PACIFIC DRILLING S.A., 20-F filed on 2/24/2017
Annual and Transition Report (foreign private issuer)
Document and Entity Information
12 Months Ended
Dec. 31, 2016
Document And Entity Information [Abstract]
 
Document Type
20-F 
Amendment Flag
false 
Document Period End Date
Dec. 31, 2016 
Document Fiscal Year Focus
2016 
Document Fiscal Period Focus
FY 
Entity Registrant Name
PACIFIC DRILLING S.A. 
Entity Central Index Key
0001517342 
Current Fiscal Year End Date
--12-31 
Entity Well-Known Seasoned Issuer
No 
Entity Current Reporting Status
Yes 
Entity Filer Category
Non-accelerated Filer 
Entity Voluntary Filers
No 
Entity Common Stock, Shares Outstanding
21,183,852 
Consolidated Statements of Operations (USD $)
In Thousands, except Per Share data, unless otherwise specified
12 Months Ended
Dec. 31, 2016
Dec. 31, 2015
Dec. 31, 2014
Revenues
 
 
 
Contract drilling
$ 769,472 
$ 1,085,063 
$ 1,085,794 
Costs and expenses
 
 
 
Operating expenses
(290,038)
(431,261)
(459,617)
General and administrative expenses
(63,379)
(55,511)
(57,662)
Depreciation expense
(275,901)
(243,457)
(199,337)
Total costs and expenses
(629,318)
(730,229)
(716,616)
Loss from construction contract rescission
 
(40,155)
 
Operating income
140,154 
314,679 
369,178 
Other income (expense)
 
 
 
Interest expense
(189,044)
(156,361)
(130,130)
Gain on debt extinguishment
36,233 
 
 
Other expense
(2,393)
(3,217)
(5,171)
Income (loss) before income taxes
(15,050)
155,101 
233,877 
Income tax expense
(22,107)
(28,871)
(45,620)
Net income (loss)
$ (37,157)
$ 126,230 
$ 188,257 
Earnings (loss) per common share, basic (Note 9) (in dollars per share)
$ (1.76)
$ 5.97 
$ 8.67 
Weighted-average number of common shares, basic (Note 9)
21,167 
21,145 
21,722 
Earnings per common share, diluted (Note 9) (in dollars per share)
$ (1.76)
$ 5.97 
$ 8.66 
Weighted-average number of common shares, diluted (Note 9)
21,167 
21,156 
21,737 
Consolidated Statements of Comprehensive Income (USD $)
In Thousands, unless otherwise specified
12 Months Ended
Dec. 31, 2016
Dec. 31, 2015
Dec. 31, 2014
Statement of Comprehensive Income [Abstract]
 
 
 
Net income (loss)
$ (37,157)
$ 126,230 
$ 188,257 
Other comprehensive income (loss):
 
 
 
Unrecognized loss on derivative instruments
(6,290)
(14,889)
(19,385)
Reclassification adjustment for loss on derivative instruments realized in net income (Note 10)
8,798 
10,440 
7,737 
Reclassification adjustment for loss on derivative instruments realized in property and equipment (Note 10)
1,789 
1,164 
 
Total other comprehensive income (loss)
4,297 
(3,285)
(11,648)
Total comprehensive income (loss)
$ (32,860)
$ 122,945 
$ 176,609 
Consolidated Balance Sheets (USD $)
In Thousands, unless otherwise specified
Dec. 31, 2016
Dec. 31, 2015
Assets:
 
 
Cash and cash equivalents
$ 585,980 
$ 116,033 
Restricted cash
40,188 
 
Accounts receivable
94,622 
168,050 
Materials and supplies
95,679 
98,243 
Deferred costs, current
10,454 
10,582 
Prepaid expenses and other current assets
13,892 
14,312 
Total current assets
840,815 
407,220 
Property and equipment, net
4,909,873 
5,143,556 
Long-term receivable
202,575 
202,575 
Other assets
44,944 
39,369 
Total assets
5,998,207 
5,792,720 
Liabilities and shareholders’ equity:
 
 
Accounts payable
17,870 
44,167 
Accrued expenses
45,881 
51,704 
Long-term debt, current
496,790 
76,793 
Accrued interest
14,164 
16,442 
Deferred revenue, current
45,755 
49,227 
Total current liabilities
620,460 
238,333 
Long-term debt, net of current maturities
2,648,659 
2,768,877 
Deferred revenue
32,233 
60,639 
Other long-term liabilities
30,655 
32,816 
Total long-term liabilities
2,711,547 
2,862,332 
Commitments and contingencies
   
   
Shareholders’ equity:
 
 
Common shares, $0.01 par value per share, 5,000,000 shares authorized, 22,551 and 23,277 shares issued and 21,184 and 21,121 shares outstanding as of December 31, 2016 and December 31, 2015, respectively
212 
218 
Additional paid-in capital
2,360,398 
2,383,387 
Treasury shares, at cost
 
(30,000)
Accumulated other comprehensive loss
(19,193)
(23,490)
Retained earnings
324,783 
361,940 
Total shareholders’ equity
2,666,200 
2,692,055 
Total liabilities and shareholders’ equity
$ 5,998,207 
$ 5,792,720 
Consolidated Balance Sheets (Parenthetical) (USD $)
In Thousands, except Per Share data, unless otherwise specified
Dec. 31, 2016
Dec. 31, 2015
Statement of Financial Position [Abstract]
 
 
Common shares, par value (in dollars per share)
$ 0.01 
$ 0.01 
Common shares, shares authorized
5,000,000 
5,000,000 
Common shares, shares issued
22,551 
23,277 
Common shares, shares outstanding
21,184 
21,121 
Consolidated Statements of Shareholders' Equity (USD $)
In Thousands, unless otherwise specified
Common Shares
Additional Paid-In Capital
Treasury Shares
Accumulated Other Comprehensive Loss
Retained Earnings
Total
Beginning Balance at Dec. 31, 2013
$ 217 
$ 2,360,811 
$ 0 
$ (8,557)
$ 47,453 
$ 2,399,924 
Beginning Balance (in shares) at Dec. 31, 2013
21,704 
 
706 
 
 
 
Increase (Decrease) in Stockholders' Equity [Roll Forward]
 
 
 
 
 
 
Shares issued under share-based compensation plan (in shares)
42 
 
(42)
 
 
 
Shares issued under share-based compensation plan
 
95 
 
 
 
95 
Issuance of common shares to treasury (in shares)
 
 
867 
 
 
 
Shares repurchased (in shares)
(167)
 
167 
 
 
 
Shares repurchased
 
 
(8,240)
 
 
(8,240)
Share-based compensation
 
10,484 
 
 
 
10,484 
Other comprehensive income (loss)
 
 
 
(11,648)
 
(11,648)
Net income (loss)
 
 
 
 
188,257 
188,257 
Ending Balance at Dec. 31, 2014
217 
2,371,390 
(8,240)
(20,205)
235,710 
2,578,872 
Ending Balance (in shares) at Dec. 31, 2014
21,579 
 
1,698 
 
 
 
Increase (Decrease) in Stockholders' Equity [Roll Forward]
 
 
 
 
 
 
Shares issued under share-based compensation plan (in shares)
101 
 
(101)
 
 
 
Shares issued under share-based compensation plan
(537)
 
 
 
(536)
Shares repurchased (in shares)
(559)
 
559 
 
 
 
Shares repurchased
 
 
(21,760)
 
 
(21,760)
Share-based compensation
 
12,534 
 
 
 
12,534 
Other comprehensive income (loss)
 
 
 
(3,285)
 
(3,285)
Net income (loss)
 
 
 
 
126,230 
126,230 
Ending Balance at Dec. 31, 2015
218 
2,383,387 
(30,000)
(23,490)
361,940 
2,692,055 
Ending Balance (in shares) at Dec. 31, 2015
21,121 
 
2,156 
 
 
21,121 
Increase (Decrease) in Stockholders' Equity [Roll Forward]
 
 
 
 
 
 
Shares issued under share-based compensation plan (in shares)
63 
 
(63)
 
 
 
Shares issued under share-based compensation plan
(90)
 
 
 
(89)
Cancellation of treasury shares (in shares)
 
 
(726)
 
 
 
Cancellation of treasury shares
(7)
(29,993)
30,000 
 
 
 
Share-based compensation
 
7,094 
 
 
 
7,094 
Other comprehensive income (loss)
 
 
 
4,297 
 
4,297 
Net income (loss)
 
 
 
 
(37,157)
(37,157)
Ending Balance at Dec. 31, 2016
$ 212 
$ 2,360,398 
 
$ (19,193)
$ 324,783 
$ 2,666,200 
Ending Balance (in shares) at Dec. 31, 2016
21,184 
 
1,367 
 
 
21,184 
Consolidated Statements of Cash Flows (USD $)
In Thousands, unless otherwise specified
12 Months Ended
Dec. 31, 2016
Dec. 31, 2015
Dec. 31, 2014
Cash flow from operating activities:
 
 
 
Net income (loss)
$ (37,157)
$ 126,230 
$ 188,257 
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation expense
275,901 
243,457 
199,337 
Amortization of deferred revenue
(67,053)
(86,276)
(109,208)
Amortization of deferred costs
13,945 
25,951 
51,173 
Amortization of deferred financing costs
18,786 
11,278 
10,416 
Amortization of debt discount
1,279 
1,015 
817 
Write-off of unamortized deferred financing costs
 
5,965 
 
Loss from construction contract rescission
 
38,084 
 
Deferred income taxes
15,494 
9,840 
18,661 
Share-based compensation expense
7,094 
12,534 
10,484 
Gain on debt extinguishment
(36,233)
 
 
Changes in operating assets and liabilities:
 
 
 
Accounts receivable
73,428 
62,977 
(24,949)
Materials and supplies
2,564 
(2,583)
(29,951)
Prepaid expenses and other assets
(29,276)
(10,840)
(56,493)
Accounts payable and accrued expenses
(24,843)
(18,712)
20,865 
Deferred revenue
35,175 
3,226 
117,001 
Net cash provided by operating activities
249,104 
422,146 
396,410 
Cash flow from investing activities:
 
 
 
Capital expenditures
(52,625)
(181,458)
(1,136,205)
Net cash used in investing activities
(52,625)
(181,458)
(1,136,205)
Cash flow from financing activities:
 
 
 
Net proceeds (payments) from shares issued under share-based compensation plan
(89)
(536)
95 
Proceeds from long-term debt
450,000 
315,000 
760,000 
Payments on long-term debt
(110,832)
(581,083)
(41,833)
Payments for financing costs
(25,423)
(4,070)
(7,569)
Purchases of treasury shares
 
(21,760)
(7,227)
Net cash provided by (used in) financing activities
313,656 
(292,449)
703,466 
Increase (decrease) in cash and cash equivalents
510,135 
(51,761)
(36,329)
Cash. cash equivalents and restricted cash, beginning balance
116,033 
167,794 
204,123 
Cash, cash equivalents and restricted cash, end of period
$ 626,168 
$ 116,033 
$ 167,794 
Nature of Business
Nature of Business

Note 1—Nature of Business

Pacific Drilling S.A. and its subsidiaries (“Pacific Drilling,” the “Company,” “we,” “us” or “our”) is an international offshore drilling contractor committed to being the preferred provider of offshore drilling services to the oil and natural gas industry through the use of high-specification floating rigs. Our primary business is to contract our high-specification floating rigs to drill wells for our clients.

Significant Accounting Policies
Significant Accounting Policies

Note 2—Significant Accounting Policies

Principles of Consolidation—Our consolidated financial statements include the accounts of Pacific Drilling S.A. and consolidated subsidiaries that we control by ownership of a majority voting interest and entities that meet the criteria for variable interest entities for which we are deemed to be the primary beneficiary for accounting purposes. We eliminate all intercompany transactions and balances in consolidation.

We are party to a Nigerian joint venture, Pacific International Drilling West Africa Limited (“PIDWAL”), with Derotech Offshore Services Limited (“Derotech”), a privately-held Nigerian registered limited liability company. Derotech owns 51% of PIDWAL and PIDWAL has a 50.1% ownership interest in two of our rig holding subsidiaries, Pacific Bora Ltd. and Pacific Scirocco Ltd. PIDWAL’s interest in the rig holding subsidiaries is held through a holding company of PIDWAL, Pacific Drillship Nigeria Limited (“PDNL”). Derotech will not accrue the economic benefits of its interest in PIDWAL unless and until it satisfies certain outstanding obligations to us and a certain pledge is cancelled by us. Likewise PIDWAL will not accrue the economic benefits of its interest in PDNL unless and until it satisfies certain outstanding obligations to us and a certain pledge is cancelled by us. PIDWAL and PDNL are variable interest entities for which we are the primary beneficiary. Accordingly, we consolidate all interests of PIDWAL and PDNL and no portion of their operating results is allocated to the noncontrolling interest (see Note 15—Variable Interest Entities).

