Description of Business and Summary of Significant Accounting Policies

Description of Business

Holly Energy Partners, L.P. (“HEP”) together with its consolidated subsidiaries, is a publicly held master limited partnership, currently 42% owned (including the 2% general partner interest) by HollyFrontier Corporation (formerly known as Holly Corporation) (“HFC”) and its subsidiaries. HFC changed its name in connection with the consummation of its merger of equals with Frontier Oil Corporation effective July 1, 2011.

We commenced operations on July 13, 2004 upon the completion of our initial public offering. In these consolidated financial statements, the words “we,” “our,” “ours” and “us” refer to HEP unless the context otherwise indicates.

We operate in one operating segment - the operation of petroleum product and crude pipelines and terminals, tankage and loading rack facilities.

We own and operate petroleum product and crude pipelines and terminal, tankage and loading rack facilities that support HFC’s refining and marketing operations in the Mid-Continent, Southwest and Rocky Mountain regions of the United States and Alon USA, Inc.’s (“Alon”) refinery in Big Spring, Texas. Additionally, we own a 25% joint venture interest in a 95-mile intrastate crude oil pipeline system (the “SLC Pipeline”) that serves refineries in the Salt Lake City area.

We generate revenues by charging tariffs for transporting petroleum products and crude oil through our pipelines, by charging fees for terminalling and storing refined products and other hydrocarbons, and providing other services at our storage tanks and terminals. We do not take ownership of products that we transport, terminal or store, and therefore, we are not directly exposed to changes in commodity prices.

Principles of Consolidation and Common Control Transactions

The consolidated financial statements include our accounts and those of our subsidiaries. All significant inter-company transactions and balances have been eliminated.

Most of our asset acquisitions from HFC occurred while we were a consolidated variable interest entity of HFC. Therefore, as an entity under common control with HFC, we recorded these assets on our balance sheets at HFC’s historical basis instead of our purchase price or fair value. If these assets had been acquired from third parties, our acquisition cost in excess of HFC’s basis in the transferred assets of $295 million would have been recorded as increases to our properties and equipment and intangible assets instead of reductions to our partners’ equity.

Use of Estimates

The preparation of financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Cash and Cash Equivalents

For purposes of the statements of cash flows, we consider all highly liquid investments with maturities of three months or less at the time of purchase to be cash equivalents. The carrying amounts reported on the balance sheets approximate fair value due to the short-term maturity of these instruments.

Accounts Receivable

The majority of the accounts receivable are due from affiliates of HFC, Alon or independent companies in the petroleum industry. Credit is extended based on evaluation of the customer’s financial condition and, in certain circumstances, collateral such as letters of credit or guarantees, may be required. Credit losses are charged to income when accounts are deemed uncollectible and historically have been minimal.

Inventories

Inventories consisting of materials and supplies used for operations are stated at the lower of cost, using the average cost method, or market and are shown under “Prepaid and other current assets” in our consolidated balance sheets.

Properties and Equipment

Properties and equipment are stated at cost. Properties and equipment acquired from HFC while under common control of HFC are stated at HFC’s historical basis. Depreciation is provided by the straight-line method over the estimated useful lives of the assets, primarily 25 years for terminal facilities and tankage, 25 to 32 years for pipelines and 5 to 10 years for corporate and other assets. Maintenance, repairs and major replacements are generally expensed as incurred. Costs of replacements constituting improvements are capitalized.

Transportation Agreements

The transportation agreement assets are stated at acquisition date fair value and are being amortized over the periods of the agreements using the straight-line method. See Note 6 for additional information on our transportation agreements.

Goodwill and Long-Lived Assets

Goodwill represents the excess of our cost of an acquired business over the fair value of the assets acquired, less liabilities assumed. Goodwill is not amortized and is tested for impairment annually or more frequently if events or changes in circumstances indicate goodwill may be impaired.

We evaluate long-lived assets, including definite-lived intangible assets, for potential impairment by identifying whether indicators of impairment exist and, if so, assessing whether the long-lived assets are recoverable from estimated future undiscounted cash flows. The actual amount of impairment loss, if any, to be recorded is equal to the amount by which a long-lived asset’s carrying value exceeds its fair value.

There have been no impairments to goodwill or our long-lived assets as of December 31, 2011.

