Description of Business and Summary of Significant Accounting Policies
Description of Business
InfraREIT, Inc. (Company or InfraREIT) is a Maryland corporation that is engaged in owning and leasing rate-regulated assets in Texas. The Company is structured as a real estate investment trust (REIT) for federal income tax purposes. The Company’s subsidiaries include InfraREIT Partners, LP (Operating Partnership or InfraREIT LP), a Delaware limited partnership, of which InfraREIT is the general partner; Transmission and Distribution Company, L.L.C. (TDC); and Sharyland Distribution & Transmission Services, L.L.C. (SDTS), the Company’s regulated subsidiary.
The Company has elected to be taxed as a REIT for federal income tax purposes. The Company is externally managed and advised by Hunt Utility Services, LLC (Hunt Manager), a Delaware limited liability company. Hunt Manager is responsible for managing the Company’s day-to-day affairs, subject to the oversight of the Company’s board of directors. All of the Company’s officers, including the Company’s President and Chief Executive Officer, David A. Campbell, are employees of Hunt Manager. Mr. Campbell also serves as President and Chief Executive Officer of Sharyland Utilities, L.P. (Sharyland), a Texas-based utility and the Company’s sole tenant.
The Company holds 72.4% of the outstanding partnership units (OP Units) in the Operating Partnership as of December 31, 2018. The Company includes the accounts of the Operating Partnership and its subsidiaries in the consolidated financial statements. Affiliates and current or former employees of Hunt Consolidated, Inc. (Hunt) and members of the Company’s board of directors hold the other 27.6% of the outstanding OP Units as of December 31, 2018.
SDTS’s assets are located in the Texas Panhandle; near Wichita Falls, Abilene and Brownwood; in the Permian Basin; and in South Texas. SDTS leases all its regulated assets under several lease agreements to Sharyland, which operates and maintains the regulated assets. SDTS and Sharyland are each subject to regulation as an electric utility by the Public Utility Commission of Texas (PUCT). SDTS is authorized to own and lease its assets to Sharyland under a certificate of convenience and necessity (CCN) granted by the PUCT.
Principles of Consolidation and Presentation
The consolidated financial statements include the Company’s accounts and the accounts of all other entities in which the Company has a controlling financial interest with noncontrolling interest of consolidated subsidiaries reported separately. All significant intercompany balances and transactions have been eliminated. SDTS maintains accounting records in accordance with the uniform system of accounts, as prescribed by the Federal Energy Regulatory Commission (FERC). In accordance with the applicable consolidation guidance, the Company’s consolidated financial statements reflect the effects of the different rate making principles mandated by the FERC and PUCT which regulate its subsidiaries’ operations.
The accompanying historical consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The historical financial information is not necessarily indicative of the Company’s future results of operations, financial position and cash flows.
Use of Estimates
The preparation of the Company’s consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
As the owner of rate-regulated assets, regulatory principles applicable to the utility industry also apply to SDTS. The financial statements reflect regulatory assets and liabilities under cost-based rate regulation in accordance with accounting standards related to the effect of certain types of regulation. Regulatory decisions can have an impact on the recovery of costs, the rate earned on invested capital and the timing and amount of assets to be recovered by rates. See Note 8, Other Assets.
SDTS capitalizes allowance for funds used during construction (AFUDC) during the construction of its regulated assets, and SDTS’s lease agreements with Sharyland rely on FERC definitions and accepted standards regarding capitalization of expense to define key terms in the lease such as footprint projects, which are the expenditures SDTS is obligated to fund pursuant to the leases. The amounts funded for these footprint projects include allocations of Sharyland employees’ time and overhead allocations consistent with FERC policies and U.S. GAAP. The leases define “footprint projects” to be transmission or, if applicable, distribution projects that (1) are primarily situated within the Company’s current or previous distribution service territory, as applicable; (2) physically hang from the Company’s existing transmission assets, such as the addition of another circuit to the Company’s existing transmission lines or that are physically located within one of its substations or (3) connect or are otherwise added to transmission lines or other properties that comprise a part of the 2017 Asset Exchange Transaction (as defined below).