In addition to the joint venture agreement, we are a party to marketing and logistic services agreements with Derotech and an affiliated company of Derotech. During the years ended December 31, 2016, 2015 and 2014, we incurred fees of $8.7 million, $13.9 million and $16.6 million, respectively, under such agreements.

Accounting Estimates—The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities at the balance sheet date and the amounts of revenues and expenses recognized during the reporting period. On an ongoing basis, we evaluate our estimates and assumptions, including those related to allowance for doubtful accounts, financial instruments, depreciation of property and equipment, impairment of long-lived assets, long-term receivable, income taxes, share-based compensation and contingencies. We base our estimates and assumptions on historical experience and on various other factors we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from such estimates.

Revenues and Operating Expenses—Contract drilling revenues are recognized as earned, based on contractual dayrates. In connection with drilling contracts, we may receive fees for preparation and mobilization of equipment and personnel or for capital improvements to rigs. Fees and incremental costs incurred directly related to contract preparation and mobilization along with reimbursements received for capital expenditures are deferred and amortized to revenue over the primary term of the drilling contract. The cost incurred for reimbursed capital expenditures are depreciated over the estimated useful life of the asset. We may also receive fees upon completion of a drilling contract that are conditional based on the occurrence of an event, such as demobilization of a rig. These conditional fees and related expenses are reported in income upon completion of the drilling contract. If receipt of such fees is not conditional, they are recognized as revenue over the primary term of the drilling contract. Amortization of deferred revenue and deferred mobilization costs are recorded on a straight-line basis over the primary drilling contract term, which is consistent with the general pace of activity, level of services being provided and dayrates being earned over the life of the contract.

Cash and Cash Equivalents—Cash equivalents are highly liquid investments with original maturities of three months or less that are readily convertible to known amounts of cash.

Restricted Cash—Restricted cash consists primarily of balances pledged to the lenders under our debt agreement as cash collateral.

Accounts Receivable—We record trade accounts receivable at the amount we invoice our clients. We provide an allowance for doubtful accounts, as necessary, based on a review of outstanding receivables, historical collection information and existing economic conditions. We do not generally require collateral or other security for receivables. As of December 31, 2016 and 2015, we had no allowance for doubtful accounts.

Materials and Supplies—Materials and supplies held for consumption are carried at average cost, net of allowances for excess or obsolete materials and supplies of $7.3 million and $8.0 million as of December 31, 2016 and 2015, respectively.

Property and Equipment—High-specification drillships are recorded at cost of construction, including any major capital improvements, less accumulated depreciation and if applicable, impairment. Other property and equipment is recorded at cost and consists of purchased software systems, furniture, fixtures and other equipment. Ongoing maintenance, routine repairs and minor replacements are expensed as incurred.

Interest is capitalized based on the costs of new borrowings attributable to qualifying new construction or at the weighted-average cost of debt outstanding during the period of construction. We capitalize interest costs for qualifying new construction from the point borrowing costs are incurred for the qualifying new construction and cease when substantially all the activities necessary to prepare the qualifying asset for its intended use are complete.

Property and equipment are depreciated to their salvage value on a straight-line basis over the estimated useful lives of each class of assets. Our estimated useful lives of property and equipment are as follows:

 

 

 

 

    

Years

Drillships and related equipment

 

15-35

Other property and equipment

 

2-7

 

We review property and equipment for impairment when events or changes in circumstances indicate that the carrying amounts of our assets held and used may not be recoverable. Potential impairment indicators include steep declines in commodity prices and related market conditions, actual or expected declines in rig utilization, increases in idle time or significant damage to the property and equipment that adversely affects the extent and manner of its use. We assess impairment using estimated undiscounted cash flows for the property and equipment being evaluated by applying assumptions regarding future operations, market conditions, dayrates, utilization and idle time. An impairment loss is recorded in the period if the carrying amount of the asset is not recoverable. During 2016, 2015 and 2014, there were no long-lived asset impairments.

Deferred Financing Costs—Deferred financing costs associated with long-term debt are carried at cost and are amortized to interest expense using the effective interest rate method over the term of the applicable long-term debt.

Foreign Currency Transactions—The consolidated financial statements are stated in U.S. dollars. We have designated the U.S. dollar as the functional currency for our foreign subsidiaries in international locations because we contract with clients, purchase equipment and finance capital using the U.S. dollar. Transactions in other currencies have been translated into U.S. dollars at the rate of exchange on the transaction date. Any gain or loss arising from a change in exchange rates subsequent to the transaction date is included as an exchange gain or loss. Monetary assets and liabilities denominated in currencies other than U.S. dollars are reported at the rates of exchange prevailing at the end of the reporting period. During 2016, 2015 and 2014, foreign exchange losses were $0.5 million, $3.6 million and $5.3 million, respectively, and recorded in other expense within our consolidated statements of operations.

Earnings per Share—Basic earnings per common share (“EPS”) is computed by dividing the net income by the weighted-average number of common shares outstanding for the period. Basic and diluted EPS are retrospectively adjusted for the effects of stock dividends or stock splits. Diluted EPS reflects the potential dilution from securities that could share in the earnings of the Company. Anti-dilutive securities are excluded from diluted EPS. On May 24, 2016, shareholders at our Extraordinary General Meeting approved a 1-for-10 reverse stock split of our common shares (the “Reverse Stock Split”), which became effective on May 25, 2016. All share and per share information in the accompanying financial statements has been restated retroactively to reflect the Reverse Stock Split.

Fair Value Measurements—We estimate fair value at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market for the asset or liability. Our valuation techniques require inputs that are categorized using a three-level hierarchy as follows: (1) unadjusted quoted prices for identical assets or liabilities in active markets (“Level 1”), (2) direct or indirect observable inputs, including quoted prices or other market data, for similar assets or liabilities in active markets or identical assets or liabilities in less active markets (“Level 2”) and (3) unobservable inputs that require significant judgment for which there is little or no market data (“Level 3”). When multiple input levels are required for a valuation, we categorize the entire fair value measurement according to the lowest level input that is significant to the measurement even though we may have also utilized significant inputs that are more readily observable.

Share-Based Compensation—The grant date fair value of share-based awards granted to employees is recognized as an employee compensation expense over the requisite service period on a straight-line basis. The amount of compensation expense recognized is adjusted to reflect the number of awards for which the related vesting conditions are expected to be met. The amount of compensation expense ultimately recognized is based on the number of awards that do meet the vesting conditions at the vesting date.

Derivatives—We apply cash flow hedge accounting to interest rate swaps that are designated as hedges of the variability of future cash flows. The derivative financial instruments are recorded in our consolidated balance sheets at fair value as either assets or liabilities. Changes in the fair value of derivatives designated as cash flow hedges, to the extent the hedge is effective, are recognized in accumulated other comprehensive income until the hedged item is recognized in earnings.

Hedge effectiveness is measured on an ongoing basis to ensure the validity of the hedges based on the relative cumulative changes in fair value between the derivative contract and the hedged item over time. Any change in fair value resulting from ineffectiveness is recognized immediately in earnings. Hedge accounting is discontinued prospectively if it is determined that the derivative is no longer effective in offsetting changes in the cash flows of the hedged item.

For interest rate hedges related to interest capitalized in the construction of fixed assets, other comprehensive income is released to earnings as the asset is depreciated over its useful life. For all other interest rate hedges, other comprehensive income is released to earnings as interest expense is accrued on the underlying debt.

Contingencies—We record liabilities for estimated loss contingencies when we believe a loss is probable and the amount of the probable loss can be reasonably estimated. Once established, we adjust the estimated contingency loss accrual for changes in facts and circumstances that alter our previous assumptions with respect to the likelihood or amount of loss.

Income Taxes—Income taxes are provided based upon the tax laws and rates in the countries in which our subsidiaries are registered and where their operations are conducted and income and expenses are earned and incurred, respectively. We recognize deferred tax assets and liabilities for the anticipated future tax effects of temporary differences between the financial statement basis and the tax basis of our assets and liabilities using the applicable enacted tax rates in effect the year in which the asset is realized or the liability is settled. A valuation allowance for deferred tax assets is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

We recognize tax benefits from an uncertain tax position only if it is more likely than not that the position will be sustained upon examination by taxing authorities based on the technical merits of the position. The amount recognized is the largest benefit that we believe has greater than a 50% likelihood of being realized upon settlement. Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations and the final audit of tax returns by taxing authorities. We recognize interest and penalties related to uncertain tax positions in income tax expense.

Recently Adopted Accounting Standards

Going Concern—On August 27, 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-15, Presentation of Financial Statements – Going Concern (Subtopic 205-40), which requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the financial statements are issued for both annual and interim reporting periods. We adopted the standard effective for the year ended December 31, 2016 (see Note 18).

Debt Issuance Costs—On April 7, 2015, the FASB issued ASU 2015-03, Interest - Imputation of Interest (Subtopic 835-30) - Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the debt liability rather than as an asset. We adopted the standard effective January 1, 2016 on a retrospective basis, which resulted in the netting of our deferred financing costs against long-term debt balances on our consolidated balance sheets for the periods presented (see Note 5). Deferred financing costs related to our revolving credit facility were reclassified to prepaid expenses and other current assets, and other assets. The adoption had no impact on our operating results or cash flows for the current and prior periods.

Statement of Cash Flows—On August 26, 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230), a consensus of the FASB’s Emerging Issues Task Force, which is intended to reduce diversity in practice in how certain transactions are classified in the statements of cash flows. On November 17, 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230), Restricted Cash, which requires entities to show the changes in total cash, cash equivalents, and restricted cash in the statement of cash flows. We adopted the standards effective for the year ended December 31, 2016 on a retrospective basis, which resulted in no reclassifications to prior periods. The adoption had no impact on our consolidated balance sheets or operating results.

Recently Issued Accounting Standards

Revenue Recognition—On May 28, 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This standard will replace most existing revenue recognition guidance under GAAP when it becomes effective. The standard will be effective for annual periods and interim periods beginning after December 15, 2017. Given the interaction with the accounting standards update related to Leases, we expect to adopt the updates concurrently, effective January 1, 2018, and we expect to apply the modified retrospective approach to our adoption. We are currently evaluating the requirements to determine the effect such requirements may have on our consolidated financial statements and related disclosures.

Deferred Taxes—On November 20, 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes, which requires all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. The new guidance, however, does not change the existing requirement that only permits offsetting within a tax jurisdiction. We will adopt the standard prospectively for our annual and interim periods beginning January 1, 2017, which will result in the reclassification of our deferred tax balances from current to long-term on our consolidated balance sheets. As of December 31, 2016, our current deferred tax assets and current deferred tax liabilities were $2.5 million and $1.7 million, respectively.

Leases— On February 25, 2016, the FASB issued ASU 2016-02, Leases, which (a) requires lessees to recognize a right to use asset and liability for virtually all leases, and (b) updates previous accounting standards for lessors to align certain requirements with the updates to lessee accounting standards and the revenue recognition accounting standards. The update, which permits early adoption, is effective for annual and interim periods beginning after December 15, 2018. Under the updated accounting standards, we believe that our drilling contracts may contain a lease component, and our adoption, therefore, may require that we separately recognize revenues associated with the lease and services components. Given the interaction with the accounting standards update related to revenue from contracts with customers, we expect to adopt the updates concurrently, effective January 1, 2018, and we expect to apply the modified retrospective approach to our adoption. Our adoption, and the ultimate effect on our consolidated financial statements, will be based on an evaluation of the contract-specific facts and circumstances, and such effect could introduce variability to the timing of our revenue recognition relative to current accounting standards. We are currently evaluating the requirements to determine the effect such requirements may have on our consolidated financial statements and related disclosures.

 

Share-based Payments—On March 30, 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, which requires recognition of the income tax effects of equity awards in the income statement when the awards vest or are settled. The standard also allows employers to withhold shares upon settlement of an award for an amount up to the employees’ maximum individual tax rate in the relevant jurisdiction without resulting in liability classification of the award. The standard permits entities to make an accounting policy election for the impact of forfeitures on the recognition of expense for share-based payment awards. We will adopt the standard for our annual and interim periods beginning January 1, 2017. We do not expect the adoption of the standard to have a material effect on our consolidated financial statements and related disclosures.

