The Current Pricing Environment Has Amplified Concerns Over Goodwill in E&P Transactions
The recent steep decline in oil prices has caused an uptick in goodwill being recorded in exploration and production acquisitions. Since the adoption of Accounting Standards Codification (ASC) 805, Business Combinations (formerly Statement of Financial Accounting Standards No. 141(R), which was effective for annual reporting periods starting on or after Dec. 15, 2008), the potential existence of goodwill in E&P transactions has been an on-going debate among oil and gas accountants. Six years later there is still significant diversity in practice by E&P companies in recording goodwill on their balance sheets.
In the recent pricing environment, some companies have recorded goodwill for the first time. In the fourth quarter of 2014, the amount of goodwill recorded on the balance sheets of public E&P companies increased approximately 10% to 15%.
In this article, we explore why more goodwill is being recorded in E&P transactions than in recent years as well as the potential problems that may arise if goodwill is not recorded in a transaction where it may exist.
The first step in understanding how goodwill can be present in an E&P transaction is familiarization of the relevant accounting rules. Current accounting standards require that most E&P transactions be accounted for as business combinations regardless of whether an entire company is acquired or certain properties are acquired. The ultimate determination as to whether a transaction is accounted for as a business combination or an asset acquisition is whether the properties acquired are predominately proven or unproven - no bright lines exist, and as such, the accounting determination should be made by company management and agreed to by the company's independent auditors.
ASC 805 is the relevant accounting standard for E&P transactions. Prior to the issuance of SFAS 141(R), which modified the definition of a business, most E&P transactions were treated as asset acquisitions, and the entire purchase price was spread across all assets acquired with the balance, positive or negative, pro-rata allocated to the assets.
If the determination is made that a transaction is a business combination, the assets acquired must be valued in accordance with ASC 820, Fair Value Measurements and Disclosures. ASC 820 requires that the fair value of the assets be an exit price based on market participant assumptions. As such, company-specific assumptions cannot be the basis for valuing the assets acquired.
Further, the accounting standards require the measurement/valuation date to be the closing date of the transaction, which is typically subsequent to the date of the letter of intent and the effective date of the transaction. Since deals are negotiated before the date of closing, and the agreed upon purchase price is not adjusted for changes in commodity prices between the dates of negotiation and closing, a difference in fair value can exist given the change in the market's outlook on pricing between the two dates.
What Does Goodwill in E&P Represent?
Goodwill arises when the purchase price of the acquired business exceeds the fair value of the acquired net assets. This residual amount can be considered overpaying for the business. However, goodwill in an E&P transaction can occur for a variety of reasons.
Goodwill typically results for three primary reasons:
- A buyer is willing to pay more for the assets because of synergies specific to their company or asset portfolio. Since the accounting guidance requires the assets to be valued using market participant assumptions, the buyer's specific circumstances do not factor into the fair value of the acquired assets.
- A premium may be paid in connection with the acquisition of an entire company. Typically this is due to the target company providing an ancillary benefit to the acquirer. One example of this is where a private company acquires a public company through a reverse merger to avoid the cost and time required to prepare for an Initial Public Offering.
- A significant drop in commodity prices between the negotiation date and the measurement date. Since the assets have to be valued as of the measurement date (closing date), the market's view of future commodity prices on that date drive the fair value of the properties recorded on the opening balance sheet. The market's view of future prices can change significantly in a short period of time as we have seen during the recession in 2008-2009 and 4Q14-1Q15. During these periods we not only saw a significant decline in the spot prices of commodities, but we also saw a significant decline in forward prices. Changes in forward prices significantly impact the fair value of the oil and gas properties acquired in a business combination.
What Happens to Goodwill?In the current commodity price environment, goodwill resulting from an E&P transaction may be impaired Day 1 since the cash flows from the acquired assets do not provide economic support the acquired goodwill. However, if the acquisition was booked into a reporting unit that has legacy E&P properties, the goodwill may not be impaired if the fair value of the legacy E&P properties exceeds their respective book value, and hence provide a cushion for the new properties acquired. This commonly happens if prior deals were done in a commodity price environment that is below the commodity price environment at the measurement date of the current deal, or the company has grown its reserves through the drill bit.
Goodwill is tested for impairment annually under ASC 350, Intangibles - Goodwill and Other. If a triggering event occurs, impairment is required to be assessed as of the date of the triggering event.
There were several goodwill impairments for E&P companies in the fourth quarter of 2014 as a result of the decline in commodity prices. Some companies whose annual testing date was before the decline retested their goodwill for impairment in the fourth quarter given the steep decline in commodity prices, which was considered to be a triggering event.
Downside to Not Booking Goodwill
Some companies do not book goodwill because they cannot articulate what it represents, and it is historically not common among E&P companies. However, booking any residual between the purchase price and the fair value of the assets acquired to properties instead of goodwill can create other issues as long-lived asset impairment may result.
For full cost companies, asset impairments would take the form of a full cost ceiling test write-down. Whereas successful efforts companies may experience an asset impairment under ASC 360, Impairment and Disposal of Long-Lived Assets. If asset impairment results for newly acquired properties, then it is a signal that the properties may have been overvalued on the measurement date (unless there have been significant changes in industry economic drivers between the initial measurement and impairment testing dates).
Companies should exercise caution letting the goodwill conclusion drive the valuation assumptions utilized in a purchase price allocation. Letting the goodwill conclusion drive the valuation assumptions can lead to undesirable results if multiple valuations (for example, multiple acquisitions, impairment testing and valuations for stock compensation) are required for financial reporting purposes within a relatively short amount of time. The company's independent auditors will expect consistency between valuations, and will require detailed support for significant deviations.
E&P acquisitions are unique compared to acquisitions in other industry sectors. The intent of E&P buyers is for the total consideration paid to equal the value of the assets acquired, and for no intangible assets to exist, including goodwill. The application of the accounting standards in the fair value process sometimes results in unexplained differences, which creates a dilemma for oil and gas accountants as to how best to account for it. While no perfect solution exists, it is important to understand the future accounting implications of the path chosen.