Sharyland cannot be removed as lessee without prior approval from the PUCT. SDTS transacts with Sharyland through several lease arrangements covering all the regulated assets. These lease agreements include provisions for additions and retirements of the regulated assets in the form of new construction or other capitalized projects.
Cash and Cash Equivalents
The Company considers all short-term, highly liquid investments with original maturities of three months or less to be cash equivalents. The Company’s account balances at one or more institutions periodically exceed the Federal Deposit Insurance Corporation (FDIC) insurance coverage and, as a result, there could be a concentration of credit risk related to amounts on deposit in excess of FDIC insurance coverage. The Company has not experienced any losses and believes the risk is not significant.
Restricted cash represents the principal and interest payable for two consecutive periods associated with TDC’s senior secured notes described in Note 10, Long-Term Debt.
Concentration of Credit Risk
Sharyland is the Company’s sole tenant and all the Company’s revenue is driven by the leases with Sharyland.
Inventory consists primarily of transmission and distribution parts and materials used in the construction of electric plant. Inventory is valued at average cost when it is acquired and used.
Electric Plant, net
Electric plant equipment is stated at the original cost of acquisition or construction, which includes the cost of contracted services, direct labor, materials, acquisition adjustments and overhead items. In accordance with the FERC uniform system of accounts guidance, SDTS recognizes, as a cost to construction work in progress (CWIP), AFUDC on other funds classified as other income (expense), net and AFUDC on borrowed funds classified as a reduction of the interest expense, net on the Consolidated Statements of Operations.
The AFUDC blended rate utilized was 6.3%, 4.0% and 6.7% for the years ended December 31, 2018, 2017 and 2016, respectively.
Depreciation of property, plant and equipment is calculated on a straight-line basis over the estimated service lives of the properties based on depreciation rates approved by the PUCT. Depreciation rates include plant removal costs as a component of depreciation expense, consistent with regulatory treatment. Actual removal costs incurred are charged to accumulated depreciation. When accrued removal costs exceed incurred removal costs, the difference is reclassified as a regulatory liability to retire assets in the future. The regulatory liability will be relieved as cost of removal charges are incurred upon asset retirement.
Repairs are the responsibility of Sharyland as the lessee under the lease agreements. Betterments and improvements generally are the responsibility of SDTS and are capitalized.
Provision for depreciation of electric plant is computed using composite straight-line rates as follows for each of the years ended December 31, 2018, 2017 and 2016:
1.69% - 3.15%
1.74% - 5.96%
0.80% - 5.12%
Impairment of Long-Lived Assets
The Company evaluates impairment of its long-lived assets annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss is recognized only if the carrying amount of a long-lived asset is not recoverable through expected future cash flows. Regulatory assets are charged to expense in the period in which they are no longer probable of future recovery.
Goodwill represents the excess of costs of an acquired business over the fair value of the assets acquired, less liabilities assumed. Goodwill is not amortized and is tested for impairment annually or more frequently if events or changes in circumstances arise.
Accounting Standard Update (ASU) 2011-08, Testing of Goodwill for Impairment allows entities testing goodwill for impairment the option of performing a qualitative assessment before calculating the fair value of a reporting unit (i.e. the first step of the goodwill impairment test). If entities determine, on the basis of qualitative factors, that the fair value of the reporting unit is more-likely-than-not greater than the carrying amount, a quantitative calculation would not be needed.
The Company’s annual goodwill impairment analysis, which was performed qualitatively during the fourth quarter of 2018, did not result in an impairment charge. As of December 31, 2018 and 2017, $138.4 million was recorded as goodwill on the Consolidated Balance Sheets.
An investment is considered impaired if the fair value of the investment is less than its cost. Generally, an impairment is considered other-than-temporary unless (1) the Company has the ability and intent to hold an investment for a reasonable period of time sufficient for an anticipated recovery of fair value up to (or beyond) the cost of the investment; and (2) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. If impairment is determined to be other than temporary, then an impairment loss is recognized equal to the difference between the investment’s cost and its fair value.
Deferred Financing Costs
Amortization of deferred financing costs associated with the issuance of TDC’s $25.0 million senior secured notes and the revolving credit facilities is computed using the straight-line method over the life of the loan which approximates the effective interest method. Amortization of deferred financing costs associated with SDTS is computed using the straight-line method over the life of the loan in accordance with applicable regulatory guidance.