Measurement of Credit Losses on Financial Instruments—On June 16, 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326), which introduces a new model for recognizing credit losses on financial instruments based on an estimate of current expected credit losses. The new model will apply to: (1) loans, accounts receivable, trade receivables, and other financial assets measured at amortized cost, (2) loan commitments and certain other off-balance sheet credit exposures, (3) debt securities and other financial assets measured at fair value through other comprehensive income, and (4) beneficial interests in securitized financial assets. This update is effective for annual and interim periods beginning after January 1, 2020. We are currently evaluating the effect the standard may have on our consolidated financial statements and related disclosures.

Tax Accounting for Intra-Entity Asset Transfers—On October 24, 2016, the FASB issued ASU 2016-16, Accounting for Income Taxes: Intra-Entity Asset Transfers of Assets Other than Inventory, which requires entities to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transaction occurs as opposed to deferring tax consequences and amortizing them into future periods. This update is effective for annual and interim periods beginning after January 1, 2018 with early adoption permitted, and requires a modified retrospective approach with a cumulative-effect adjustment directly to retained earnings at the beginning of the period of adoption. We are currently evaluating the effect the standard may have on our consolidated financial statements and related disclosures.

 

Property and Equipment
Property and Equipment

Note 3—Property and Equipment

Property and equipment consists of the following:

 

 

 

 

 

 

 

 

 

December 31, 

 

    

2016

    

2015

 

 

 

(in thousands)

Drillships and related equipment

 

$

5,891,860

 

$

5,856,564

Other property and equipment

 

 

20,360

 

 

14,938

Property and equipment, cost

 

 

5,912,220

 

 

5,871,502

Accumulated depreciation

 

 

(1,002,347)

 

 

(727,946)

Property and equipment, net

 

$

4,909,873

 

$

5,143,556

 

During the years ended December 31, 2016, 2015 and 2014, we capitalized interest costs of $0,  $37.1 million and $62.1 million, respectively.

Loss from Construction Contract Rescission
Loss from Construction Contract Rescission

Note 4—Loss from Construction Contract Rescission

On January 25, 2013, we entered into a contract with Samsung Heavy Industries Co., Ltd. (“SHI”) for the construction of an eighth drillship, the Pacific Zonda, which provided for a purchase price of approximately $517.5 million and an original delivery date of March 31, 2015 (the “Construction Contract”). On October 29, 2015, we exercised our right to rescind the Construction Contract due to SHI’s failure to timely deliver the drillship in accordance with the contractual specifications. The carrying value of the newbuild at the date of rescission was $315.7 million, consisting of (i) advance payments in the aggregate of $181.1 million paid by us to SHI, (ii) purchased equipment, (iii) internally capitalized construction costs and (iv) capitalized interest.

On November 25, 2015, SHI formally commenced an arbitration proceeding against us in accordance with the Construction Contract. On November 30, 2015, we made demand under the third party refund guarantee accompanying the Construction Contract for the amount of our advance payments made under the Construction Contract, plus interest. Any payment under the refund guarantee is suspended until an award under the arbitration is obtained. We do not expect a resolution of this matter until 2018 (see Note 12).

As of December 31, 2016 and 2015, we owned $75.0 million in purchased equipment for the Pacific Zonda recorded in property and equipment, a majority of which remains on board the Pacific Zonda subject to return to us by SHI. During the year ended December 31, 2015, we incurred $2.0 million in crew costs directly associated with the Pacific Zonda subsequent to our rescission of the Construction Contract. The resulting net loss recognized in the year ended December 31, 2015 was $40.2 million, which is included in “loss from construction contract rescission” in our consolidated statements of operations.

Based on our assessment of the facts and circumstances of the rescission, we believe the recovery of the advance payments and accrued interest in the amount of $202.6 million is probable,  and is thus presented as a long-term receivable from SHI on our consolidated balance sheets.

Debt
Debt

Note 5—Debt

Debt consists of the following:

 

 

 

 

 

 

 

 

 

December 31, 

 

    

2016

    

 

2015

 

 

(in thousands)

Due within one year:

 

 

 

 

 

 

2017 Senior Secured Notes

 

$

438,880

 

$

 —

2018 Senior Secured Term Loan B

 

 

7,500

 

 

7,500

Senior Secured Credit Facility

 

 

79,757

 

 

82,083

Less: unamortized deferred financing costs

 

 

(29,347)

 

 

(12,790)

Total current debt

 

 

496,790

 

 

76,793

Long-term debt:

 

 

 

 

 

 

2017 Senior Secured Notes

 

 

 —

 

 

498,887

2018 Senior Secured Term Loan B

 

 

715,206

 

 

721,958

2013 Revolving Credit Facility

 

 

500,000

 

 

50,000

Senior Secured Credit Facility

 

 

697,569

 

 

775,000

2020 Senior Secured Notes

 

 

750,000

 

 

750,000

Less: unamortized deferred financing costs

 

 

(14,116)

 

 

(26,968)

Total long-term debt

 

 

2,648,659

 

 

2,768,877

Total debt

 

$

3,145,449

 

$

2,845,670

 

2017 Senior Secured Notes

In November 2012, Pacific Drilling V Limited (“PDV”), an indirect, wholly-owned subsidiary of the Company, and the Company, as guarantor, completed a private placement of $500.0 million in aggregate principal amount of 7.25% senior secured notes due 2017 (the “2017 Senior Secured Notes”). The 2017 Senior Secured Notes bear interest at 7.25% per annum, payable semiannually on June 1 and December 1, and mature on December 1, 2017.

The 2017 Senior Secured Notes are secured by a first-priority security interest (subject to certain exceptions) in the Pacific Khamsin, and substantially all of the other assets of PDV, including an assignment of earnings and insurance proceeds related to the Pacific Khamsin.

On or after December 1, 2015, PDV may redeem the 2017 Senior Secured Notes at the redemption prices plus accrued and unpaid interests specified in the indenture for the Notes.

The 2017 Senior Secured Notes contain provisions that limit, with certain exceptions, the ability of PDV, the Company and the Company’s other restricted subsidiaries to (i) pay dividends, make distributions, purchase or redeem the Company’s capital stock or subordinated indebtedness of PDV or any guarantor or make other restricted payments (subject to certain exceptions), (ii) incur or guarantee additional indebtedness or issue preferred stock, (iii) create or incur liens, (iv) create unrestricted subsidiaries, (v) enter into transactions with affiliates, (vi) enter into new lines of business, (vii) transfer or sell the Pacific Khamsin and other related assets and (viii) merge or demerge. These covenants are subject to exceptions and qualifications set forth in the indenture for the Notes.

On October 5, 2016, the Company, PDV and the indenture trustee entered into an amendment to the indenture governing the 2017 Senior Secured Notes, which modified a covenant in the indenture to allow the Company or certain of its subsidiaries (other than PDV) to incur indebtedness in an amount calculated with reference to the number of vessels owned by the Company or any of its subsidiaries (including PDV), based on a formula prescribed in the indenture. This amendment aligns this provision with the same provision in the indenture governing the Company’s 2020 Senior Secured Notes (as defined below).  Following this amendment, the Company drew the remaining $215.0 million available under its 2013 Revolving Credit Facility (as defined below), which was previously limited by the secured debt incurrence covenant in the indenture governing the 2017 Senior Secured Notes.

During the year ended December 31, 2016, we repurchased $60.6 million of our 2017 Senior Secured Notes for a purchase price of $23.6 million plus accrued interest. We recorded the resulting gain, net of the corresponding unamortized deferred financing costs and debt discount, of $36.2 million, as a gain on debt extinguishment in our statements of operations.

Senior Secured Credit Facility

In February 2013, Pacific Sharav S.à r.l. and Pacific Drilling VII Limited (collectively, the “SSCF Borrowers”) and the Company, as guarantor, entered into a senior secured credit facility agreement, as amended and restated (the “SSCF”), to finance the construction, operation and other costs associated with the Pacific Sharav and the Pacific Meltem (the “SSCF Vessels”). The SSCF is primarily secured on a first priority basis by liens on the SSCF Vessels, and by an assignment of earnings and insurance proceeds relating thereto.

In 2015, we completed the final drawdown under this facility, resulting in a cumulative total drawdown of $985.0 million. We do not have any undrawn capacity on this facility as of December 31, 2016.

Following the final drawdown, the SSCF consisted of two principal tranches: (i) a Commercial Tranche of $492.5 million provided by a syndicate of commercial banks and (ii) a Garanti — Instituttet for Eksportkreditt (“GIEK”) Tranche of $492.5 million guaranteed by GIEK, comprised of two sub-tranches: (x) an Eksportkreditt Norge AS (“EKN”) sub-tranche of $246.3 million and (y) a bank sub-tranche of $246.3 million.

Borrowings under (A) the Commercial Tranche bear interest at London Interbank Offered Rate (“LIBOR”) plus a margin of 3.75%, (B) the EKN sub-tranche bear interest, at our option, at (i) LIBOR plus a margin of 1.5% (which margin may be reset on May 31, 2019) or (ii) at a Commercial Interest Reference Rate of 2.37% and (C) the bank sub-tranche bear interest at LIBOR plus a margin of 1.5%. Borrowings under both sub-tranches are also subject to a guarantee fee of 2% per annum. Interest is payable quarterly. We have entered into interest rate swaps to hedge against fluctuations in LIBOR (see Note 10).

The Commercial Tranche matures on May 31, 2019. Loans made with respect to the Pacific Sharav under the GIEK Tranche mature on May 12, 2026. Loans made with respect to the Pacific Meltem under the GIEK Tranche mature on November 24, 2026. The GIEK Tranche contains a put option exercisable if the Commercial Tranche is not refinanced or renewed on or before February 28, 2019. If the GIEK Tranche put option is exercised, each SSCF Borrower must prepay, in full, the portion of all outstanding loans that relate to the GIEK Tranche, on or before May 31, 2019, without any premium, penalty or fees of any kind. The SSCF requires semiannual amortization payments of $39.9 million.

The SSCF requires compliance with certain affirmative and negative covenants that are customary for such financings. These include the following financial covenants:

·

Consolidated Tangible Net Worth: maintain at least $1.0 billion consolidated tangible net worth.

·

Maximum Leverage Ratio: maintain a net debt to EBITDA ratio no greater than 4.75 to 1.00 as of December 31, 2015 and increasing incrementally to 6.00 to 1.00 during the period from July 1, 2016 through December 31, 2017 (other than the fiscal quarters ending March 31, 2017 and June 30, 2017 as described below), and 4.00 to 1.00, thereafter.

·

Total Debt to Capitalization Ratio: maintain a ratio of not greater than 3.0 to 5.0 of total debt to total capitalization.

·

Loan to Rig Value Covenant: maintain loan to value of the vessels securing the SSCF to equal at least 125% of the outstanding SSCF balance as of each semi-annual valuation date (other than the valuation date originally scheduled for June 30, 2017).

·

Minimum Liquidity: maintain no less than $50.0 million in cash and cash equivalents.

·

Net Debt to Applicable Rigs ratio: maintain a net debt per rig ratio of not greater than $425.0 million through June 30, 2016 and decreasing incrementally to $360.0 million during the period from October 1, 2017 through December 31, 2017 (maintained at $400.0 million through June 30, 2017 as described below).  

In addition, the SSCF contains restrictions on the ability of the Company to pay dividends or make distributions to its shareholders or transact with business affiliates. The SSCF also limits the ability of the SSCF Borrowers to incur additional indebtedness or liens, sell assets, make certain investments or transact with affiliates, among others.

Borrowings under the SSCF may be prepaid in whole or in part at any time, without any premium or penalty other than customary interest rate breakage payments, as applicable. The SSCF contains events of default that are usual and customary for a financing of this type, size and purpose. Upon the occurrence of an event of default, borrowings under the SSCF are subject to acceleration.

As of December 31, 2016, we had pledged $31.7 million as collateral to the SSCF lenders to comply with the loan to rig value covenant, which requires semi-annual broker valuations of the vessels securing the SSCF to equal at least 125% of the outstanding SSCF balance as of each valuation date. The pledged amount was classified as restricted cash on our consolidated balance sheets.

