1/15/2015

Introduction

Goodwill and Impairments: What You

Need to Know
Brian A. Reed, CPA, ABV
Partner, Transaction Advisory Services

Brian Reed, CPA/ABV, CVA, has more than 14 years of financial

advisory experience ranging from acquisition due diligence to
valuation services. With extensive experience providing services
to the manufacturing, retail, distribution, software, oil and gas, and
professional services industries, Brians diverse knowledge and technical skills
allow him to provide comprehensive consulting services to his clients.
Brian is an active member of the National Association of Certified Valuators and
Analysts, in addition to several accounting professional organizations. He is a
frequent author of articles for professional and business publications, providing
valuable industry insights. Brian earned a bachelors degree from the University
of Texas at Austin and a masters degree from Tulane University.

Agenda

Objectives

Introduction
Objectives
Industry overview
Industry valuation metrics
Overview of impairment
guidance
Determining Fair Value
Lessons Learned

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

1/15/2015

Industry overview

Industry overview, cont.

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%

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 oilprice 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.

Oil-related shale up 6.4%

Gas related down 8.2%.
Source: Bloomberg

Source: Bloomberg

Industry overview, cont.

Industry overview, cont.

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.

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 OPECs 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&Ps peer group
underperformed the S&P 500 index in 2014 after crude
prices plunged.

Source: Bloomberg

Source: Bloomberg

1/15/2015

Industry overview, cont.

Industry overview, cont.

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.

Athlon, RSP Permian and Diamondback lead equity

performance among U.S. crude oil production peers
in 2014.
The years 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

Source: Bloomberg

Industry overview, cont.

Industry overview, cont.

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.

The European Central Banks 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

Source: Bloomberg

10

11

1/15/2015

WTI v US dollar

Industry overview, cont.

0.95

$145.00

0.90
$125.00

0.85
0.80

$105.00

0.75
$85.00

0.70
0.65

$65.00

0.60
$45.00
0.55
$25.00
1/2/2007

1/2/2008

1/2/2009

1/2/2010

1/2/2011

WTIFrontMonth(R1)

1/2/2012

1/2/2013

1/2/2014

0.50
1/2/2015

USDEURXRate(R2)

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

Source: Bloomberg

12

13

Industry overview, cont.

E&P Spending vs. OFS

$500,000

$120.00

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

$450,000
$100.00

$400,000
$350,000

$80.00

$300,000
$60.00

$250,000
$200,000

$40.00

$150,000
$100,000

$20.00

$50,000
$0.00

$0
2008

2009

2010

E&P Spending
Source: Bloomberg

2011

2012

OFS Revenue

2013

WTI Price
Source: Bloomberg

14

15

1/15/2015

U.S. OFS production

vs. Rig Count

2014 T12M Independent E&Ps CapEx

12,000

150.0%

14,000

2,500

12,000

10,000

100.0%

2,000
10,000

8,000
50.0%

1,500

8,000
6,000
0.0%

6,000

1,000

4,000
4,000
-50.0%

2,000

500
2,000

-100.0%
-

2004

CAPEX

Growth

2005

2006

2007

2008

U.S. Production

Source: Bloomberg

2009

2010

U.S. Rig Count

2011

2012

2013

Source: Bloomberg

16

17

EV/EBITDA vs. WTI

2015 & 2016 Expectations

1/1/2006 1/14/2015
$160.00

FY 2015 Estimated

Revenue growth

EBITDA growth

EPS growth

12.00x

$140.00
10.00x

North America Independent E&Ps

18.2%

45.6%

-146.6%

$120.00

1.9%

8.8%

8.5%

$100.00

8.00x

S&P Index

$80.00

6.00x

$60.00
4.00x

FY 2016 Estimated

Revenue growth

EBITDA growth

EPS growth

$40.00
2.00x

North America Independent E&Ps

9.6%

11.4%

-107.2%

S&P Index

5.1%

9.2%

12.6%

$20.00
$0.00
1/3/2006

1/3/2007

1/3/2008

1/3/2009

1/3/2010
WTI

Source: Bloomberg

1/3/2011

1/3/2012

1/3/2013

1/3/2014

0.00x
1/3/2015

EV/EBITDA
Source: Bloomberg

18

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Historical Oil & Gas Prices

Oil and Gas Services Transactions

Sale Date SIC

Business Description

Revenue

8/4/2014

1389 Excavation Earth Moving - Oil and Gas Support Services

8/4/2014

1389 Fabricates, Sells, Rents, and Services Natural Gas Compressors

4/7/2014

1389 Provide Portable liquid Storage Tank Container Rental

EV/Rev

$5,538,224

8/19/2013 1389 Manufactures and Sells Custom Liquid Storage and Containment Solutions
4/25/2013 1389 Saltwater Disposal Facility Serving Customers in the Barnett Shale Area
Engages in the Acquisition, Exploration, Development, and Production of Crude Oil,
8/1/2012
1311 Natural Gas, and Related Products

EV/EBITDA

$10.00

0.65x

2.07x

$9.00

$345,590,000

2.39x

8.88x

$8.00

$44,357,221

2.32x

5.06x

$7.00

$47,830,000

0.29x

n/a

$2,974,372

1.75x

5.64x

$137,748,000

2.18x

3.71x

$120.00

$100.00

$80.00

$6.00
$5.00

$60.00

$4.00
6/1/2012

1389 Operates Four Salt Water Injection Disposal Wells

The company performs water disposal services for customers in the Appalachian
2/17/2012 1389 Region of the United States

