goodwill and impairments_what you need to know_0

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Goodwill and Impairments: What You Need to Know

Brian A. Reed, CPA, ABVPartner, Transaction Advisory Services

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Introduction

Brian Reed, CPA/ABV, CVA, has more than 14 years of financialadvisory experience ranging from acquisition due diligence tovaluation services. With extensive experience providing servicesto the manufacturing, retail, distribution, software, oil and gas, and

professional services industries, Brian’s diverse knowledge and technical skillsallow him to provide comprehensive consulting services to his clients.

Brian is an active member of the National Association of Certified Valuators andAnalysts, in addition to several accounting professional organizations. He is afrequent author of articles for professional and business publications, providingvaluable industry insights. Brian earned a bachelor’s degree from the Universityof Texas at Austin and a master’s degree from Tulane University.

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Agenda

• Introduction

• Objectives

• Industry overview

• Industry valuation metrics

• Overview of impairment guidance

• Determining Fair Value

• Lessons Learned

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Objectives

• Examine the trends and expectations in the oil and gas industry

• Examine the current valuation metrics in the oil and gas industry

• Examine procedures generally used in assessing goodwill and long-lived assets impairment

• Examine processes to follow with impairment of long-lived assets

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Industry overview

• Oilfield service (“OFS”) companies depend on exploration and production (“E&P”) companies’ spending for revenue generation

• Capital spending on exploration and development work grew at compounded annual growth rate of 15.3% from 2005 through 2013

• U.S. land rig count up more than 9.8% in 2014.

• U.S horizontal rig count increased by 19.5% in 2014.

• Total well counts are up 5.4%– Oil-related shale up 6.4%

– Gas related down 8.2%.

Source: Bloomberg

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Industry overview, cont.

• Onshore E&P drilling capital spending may decline modestly during the next few quarters as firms make cash preservation a priority in the current depressed oil-price environment.

• U.S. benchmark oil prices at less than $50 a barrel– Rig count declines may accelerate rapidly in the next several

months

• The U.S. oil rig count fell by 61 to 1,421 in the week ended January 9, 2015, according to Baker Hughes.

Source: Bloomberg

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• WTI prices averaged $92.91 a barrel in 2014

• WTI prices averaged $56.42 a barrel from 12/1/2014 through 1/13/2015

• Oil prices fell 57.4% from their 2014 peak of $107.26 to $45.7 reported on January 13, 2015.

• Henry Hub prices averaged $4.26 per million Btu in 2014

• Henry Hub prices averaged $3.35 per million Btu from 12/1/2014 through 1/13/2015

• Henry Hub natural gas prices have decline 13% in 2014 as output has exceeded seasonal weather demand.

Source: Bloomberg

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• U.S. oil and gas valuations have been negatively affected by the converging forces of deflation, increased oil output from developed nations, the strengthening of the U.S. dollar, and OPEC’s indecision.

• Multiples fell 11% in 3Q 2014

• Volatility will continue to influence equity direction with valuations at the low end of the historical range.

• The North American independent E&P’s peer group underperformed the S&P 500 index in 2014 after crude prices plunged.

Source: Bloomberg

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• Athlon, RSP Permian and Diamondback lead equity performance among U.S. crude oil production peers in 2014.

• The year’s worst performers include ones with greater oil exposure and smaller producers with insufficient geographic scale or higher costs.

• Gas E&P equities have fallen 42% in 2014.

Source: Bloomberg

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• Rice Energy, which went public in 2014, have kept pace with the broader market, given the scarcity of mid-cap companies exposed to Appalachia.

• While equity performance has been mostly positive in 1Q over the past five years, the returns for U.S. natural gas production equities may not improve in 1Q 2015 even with seasonal weather-induced gas demand.

• U.S. gas output will reach a new high in 2015 while demand during the withdrawal season is likely to restrain prices.

Source: Bloomberg

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• Federal Reserve monetary policy has been supportive of oil prices, and commodities in general, for several years.

• A slowing in domestic money supply growth, coupled with steady declines in the velocity of money, may be a significant challenge for higher oil prices and other dollar-based commodities.

Source: Bloomberg

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• The European Central Bank’s new stimulus plan may depress prices of U.S. dollar-dominated energy commodities. The additional euro liquidity may drive down the European benchmark currency as investors, seeking channels for the new liquidity outside of Europe, bid up the U.S. dollar and Asian currencies.

