, users have the option to choose which method they prefer. The decision to choose between the indirect and the direct method has led to much disagreement and controversy. While support exists for both sides of the spectrum, the debate still continues today.
Supporters of the direct method of the statement of cash flows, reports all of the major classes of operating cash inflows and outflows. This method is more in line with the FASB’s initial purpose in mandating that a statement of cash flows be prepared as opposed to a statement of change in financial position, which was cited in the FASB’s issuance of SFAS 95 in November, 1987. Those who support the direct method of cash flow reporting argue that it is exactly as it sounds, more direct. It is clearer and does a better job of showing how a company is able to maintain and operate its company and tells if the company is doing so efficiently. Complaints do exist with regard to the viability of the direct method of cash flows. Some users feel that the direct method presents cash flow information from the net income statement on a cash basis as opposed to an accrual basis of accounting. This they deem as misleading because it shows that net cash flow from operations is as indicative of a company’s performance as is net income. This can lead to discrepancies because of the key differences between the accrual and cash basis methods of accounting. For example a sale can be made as a receivable and under the accrual basis of accounting will be counted in net income but under the cash basis it will not be recognized until the cash is collected. Those who support the indirect method of cash flows maintain that the method synchronizes the income statement with the statement of cash flows and the balance sheet. They are also cite that an additional disclosure is needed to reconcile net cash with net income, but the necessity for providing this additional information is not a large burden as critics will make it out to be.
A study by Stock and Watson (1984) indicates that users’ decisions are influenced by which reporting method for cash flows is used. Given that users make different determinations on financial positions based on the method a company is using in preparing its financial statements and the fact that this is an ongoing topic of debate within the realm of accounting, tons of research has been done regarding the implications of using either of these two methods over the other. According to Hard and Vanecek (1991), the decision of which method to use should be specific to the individual user’s task.
The use of the statement of cash flows has proven critical for investors, creditors and financial analysts in their detailed reviews of the financial standing of various companies. A survey of user preferences, categorized by business sector and respondent perspective (manager and investor) showed that more manager level personalities preferred the indirect method than did investors and analysts. The majority of users preferred the indirect method, a total of 78.9% to be exact.
Managers and investors were polled to determine the reasons they preferred either of the two methods over the other. More managers than investors who preferred the indirect method cited familiarity with format and the ability to determine the difference between net income and cash flow from operations as the main reason for their decision. For proponents of the direct method, the opposite was true in both categories, as a higher percentage of investors reported preferring the direct method for its familiarity and ability to differentiate between net income and cash flow from operations. Proponents of the indirect method did not cite being able to determine cash paid/received as a reason for their choice, while this was largely the cash for advocates of the direct method. Consistency in comparisons from year to year was not significant for advocates of the direct method, while it was highly significant for those in favor of the indirect method. As a result of the poll, for both the direct and indirect method, investors seemed to be more concerned than did managers in determining the change in accounts payable and accounts receivable.
In looking at respondents categorized by different business sectors, users placed more importance on familiarity, consistency, seeing change in accounts payable and receivable and understanding the difference between net income and cash flow from operations, as reasons they prefer the indirect method to the direct method. The manufacturing sector reported preferring the indirect method more than the direct method and cited familiarity as the main reason in its thinking. The merchandising sector cited knowing the change in accounts receivable and payable as the most important reason for choosing the indirect method. The services sector also reported preferring the indirect method over the direct method. Financial companies remained divided when deciding between the direct and indirect methods. The utilities sector, which is actually required to use the direct method, reported preferring the indirect method. While the majority of business segment users prefer the indirect method, those that do prefer the direct method cite being able to see cash being paid as the most important reason in their line of thinking.
It is apparent that there are many advocates for both methods so it is hard to say definitively that one is better than the other. Every user has his or her own distinct reason for choosing the direct method over the indirect method and vice versa. According to Brahmasrene, Strupeck and Whitten, financial statement users should base their usage on market needs and the evolution of financial models. The incidents of citing familiarity as a preference for the indirect method is something that will fade over time as users become more familiar with the SFAS 95. Users who are concerned with consistency can just take prior year cash flow statements and reorganize them to be in line with the new methods. With the advent of computer software and technology, the direct method is more commonly being preferred and used today. As this article is dated around 9 years ago, it gives a sense of why users had difficulty in adjusting from the statement of change in financial position to the direct method of cash flows. As we continue to age and progress we will inevitably see more and more users prefer the direct method to the point where the indirect method will eventually be phased out. Until then though, there will still be a heavy segment of advocates who might be a little bit older fashioned, that defend to the death their preference of the indirect method of cash flow reporting.
References:
1. Pratt, Jamie, “Financial Accounting in an Economic Text”, Eighth Edition, John Wiley & Sons, Inc, 2011