On January 20, 2017, we entered into Amendment No. 6 to the SSCF (the “SSCF Sixth Amendment”), which for the fiscal quarters ending on March 31, 2017 and June 30, 2017 (i) waives any breach of our obligation to comply with the Maximum Leverage Ratio covenant and (ii) amends the Net Debt to Applicable Rigs covenant to require us to maintain such ratio at no greater than $400.0 million per rig, which in each case is calculated on the last day of the applicable fiscal quarter under the SSCF. In addition, the SSCF Sixth Amendment waives the application of the loan to rig value covenant in the SSCF on the next valuation date, June 30, 2017. Concurrently with the execution of the SSCF Sixth Amendment, we made a $76.0 million prepayment of the SSCF, in accordance with our obligation to maintain the loan to rig value covenant in the SSCF at the required level as at December 31, 2016, and we applied the cash collateral of $31.7 million to the next principal installments due in May 2017 under the SSCF. Following the SSCF Sixth Amendment, our outstanding balance under the SSCF was $669.7 million, with no undrawn capacity.

2020 Senior Secured Notes

On June 3, 2013, we completed a $750.0 million private placement of 5.375% senior secured notes due 2020 (the “2020 Senior Secured Notes”).

The 2020 Senior Secured Notes bear interest at 5.375% per annum, payable semiannually on June 1 and December 1, and mature on June 1, 2020.

The 2020 Senior Secured Notes are guaranteed by each of our subsidiaries that own the Pacific Bora, the Pacific Mistral, the Pacific Scirocco and the Pacific Santa Ana (the “Shared Collateral Vessels”), each of our subsidiaries that own or previously owned equity or similar interests in a Shared Collateral Vessel-owning subsidiary, and certain other of our subsidiaries that are parties to charters in respect of the Shared Collateral Vessels, and will be guaranteed by certain other future subsidiaries. The indenture for the 2020 Senior Secured Notes allows for the issuance of up to $100.0 million of additional notes provided no default is continuing and we are otherwise in compliance with all applicable covenants. The RCF Sixth Amendment (as defined below) currently restricts us from incurring additional secured debt.

The 2020 Senior Secured Notes are secured, on an equal and ratable, first priority basis, with the obligations under the Senior Secured Term Loan B (as defined below), the 2013 Revolving Credit Facility (as defined below) and certain future obligations, subject to payment priorities in favor of lenders under the 2013 Revolving Credit Facility pursuant to the terms of an intercreditor agreement (the “Intercreditor Agreement”), by liens on the Shared Collateral Vessels, a pledge of the equity of the entities that own the Shared Collateral Vessels, assignments of earnings and insurance proceeds with respect to the Shared Collateral Vessels, and certain other assets of the subsidiary guarantors (collectively, the “Shared Collateral”).

Beginning on June 1, 2016 the Company may redeem the 2020 Senior Secured Notes at a redemption price of 104.031% of the principal amount, and at declining redemption prices thereafter as specified in the indenture.

The indenture for the 2020 Senior Secured Notes contains covenants that, among other things, limits the Company’s and its restricted subsidiaries’ ability to (i) pay dividends, make distributions, purchase or redeem the Company’s capital stock or its or its subsidiary guarantors’ subordinated indebtedness or make other restricted payments, (ii) incur or guarantee additional indebtedness or issue preferred stock, (iii) create or incur liens, (iv) create unrestricted subsidiaries, (v) enter into transactions with affiliates, (vi) enter into new lines of business and (vii) transfer or sell assets or enter into mergers.

The indenture for the 2020 Senior Secured Notes contains events of default that are usual and customary for a financing of this type, size and purpose. Upon the occurrence of an event of default, the 2020 Senior Secured Notes are subject to acceleration.

2018 Senior Secured Institutional Term Loan – Term Loan B

On June 3, 2013, we entered into a $750.0 million senior secured institutional term loan maturing 2018 (the “Senior Secured Term Loan B”). The Senior Secured Term Loan B bears interest, at our election, at either (1) LIBOR, which will not be less than a floor of 1% plus a margin of 3.5% per annum, or (2) a rate of interest per annum equal to (i) the prime rate for such day, (ii) the sum of the federal funds rate plus 0.5% or (iii) 1% per annum above the one-month LIBOR, whichever is the highest rate in each case plus a margin of 2.5% per annum. Interest is payable quarterly. The Senior Secured Term Loan B requires quarterly amortization payments of $1.9 million and matures on June 3, 2018. We have entered into interest rate swaps to hedge against fluctuations in LIBOR (see Note 10).

The Senior Secured Term Loan B has an accordion feature that would permit additional loans to be extended so long as our total outstanding obligations in connection with the Senior Secured Term Loan B and the 2020 Senior Secured Notes do not exceed $1.7 billion. The RCF Sixth Amendment (as defined below) currently restricts us from incurring additional secured debt.

The Senior Secured Term Loan B is secured by the Shared Collateral and subject to the terms and provisions of the Intercreditor Agreement.

The Senior Secured Term Loan B requires compliance with certain affirmative and negative covenants that are customary for such financings. These include restrictions on the Company’s and its restricted subsidiaries’ ability to (i) pay dividends, make distributions, purchase or redeem the Company’s capital stock or its or its subsidiary guarantors’ subordinated indebtedness or make other restricted payments, (ii) incur or guarantee additional indebtedness or issue preferred stock, (iii) create or incur liens, (iv) create unrestricted subsidiaries, (v) enter into transactions with affiliates, (vi) enter into new lines of business and (vii) transfer or sell assets or enter into mergers. These covenants are subject to important exceptions and qualifications set forth in the Senior Secured Term Loan B, including the ability to incur certain amounts of secured indebtedness to finance the construction of additional drillships.

The Senior Secured Term Loan B contains events of default that are usual and customary for a financing of this type, size and purpose. Upon the occurrence of an event of default, borrowings under the Senior Secured Term Loan B are subject to acceleration.

2013 Revolving Credit Facility

On June 3, 2013, we entered into a $500.0 million senior secured revolving credit facility maturing 2018, (as amended, the “2013 Revolving Credit Facility”). The 2013 Revolving Credit Facility is secured by the Shared Collateral and subject to the provisions of the Intercreditor Agreement. Prior to the RCF Sixth Amendment (as defined below), the 2013 Revolving Credit Facility permitted loans to be extended up to a maximum sublimit of $500.0 million and permitted letters of credit to be issued up to a maximum sublimit of $300.0 million, subject to a $500.0 million overall facility limit.

Borrowings under the 2013 Revolving Credit Facility bear interest, at our option, at either (1) LIBOR plus a margin ranging from 3.25% to 3.75% based on our leverage ratio, or (2) a rate of interest per annum equal to (i) the prime rate for such day, (ii) the sum of the federal funds rate plus 0.5% or (iii) 1% per annum above the one-month LIBOR, whichever is the highest rate in each case plus a margin ranging from 2.25% to 2.75%  per annum based on our leverage ratio. Undrawn commitments accrue a fee ranging from 1.3% to 1.5% per annum based on our leverage ratio. Interest is payable quarterly. Outstanding but undrawn letters of credit accrue a fee at a rate equal to the margin on LIBOR loans minus 1%. The 2013 Revolving Credit Facility matures on June 3, 2018.

Borrowings under the 2013 Revolving Credit Facility may be prepaid, and commitments under the 2013 Revolving Credit Facility may be reduced, in whole or in part at any time, without any premium or penalty other than LIBOR breakage payments.

The 2013 Revolving Credit Facility requires compliance with certain affirmative and negative covenants that are customary for such financings. These include the following financial covenants:

·

Maximum Leverage Ratio: maintain adjusted net debt to EBITDA ratio no greater than 4.75 to 1.00 as of December 31, 2015 and increasing incrementally to 6.00 to 1.00 during the period from July 1, 2016 through December 31, 2017 (other than the fiscal quarters ending March 31, 2017 and June 30, 2017, as described below), and 4.25 to 1.00, thereafter.

·

Minimum Liquidity: maintain no less than $100.0 million in cash and cash equivalents (including undrawn capacity for borrowings under the 2013 Revolving Credit Facility).

·

Net Debt to Applicable Rigs ratio: maintain a net debt per rig ratio of not greater than $425.0 million through June 30, 2016 and decreasing incrementally to $360.0 million during the period from October 1, 2017 through December 31, 2017 (maintained at $400.0 million through June 30, 2017, as described below).  

In addition, the 2013 Revolving Credit Facility contains restrictions on the ability of the Company to pay dividends or make distributions to its shareholders and restrictions on the Company’s and its subsidiaries’ ability to incur additional indebtedness or liens, sell assets, make investments or engage in transactions with affiliates, among others.

The 2013 Revolving Credit Facility contains events of default that are usual and customary for a financing of this type, size and purpose. Upon the occurrence of an event of default, (i) commitments and letters of credit under the 2013 Revolving Credit Facility could be subject to termination, (ii) borrowings under the 2013 Revolving Credit Facility could be subject to acceleration, and (iii) outstanding letters of credit could be subject to cash collateralization.

On January 20, 2017, we entered into Amendment No. 6 to the 2013 Revolving Credit Facility (the “RCF Sixth Amendment”, and together with the SSCF Sixth Amendment, the “Sixth Amendments”), which for the fiscal quarters ending on March 31, 2017 and June 30, 2017 (i) waives any breach of our obligation to comply with the Maximum Leverage Ratio covenant and (ii) amends the Net Debt to Applicable Rigs covenant to require us to maintain such ratio at no greater than $400.0 million per rig, which in each case is calculated on the last day of the applicable fiscal quarter under the 2013 Revolving Credit Facility. In addition, the RCF Sixth Amendment restricts our ability to grant additional liens or refinance certain existing indebtedness until the earlier of (i) our election and compliance with the Maximum Leverage Ratio and Net Debt to Applicable Rigs covenants under the 2013 Revolving Credit Facility and (ii) publication of our financial results for the fiscal quarter ending September 30, 2017. In consideration for the RCF Sixth Amendment, we permanently repaid and cancelled commitments for $25.0 million under the 2013 Revolving Credit Facility. Following the RCF Sixth Amendment, our outstanding balance under the 2013 Revolving Credit Facility was $475.0 million, with no undrawn capacity.

Covenant Compliance

As of December 31, 2016, we were in compliance with all of our debt covenants. See Note 18 for further discussion on our future covenant compliance.

Maturities of Long-Term Debt

As of December 31, 2016, the aggregate maturities of our debt, including net unamortized discounts of $1.5 million, were as follows:

 

 

 

 

 

    

(in thousands)

Years ending December 31, 

 

 

 

2017

 

$

526,621

2018

 

 

1,296,007

2019

 

 

617,812

2020

 

 

750,000

2021

 

 

 —

Thereafter

 

 

 —

        Total

 

$

3,190,440

 

Income Taxes
Income Taxes

Note 6—Income Taxes

Pacific Drilling S.A., a holding company and Luxembourg resident, is subject to Luxembourg corporate income tax and municipal business tax at a combined rate of 29.2%. Qualifying dividend income and capital gains on the sale of qualifying investments in subsidiaries are exempt from Luxembourg corporate income tax and municipal business tax. Consequently, Pacific Drilling S.A. expects dividends from its subsidiaries and capital gains from sales of investments in its subsidiaries to be exempt from Luxembourg corporate income tax and municipal business tax.

Income taxes have been provided based on the laws and rates in effect in the countries in which our operations are conducted or in which our subsidiaries are considered residents for income tax purposes. Our income tax expense or benefit arises from our mix of pretax earnings or losses, respectively, in the international tax jurisdictions in which we operate. Because the countries in which we operate have different statutory tax rates and tax regimes with respect to one another, there is no expected relationship between the provision for income taxes and our income or loss before income taxes.