• WTI crude oil tends to be inversely correlated with the U.S. dollar, so any WTI price increase may be restrained.

Source: Bloomberg

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WTI v US dollar

Source: Bloomberg

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

0.90

0.95

$25.00

$45.00

$65.00

$85.00

$105.00

$125.00

$145.00

1/2/2007 1/2/2008 1/2/2009 1/2/2010 1/2/2011 1/2/2012 1/2/2013 1/2/2014 1/2/2015

WTI Front Month (R1) USDEUR X‐Rate (R2)

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• U.S. oil output will likely be more sustainable, even with revisions to WTI prices.

• Volume may average just above 9.4 million barrels in 2015, which would be a 10% increase from 2014 even though prices averaging $78, down about 18% based on EIA data.

• Operators will focus on drilling their highest rate of return inventory.

• Output may surpass expected levels due to an absent restrained credit availability or hedging to protect drilling programs.

Source: Bloomberg

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• U.S. oil-levered companies may not adjust spending plans should the recent WTI oil price decline continue

• Producers who report consistent volume and reserve growth tend to be rewarded by investors with more sustainable stock prices

• Break-even thresholds suggest crude oil prices will need to decline further before activity is re-evaluated

• Hedging programs buffer operator cash flow and may sustain drilling plans

Source: Bloomberg

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E&P Spending vs. OFS

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

$500,000

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

2008 2009 2010 2011 2012 2013

E&P Spending OFS Revenue WTI PriceSource: Bloomberg

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2014 T12M Independent E&Ps’ CapEx

Source: Bloomberg

-100.0%

-50.0%

0.0%

50.0%

100.0%

150.0%

-

2,000

4,000

6,000

8,000

10,000

12,000

CAPEX Growth

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U.S. OFS production vs. Rig Count

-

500

1,000

1,500

2,000

2,500

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

U.S. Production U.S. Rig CountSource: Bloomberg

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2015 & 2016 Expectations

Source: Bloomberg

FY 2015 Estimated Revenue growth EBITDA growth EPS growth

North America Independent E&Ps 18.2% 45.6% -146.6%

S&P Index 1.9% 8.8% 8.5%

FY 2016 Estimated Revenue growth EBITDA growth EPS growth

North America Independent E&Ps 9.6% 11.4% -107.2%

S&P Index 5.1% 9.2% 12.6%

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EV/EBITDA vs. WTI1/1/2006 – 1/14/2015

Source: Bloomberg

0.00x

2.00x

4.00x

6.00x

8.00x

10.00x

12.00x

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

$140.00

$160.00

1/3/2006 1/3/2007 1/3/2008 1/3/2009 1/3/2010 1/3/2011 1/3/2012 1/3/2013 1/3/2014 1/3/2015

WTI EV/EBITDA

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2020

Oil and Gas Services Transactions

Sale Date SIC Business Description Revenue EV/Rev EV/EBITDA

8/4/2014 1389 Excavation Earth Moving - Oil and Gas Support Services $5,538,224 0.65x 2.07x

8/4/2014 1389 Fabricates, Sells, Rents, and Services Natural Gas Compressors $345,590,000 2.39x 8.88x

4/7/2014 1389 Provide Portable liquid Storage Tank Container Rental $44,357,221 2.32x 5.06x

8/19/2013 1389 Manufactures and Sells Custom Liquid Storage and Containment Solutions $47,830,000 0.29x n/a

4/25/2013 1389 Saltwater Disposal Facility Serving Customers in the Barnett Shale Area $2,974,372 1.75x 5.64x

8/1/2012 1311Engages in the Acquisition, Exploration, Development, and Production of Crude Oil, Natural Gas, and Related Products $137,748,000 2.18x 3.71x

6/1/2012 1389 Operates Four Salt Water Injection Disposal Wells $8,004,000 3.92x 7.09x

2/17/2012 1389The company performs water disposal services for customers in the Appalachian Region of the United States $13,076,872 0.76x n/a

2/2/2012 1389 Gas Industry Site Development Company $10,897,000 1.47x 5.10x

6/29/2011 1311 Gas and Oil exploration $8,750,000 2.96x 3.18x

5/2/2011 1311

Operates Energy Infrastructure Assets, Natural Gas Liquids and Refined Products Storage, Pipelines, Gas Gathering and Processing Facilities, Coal Blending, and Transport Facilities $346,514,000 5.69x 14.77x