$8,004,000

3.92x

7.09x

$13,076,872

0.76x

n/a

$40.00

$3.00
$2.00

2/2/2012

1389 Gas Industry Site Development Company

6/29/2011 1311 Gas and Oil exploration

5/2/2011

Operates Energy Infrastructure Assets, Natural Gas Liquids and Refined Products
Storage, Pipelines, Gas Gathering and Processing Facilities, Coal Blending, and
1311 Transport Facilities

Median

$10,897,000

1.47x

5.10x

$8,750,000

2.96x

3.18x

$346,514,000

5.69x

14.77x

$13,076,872

2.18x

5.10x

$20.00

$1.00
$0.00

$0.00
2008

2009

2010

2011

2012

Henry Hub

2013

2014

2015

WTI

Source: Pratt Stats

Source: Bloomberg

20

21

Expected Oil and Gas Prices

2014 Decline in Average Oil & Gas Prices

$4.50

$120.00

$5.00

$80.00

$4.50

$4.00
$100.00
$3.50

$70.00

$4.00
$60.00

$3.00

$80.00

$3.50
$50.00

$3.00

$2.50
$60.00
$2.00
$40.00

$1.50

$40.00

$2.50
$2.00

$30.00

$1.50

$1.00
$20.00
$0.50

$10.00

$0.50

$0.00

$0.00

$20.00
$1.00

$0.00

$0.00
2015
Henry Hub

WTI

2016

2017

2018

2019
Henry Hub

Source: Bloomberg

2020

2021

2022

2023

WTI
Source: Bloomberg

22

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1/15/2015

Rig count and spending

2,500

Proper Reporting
$500,000
$450,000

2,000

$400,000
$350,000

1,500

$300,000
$250,000

1,000

$200,000
$150,000

500

$100,000
$50,000

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

$0
2004

2005

2006

2007

2008

2009

U.S. Rig Count

2010

2011

2012

E&P Spending ($ MM)

2013

2014

2015

Source: Bloomberg

Source: Deloitte. Oil & gas Spotlight

24

25

Successful-efforts method, cont.

SEM - (1) Timing of impairment testing

and impairment indicators

Guidance in ASC 932-360-351 and ASC 360-1035 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.

Source: Deloitte. Oil & gas Spotlight

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
groups 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.

Source: Deloitte. Oil & gas Spotlight

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1/15/2015

SEM - (1) Timing of impairment testing

and impairment indicators, cont.

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).

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.

Source: Deloitte. Oil & gas Spotlight

Source: FASB Codification

28

29

ASC 932-360-35-19 Sufficient

progress, cont.

SEM - (2) Measurement of Impairment

Loss

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

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 groups undiscounted cash flows with
the asset groups 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 groups fair value with its carrying amount.
An impairment loss would be recorded and measured as the amount
by which the asset groups carrying amount exceeds its fair value.
Source: Deloitte. Oil & gas Spotlight

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31

1/15/2015

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.

SEM - (4) Recognition of Impairment

Loss

Source: Deloitte. Oil & gas Spotlight

An impairment loss for a proved property asset group will reduce

only the carrying amounts of the groups 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 assets 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 writedowns.
Source: Deloitte. Oil & gas Spotlight

32

Full-cost method

33

Full-cost method, cont.

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.

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.

Source: Deloitte. Oil & gas Spotlight

Source: Deloitte. Oil & gas Spotlight

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35

1/15/2015

FCM - (1) Timing of impairment testing

and impairment indicators

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

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.

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.

Source: Deloitte. Oil & gas Spotlight

Source: Deloitte. Oil & gas Spotlight

36

FCM - (3) Level at Which Impairment

is Assessed

37

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.

Companies that apply the FCM generally

establish cost centers on a country-bycountry basis and assess impairment at the
cost-center level.

Source: Deloitte. Oil & gas Spotlight

Source: Deloitte. Oil & gas Spotlight

38

39

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1/15/2015

Impairment indicators for O&G

entity

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.

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: Deloitte. Oil & gas Spotlight

Source: Interpretation of Subtopic 360-10

40

Determining Fair Value

41

Determining FMV, cont.

To determine the fair value of

O&G assets, valuation
specialists primarily use the
income approach, the market
approach, and the asset
approach.

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

Source: Deloitte. Oil & gas Spotlight

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.
Source: Deloitte. Oil & gas Spotlight

42

43

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1/15/2015

Cash Flow Projections

Pricing and Price Differentials

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.

Source: Deloitte. Oil & gas Spotlight

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.

Source: Deloitte. Oil & gas Spotlight

44

Pricing and Price Differentials,

cont.

45

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.

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.
Source: Deloitte. Oil & gas Spotlight

Source: Deloitte. Oil & gas Spotlight

46

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1/15/2015

Risk Factors

Tax Effect

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)
2)

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.

Incorporate the risk factors in the discount rate, or

Apply the risk factors to discounted cash flows.

Source: Deloitte. Oil & gas Spotlight

Source: Deloitte. Oil & gas Spotlight

48

Appendix: Abbreviations

DCF
E&P
FCM
O&G
OFS
SEM
WACC

49

Disclaimer of Liability

Discounted cash flow

Exploration and production
Full-cost method
Oil and gas
Oilfield services
Successful-efforts method
Weighted Average Cost of Capital

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?

52

14