Income (loss) before income taxes consists of the following:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Years ended December 31, 

 

 

2016

    

 

2015

    

 

2014

 

    

 

(in thousands)

Luxembourg

 

$

190,849

 

 

$

94,558

 

 

$

36,783

United States

 

 

3,855

 

 

 

4,812

 

 

 

3,631

Other jurisdictions

 

 

(209,754)

 

 

 

55,731

 

 

 

193,463

Income (loss) before income taxes

 

$

(15,050)

 

 

$

155,101

 

 

$

233,877

 

The components of income tax (provision) / benefit consists of the following:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Years ended December 31, 

 

    

2016

    

 

2015

    

 

2014

 

 

 

(in thousands)

Current income tax benefit (expense):

 

 

 

 

 

 

 

 

 

 

 

Luxembourg

 

$

53

 

 

$

(1,107)

 

 

$

(979)

United States

 

 

(1,874)

 

 

 

(2,347)

 

 

 

(6,030)

Other foreign

 

 

(4,792)

 

 

 

(15,577)

 

 

 

(19,950)

Total current

 

$

(6,613)

 

 

$

(19,031)

 

 

$

(26,959)

Deferred tax benefit (expense):

 

 

 

 

 

 

 

 

 

 

 

Luxembourg

 

$

(2,893)

 

 

$

(2,908)

 

 

$

(1)

United States

 

 

(448)

 

 

 

(1,071)

 

 

 

4,281

Other foreign

 

 

(12,153)

 

 

 

(5,861)

 

 

 

(22,941)

Total deferred

 

$

(15,494)

 

 

$

(9,840)

 

 

$

(18,661)

Income tax expense

 

$

(22,107)

 

 

$

(28,871)

 

 

$

(45,620)

 

A reconciliation between the Luxembourg statutory rate of 29.2% for the years ended December 31, 2016, 2015 and 2014 and our effective tax rate is as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Years ended December 31, 

 

    

2016

    

2015

    

2014

Statutory rate

 

 

29.2

%

 

 

29.2

%

 

 

29.2

%

Effect of tax rates different than the Luxembourg statutory tax rate

 

 

(13.2)

%

 

 

(22.5)

%

 

 

(27.6)

%

Change in valuation allowance

 

 

(85.1)

%

 

 

10.6

%

 

 

10.2

%

Changes in unrecognized tax benefits

 

 

(75.9)

%

 

 

1.9

%

 

 

10.1

%

Equity based compensation shortfall

 

 

(7.0)

%

 

 

1.4

%

 

 

%

Adjustments related to prior years

 

 

5.1

%

 

 

(2.0)

%

 

 

(2.4)

%

Effective tax rate

 

 

(146.9)

%

 

 

18.6

%

 

 

19.5

%

 

The components of deferred tax assets and liabilities consists of the following:

 

 

 

 

 

 

 

 

 

December 31, 

 

    

2016

    

2015

 

 

 

(in thousands)

Deferred tax assets:

 

 

 

 

 

 

Net operating loss carryforwards

 

$

26,190

 

$

40,422

Depreciation and amortization

 

 

25,109

 

 

62,702

Accrued payroll expenses

 

 

9,471

 

 

7,662

Deferred revenue

 

 

5,744

 

 

8,851

Other

 

 

1,622

 

 

2,025

Deferred tax assets

 

 

68,136

 

 

121,662

Less: valuation allowance

 

 

(45,766)

 

 

(94,422)

Total deferred tax assets

 

$

22,370

 

$

27,240

 

 

 

 

 

 

 

Deferred tax liabilities:

 

 

 

 

 

 

Depreciation and amortization

 

$

(7,465)

 

$

(3,642)

Deferred expenses

 

 

(8,598)

 

 

(12,483)

Other

 

 

(1,083)

 

 

(1,817)

Total deferred tax liabilities

 

$

(17,146)

 

$

(17,942)

 

 

 

 

 

 

 

Net deferred tax assets

 

$

5,224

 

$

9,298

 

As of December 31, 2016 and 2015, the Company had gross deferred tax assets of $26.2 million and $40.4 million, respectively, related to loss carry forwards in various worldwide tax jurisdictions. The majority of the loss carry forwards have no expiration.

A valuation allowance for deferred tax assets is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized. As of December 31, 2016 and 2015, the valuation allowance for deferred tax assets was $45.8 million and $94.4 million, respectively. The decrease in our valuation allowance primarily resulted from the removal of the deferred tax asset and valuation allowance related to the excess of tax basis over book basis for certain of our drillships, as we believe it is remote that the benefit of the deferred tax asset will be realized.

We consider the earnings of certain of our subsidiaries to be indefinitely reinvested. Accordingly, we have not provided for taxes on these unremitted earnings. Should we make distributions from the unremitted earnings of these subsidiaries, we would be subject to taxes payable to various jurisdictions. At December 31, 2016, the amount of indefinitely reinvested earnings was approximately $40.7 million. If all of these indefinitely reinvested earnings were distributed, we would be subject to estimated taxes of approximately $2.0 million as of December 31, 2016.

We recognize tax benefits from an uncertain tax position only if it is more likely than not that the position will be sustained upon examination by taxing authorities based on the technical merits of the position. The amount recognized is the largest benefit that we believe has greater than a 50% likelihood of being realized upon settlement. As of December 31, 2016, we had $34.0 million of unrecognized tax benefits which was included in other long-term liabilities on our consolidated balance sheets and would impact our consolidated effective tax rate if realized. To the extent we have income tax receivable balances available to utilize against amounts payable for unrecognized tax benefits, we have presented such receivable balances as a reduction to other long-term liabilities on our consolidated balance sheets. A reconciliation of the beginning and ending amount of unrecognized tax benefits for the years ended December 31, 2016 and 2015 is as follows:

 

 

 

 

 

 

 

 

 

December 31, 

 

    

2016

    

2015

 

 

 

(in thousands)

Balance, beginning of year

 

$

24,914

 

$

23,248

Increases in unrecognized tax benefits as a result of tax  positions taken during prior years

 

 

 —

 

 

1,327

Decreases in unrecognized tax benefits as a result of tax positions taken during prior years

 

 

 —

 

 

(9,592)

Increases in unrecognized tax benefits as a result of tax positions taken during current year

 

 

9,113

 

 

9,931

Balance, end of year

 

$

34,027

 

$

24,914

 

Accrued interest and penalties totaled $4.8 million and $2.5 million as of December 31, 2016 and 2015, respectively, and were included in other long-term liabilities on our consolidated balance sheets. We recognized expense of $2.3 million, $1.2 million, and $1.0 million associated with interest and penalties during the years ended December 31, 2016, 2015 and 2014, respectively. Interest and penalties are included in income tax expense in our consolidated statements of operations.

The Company is subject to taxation in various U.S., foreign, and state jurisdictions in which it conducts business. Tax years as early as 2011 remain subject to examination. As of December 31, 2016, the Company has ongoing tax audits in Nigeria and Brazil.

Shareholders' Equity
Shareholders' Equity

Note 7—Shareholders’ Equity

In 2014, the Company’s shareholders approved, and the Board of Directors authorized, a share repurchase program for the repurchase of up to 0.8 million shares and up to $30.0 million. In 2015, we completed this repurchase program through cumulative buybacks of 0.7 million shares at an aggregate cost of $30.0 million. Repurchased shares of our common stock are held as treasury shares until they are reissued or retired.

On May 2, 2016, shareholders at our Extraordinary General Meeting approved the cancellation of 0.7 million treasury shares that we repurchased under our share repurchase program. We accounted for this non-cash transaction by netting the treasury shares at total cost of $30.0 million against the statutory share capital of the cancelled shares and additional paid-in capital. Upon cancellation, the cancelled shares were returned to authorized but unissued shares.

On May 24, 2016, shareholders at our Extraordinary General Meeting approved a 1-for-10 reverse stock split of our common shares. The Reverse Stock Split became effective and our common shares began trading on a split-adjusted basis as of the commencement of trading on May 25, 2016. On the effective date of the Reverse Stock Split, our shareholders received one new common share for every 10 common shares they owned. No fractional shares were issued in connection with the Reverse Stock Split; instead holders of fractional shares were paid in cash for any fractional interests, which was not material in the aggregate. All share and per share information in the accompanying financial statements has been restated retroactively to reflect the Reverse Stock Split.

 

As of December 31, 2016, the Company’s share capital consists of 5.0 billion common shares authorized, $0.01 par value per share, 22.6 million common shares issued and 21.2 million common shares outstanding of which approximately 70.8% is held by Quantum Pacific (Gibraltar) Limited.

Share-Based Compensation
Share-Based Compensation

Note 8—Share-Based Compensation

We recorded share-based compensation expense and related tax benefit within our consolidated statements of operations as follows:

 

 

 

 

 

 

 

 

 

 

 

 

Years Ended December 31, 

 

    

2016

    

2015

    

2014

 

 

 

(in thousands)

Operating expenses

 

$

658

 

$

4,650

 

$

3,131

General and administrative expenses

 

 

6,436

 

 

7,884

 

 

7,353

Share-based compensation expense

 

 

7,094

 

 

12,534

 

 

10,484

Tax benefit (a)

 

 

(2,011)

 

 

(2,690)

 

 

(2,154)

Total

 

$

5,083

 

$

9,844

 

$

8,330

(a)

The effects of tax benefits from share-based compensation expense are included within income tax expense in our consolidated statements of operations.

Stock Options

In 2011, the Board approved the creation of the Pacific Drilling S.A. 2011 Omnibus Stock Incentive Plan (the “2011 Stock Plan”), which provides for issuance of common stock options, as well as share appreciation rights, restricted shares, restricted share units and other equity based or equity related awards to directors, officers, employees and consultants. The Board also resolved that 0.7 million common shares of Pacific Drilling S.A. be reserved and authorized for issuance pursuant to the terms of the 2011 Stock Plan. In 2014, the Board approved an amendment to the 2011 Stock Plan increasing the number of common shares reserved and available for issuance from 0.7 million to 1.6 million.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model utilizing the assumptions noted in the table below. Given the insufficient historical data available regarding the volatility of the Company’s traded share price, expected volatility of the Company’s share price does not solely provide a reasonable basis for estimating volatility. Instead, the expected volatility utilized in our Black-Scholes valuation model is based on the volatility of the Company’s traded share price for the period available following the initial public offering of our shares and the implied volatilities from the expected volatility of a representative group of our publicly listed industry peer group for prior periods. Additionally, given the lack of historical data available, the expected term of the options is calculated using the simplified method because the historical option exercise experience of the Company does not provide a reasonable basis for estimating expected term. Options granted generally vest 25% annually over four years, have a 10-year contractual term and will be settled in shares of our stock. The risk free interest rates are determined using the implied yield currently available for zero-coupon U.S. government issues with a remaining term equal to the expected life of the options.

During the year ended December 31, 2016, there were no options granted. During the years ended December 31, 2015 and 2014, the fair value of the options granted was calculated using the following weighted-average assumptions:

 

 

 

 

 

 

 

 

 

2015

 

2014

 

    

Stock Options

    

Stock Options

Expected volatility

 

40.9

%

 

46.3

%

Expected term (in years)

 

6.25

 

 

6.25

 

Expected dividends

 

 —

 

 

 —

 

Risk-free interest rate

 

1.7

%

 

1.9

%

 

A summary of option activity under the 2011 Stock Plan as of and for the year ended December 31, 2016 is as follows:

 

 

 

 

 

 

 

 

 

 

 

 

    

Number of
Shares
Under
Option

    

 

Weighted-
Average
Exercise
Price

    

Weighted-
Average
Remaining
Contractual
Term

    

 

Aggregate
Intrinsic
Value

 

 

(in thousands)

 

 

(per share)

 

(in years)

 

 

(in thousands)

Outstanding — January 1, 2016

 

640

 

$

74.02

 

 

 

 

 

Granted

 

 —

 

 

 —

 

 

 

 

 

Exercised

 

 —

 

 

 —

 

 

 

 

 

Cancelled or forfeited

 

(3)

 

 

36.40

 

 

 

 

 

Outstanding — December 31, 2016

 

637

 

$

74.24

 

6.7

 

$

 —

Exercisable — December 31, 2016

 

395

 

$

90.66

 

5.6

 

$

 —

 

The weighted-average grant date fair value of options granted during the years ended December 31, 2015 and 2014 was $14.90 and $51.00 per option, respectively.

During the years ended December 31, 2016, 2015 and 2014, there were 0,  0 and 8,500 options exercised, respectively. As of December 31, 2016, total compensation costs related to nonvested option awards not yet recognized was $2.8 million and was expected to be recognized over 1.9 years.

Restricted Stock Units

Pursuant to the 2011 Stock Plan, the Company has granted restricted stock units to certain members of our Board of Directors, executives and employees. Restricted stock units granted by the Company will be settled in shares of our stock and generally vest over a period of two to four years. The fair value of restricted stock units is determined using the market value of our shares on the date of grant.

A summary of restricted stock units activity under the 2011 Stock Plan as of and for the year ended December 31, 2016 was as follows:

 

 

 

 

 

 

 

    

Number of
Restricted
Stock
Units

    

Weighted-Average
Grant-Date Fair
Value

 

 

(in thousands)

 

 

(per share)

Nonvested — January 1, 2016

 

249

 

$

53.90

Granted

 

418

 

 

5.29

Vested

 

(81)

 

 

59.57

Cancelled or forfeited

 

(6)

 

 

34.73

Nonvested —  December 31, 2016

 

580

 

$

18.14

 

The weighted-average grant-date fair value of restricted stock units granted was $36.40 and $100.60 per share for the years ended December 31, 2015 and 2014, respectively. The total grant-date fair value of the restricted stock units vested was $4.8 million, $9.7 million and $4.1 million for the years ended December 31, 2016, 2015 and 2014, respectively.