Median $13,076,872 2.18x 5.10x

Source: Pratt Stats

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Historical Oil & Gas Prices

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

$0.00

$1.00

$2.00

$3.00

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$5.00

$6.00

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$8.00

$9.00

$10.00

2008 2009 2010 2011 2012 2013 2014 2015

Henry Hub WTISource: Bloomberg

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2014 Decline in Average Oil & Gas Prices

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$20.00

$40.00

$60.00

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$120.00

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$3.00

$3.50

$4.00

$4.50


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Expected Oil and Gas Prices

$0.00

$10.00

$20.00

$30.00

$40.00

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$60.00

$70.00

$80.00

$0.00

$0.50

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$2.50

$3.00

$3.50

$4.00

$4.50

$5.00

2015 2016 2017 2018 2019 2020 2021 2022 2023


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Rig count and spending

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

$500,000

-

500

1,000

1,500

2,000

2,500

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

U.S. Rig Count E&P Spending ($ MM)Source: Bloomberg

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Proper Reporting

• There are different factors that an E&P company should consider in assessing and accounting for impairment of its O&G assets under either the successful efforts method (“SEM”) or the full-cost method (“FCM”).

• E&P companies that use the SEM to account for impairment of their O&G assets should apply the guidance in ASC 932-360-351 and ASC 360-10-35.

• E&P companies that use the FCM of accounting should apply the guidance in Regulation S-X, Rule 4-10;2 SAB Topic 12.D;3 and FRC Section 406.01.c.4

Source: Deloitte. Oil & gas Spotlight

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Successful-efforts method, cont.

• Guidance in ASC 932-360-351 and ASC 360-10-35 addresses

– (1) the timing of impairment testing and impairment indicators,

– (2) measurement of an impairment loss,

– (3) the level at which an impairment is assessed,

– (4) recognition of an impairment loss.


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SEM - (1) Timing of impairment testing and impairment indicators

• An E&P company generally performs a traditional two-step impairment analysis in accordance with ASC 360 when considering whether to assess proved O&G properties for indications of impairment.

• Proved properties in an asset group should be tested for recoverability whenever events or changes in circumstances indicate that the asset group’s carrying amount may not be recoverable.

• Generally, companies that apply the SEM will perform an annual impairment assessment upon receiving their annual reserve report by preparing a cash flow analysis.

• When performing an impairment analysis, such companies typically do not apply a risk factor to the proved reserves.

• Companies can consider proved reserves and other resources since these are all included in the value of the assets.


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SEM - (1) Timing of impairment testing and impairment indicators, cont.

• E&P companies should assess unproved properties periodically (i.e., at least annually) to determine whether they have been impaired.

• The assessment of these properties is based mostly on qualitative factors. – Exploratory wells are presumed to be impaired if the “sufficient

progress” criteria as defined in ASC 932-360-35 are not met

– Or if information exist that raises substantial doubt about the economic or operational viability of the project.


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ASC 932-360-35-19 – Sufficient progress

“All relevant facts and circumstances shall be evaluated when determining whether an entity is making sufficient progress on assessing the reserves and the economic and operating viability of the project. The following are some indicators, among others, that an entity is making sufficient progress (see the following paragraph). No single indicator is determinative. An entity shall evaluate indicators in conjunction with all other relevant facts and circumstances. These indicators include:

a) Commitment of project personnel who are at the appropriate levels and who have the appropriate skills,

b) Costs that are being incurred to assess the reserves and their potential development,

c) An assessment process covering the economic, legal, political, and environmental aspects of the potential development is in progress,

d) Existence (or active negotiations) of sales contracts with customers for the oil and gas,

e) Existence (or active negotiations) of agreements with governments, lenders, and venture partners,

f) Outstanding requests for proposals for development of any required facilities,

g) Existence of firm plans, established timetables, or contractual commitments, which may include seismic testing and drilling of additional exploratory wells,

h) Progress that is being made on contractual arrangements that will permit future development, and

i) Identification of existing transportation and other infrastructure that is or will be available for the project (subject to negotiations for use).”

Source: FASB Codification

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ASC 932-360-35-19 – Sufficient progress, cont.