Article Source: http://www.ft.com/intl/cms/s/0/e1782cc4-e95a-11e2-9f11-00144feabdc0.html#axzz2mjdayvNs

This article examines various reasons surrounding P&G’s declining global market share and how the decision in July 2013 to bring back former CEO, AG Lafley (served from 2000-2009) could serve to reinvigorate the company, returning it to the true consumer goods product giant it has been for the last 175 years.

According to the author, although P&G is still the world leader consumer goods products company, their sales revenue, profit, and overall market share have not been consistent in the last few years, particularly since the economic decline that began in 2008. The company’s inability to increase sales without also providing an increased return on income (ROI) is something that P&G has been struggling with as of the last few years – as costs have increased so has sales, but consequently a decline in ROI is also evident. The key for P&G and Lafley will be to figure out a way to reduce overhead costs while still maintaining high sales figures and amplify profitability.

To fully understand this issue, one must understand the values that P&G as a company considers to be important and how those values may no loner necessarily be in-line with the needs of the consumer, thereby negatively affecting P&G revenue and profit growth.

As discussed during the case presentation this week, P&G grew from a small family business that specialized in soap and candle making into a multinational packaged consumer goods company operating in over 80 countries through innovative product advances. For example, P&G, in launching Crest, made it the first company to develop and market a fluoride toothpaste, allowing it to dominate the United States toothpaste market for over 10 years (due to patent protection preventing any other company from marketing and launching a competing fluoride toothpaste product) or the development of the Swiffer Sweeper which has dominated the market since 2000. With this penchant for innovation, P&G was able to market many of their goods as premium products that came with corresponding price tags.

Inventions such as Crest, Swiffer, and others are what fueled the rapid growth and dominance of the P&G brand and the company particularly capitalized on this and the prices these products could command in the years leading up to the 2008 recession. With the recession came declined consumer expenditures on many of the premium beauty and household goods offered by P&G – consumer behavior rapidly commoditized these products and instead of altering their corporate strategy in response to this change, the firm further stuck their heels in and drove prices even higher in spite of the worst recession many had ever seen in their lifetime. These decisions allowed other consumer goods companies such as Unilever and Colgate-Palmolive to obtain increased market share in areas where P&G previously was the clear winner.

In this respect, it is easy to see why although P&G is still more profitable than most of its competitors, its inability to simultaneously achieve increased profit and sales revenue growth in the same fiscal year and fully maximize its profitability is troubling for investors and financial analysts alike. It provides an explanation for how the company “lost share in 49% of the markets where it competes in the first quarter of this year.” P&G has chosen a path where many of their consumers can no longer afford or just simply are no longer interested to follow along on. Once consumers have tried other brands and have determined they deliver comparable results as pricier P&G products do, there is no reason why they would return to purchasing P&G goods that not only are more expensive, but do not deliver a substantial difference in intrinsic value.

Additionally, the power that P&G’s headquarters in middle-America, USA (Cincinnati, Ohio) has and exerts over the overall direction and strategy of the business makes it hard for the company to thrive in global markets – essentially, they are just unable to be (and stay) in touch with the increasingly diversified and divergent needs of an international market. The company itself has a very centralized organizational structure making it difficult for it to gain share in emerging international markets; only 40% of P&G sales (an improvement from 33% in 2008), whereas 57% of Unilever sales and 53% of Colgate sales come from these markets. The organizational structure and one-track focus on innovation is also to blame for the ability of start-ups selling razors online to undercut and underprice Gillette’s line of razors and has the potential to significantly impact the profitability of that P&G division.

In conclusion, the “end” as we know it for P&G is nowhere near, but if the company and its newly reappointed CEO would like to remain a highly and consistently profitable going-concern for decades to come, the business must realign itself with its consumer target base. This means understanding that although innovation is what brought the company to where they are now, it is not necessarily what will keep them there. When it comes to household goods, consumers do not always want the most innovative cleaning product – instead they want the best product they can get for the best price that they can get. Lastly, emerging markets should be a top priority for P&G and this can only be effectively accomplished by having field offices and research facilities in those global markets where P&G either has a leading market share or has identified as a rapidly growing and untapped geographic location that can provide substantial returns for the firm.