As of December 31, 2016, total compensation costs related to nonvested restricted stock units not yet recognized was $6.3 million and is expected to be recognized over a weighted-average period of 2.0 years.

Earnings per Share
Earnings per Share

Note 9—Earnings per Share

The following reflects the income and the share data used in the basic and diluted EPS computations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Years Ended December 31, 

 

    

2016

    

2015

    

2014

 

 

 

(in thousands, except per share information)

Numerator:

 

 

 

 

 

 

 

 

 

Net income (loss), basic and diluted

 

$

(37,157)

 

$

126,230

 

$

188,257

Denominator:

 

 

 

 

 

 

 

 

 

Weighted-average number of common shares outstanding, basic

 

 

21,167

 

 

21,145

 

 

21,722

Effect of share-based compensation awards

 

 

 —

 

 

11

 

 

15

Weighted-average number of common shares outstanding, diluted

 

 

21,167

 

 

21,156

 

 

21,737

Earnings (loss) per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(1.76)

 

$

5.97

 

$

8.67

Diluted

 

$

(1.76)

 

$

5.97

 

$

8.66

 

The following table presents the share effects of share-based compensation awards excluded from our computations of diluted EPS as their effect would have been anti-dilutive for the periods presented:

 

 

 

 

 

 

 

 

 

Years Ended December 31, 

 

    

2016

    

2015

    

2014

 

 

(in thousands)

Share-based compensation awards

 

1,217

 

889

 

620

 

Derivatives
Derivatives

Note 10—Derivatives

We are currently exposed to market risk from changes in interest rates and foreign exchange rates. From time to time, we may enter into a variety of derivative financial instruments in connection with the management of our exposure to fluctuations in interest rates and foreign exchange rates. We do not enter into derivative transactions for speculative purposes; however, for accounting purposes, certain transactions may not meet the criteria for hedge accounting.

In 2013, we entered into an interest rate swap as a cash flow hedge against future fluctuations in LIBOR with a notional value of $712.5 million. The interest rate swap does not amortize and matures on December 3, 2017. On a quarterly basis, we pay a fixed rate of 1.56% and receive the maximum of 1% or three-month LIBOR.

In 2013, we also entered into an interest rate swap as a cash flow hedge against future fluctuations in LIBOR with a notional value of $400.0 million. The interest rate swap does not amortize and matures on July 1, 2018. On a quarterly basis, we pay a fixed rate of 1.66% and receive three-month LIBOR.

In 2014, we entered into a series of foreign currency forward contracts as a cash flow hedge against future exchange rate fluctuations between the Euro and U.S. Dollar. We used the forward contracts to hedge Euro payments for forecasted capital expenditures. Upon settlement, we paid U.S. Dollars and received Euros at forward rates ranging from $1.25 to $1.27. As of December 31, 2016, the forward contracts were fully settled. As a result of settling the effective hedge for the years ended 2016 and 2015, we incurred net cash outflows of $1.8 million and $1.2 million, respectively, based on the prevailing Euro exchange rates and reclassified the amounts from accumulated other comprehensive income to property and equipment.

The following table provides data about the fair values of derivatives that are designated as hedge instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 

Derivatives Designated as Hedging Instruments

    

Balance Sheet Location

    

2016

    

2015

 

 

 

 

 

(in thousands)

Short-term - Interest rate swaps

 

Accrued expenses

 

$

(3,838)

 

$

(5,899)

Long-term - Interest rate swaps

 

Other long-term liabilities

 

 

(84)

 

 

(238)

Short-term -  Foreign currency forward contracts

 

Accrued expenses

 

 

 —

 

 

(1,584)

Total

 

 

 

$

(3,922)

 

$

(7,721)

 

We have elected not to offset the fair value of derivatives subject to master netting agreements, but to report them on a gross basis on our consolidated balance sheets.

The following table summarizes the cash flow hedge gains and losses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives in Cash Flow
Hedging Relationships

 

Gain (Loss) Recognized
in Other Comprehensive Income (“OCI”) for the
Year Ended December 31, 

 

Loss Reclassified
from Accumulated OCI into
Income for the
Year Ended December 31, 

 

Gain (Loss) Recognized in

Income (Ineffective Portion and

Amount Excluded from Effectiveness

Testing) for the

Year ended December 31, 

 

 

2016

 

2015

 

2014

 

2016

 

2015

 

2014

 

2016

 

2015

 

2014

 

 

(in thousands)

Interest rate swaps

 

$

2,713

 

$

(1,701)

 

$

(11,085)

 

$

8,798

 

$

10,440

 

$

7,737

 

$

 —

 

$

 —

 

$

 —

Foreign currency forward contracts

 

$

1,584

$ -

$

(1,584)

$ -

$

(563)

 

$

 —

$ -

$

 —

$ -

$

 —

 

$

 —

$ -

$

(296)

$ -

$

 —

 

As of December 31, 2016, the estimated amount of net losses associated with derivative instruments that would be reclassified from accumulated comprehensive loss to earnings during the next twelve months was $4.6 million. During the years ended December 31, 2016, 2015 and 2014, we reclassified $8.0 million, $9.6 million and $7.0 million to interest expense and $0.8 million, $0.8 million and $0.8 million to depreciation from accumulated other comprehensive income, respectively.

Fair Value Measurements
Fair Value Measurements

Note 11—Fair Value Measurements

We estimated fair value by using appropriate valuation methodologies and information available to management as of December 31, 2016 and 2015. Considerable judgment is required in developing these estimates, and accordingly, estimated values may differ from actual results.

The estimated fair value of accounts receivable, accounts payable and accrued expenses approximated their carrying value due to their short-term nature. It is not practicable to estimate the fair value of our receivable from SHI. It is also not practicable to estimate the fair value of our SSCF debt and 2013 Revolving Credit Facility. The following table presents the carrying value and estimated fair value of our other long-term debt instruments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 

 

 

2016

 

2015

 

 

Carrying

 

Estimated Fair

 

Carrying

 

Estimated Fair

 

    

Value

    

Value

    

Value

    

Value

 

 

 

(in thousands)

2017 Senior Secured Notes

 

$

438,880

 

$

208,698

 

$

498,887

 

$

250,000

2018 Senior Secured Term Loan B

 

 

722,706

 

 

256,931

 

 

729,458

 

 

307,125

2020 Senior Secured Notes

 

 

750,000

 

 

270,000

 

 

750,000

 

 

322,500

 

We estimate the fair values of our variable-rate and fixed-rate debt using quoted market prices to the extent available and significant other observable inputs, which represent Level 2 fair value measurements.

The following table presents the carrying value and estimated fair value of our financial instruments recognized at fair value on a recurring basis:

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2016

 

    

 

 

    

Fair Value Measurements Using

 

 

Carrying

 

 

    

 

 

    

 

 

 

Value

 

Level 1

 

Level 2

 

Level 3

Liabilities:

 

(in thousands)

Interest rate swaps

 

$

(3,922)

 

 —

 

$

(3,922)

 

 —

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2015

 

 

 

 

 

Fair Value Measurements Using

 

 

Carrying

 

 

 

 

 

 

 

 

    

Value

    

Level 1

    

Level 2

    

Level 3

 

 

 

(in thousands)

Liabilities:

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

(6,137)

 

 —

 

$

(6,137)

 

 —

Foreign currency forward contracts

 

 

(1,584)

 

 —

 

$

(1,584)

 

 —

 

We use an income approach to value assets and liabilities for outstanding interest rate swaps and foreign currency forward contracts. These contracts are valued using a discounted cash flow model that calculates the present value of future cash flows under the terms of the contracts using market information as of the reporting date, such as prevailing interest rates and forward rates. The determination of the fair values above incorporated various factors, including the impact of the counterparty’s non-performance risk with respect to our financial assets and our non-performance risk with respect to our financial liabilities.

See Note 10 for further discussion of our use of derivative instruments and their fair values.

Commitments and Contingencies
Commitments and Contingencies

Note 12—Commitments and Contingencies

Operating Leases—We lease office space in countries in which we operate. As of December 31, 2016, the future minimum lease payments under the non-cancelable operating leases with lease terms in excess of one year was as follows:

 

 

 

 

 

    

(In thousands)

Years Ending December 31, 

    

 

 

2017

 

$

2,287

2018

 

 

2,196

2019

 

 

2,083

2020

 

 

2,121

2021

 

 

2,160

Thereafter

 

 

5,942

Total future minimum lease payments

 

$

16,789

 

During the years ended December 31, 2016, 2015 and 2014, rent expense was $2.5 million, $3.0 million and $4.5 million, respectively.

Commitments—As of December 31, 2016, we had no material commitments.

Customs Bonds—As of December 31, 2016, we were contingently liable under certain customs bonds totaling approximately $145.0 million issued as security in the normal course of our business.

Contingencies—It is to be expected that we will routinely be involved in litigation and disputes arising in the ordinary course of our business.

On April 16, 2013, Transocean Offshore Deepwater Drilling, Inc. (“Transocean”) filed a complaint against us in the United States District Court for the Southern District of Texas alleging infringement of their dual activity patents, which was supplemented by an Amended Complaint filed on May 13, 2013. In its Amended Complaint, Transocean seeks relief in the form of a permanent injunction, compensatory damages, enhanced damages, court costs and fees. On May 31, 2013, we filed our Answer to the Amended Complaint and our Counterclaims seeking Declaratory Judgments that we do not infringe the asserted Transocean patents and that such patents are invalid and unenforceable. The trial was set for August 8, 2016; however, the Court has granted a stay of the litigation pending the resolution of three Inter Partes Reviews (“IPRs”) instituted by the U.S. Patent and Trademark Office (“PTO”) on March 28, 2016 with respect to the same three patents that are the subject of Transocean’s litigation against us. The PTO instituted the IPRs upon the petition of Seadrill Americas, Inc., Seadrill Gulf Operations Auriga, LLC, Seadrill Gulf Operations Vela, LLC and Seadrill Gulf Operations Neptune, LLC (collectively, “Seadrill”) based on a finding by the PTO that there is a reasonable likelihood that Seadrill will succeed in proving that at least one of the asserted claims of each of the Transocean patents is invalid. Resolution of the IPRs is expected by the end of March 2017. We do not believe that the ultimate liability, if any, resulting from this litigation will have a material adverse effect on our financial position, results of operations or cash flows.

On October 29, 2015, we exercised our right to rescind the Construction Contract with SHI for the drillship the Pacific Zonda due to SHI’s failure to timely deliver the drillship in accordance with the contractual specifications. SHI rejected our rescission, and on November 25, 2015, formally commenced an arbitration proceeding against us in London under the Arbitration Act 1996 before a tribunal of three arbitrators (as specified in the Construction Contract). SHI claims that we wrongfully rejected their tendered delivery of the drillship and seeks the final installment of the purchase price under the Construction Contract. On November 30, 2015, we made demand under the third party refund guarantee accompanying the Construction Contract for the amount of our advance payments made under the Construction Contract, plus interest. Any payment under the refund guarantee is suspended until an award under the arbitration is obtained. Pursuant to a mutually agreed scheduling order, SHI filed its claims submission on January 29, 2016. We responded with our defense and counterclaim on February 26, 2016 and, in addition to seeking repayment of our advance payments made under the Construction Contract, our counterclaim also seeks the return of our purchased equipment, or the value of such equipment, and damages for our wasted expenditures. SHI submitted their response to our defense and counterclaim on April 11, 2016, we filed our rejoinder on May 23, 2016 and SHI filed its sur-rejoinder on July 8, 2016. The pleadings and the disclosure phase of the arbitration proceeding are now complete, and the preparation of witness statements and expert reports is in process. A hearing for the arbitration proceeding has been set for February 5, 2018. We do not believe that the ultimate outcome resulting from this arbitration will have a material adverse effect on our financial position, results of operations or cash flows.