The Company may use derivatives from time to time to hedge against changes in cash flows related to interest rate risk (cash flow hedging instrument). Accounting Standards Codification (ASC) Topic 815, Derivatives and Hedging requires all derivatives be recorded on the Consolidated Balance Sheets at fair value. The Company determines the fair value of the cash flow hedging instrument based on the difference between the cash flow hedging instrument’s fixed contract price and the underlying market price at the determination date. The asset or liability related to the cash flow hedging instrument is recorded on the Consolidated Balance Sheets at its fair value.
Unrealized gains and losses on the effective cash flow hedging instrument are recorded as components of accumulated other comprehensive income. Realized gains and losses on the cash flow hedging instrument are recorded as adjustments to interest expense. Settlements of derivatives are included within operating activities on the Consolidated Statements of Cash Flows. Any ineffectiveness in the cash flow hedging instrument is recorded as an adjustment to interest expense in the current period. The Company did not have any derivative financial instruments during 2018, 2017 or 2016.
The Company elected to be treated as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, commencing with its taxable year ended December 31, 2010. As a result, the Company generally will not be subject to federal income tax on its taxable income that is distributed to its stockholders. A REIT is subject to a number of other organizational and operational requirements, including a requirement that it currently distribute at least 90% of its annual taxable income (with certain adjustments). As a REIT, the Company expects to distribute at least 100% of its taxable income. Accordingly, there is no provision for federal income taxes in the accompanying consolidated financial statements. Even if the Company maintains its qualification for taxation as a REIT, it may be subject to certain state and local taxes on its income and property, including excise taxes, and federal corporate income taxes on any undistributed income.
The Company recognizes the impact of tax return positions that are more-likely-than-not to be sustained upon audit. Significant judgment is required to evaluate uncertain tax positions. The evaluation of uncertain tax positions is based upon a number of factors, including changes in facts or circumstances, changes in tax law, correspondence with tax authorities during the course of audits and effective settlement of audit issues.
In December 2017, the Tax Cuts and Job Acts (TCJA) was signed into law resulting in significant changes to federal tax laws effective for taxable years beginning on or after January 1, 2018. See Note 19, Income Taxes for additional information.
The Company, through its subsidiaries, is the owner of regulated assets and recognizes lease revenue over the term of lease agreements with Sharyland. The Company’s lease revenue includes annual payments and additional rents based upon a percentage of revenue earned by Sharyland on the leased assets in excess of annual specified breakpoints. In accordance with the lease agreements, Sharyland, the lessee and operator of the regulated assets, is responsible for the maintenance and operation of the regulated assets and primarily responsible for compliance with all regulatory requirements of the PUCT, the FERC or any other regulatory entity with jurisdiction over the regulated assets on the Company’s behalf and with the Company’s cooperation. Each of the lease agreements with Sharyland is a net lease that obligates the lessee to pay all property related expenses, including maintenance, repairs, taxes and insurance, and to comply with the terms of the SDTS secured credit facilities and note purchase agreements. The Company recognizes base rent under these leases on a straight-line basis over the applicable lease term.
The current lease agreements provide for periodic supplemental adjustments of base rent based upon capital expenditures made by SDTS. The Company recognizes supplemental adjustments of base rent as a modification under these leases on a prospective straight-line basis over the applicable lease term. The Company recognizes percentage rent under these leases once the revenue earned by Sharyland on the leased assets exceeds the annual specified breakpoints.
Asset Retirement Obligations
The Company has identified, but not recognized, asset retirement obligation liabilities related to the regulated assets as a result of certain easements on property on which the Company has assets. Generally, such easements are perpetual and require only the retirement and removal of the assets upon cessation of the property’s use. Management has not estimated and recorded a retirement liability for such easements because the Company plans to use the facilities indefinitely.
Interest Expense, net
The Company’s interest expense, net primarily consists of interest expense from the senior secured notes, senior secured term loan and credit facilities, see Note 9, Borrowings Under Credit Facilities and Note 10, Long-Term Debt. AFUDC on borrowed funds of $2.8 million, $3.0 million and $3.1 million was recognized as a reduction of the Company’s interest expense during the years ended December 31, 2018, 2017 and 2016, respectively.