Article Source: http://online.wsj.com/news/articles/SB10001424127887324010704578418361635041842

As a major manufacturer of consumer goods, Procter and Gamble must buy large quantities of raw and unfinished materials from suppliers. Like nearly all large corporations, P&G buys their supplies on credit from their distributors. This represents an accounts payable for P&G, and an accounts receivable for the supplier.

According to the Wall Street Journal article, as of April 2013, the average payable for P&G to their suppliers was roughly 45 days. While this is better than the typical “net 30” terms a smaller company may see, company executives at P&G saw an opportunity to safely increase the amount of time that they could leverage to pay their suppliers. It is in a company’s best interest to have as much time to pay for services/goods as possible, seeing that they could use that time to generate income through operating or investing activities.

The greatest benefit for Procter and Gamble to delay their payables is that it can free up $2 billion dollars in cash. P&G could use that cash to fund a variety of things, such as stock buybacks, investing in operations, etc.

Any benefit to P&G in terms of delaying payables will have an inverse effect on their suppliers. Taking longer to receive cash will cause the supplier’s AR to swell, and may be forced to take out bridge loans from banks to cover any liquidity problems this may cause. The Wall Street Journal talked to the CEO of a Eastek International, who is a contract manufacturer of medical equipment and industrial products. Mr. Rocco stated that extended payment terms “become a cost of doing business”. He also elaborated by stating that the increased working capital demands make a company become more conservative about hiring additional employees and expanding their business in other manors. While Eastek is not a supplier of P&G, their plight regarding having the accept extended payment options from important customers is quite similar to the situation that will be facing many of P&G’s suppliers.

As seen in the article, Procter & Gamble believes that it can raise its average payable time from 45 days to 75 days. While this seems significant, many other companies in the consumer goods industry often take 60-100 days on average to square up on their payables. In order to make this change somewhat more palatable to its suppliers, Procter & Gamble is “working with banks that will offer to advance cash to suppliers after 15 days for a fee.” This would definitely help solve some of the problems that can arise when liquidity for a company dries up, but obviously is not an ideal situation for a supplier to get in. Below is a graphic illustration of the original “net 45”, and the possible implications of the new “net 75”.

One last topic the article discusses is the ripple effect that extending the time on payables can have on an industry as a whole. The larger companies will be significantly more effective in leveraging their size to receive better terms, but that may not be the case for smaller entities. These smaller companies may not receive extra time to turn around the raw goods to pay for them, and may see their suppliers increase the cost of goods, almost as a subsidy to the larger companies that are taking longer to pay for those same suppliers.

In class we have discussed different aspects that surround accounts payable and accounts receivable. Depending on whether you are a supplier or a producer, extending payment time can have either a positive or negative effect on the corporate entity. For the producer, especially one that ages their receivables, longer time frames to get paid represents a greater and greater liability (contra account) in the form of an allowance for bad debts. On the other hand, the producer, who is dealing with an accounts payable, has no such predicament. The positive nature of this for the producer comes from the extra time given to generate cash, and use it in different manors that management sees fit.

Overall, credit terms are extremely important to both parties. A producer needs some time to generate cash and pay back the supplier, while the supplier needs to be paid on a regular basis so they can maintain liquidity, and sustain their own operations. This article points out that companies with economies of scale have more leverage to dictate their payable terms, and the inverse effect it has on smaller companies in its industry, and for the suppliers that do business with those companies.

-Andrew Barnett

Article Reference:

http://online.wsj.com/news/articles/SB10001424052702304607104579213403150284332

Companies buyback their outstanding shares for a number of reasons. Some of these reasons are:

1. To distribute earnings in a tax-effecient way. Paying dividends creates a tax liability on shareholders. Buying back shares, on the other hand, is more effective in terms of taxes paid by investors.

2. To compensate for stock options and bonuses. When the company issues stock options, the number of outstanding shares in the market increases. To offset this effect and contain dilution of ownership, companies may choose to buyback currently outstanding shares and use these to issue stock options.

3. The company feels the stocks are undervalued. So they buy it back at the undervalued price.

4. Boost key financial measures such as Return on Equity and Earnings per Share. When shares are repurchased, the number of shares outstanding decreases but the earnings of the company remain unchanged. This boosts key ratios.

5. Push up the stock price. When shares are repurchased, a scarcity is created in the market which automatically pushes up prices.