Concentrations of Credit and Market Risk
Concentrations of Credit and Market Risk

Note 13—Concentrations of Credit and Market Risk

Financial instruments that potentially subject the Company to credit risk are primarily cash equivalents, restricted cash and accounts receivable. At times, cash equivalents and restricted cash may be in excess of FDIC insurance limits. With regards to accounts receivable, we have an exposure from our concentration of clients within the oil and natural gas industry. This industry concentration has the potential to impact our exposure to credit and market risks as our clients could be affected by similar changes in economic, industry or other conditions. However, we believe that the credit risk posed by this industry concentration has been largely offset by the creditworthiness of our client base. During the years ended December 31, 2016, 2015 and 2014, the percentage of revenues earned from our clients was as follows:

 

 

 

 

 

 

 

 

 

 

 

 

Years Ended December 31, 

 

    

2016

    

2015

    

2014

Chevron

 

77.1

%

 

81.2

%

 

67.4

%

Total

 

22.9

%

 

17.2

%

 

17.3

%

Petrobras

 

 —

%

 

1.6

%

 

15.3

%

 

Some of our employees in Nigeria are represented by unions. As of December 31, 2016 and 2015, approximately 1% and 20% of our labor force was covered by collective bargaining agreements, all of which are subject to annual salary negotiation.

Segments and Geographic Areas
Segments and Geographic Areas

Note 14—Segments and Geographic Areas

Our drillships are part of a single, global market for contract drilling services and can be redeployed globally due to changing demands. We consider the operations of each of our drillships to be an operating segment. We evaluate the financial performance of each of our drillships and our overall fleet based on several factors, including revenues from clients and operating profit. The consolidation of our operating segments into one reportable segment is attributable to how we manage our fleet, including the nature of our services provided, type of clients we serve and the ability of our drillships to operate in a single, global market. The accounting policies of our operating segments are the same as those described in the summary of significant accounting policies (see Note 2).

As of December 31, 2016, the Pacific Bora and the Pacific Scirocco were located offshore Nigeria, and the Pacific Santa Ana and the Pacific Sharav were located offshore the United States. As of December 31, 2016, the Pacific Mistral and the Pacific Meltem were anchored at Aruba, and the Pacific Khamsin was anchored at Cyprus.

During the years ended December 31, 2016, 2015 and 2014, the percentage of revenues earned by geographic area, based on drilling location, is as follows:

 

 

 

 

 

 

 

 

 

 

 

 

Years Ended December 31, 

 

    

2016

    

2015

    

2014

Gulf of Mexico

 

56.9

%

 

38.1

%

 

24.5

%

Nigeria

 

43.1

%

 

60.3

%

 

60.2

%

Brazil

 

 —

%

 

1.6

%

 

15.3

%

 

Variable Interest Entities
Variable Interest Entities

Note 15—Variable Interest Entities

The carrying amounts associated with our consolidated variable interest entities, after eliminating the effect of intercompany transactions, were as follows:

 

 

 

 

 

 

 

 

 

December 31, 

 

    

2016

    

2015

 

 

(in thousands)

Assets

 

$

10,020

 

$

17,612

Liabilities

 

 

(2,247)

 

 

(19,250)

Net carrying amount

 

$

7,773

 

$

(1,638)

 

PIDWAL is a joint venture formed to provide drilling services in Nigeria and to hold an equity investment in PDNL. PDNL is a company owned by us and PIDWAL, formed to hold the equity investments in certain of our rig-owning entities operating in Nigeria. We determined that each of these companies met the criteria of a variable interest entity for accounting purposes because its equity at risk was insufficient to permit it to carry on its activities without additional subordinated financial support from us. We also determined that we were the primary beneficiary for accounting purposes since (a) for PIDWAL, we had the power to direct the day-to-day management and operations of the entity, and for PDNL we had the power to secure and direct its equity investment, which are the activities that most significantly impact each entity’s economic performance, and (b) we had the obligation to absorb losses or the right to receive a majority of the benefits that could be potentially significant to the variable interest entities. As a result, we consolidate PIDWAL and PDNL in our consolidated financial statements.

During the years ended December 31, 2016 and 2015, we provided financial support to PIDWAL to enable it to operate as a going concern by funding its working capital via intercompany loans and payables. We also issued corporate guarantees in the amount of $145.0 million in customs bonds issued as credit support for temporary import bonds issued in favor of PIDWAL as of December 31, 2016.

During the years ended December 31, 2016 and 2015, we provided financial support to PDNL to fund its equity investment in our rig-owning entities operating in Nigeria via intercompany loans. Both the equity investment and intercompany loans of PDNL are eliminated upon consolidation.

Retirement Plans
Retirement Plans

Note 16—Retirement Plans

Pacific Drilling sponsors a defined contribution retirement plan covering substantially all U.S. employees and an international savings plan covering international employees. During the years ended December 31, 2016, 2015 and 2014, our total employer contributions to both plans amounted to $4.1 million, $7.0 million and $6.9 million, respectively.

 

Supplemental Cash Flow Information
Supplemental Cash Flow Information

Note 17—Supplemental Cash Flow Information

During the years ended December 31, 2016, 2015 and 2014, we paid $169.8 million, $164.5 million and $135.4 million of interest, net of amounts capitalized, respectively. During the years ended December 31, 2016, 2015 and 2014, we paid income taxes of $12.3 million, $27.2 million, and $31.7 million, respectively.

Within our consolidated statements of cash flows, capital expenditures represent expenditures for which cash payments were made during the period. These amounts exclude accrued capital expenditures, which are capital expenditures that were accrued but unpaid. During the years ended December 31, 2016, 2015 and 2014, changes in accrued capital expenditures were $(9.0) million, $9.9 million and $(23.9) million, respectively.

During the years ended December 31, 2016, 2015 and 2014, non-cash amortization of deferred financing costs and accretion of debt discount totaling $0,  $3.5 million and $5.1 million were capitalized to property and equipment, respectively. Accordingly, these amounts are excluded from capital expenditures in our consolidated statements of cash flows for the years ended December 31, 2016, 2015 and 2014.

 

During the year ended December 31, 2016, we cancelled 0.7 million treasury shares that we repurchased under our share repurchase program. We accounted for this non-cash transaction by netting the treasury shares at total cost of $30.0 million against the statutory share capital of the cancelled shares and additional paid-in capital.

Liquidity
Liquidity

Note 18—Liquidity

 

Our liquidity fluctuates depending on a number of factors, including, among others, our revenue efficiency and the timing of accounts receivable collection as well as payments for operating costs and debt repayments. Primary sources of funds for our short-term liquidity needs are expected to be our cash flow generated from operating activities and existing cash, cash equivalents and restricted cash balances. At December 31, 2016, we had $586.0 million of cash and cash equivalents and $40.2 million of restricted cash.  On January 20, 2017, in connection with the Sixth Amendments, we paid a total of $133.7 million to our lenders.  We do not have additional borrowing capacity under our 2013 Revolving Credit Facility or SSCF, and the RCF Sixth Amendment restricts our ability to incur additional secured debt.

 

Market conditions in the offshore drilling industry in recent years have led to materially lower levels of spending for offshore exploration and development by our current and potential customers on a global basis while at the same time supply of available high specification drillships has increased, which in turn has negatively affected our revenue, profitability and cash flows. As a result, we are engaged in discussions with all of our stakeholders, including our bank lenders under the 2013 Revolving Credit Facility and the SSCF (the “Lenders”) and an ad hoc group of holders of our capital markets indebtedness (the “Ad Hoc Group”), regarding a restructuring of the Company’s existing capital structure to be sustainable in the longer term.

 

As discussed in Note 5, the Sixth Amendments modify or waive application of certain financial covenants for the fiscal quarters ending on March 31, 2017 and June 30, 2017. However, if current market conditions persist, we expect that we will be in violation of the maximum leverage ratio covenant in our 2013 Revolving Credit Facility and our SSCF for the fiscal quarter ending on September 30, 2017. If we are unable to obtain waivers of such covenants or amendments to the debt agreements, such covenant default would entitle the Lenders to declare all outstanding amounts under such debt agreements to be immediately due and payable. Such acceleration would also trigger the cross-default provisions of our 2017 Senior Secured Notes, the Senior Secured Term Loan B and the 2020 Senior Secured Notes.

 

If we are unable to refinance our 2017 Senior Secured Notes prior to their maturity in December 2017 or complete a restructuring and current market conditions persist, the Company may not have sufficient liquidity to meet its debt obligations over the next year following the date of the issuance of these financial statements.  As such, this condition gives rise to substantial doubt about the Company’s ability to continue as a going concern.

 

As a result, we, with the assistance of our advisors, are evaluating various alternatives to address our liquidity and capital structure, which may include a private restructuring or a negotiated restructuring of our debt under the protection of Chapter 11 of the U.S. Bankruptcy Code. We are currently negotiating with the Lenders and the Ad Hoc Group in order to reach terms acceptable to all stakeholders for a restructuring. If such negotiations do not result in completion of the restructuring, we may be forced to seek a reorganization under Chapter 11 of the U.S. Bankruptcy Code.

 

As there can be no assurance given that these negotiations will be successfully concluded, there exists substantial doubt about the Company’s ability to continue as a going concern over the next year following the date of the issuance of these financial statements.

Subsequent Events
Subsequent Events

Note 19—Subsequent Events

On January 20, 2017, we entered into the SSCF Sixth Amendment for the SSCF and the RCF Sixth Amendment for the 2013 Revolving Credit Facility (see Note 5).

Significant Accounting Policies (Policies)

Principles of Consolidation—Our consolidated financial statements include the accounts of Pacific Drilling S.A. and consolidated subsidiaries that we control by ownership of a majority voting interest and entities that meet the criteria for variable interest entities for which we are deemed to be the primary beneficiary for accounting purposes. We eliminate all intercompany transactions and balances in consolidation.

We are party to a Nigerian joint venture, Pacific International Drilling West Africa Limited (“PIDWAL”), with Derotech Offshore Services Limited (“Derotech”), a privately-held Nigerian registered limited liability company. Derotech owns 51% of PIDWAL and PIDWAL has a 50.1% ownership interest in two of our rig holding subsidiaries, Pacific Bora Ltd. and Pacific Scirocco Ltd. PIDWAL’s interest in the rig holding subsidiaries is held through a holding company of PIDWAL, Pacific Drillship Nigeria Limited (“PDNL”). Derotech will not accrue the economic benefits of its interest in PIDWAL unless and until it satisfies certain outstanding obligations to us and a certain pledge is cancelled by us. Likewise PIDWAL will not accrue the economic benefits of its interest in PDNL unless and until it satisfies certain outstanding obligations to us and a certain pledge is cancelled by us. PIDWAL and PDNL are variable interest entities for which we are the primary beneficiary. Accordingly, we consolidate all interests of PIDWAL and PDNL and no portion of their operating results is allocated to the noncontrolling interest (see Note 15—Variable Interest Entities).

In addition to the joint venture agreement, we are a party to marketing and logistic services agreements with Derotech and an affiliated company of Derotech. During the years ended December 31, 2016, 2015 and 2014, we incurred fees of $8.7 million, $13.9 million and $16.6 million, respectively, under such agreements.

Accounting Estimates—The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”) requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities at the balance sheet date and the amounts of revenues and expenses recognized during the reporting period. On an ongoing basis, we evaluate our estimates and assumptions, including those related to allowance for doubtful accounts, financial instruments, depreciation of property and equipment, impairment of long-lived assets, long-term receivable, income taxes, share-based compensation and contingencies. We base our estimates and assumptions on historical experience and on various other factors we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from such estimates.

Revenues and Operating Expenses—Contract drilling revenues are recognized as earned, based on contractual dayrates. In connection with drilling contracts, we may receive fees for preparation and mobilization of equipment and personnel or for capital improvements to rigs. Fees and incremental costs incurred directly related to contract preparation and mobilization along with reimbursements received for capital expenditures are deferred and amortized to revenue over the primary term of the drilling contract. The cost incurred for reimbursed capital expenditures are depreciated over the estimated useful life of the asset. We may also receive fees upon completion of a drilling contract that are conditional based on the occurrence of an event, such as demobilization of a rig. These conditional fees and related expenses are reported in income upon completion of the drilling contract. If receipt of such fees is not conditional, they are recognized as revenue over the primary term of the drilling contract. Amortization of deferred revenue and deferred mobilization costs are recorded on a straight-line basis over the primary drilling contract term, which is consistent with the general pace of activity, level of services being provided and dayrates being earned over the life of the contract.

Revenues and Operating Expenses—Contract drilling revenues are recognized as earned, based on contractual dayrates. In connection with drilling contracts, we may receive fees for preparation and mobilization of equipment and personnel or for capital improvements to rigs. Fees and incremental costs incurred directly related to contract preparation and mobilization along with reimbursements received for capital expenditures are deferred and amortized to revenue over the primary term of the drilling contract. The cost incurred for reimbursed capital expenditures are depreciated over the estimated useful life of the asset. We may also receive fees upon completion of a drilling contract that are conditional based on the occurrence of an event, such as demobilization of a rig. These conditional fees and related expenses are reported in income upon completion of the drilling contract. If receipt of such fees is not conditional, they are recognized as revenue over the primary term of the drilling contract. Amortization of deferred revenue and deferred mobilization costs are recorded on a straight-line basis over the primary drilling contract term, which is consistent with the general pace of activity, level of services being provided and dayrates being earned over the life of the contract.

