From 2009 through November 2014, energy companies experienced tremendous growth attributed to innovation and efficiency in drilling unconventional resources. Exploration and production (E&P) companies enhanced oil and gas extraction, leading to significant increases in returns for both E&P and oilfield services (OFS) companies, and became a catalyst for mergers and acquisitions. Companies reported significant increases in asset values, including goodwill and other indefinite-lived assets. A sample of 92 OFS companies with market capitalizations between $50 million and $8 billion as of October 2015 reported a 33 percent increase in goodwill balances from 2009 through late 2014 (approximately $42.3 billion in total).
As these indefinite-lived assets are not amortized, impairment testing is required to demonstrate that the fair value of recorded assets exceeds corresponding book values. Entities are required to perform an annual impairment test for these assets unless there is evidence of a “triggering event.” A triggering event would require the entity to perform an impairment test on that date. The following general economic factors should be taken into consideration when identifying potential triggering events:
- Decline of market capitalization
- Decreased revenue expectations
- Compression of profit margins
- Increased economic uncertainty (discount rate)
- Expiration and limited access to hedging counterparties
Commodity Price Decline And The Recovery Expectations
In late 2014, the Organization of the Petroleum Exporting Countries (OPEC) elected to maintain high levels of production, resulting in an industry-wide decline of U.S. crude oil production, prices and E&P capital expenditures. Commodity prices declined to levels last seen during the financial crisis in 2008 to 2009. Some analysts anticipated a slow recovery, citing fundamentals of oversupply. Despite the pessimism of this minority, the hopeful and prevalent view amongst industry participants and analysts was a V-shaped recovery period, similar to the recovery after the financial crisis. The price environment led some companies to impair their assets at the end of 2014. But given the contango in the crude oil forward curve (upward trending forward curve) and the V-shaped recovery expectations, the vast majority of companies did not view the price declines as having a long-term impact on their indefinite-lived asset values, which limited impairments in 2014.
Crude oil prices have stabilized around $50 per barrel for most of 2015 due to a decrease in demand and stable supply from more efficient extraction in the U.S. and continued production in the Middle East. The industry outlook has adjusted accordingly and the expected recovery unfortunately looks more like an “L,” as opposed to a “V.” Absent any specific evidence mitigating an impairment indication, we anticipate that previously reported fair values may still be overstated.
Current industry conditions have prompted a heightened awareness amongst auditors, investors and regulatory authorities. Based on our review of oilfield services and E&P companies, we have identified a significant number of companies that have addressed the lower commodity price environment, compressed profit margins and commodity price uncertainty by testing and, at times, realizing impairments of definite and indefinite-lived assets (particularly goodwill).
Given that a significant number of companies perform annual impairment testing in the 4th quarter, we anticipate that the quantity and magnitude of impairments realized by OFS and E&P companies will increase dramatically for the end of fiscal year 2015.
Trends In Recent Impairments
We reviewed financial data for 92 oilfield service companies with market capitalizations between $50 million and $8 billion. Of this sample, 21 companies booked approximately $8.6 billion of goodwill impairments through year-end 2014. 32 companies from the same sample reported approximately $11.1 billion of goodwill impairments from the end of 2014 through the end of October 2015.
Similarly, we reviewed financial data for 64 E&P companies with market capitalizations between $50 million and $3 billion as of October 2015. Of this sample, approximately $6.7 billion of long-lived asset impairments (15 companies) were realized by 2014 year-end. An additional 27 companies (42.2 percent) from the same sample reported approximately $14.5 billion of long-lived asset impairments from the end of 2014 through the end of October 2015.
The increased quantity and magnitude of reported impairments in 2015 is indicative of the consensus regarding the shape of the recovery. As we expected, many companies did not realize impairments at year-end 2014, as they were anticipating a quick recovery. We believe every company should have a thorough process to test for impairment as regulators, shareholders and external auditors are anticipating that fair values may be overstated.
Financial Reporting Risks
The integrity of financial reporting standards remains paramount to the Financial Accounting Standards Board (FASB). Timely and knowledgeable application of this guidance is recommended to maintain investor confidence and reduce regulatory risks. It is important to appreciate the risks associated with financial reporting.
For example, hedge fund manager David Einhorn placed a short position on The St. Joe Company, predominantly based on a review of the company’s prior impairment testing, consideration of the company’s financials and industry-related economic fundamentals. His findings supported his contention that the company overstated earnings and asset values. His trading activity ultimately led to a U.S. Securities and Exchange Commission (SEC) investigation of the company’s financial reporting procedures. The SEC identified significant deficiencies that inevitably resulted in the company paying approximately $3.7 million to investors and regulators.
Next Steps For Impairment Testing
Whether considering a triggering event or as part of an annual impairment review under ASC 350, an entity should first consider a “step zero” test of impairment. This entails a qualitative impairment assessment with the following requisite considerations:
- Review of current financial position (i.e., carrying amount of assets, profitability, etc.)
- Review of the most recent step 1 impairment conclusions and analyses performed, including:
- Identification and consideration of key economic factors that may impact previous step 1 valuation inputs (e.g., decrease in cash flow expectations)
In our experience, companies are required to document each factor influencing fair value measurement and impairment determinations. Providing sufficient support for each factor, while difficult, will promote auditor / regulator acceptance, and may relieve the need for a step 1 impairment test under ASC 350.
Failure to provide sufficient qualitative support in step zero results in the need to perform a step 1 analysis. The requirement is a quantitative measurement of impairment. The company must demonstrate that the fair value of the subject equity exceeds its book value. To the extent the book value of equity (adjusted as applicable under ASC 360) exceeds the fair value determination, then an indication of impairment still exists and implementation of step 2 under ASC 350 is required as a final determination of impairment. Under step 2, all “identifiable and separable” assets (except Workforce), existing as of the measurement date, require a fair value determination. An estimate of goodwill can then be derived based on the amount by which the company’s enterprise value exceeds the aggregate fair value of these assets. The FASB is deliberating simplifying these requirements. They are only in initial deliberations and any changes would not be approved and effective before this fiscal year end.
For long-lived assets under ASC 360, steps 1 and 2 are both quantitative tests. Impairment testing for long-lived assets is prompted by a triggering event or when step 1 testing of indefinite-lived assets results in an indication of impairment. Step 1 compares the assets or asset group’s undiscounted cash flows with its carrying value. If the carrying value exceeds the aggregate cash flows, then an indication of impairment exists. Step 2 is merely the fair value determination of the subject long-lived asset(s) and will become the new carrying value of the asset. This fair value determination is then utilized to determine a new (adjusted) carrying value prior to the implementation of impairment testing under ASC 350.
In our recent experience, many companies have already responded to the L-shaped recovery, or are currently evaluating their assets, both indefinite and long-lived, for impairment. In response to the industry-wide economic downturn, many service providers have been obliged to moderate costs in an effort to mutually endure these events. A&M Valuation Services is part of this collective and will provide a complimentary ASC 350 “step zero” impairment test and corresponding compliance assessment.
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