“Long delays in the assessment or development plan (whether anticipated or unexpected) may raise doubts about whether the entity is making sufficient progress to continue the capitalization of exploratory well or exploratory-type stratigraphic well costs after the completion of drilling. The longer the assessment process for the reserves and the project, the more difficult it is to conclude that the entity is making sufficient progress to continue the capitalization of those exploratory well or exploratory-type stratigraphic well costs.”

Source: FASB Codification

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SEM - (2) Measurement of Impairment Loss

• A company that applies the SEM will test an asset group for impairment by using the two-step process detailed in ASC 360.

• Under step 1, the company will perform a cash flow recoverability test by comparing the asset group’s undiscounted cash flows with the asset group’s carrying value.

• The carrying amount of the asset group is not recoverable if it exceeds the sum of the undiscounted cash flows that are expected to result from the use and eventual disposition of the asset group.

• If the asset group fails the cash flow recoverability test, the company will perform a fair value assessment under “Step 2” to compare the asset group’s fair value with its carrying amount.

• An impairment loss would be recorded and measured as the amount by which the asset group’s carrying amount exceeds its fair value.


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SEM - (3) Level at Which Impairment is Assessed

• When determining the level at which an impairment should be assessed, a company that applies the SEM should consider whether the property is proved or unproved.

• Proved properties must be grouped at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets.

• Typically, the impairment evaluation of O&G-producing properties is performed on a field-by-field basis or, if there is a significant shared infrastructure (e.g., platform), by logical grouping of assets.

• Unproved properties should be assessed on a property-by property basis or, if acquisition costs are not significant, by an appropriate grouping.


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SEM - (4) Recognition of Impairment Loss

• An impairment loss for a proved property asset group will reduce only the carrying amounts of the group’s long-lived assets.

• The loss should be allocated to the long-lived assets of the group on a pro rata basis by using the relative carrying amounts of those assets; however, the loss allocated to an individual long-lived asset of the group should not reduce the asset’s carrying amount to less than its fair value if that fair value is determinable without undue cost and effort.

• For unproved properties, if the results of the assessment indicate impairment, a loss should be recognized by providing a valuation allowance.

• Under the SEM, companies are prohibited from reversing write-downs.


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Full-cost method

• Companies that apply the FCM are required to perform a full-cost ceiling test on proved properties each reporting period.

• Unproved properties must be assessed at least annually for inclusion in the full-cost pool, subject to amortization.

• To assess whether their O&G assets are impaired, E&P companies that use the FCM of accounting should apply the guidance in Regulation S-X, Rule 4-10; SAB Topic 12.D; and FRC Section 406.01.c.


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Full-cost method, cont.

• Like successful-efforts accounting guidance, this guidance addresses

– (1) the timing of impairment testing and impairment indicators,

– (2) measurement of an impairment loss,

– (3) the level at which an impairment is assessed, and

– (4) recognition of an impairment loss.


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FCM - (1) Timing of impairment testing and impairment indicators

• Under the FCM, a full-cost ceiling test must be performed on proved properties each reporting period.

• Further, unproved properties must be assessed periodically (at least annually) for inclusion in the full-cost pool, subject to amortization.


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FCM - (2) Measurement of Impairment Loss

• The full-cost accounting approach requires a write-down of the full-cost asset pool when net unamortized cost less related deferred income taxes exceeds 1) The discounted cash flows from proved properties (i.e., estimated

future net revenues less estimated future expenditures to develop and produce proved reserves),

2) the cost of unproved properties not included in the costs being amortized, and

3) the cost of unproved properties included in the costs being amortized. The write-down would be reduced by the income tax effects related to the difference between the book basis and the tax basis of the properties involved. For purposes of this calculation, the tax effects cannot result in a net tax benefit.


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FCM - (3) Level at Which Impairment is Assessed

Companies that apply the FCM generally establish cost centers on a country-by-country basis and assess impairment at the cost-center level.


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FCM - (4) Recognition of Impairment Loss

• When recognizing an impairment loss, companies that apply the FCM should reduce the carrying value of the full-cost asset pool and record the excess above the ceiling as a charge to expense in continuing operations.

• Like the SEM, the FCM precludes companies from reversing write-downs.


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Differences in Methods

• The fundamental difference between these two methods lies in their treatment of expenses related to the exploration of new O&G reserves.