Cash and Cash Equivalents—Cash equivalents are highly liquid investments with original maturities of three months or less that are readily convertible to known amounts of cash.

Restricted Cash—Restricted cash consists primarily of balances pledged to the lenders under our debt agreement as cash collateral.

Accounts Receivable—We record trade accounts receivable at the amount we invoice our clients. We provide an allowance for doubtful accounts, as necessary, based on a review of outstanding receivables, historical collection information and existing economic conditions. We do not generally require collateral or other security for receivables. As of December 31, 2016 and 2015, we had no allowance for doubtful accounts.

Materials and Supplies—Materials and supplies held for consumption are carried at average cost, net of allowances for excess or obsolete materials and supplies of $7.3 million and $8.0 million as of December 31, 2016 and 2015, respectively.

Property and Equipment—High-specification drillships are recorded at cost of construction, including any major capital improvements, less accumulated depreciation and if applicable, impairment. Other property and equipment is recorded at cost and consists of purchased software systems, furniture, fixtures and other equipment. Ongoing maintenance, routine repairs and minor replacements are expensed as incurred.

Interest is capitalized based on the costs of new borrowings attributable to qualifying new construction or at the weighted-average cost of debt outstanding during the period of construction. We capitalize interest costs for qualifying new construction from the point borrowing costs are incurred for the qualifying new construction and cease when substantially all the activities necessary to prepare the qualifying asset for its intended use are complete.

Property and equipment are depreciated to their salvage value on a straight-line basis over the estimated useful lives of each class of assets. Our estimated useful lives of property and equipment are as follows:

 

 

 

 

    

Years

Drillships and related equipment

 

15-35

Other property and equipment

 

2-7

 

We review property and equipment for impairment when events or changes in circumstances indicate that the carrying amounts of our assets held and used may not be recoverable. Potential impairment indicators include steep declines in commodity prices and related market conditions, actual or expected declines in rig utilization, increases in idle time or significant damage to the property and equipment that adversely affects the extent and manner of its use. We assess impairment using estimated undiscounted cash flows for the property and equipment being evaluated by applying assumptions regarding future operations, market conditions, dayrates, utilization and idle time. An impairment loss is recorded in the period if the carrying amount of the asset is not recoverable. During 2016, 2015 and 2014, there were no long-lived asset impairments.

Deferred Financing Costs—Deferred financing costs associated with long-term debt are carried at cost and are amortized to interest expense using the effective interest rate method over the term of the applicable long-term debt.

Foreign Currency Transactions—The consolidated financial statements are stated in U.S. dollars. We have designated the U.S. dollar as the functional currency for our foreign subsidiaries in international locations because we contract with clients, purchase equipment and finance capital using the U.S. dollar. Transactions in other currencies have been translated into U.S. dollars at the rate of exchange on the transaction date. Any gain or loss arising from a change in exchange rates subsequent to the transaction date is included as an exchange gain or loss. Monetary assets and liabilities denominated in currencies other than U.S. dollars are reported at the rates of exchange prevailing at the end of the reporting period. During 2016, 2015 and 2014, foreign exchange losses were $0.5 million, $3.6 million and $5.3 million, respectively, and recorded in other expense within our consolidated statements of operations.

Earnings per Share—Basic earnings per common share (“EPS”) is computed by dividing the net income by the weighted-average number of common shares outstanding for the period. Basic and diluted EPS are retrospectively adjusted for the effects of stock dividends or stock splits. Diluted EPS reflects the potential dilution from securities that could share in the earnings of the Company. Anti-dilutive securities are excluded from diluted EPS. On May 24, 2016, shareholders at our Extraordinary General Meeting approved a 1-for-10 reverse stock split of our common shares (the “Reverse Stock Split”), which became effective on May 25, 2016. All share and per share information in the accompanying financial statements has been restated retroactively to reflect the Reverse Stock Split.

Fair Value Measurements—We estimate fair value at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market for the asset or liability. Our valuation techniques require inputs that are categorized using a three-level hierarchy as follows: (1) unadjusted quoted prices for identical assets or liabilities in active markets (“Level 1”), (2) direct or indirect observable inputs, including quoted prices or other market data, for similar assets or liabilities in active markets or identical assets or liabilities in less active markets (“Level 2”) and (3) unobservable inputs that require significant judgment for which there is little or no market data (“Level 3”). When multiple input levels are required for a valuation, we categorize the entire fair value measurement according to the lowest level input that is significant to the measurement even though we may have also utilized significant inputs that are more readily observable.

Share-Based Compensation—The grant date fair value of share-based awards granted to employees is recognized as an employee compensation expense over the requisite service period on a straight-line basis. The amount of compensation expense recognized is adjusted to reflect the number of awards for which the related vesting conditions are expected to be met. The amount of compensation expense ultimately recognized is based on the number of awards that do meet the vesting conditions at the vesting date.

Derivatives—We apply cash flow hedge accounting to interest rate swaps that are designated as hedges of the variability of future cash flows. The derivative financial instruments are recorded in our consolidated balance sheets at fair value as either assets or liabilities. Changes in the fair value of derivatives designated as cash flow hedges, to the extent the hedge is effective, are recognized in accumulated other comprehensive income until the hedged item is recognized in earnings.

Hedge effectiveness is measured on an ongoing basis to ensure the validity of the hedges based on the relative cumulative changes in fair value between the derivative contract and the hedged item over time. Any change in fair value resulting from ineffectiveness is recognized immediately in earnings. Hedge accounting is discontinued prospectively if it is determined that the derivative is no longer effective in offsetting changes in the cash flows of the hedged item.

For interest rate hedges related to interest capitalized in the construction of fixed assets, other comprehensive income is released to earnings as the asset is depreciated over its useful life. For all other interest rate hedges, other comprehensive income is released to earnings as interest expense is accrued on the underlying debt.

Contingencies—We record liabilities for estimated loss contingencies when we believe a loss is probable and the amount of the probable loss can be reasonably estimated. Once established, we adjust the estimated contingency loss accrual for changes in facts and circumstances that alter our previous assumptions with respect to the likelihood or amount of loss.

Income Taxes—Income taxes are provided based upon the tax laws and rates in the countries in which our subsidiaries are registered and where their operations are conducted and income and expenses are earned and incurred, respectively. We recognize deferred tax assets and liabilities for the anticipated future tax effects of temporary differences between the financial statement basis and the tax basis of our assets and liabilities using the applicable enacted tax rates in effect the year in which the asset is realized or the liability is settled. A valuation allowance for deferred tax assets is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized.

We recognize tax benefits from an uncertain tax position only if it is more likely than not that the position will be sustained upon examination by taxing authorities based on the technical merits of the position. The amount recognized is the largest benefit that we believe has greater than a 50% likelihood of being realized upon settlement. Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations and the final audit of tax returns by taxing authorities. We recognize interest and penalties related to uncertain tax positions in income tax expense.

Recently Adopted Accounting Standards

Going Concern—On August 27, 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-15, Presentation of Financial Statements – Going Concern (Subtopic 205-40), which requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the financial statements are issued for both annual and interim reporting periods. We adopted the standard effective for the year ended December 31, 2016 (see Note 18).

Debt Issuance Costs—On April 7, 2015, the FASB issued ASU 2015-03, Interest - Imputation of Interest (Subtopic 835-30) - Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the debt liability rather than as an asset. We adopted the standard effective January 1, 2016 on a retrospective basis, which resulted in the netting of our deferred financing costs against long-term debt balances on our consolidated balance sheets for the periods presented (see Note 5). Deferred financing costs related to our revolving credit facility were reclassified to prepaid expenses and other current assets, and other assets. The adoption had no impact on our operating results or cash flows for the current and prior periods.

Statement of Cash Flows—On August 26, 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230), a consensus of the FASB’s Emerging Issues Task Force, which is intended to reduce diversity in practice in how certain transactions are classified in the statements of cash flows. On November 17, 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230), Restricted Cash, which requires entities to show the changes in total cash, cash equivalents, and restricted cash in the statement of cash flows. We adopted the standards effective for the year ended December 31, 2016 on a retrospective basis, which resulted in no reclassifications to prior periods. The adoption had no impact on our consolidated balance sheets or operating results.

Recently Issued Accounting Standards

Revenue Recognition—On May 28, 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This standard will replace most existing revenue recognition guidance under GAAP when it becomes effective. The standard will be effective for annual periods and interim periods beginning after December 15, 2017. Given the interaction with the accounting standards update related to Leases, we expect to adopt the updates concurrently, effective January 1, 2018, and we expect to apply the modified retrospective approach to our adoption. We are currently evaluating the requirements to determine the effect such requirements may have on our consolidated financial statements and related disclosures.

Deferred Taxes—On November 20, 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes, which requires all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. The new guidance, however, does not change the existing requirement that only permits offsetting within a tax jurisdiction. We will adopt the standard prospectively for our annual and interim periods beginning January 1, 2017, which will result in the reclassification of our deferred tax balances from current to long-term on our consolidated balance sheets. As of December 31, 2016, our current deferred tax assets and current deferred tax liabilities were $2.5 million and $1.7 million, respectively.

Leases— On February 25, 2016, the FASB issued ASU 2016-02, Leases, which (a) requires lessees to recognize a right to use asset and liability for virtually all leases, and (b) updates previous accounting standards for lessors to align certain requirements with the updates to lessee accounting standards and the revenue recognition accounting standards. The update, which permits early adoption, is effective for annual and interim periods beginning after December 15, 2018. Under the updated accounting standards, we believe that our drilling contracts may contain a lease component, and our adoption, therefore, may require that we separately recognize revenues associated with the lease and services components. Given the interaction with the accounting standards update related to revenue from contracts with customers, we expect to adopt the updates concurrently, effective January 1, 2018, and we expect to apply the modified retrospective approach to our adoption. Our adoption, and the ultimate effect on our consolidated financial statements, will be based on an evaluation of the contract-specific facts and circumstances, and such effect could introduce variability to the timing of our revenue recognition relative to current accounting standards. We are currently evaluating the requirements to determine the effect such requirements may have on our consolidated financial statements and related disclosures.

 

Share-based Payments—On March 30, 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, which requires recognition of the income tax effects of equity awards in the income statement when the awards vest or are settled. The standard also allows employers to withhold shares upon settlement of an award for an amount up to the employees’ maximum individual tax rate in the relevant jurisdiction without resulting in liability classification of the award. The standard permits entities to make an accounting policy election for the impact of forfeitures on the recognition of expense for share-based payment awards. We will adopt the standard for our annual and interim periods beginning January 1, 2017. We do not expect the adoption of the standard to have a material effect on our consolidated financial statements and related disclosures.

Measurement of Credit Losses on Financial Instruments—On June 16, 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326), which introduces a new model for recognizing credit losses on financial instruments based on an estimate of current expected credit losses. The new model will apply to: (1) loans, accounts receivable, trade receivables, and other financial assets measured at amortized cost, (2) loan commitments and certain other off-balance sheet credit exposures, (3) debt securities and other financial assets measured at fair value through other comprehensive income, and (4) beneficial interests in securitized financial assets. This update is effective for annual and interim periods beginning after January 1, 2020. We are currently evaluating the effect the standard may have on our consolidated financial statements and related disclosures.

Tax Accounting for Intra-Entity Asset Transfers—On October 24, 2016, the FASB issued ASU 2016-16, Accounting for Income Taxes: Intra-Entity Asset Transfers of Assets Other than Inventory, which requires entities to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transaction occurs as opposed to deferring tax consequences and amortizing them into future periods. This update is effective for annual and interim periods beginning after January 1, 2018 with early adoption permitted, and requires a modified retrospective approach with a cumulative-effect adjustment directly to retained earnings at the beginning of the period of adoption. We are currently evaluating the effect the standard may have on our consolidated financial statements and related disclosures.

Significant Accounting Policies (Tables)
Estimated useful lives of property and equipment

 

 

 

 

    

Years

Drillships and related equipment

 

15-35

Other property and equipment

 

2-7

 

Property and Equipment (Tables)
Summary of property and equipment

 

 

 

 

 

 

 

 

 

December 31, 

 

    

2016

    

2015

 

 

 

(in thousands)