6. Lastly, to signal to the market that the company is optimistic about its growth prospects. Share repurchases send a message to the investors that the company is performing well and the management, which knows the most about the company, is confident  about its future potential, which is why they are buying back shares. This serves to mollify investors and reduce investor pressure on the management.

Novartis, which has come under a lot of pressure from its investors of late, is using the share buyback program to pacify them and renew their confidence in the company. Because their current prices have not progressed in alignment with industry prices, they are trying to project to the market that they think that the company is undervalued and its potential is much higher than what current prices reflect.

As noted by the Citigroup analyst, the buyback also improves the performance of the company on paper (“materially elevated”) because key measures like Price per Share will automatically improve upon buyback even though the actual performance of the company remains the same.

“Procter & Gamble sticks by forecasts; profit meets expectations”

Source: http://www.reuters.com/article/2013/10/25/us-procter-results-idUSBRE99O0DZ20131025

Procter & Gamble released its quarterly report on Oct. 25, 2013 with net earnings of $3,057 million and other comprehensive income of $768 million. and announced that its earnings met Wall Street’s expectations. However, P&G’s stock price fell about 1% to $79.93 in the morning trading on the same day, which didn’t significantly indicate that some investors had a higher expectation of P&G’s performance and were disappointed. The remarkable increase of P&G’s stock price (2.46%) at the beginning of the announcement week is the primary reason for the minor falling. Moreover, around 65% S&P 500 companies beat earnings estimates. By barely meeting estimates, P&G sent the signal that its stock was trading at fair valuation.

In my view, looking at the half-day trading post announcement is also an inconclusive way to analyze stock reaction. Given fairly good visibility in the few days prior to announcement stocks usually runs before earnings release. For complete analysis, I will look at five-days accumulative return (from Oct. 21 to Oct. 25) around the announcement date. The returns for five days were: 1.79%, 0.66%, -0.37% and -0.76%. The average increase of P&G’s stock price was 0.33%. So we can conclude that P&G stock possesses a fair market value.

Till now, P&G issued total 8,018.4 million shares in 2013 (4,009.2 in September and 4,009.2 in June) and it expected 5-7% growth in earnings per share this fiscal year, which is a big challenge as they are running promotions intensively and as there are intensive competitions from Unilever, Colgate, etc. The best way to realize the increase of profit and market share is innovation. However, in order to avoid the manipulation of earnings per share, we should focus on the P&G’s treasury purchase because this action would greatly enhance the value of EPS.

References:

http://investing.businessweek.com/research/stocks/financials/drawFiling.asp?docKey=137-000008042413000089-6NK4BQ6LL813AQ43T1MRPU2DJH&docFormat=HTM&formType=10-Q

http://finance.yahoo.com/echarts?s=PG+Interactive#symbol=pg;range=3m;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

Written by Yi Kan (Dustin)

Dec. 6, 2013

Capital lease accounting is one of the area where IFRS differs from U.S. GAAP. The broader difference between GAAP and IFRS is that IFRS classification criteria are less detailed that GAAP. US GAAP specifies the four criteria to identify a lease as a capital lease. If any one of the criteria is met the lease should be treated as capital lease.

1)      The lease transfers ownership of the property to the lessee.

2)      The lease contains a bargain purchase option.

3)      The lease term is 75 % or more of the useful life of the property.

4)      The present value of the lease payments equals or exceeds 90% of the Fair Market Value of the property.

IFRS leaves more to the judgment of the manager, stating that capital lease accounting should be used if substantially all the risks and rewards incidental to ownership have been transferred from the lessor to the lessee whereas US GAAP criteria are more detailed as it mentions of exact percentages. This difference is one of many where IFRS relies on judgment (principle based) and U.S. GAAP relies on rules (rule based).

Companies can practice off-balance-sheet financing by shaping lease contracts so that none of the four criteria are met, which, in turn, allows them to account for leases as operating leases that may in economic substance be capital leases. Such treatment keeps the liability related with the lease off the balance sheet.

Though government is trying to improve the accounting standards post Enron incident, US companies are still allowed to keep off their balance sheets billions of dollars of lease obligations which are same as the obligations of bank loans or other borrowings. The practice is followed in all type of industries and the scale of these off balance sheet obligations is very huge. For e.g.:

US Airways Group Inc.: which recently filed for Chapter 11 bankruptcy protection, showed only $3.15 billion in long-term debt on its most recently audited balance sheet, for 2003, and didn’t include the $7.39 billion in operating-lease commitments it had on its fleet of passenger jets.

