How To Determine the Fair Value of E&P Assets for Business Combinations vs. Asset Acquisitions
Determining whether an exploration and production (“E&P”) transaction is a business combination or asset acquisition isn’t a simple process. We’ve seen an increase in documentation requirements from regulators and auditors, as well as a continued emphasis on timeliness of deliverables. Due to these complexities, we find ourselves often helping clients determine whether a transaction should be accounted for as a business combination or asset acquisition in parallel with performing a purchase price allocation (“PPA”).
An E&P PPA is typically conducted after a transaction has been determined to be a business combination because, in an asset acquisition, substantially all of the purchase consideration is booked to the single (or similar) identifiable asset (i.e. proved or unproved reserves) and, as such, there are no other assets to allocate value to, including goodwill (or alternatively, a bargain purchase).
"Given the subjectivity in valuing E&P assets, the more robust the analysis performed, the better."
In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-01, which clarified the definition of a business. The framework provided guidance on determining whether transactions should be accounted for as business combinations or asset acquisitions. The FASB is currently in phase 3 (final phase) of the “definition of a business project”. In practice, we expect the FASB’s issuance of the framework will deem more transactions as asset acquisitions. Herein, we highlight key considerations for:
- Determining whether an E&P transaction should be accounted for as a business combination or asset acquisition;
- When a purchase price allocation is required; and
- The allocation of goodwill or bargain purchase in an asset acquisition.
Business Combination or Asset Acquisition?
In determining whether an E&P transaction should be accounted for as a business combination or asset acquisition under Accounting Standards Codification Topic 805 – Business Combinations (“ASC 805”) (as amended by ASU 2017-01), an entity first evaluates whether substantially all the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets (also referred to as the “screen”). If the screen is met (i.e., the transaction includes substantially proved reserves or substantially unproved reserves), the set of assets and activities isn’t considered to be a business. If the screen isn’t met (i.e. the transaction includes both proved and unproved reserves), the entity evaluates the “framework” to determine whether the set of assets meets the definition of a business.
The framework includes separate criteria for evaluating assets that have outputs (see ASC 805-10-55-5E) and assets that don’t have outputs (see ASC 805-10-55-5D); however, there is no specific guidance for determining which set of criteria to apply when a single transaction consists of assets both with and without outputs.
"Where possible, valuation assumptions should be supported by qualitative and/or quantitative documentation and multiple sources should be considered in determining fair values."
To be considered a business under the framework when the set has outputs (that is, there’s a continuation of revenue before and after the transaction), the set will have both an input and a substantive process that together significantly contribute to the ability to create outputs. Conversely, in order to be considered a business under the framework when the set doesn’t have outputs, it’s required that the set have an input or inputs that the organized workforce could develop (or is developing) or convert into future outputs. If the requirements aren’t met in order to be considered a business under the framework when the set has outputs or when the assets don’t have outputs, the transaction would be considered an asset acquisition.
When Is A Purchase Price Allocation Required?
When a transaction is determined to be a business combination under ASC 805, a PPA is required and the acquired assets and liabilities are stated at fair value.
For E&P transactions, this isn’t as easy as using the PV-10 from a reserve report. Determining the fair value of E&P assets is a complex process. Examples of other assets acquired in an E&P transaction may include, but is not limited to, unevaluated acreage, take-or-pay contracts (liability) and favorable or unfavorable contracts. Any excess consideration over the fair value of the subject assets represents goodwill (or bargain purchase, if there is a deficit). In our experience of performing PPAs for E&P transactions, often little to no residual remains unallocated to the subject assets. When an immaterial amount of residual remains, often it’s allocated to unproved properties or a pro rata allocation is applied to the identified assets. This determination is made by the acquiror’s management team.
When a transaction is determined to be an asset acquisition, the assets acquired are based on allocating the cost of the transaction on a relative fair value basis, and no goodwill (or bargain purchase) is recognized. Whether an asset acquisition or a business combination exists, an acquiror must determine the fair value of each asset to allocate the total consideration (see paragraph BC 19 of ASU 2017-01).
Allocation Of Goodwill Or Bargain Purchase For An Asset Acquisition
Goodwill (or a bargain purchase) isn’t recognized in an asset acquisition. Instead, any excess (or deficit) consideration is allocated based on ASC Topic 350: Intangibles – Goodwill and Other (“ASC 350”) relative fair value basis to the identifiable net assets, excluding non-qualifying assets (i.e. cash, deferred tax assets, other current assets, etc.).
As the FASB improves the accounting for business combinations and asset acquisitions, Opportune’s Valuation and Complex Financial Reporting practices continue to serve our clients with providing the fair value of E&P assets and documentation for determining whether a transaction should be accounted for as a business combination or asset acquisition. Given the subjectivity in valuing E&P assets, the more robust the analysis performed, the better. Where possible, valuation assumptions should be supported by qualitative and/or quantitative documentation and multiple sources should be considered in determining fair values.
About the Authors:
Lauren Clyburn is a Director in the Valuation practice of Opportune LLP and is based in Houston, Texas. Lauren has over 10 years of valuation experience and specializes in working with clients within the energy industry performing business valuations for financial reporting, tax, and litigation purposes. Prior to joining Opportune, Lauren worked as a Manager in the Valuation practice at KPMG in Houston and did a rotation in KPMG’s London, England office. She has a BBA degree in Finance from Texas A&M University
Michael Vanderhider is a Director in Opportune LLP’s Complex Financial Reporting practice based in Houston. Michael has nearly 10 years of accounting experience, including financial statement and internal control audits, SEC reporting and filings, GAAP compliance, IPO support and technical accounting. He is also skilled in the Sarbanes-Oxley Act. Prior to joining Opportune, Michael was Audit and Assurance Senior Manager for Deloitte & Touche LLP where he was responsible for the auditing of financial statements and internal controls over financial reporting and researched current accounting concepts for compliance with GAAP. Michael earned a BBA degree in Accounting and an MS degree in Finance at Texas A&M University. He is also a Certified Public Accountant licensed in the State of Texas.