Investment in SLC Pipeline

We account for our 25% SLC Pipeline joint venture interest using the equity method of accounting, whereby we record our pro-rata share of earnings of the SLC Pipeline, and contributions to and distributions from the SLC Pipeline as adjustments to our investment balance. As of December 31, 2011, our underlying equity in the SLC Pipeline was $60.9 million compared to our recorded investment balance of $25.3 million, a difference of $35.6 million. We are amortizing this difference as an adjustment to our pro-rata share of earnings.

Asset Retirement Obligations

We record legal obligations associated with the retirement of our long-lived assets that result from the acquisition, construction, development and/or the normal operation of our long-lived assets. The fair value of the estimated cost to retire a tangible long-lived asset is recorded in the period in which the liability is incurred and when a reasonable estimate of the fair value of the liability can be made. At December 31, 2011 and 2010, we have retirement obligations of $0.7 million that are recorded under “Other long-term liabilities” in our consolidated balance sheets.

Revenue Recognition

Revenues are recognized as products are shipped through our pipelines and terminals or other services have been rendered. Billings to customers for obligations under their quarterly minimum revenue commitments are recorded as deferred revenue liabilities if the customer has the right to receive future services for these billings. The revenue is recognized at the earlier of:


•	the customer receives the future services provided by these billings,


•	the period in which the customer is contractually allowed to receive the services expires, or


•	we determine a high likelihood that we will not be required to provide services within the allowed period.

We determine that we will not be required to provide services within the allowed period when, based on current and projected shipping levels, our pipeline systems will not have the necessary capacity to enable a customer to exceed its minimum volume levels to such a degree as to utilize the shortfall credit within its respective contractual shortfall make-up period or the customer acknowledges that its anticipated shipment levels will not permit it to utilize such a shortfall credit within the respective contractual make-up period. To date, we have not recognized any shortfall billings as revenue prior to the expiration of the contractual term period.

We have additional pipeline transportation revenues under an operating lease to a third party of an interest in the capacity of one of our pipelines.

Taxes billed and collected from our pipeline and terminal customers are recorded on a net basis with no effect on net income.

Environmental Costs

Environmental costs are expensed if they relate to an existing condition caused by past operations and do not contribute to current or future revenue generation. Liabilities are recorded when site restoration and environmental remediation, cleanup and other obligations are either known or considered probable and can be reasonably estimated. Environmental costs recoverable through insurance, indemnification agreements or other sources are included in other assets to the extent such recoveries are considered probable. At December 31, 2011 and 2010, we had net accruals for environmental remediation obligations of $1 million and $0.3 million, respectively.

Income Tax

We are subject to the Texas margin tax that is based on our Texas sourced taxable margin. The tax is calculated by applying a tax rate to a base that considers both revenues and expenses and therefore has the characteristics of an income tax.

We are organized as a pass-through for federal income tax purposes. As a result, our partners are responsible for federal income taxes based on their respective share of taxable income.

Net income for financial statement purposes may differ significantly from taxable income reportable to unitholders as a result of differences between the tax bases and financial reporting bases of assets and liabilities and the taxable income allocation requirements under the partnership agreement.

Net Income per Limited Partners’ Unit

We use the two-class method when calculating the net income per unit applicable to limited partners, which is based on the weighted-average number of common and subordinated units outstanding during the year. Net income per unit applicable to limited partners (including subordinated unit holders) is computed by dividing limited partners’ interest in net income, after deducting the general partner’s 2% interest and incentive distributions, by the weighted-average number of outstanding common and subordinated units. We have not had any subordinated units outstanding since May 2010.

New Accounting Pronouncements

Presentation of Comprehensive Income

In June 2011, an accounting standard update was issued that requires the presentation of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements and eliminates the option to present the components of other comprehensive income in the statement of partners’ equity. This standard is effective January 1, 2012 and will be applied retrospectively upon implementation. This standard will not have an impact on our financial condition, results of operations and cash flows.

Intangibles — Goodwill and Other: Testing Goodwill for Impairment

In September 2011, an accounting standard update was issued that allows entities an option to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. This standard is effective for annual and interim goodwill impairment tests performed beginning January 1, 2012. This standard will not have an impact on our financial condition, results of operations and cash flows.