Drugstore chain Walgreen co.: shows no debt on its balance sheet, but it is responsible for $19.3 billion of operating-lease payments mainly on stores over the next 25 years.

For the companies in the Standard & Poor’s 500-stock index, off-balance-sheet operating-lease commitments, as revealed in the footnotes to their financial statements, total $482 billion.

A company’s financial health is measured by its debt levels. This treatment of leases in an unclear way can complicate the interpretation of any financial ratio (e.g., return on assets or capital structure leverage) evaluations across the two companies; and the different accounting handling for many leases means that a big portion of business financing rests in the shadows. In spite of all the stringent laws and regulations set up since Enron collapse, officials have left lease accounting principally untouched.

Reference:

http://online.wsj.com/news/articles/SB109580870299124246

Under current FASB and IFRS standards, companies have been able to account for certain leases under two separate methods: capital leases and operating lease. Capital leases call for bringing the asset and liability onto the books and recognizing interest and depreciation expense. Operating leases allows for companies to leave the asset off the book and recognize the entire cost as a rental or lease expense.

Possible accounting changes may be coming in the way that companies will have to recognize all leases as capital leases, no matter how they fall into FASBs 4 criteria or IFRSs basic guidelines. The push behind this change is that with only one way to account for leases, company financial statements will be more comparable from business to business and will ultimately help the investor.

To make this change happen, $1.25 trillion in assets will be added to companies’ books according the SEC. This could be a very costly expenditure for companies. The accounting that will be required to transition to and upkeep the new lease accounting will cost businesses significant dollars.

Some are saying that this is a great opportunity for companies to gain an advantage. By requiring all leased assets to be put on the books, companies can gain a competitive advantage by taking a deeper look at what these assets have actually been providing for their bottom line over the years. A large majority of companies only use basic spreadsheets to keep track of their leases which offers little insight. If companies can utilize big data to take a look at all these new assets, some gains could be made in ROA (return on asset).

In conclusion, companies will need to comply with whatever changes may come so they might as well seek to turn these seemingly negative changes into a positive.

References:

http://blogs.wsj.com/cfo/2013/09/10/its-midnight-on-sept-13-do-you-know-where-your-leases-are/?KEYWORDS=Lease+accounting

Payton W. Fedell

We can add to our knowledge of leases a new term:  held by production.  The article in the Wall Street Journal, “Second Life for an Old Oil Field; Texas’ Permian Basin, Where Output Peaked in ’70s, Now a Hot Site for Horizontal Drilling,” describes how oil companies in the Texas Permian oil field have increased their investing activities by discovering new ways of tapping oil by drilling horizonally  through several layers simultaneously.  The article mentions that since this is an established oil field “drillers don’t have to rush in before their leases on land expire; most leases automatically continue in effect once oil starts coming out of the ground (the industry calls this “leases held by production”).

Negotiating leases as held for production provides oil companies great savings and advantages.  The “held by production” provision allows the companies to continue drilling activities on the property as long as it is producing a minimum paying amount of oil or gas, thereby extending the lessee’s right to operate the property beyond the initial lease term. Energy companies can avoid renegotiating leases upon expiry of the initial term. This results in considerable savings to them, particularly in geographical areas that have become “hot” due to prolific output from oil and gas wells. With property prices in such areas generally on an upward trend, leaseholders would demand significantly higher prices to renegotiate leases.

For accounting puposes FASB  defines a lease is an agreement conveying the right to use property, plant, and equipment (PP&E) and excludes lease agreements to explore or exploit resources such as oil, gas, and minerals. This means that if a company leases land to drill for oil, that land land can be kept off the balance sheet if it treated as an operating lease.

In a dramatic change on May 16, 2013, the FASB and IASB jointly issued a revised exposure draft (ED)on lease accounting. Under the proposal, lessees would record most leases that are currently treated as operating leases on the balance sheet by recognizing a right-of-use (ROU) asset and a corresponding lease liability. This would affect the oil and gas industry because of its extensive use of fixed assets under contracts that may qualify as leases under the proposed guidance.

References:

Second Life for an Old Oil Field; Texas’ Permian Basin, Where Output Peaked in ’70s, Now a Hot Site for Horizontal Drilling. WSJ. Noveber 19, 2003.

Investopedia.com

Oil and Gas Spotlight- FASB and IASB Re-Lease proposed standard. Issue 2, July 2013. Deloitte.

Second Life for an Old Oil Field; Texas’ Permian Basin, Where Output Peaked in ’70s, Now a Hot Site for Horizontal Drilling