• The accounting method used will directly affect how net income and cash flows are reported.


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Impairment indicators for O&G entity

• Events or changes in circumstances that would indicate a need to assess the recoverability of the carrying amount of O&G assets– If there has been a significant decrease in O&G prices, and

commodities usually use forward prices in the forward contract marketplace

– The presence of drilling of a development dry hole or significant downward reserve revisions, which may indicate there has been a decrease in market value

– If property-level operating statements demonstrate current-period operating losses combined with operating losses over a period of several months

• Operating losses = Revenues – production costs – lease operating expenses – and depreciation, depletion, and amortization

Source: Interpretation of Subtopic 360-10

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Determining Fair Value

To determine the fair value of O&G assets, valuation specialists primarily use the income approach, the market approach, and the asset approach.


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Determining FMV, cont.

• When using the income approach, E&P companies generally apply a discounted cash flow (“DCF”) model that is based on assumptions such as those related to

– cash flow projections,

– pricing and price differentials,

– discount rate,

– risk factors, and

– the tax effect.

• Under both the income approach and the market approach, E&P companies need to consider the market participant concept when determining the fair value of their O&G assets.


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Cash Flow Projections

• E&P companies need to determine the cash flow projections that will be incorporated in their DCF model.

• Generally, these projections are based on a production profile that is developed by a third-party engineering firm or prepared internally by company engineers.


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Pricing and Price Differentials

• Generally, E&P companies use forward strip pricing as determined by the NYMEX or other pricing benchmarks (e.g., Brent, WTI) in their DCF model.

• Forward strip pricing over a period of up to five years is useful for valuation purposes since there is active futures trading activity within that time horizon.

• Beyond year 5, a company should estimate prices by using more subjective judgments that typically involve applying an inflation factor to the year-5 NYMEX futures price.

• Pricing benchmarks can vary greatly depending on location.

• Commodity price differentials are another key metric that could affect the assumptions used in the DCF model.


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Pricing and Price Differentials, cont.

• Oil prices can vary as a result of multiple factors, including – (1) oil quality,

– (2) transportation costs, and

– (3) proximity to market.

• Similarly, natural gas prices can vary widely by delivery point since transportation is a large component of cost.


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Discount Rate

• E&P companies should consider various factors when determining the discount rate to use in their valuation models.

• One consideration is the basis for the discount rate (e.g., whether to use a weighted average cost of capital (“WACC”) rate or rates detailed in the SPEE annual survey).

• Also, companies need to consider whether to use an after-tax discount rate or after-tax undiscounted cash flows in their fair value calculations.


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Risk Factors

• Since unproved reserves are inherently more uncertain than proved reserves, risk factors related to unproved reserves are much more significant than those related to proved reserves.

• When E&P companies perform an impairment analysis under the SEM, they typically use a zero percent risk factor for proved properties.

• When these companies perform purchase accounting, however, they apply a variety of risk factors to different categories of proved reserves.

• This seeming inconsistency in practice could prompt auditors and regulators to raise questions about how the risk factors are being applied.

• Further, when E&P companies perform a valuation of O&G assets, they either

1) Incorporate the risk factors in the discount rate, or

2) Apply the risk factors to discounted cash flows.


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Tax Effect

• E&P companies should also consider whether to incorporate assumptions about the tax effect in the DCF models.

• This consideration is critical since results may vary depending on whether pretax or post-tax amounts are used.

• Generally, pretax models are more commonly used in the valuation of O&G assets outside the United States.


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Appendix: Abbreviations• DCF

• E&P

• FCM

• O&G

• OFS

• SEM

• WACC

• Discounted cash flow

• Exploration and production

• Full-cost method

• Oil and gas

• Oilfield services

• Successful-efforts method

• Weighted Average Cost of Capital

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Disclaimer of Liability

Weaver provides the information in this presentation for general guidance only, and it does not constitute the provision of legal, tax, financial accounting or investment advice, or professional consulting of any kind. The information included herein should not be used as a substitute for consultation with professional tax, financial accounting, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax information is not intended to be used and cannot be used by any taxpayer for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is" with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.

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QUESTIONS?

goodwill and impairments_what you need to know_0

Documents

benchmark oil prices

oil rig count

gas industry

increased oil output

wti prices

oilrelated shale

henry hub prices

gas valuations