Other Income, net
AFUDC on other funds of $1.1 million, $0.7 million and $3.7 million was recognized in other income, net during the years ended December 31, 2018, 2017 and 2016, respectively.
Fair Value of Financial Instruments
ASC Topic 820, Fair Value Measurements and Disclosures sets forth a framework for measuring fair value and required disclosures about fair value measurements of assets and liabilities in accordance with U.S. GAAP.
Level 1 — Quoted prices in active markets for identical assets and liabilities.
Level 2 — Valuations based on one or more quoted prices in markets that are not active; quoted prices for similar assets or liabilities in active markets; inputs that are observable other than quoted prices for the asset or the liability; or inputs that are derived principally from or corroborated by observable market data by correlation or other means.
Level 3 — Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
Recent Accounting Guidance
Recently Adopted Accounting Guidance
In May 2014, the Financial Accounting Standards Board (FASB) issued ASU 2014-09, Revenue from Contracts with Customers. ASU 2014-09 requires revenue to be recognized when promised goods or services are transferred to customers in an amount that reflects the expected consideration for these goods and services. As part of this guidance, lease transactions have been excluded from the requirements of this standard. We adopted this guidance on January 1, 2018, and it had no impact on our financial position, results of operations and cash flows.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Clarification of Certain Cash Receipts and Cash Payments. The objective of ASU 2016-15 is to eliminate the diversity in practice related to the classification of certain cash receipts and payments in the statement of cash flows by adding or clarifying guidance on eight specific cash flow issues. The new standard should be applied retrospectively to all periods presented, unless deemed impracticable, in which case prospective application is permitted. We adopted the new guidance on January 1, 2018, and the new guidance did not impact our Consolidated Statement of Cash Flows.
In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (A Consensus of the FASB Emerging Issues Task Force). ASU 2016-18 adds to or clarifies current guidance on the classification and presentation of restricted cash in the statement of cash flows. The new guidance requires entities to include in their cash and cash equivalent balances in the statement of cash flows those amounts that are deemed to be restricted cash and restricted cash equivalents. We adopted the guidance on January 1, 2018 and have adjusted all periods presented for the change in presentation of restricted cash on our Consolidated Statement of Cash Flows.
Recent Accounting Guidance Not Yet Adopted
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 amended the existing accounting standard for lease accounting, including requiring lessees to recognize all leases on their balance sheets with terms of more than twelve months and making targeted changes to lessor accounting. In January 2018, the FASB issued ASU 2018-01, Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842. ASU 2018-01 permits an entity to elect not to evaluate land easements under ASU 2016-02 that exist or expired before the entity’s adoption of ASU 2016-02 and that were not previously considered leases. In December 2018, the FASB issued ASU 2018-20, Leases (Topic 842), Narrow-Scope Improvements for Lessors which permits an entity to elect not to evaluate whether certain sales taxes and other similar taxes are lessor or lessee costs giving the entity the ability to exclude costs paid on behalf of the lessor by the lessee directly to third parties from the lessor’s income statement. In July 2018, the FASB issued ASU 2018-11, Leases (Topic 842): Targeted Improvements which provides an additional transition method. This transition method allows an entity to initially apply the new lease standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. We will adopt the new guidance using this transition method and other guidance discussed herein as of January 1, 2019. The adoption of new guidance will have a minimal impact on our financial position, results of operations and cash flows due to the limited changes related to lessor transactions. However, additional disclosures are required, and full annual disclosures are required for each interim period of 2019.
In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement, which eliminates, modifies and adds disclosure requirements for fair value measurements. The amendments are effective for all entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. Early adoption is permitted. An entity is permitted to early adopt any removed or modified disclosures upon issuance of the guidance and delay adoption of the additional disclosures until their effective date. The Company is currently assessing the timing and impact of adopting the new guidance but does not expect it to have a material impact on the Company’s financial position or results of operations.
U.S. GAAP establishes standards for reporting financial and descriptive information about a company’s reportable segments. Management has determined that the Company has one reportable segment, with activities related to ownership and leasing of rate-regulated assets.