Lucas M. Parris

Executive SummaryPreliminary results for 2023 show that the number of goodwill impairments is increasing for both large and middle-market public companies. Based on data through November, the number of impairments recorded by firms on the S&P 500 and Russell 2000 indices had already eclipsed 2021 and 2022 full-year figures. Interestingly, these trends materialized even as the indices themselves posted favorable total returns for the year of 25% and 14%, respectively. Public and private companies currently in the process of performing their annual/interim impairment tests should be on the alert if their peer group turns out to be the one recording impairment charges.Back in 2020, the stock market downturn stemming from pandemic shutdowns resulted in triggering events and impairment charges for many companies.This was especially evident among smaller publicly-traded companies (as tracked by the Russell 2000 versus the S&P 500).The number of charges dropped drastically in 2021 (even compared to 2019 results), suggesting that some of the 2020 impairment charges may have reflected a pull-forward of later charges.Since that time, the number and percentage of companies recording charges has steadily increased, with preliminary figures for 2023 already exceeding the numbers recorded in 2022.Total Goodwill Impairment Charges and % of companies with GW that recorded chargesThis trend held across sectors as well.In the Russell 2000, eight of eleven sectors reported an increase in number of charges to goodwill between 2019 and 2020.Charges in the consumer staples sector declined among S&P 500 companies, while increasing for Russell 2000 companies.Charges in the utilities sector declined for S&P 500 companies but remained stable for Russell 2000 companies.For both groups of companies, charges taken by the materials sector declined.Following 2020, impairment charges dropped below 2019 levels – sharply, in the case of many sectors over 2021 through 2022.More recently, the number of charges and the magnitude of total goodwill charges for the first eleven months of 2023 had already exceeded the full year of 2022.Additional impairments may be on the way as companies complete and file their year-end financials. Based on the preliminary figures for the Russell 2000, the sectors recording the most charges appear to be healthcare and industrials.Despite the increase in impairment charges taken in 2020, the number of small-cap companies reporting year-end goodwill balances increased in 2020 and continued to increase through 2022 and 2023.Approximately 60% of Russell 2000 companies carried goodwill in 2019, while over 63% did so in 2023.The percentage of S&P 500 companies reporting goodwill declined from 89% in 2019 to 86% in 2023.Percent of Companies Reporting GoodwillIt is impossible to attribute the rise in impairment charges to a single specific factor. However, it is likely that rising interest rates and higher inflation played a significant role in 2023 results. Impairment charges also tend to have a larger impact on smaller companies.Generally speaking, smaller companies tend to be less diversified in terms of product or service offerings, and their client bases may be more sensitive to external economic factors.Ultimately, the preliminary data for 2023 shows that impairments do not necessarily taper off when overall equity markets are rising. Company-specific factors, including financial performance relative to history, expectations, and peer performance, are critical when evaluating goodwill for potential impairment. Will the impairment trends seen in the large and middle-market public markets extend to private companies? Perhaps.The valuation specialists at Mercer Capital have experience in implementing both the qualitative and quantitative aspects of goodwill impairment testing under ASC 350. If you have questions, please contact a member of Mercer Capital’s Financial Statement Reporting Group.

Many business owners tend to rely on industry rules of thumb when estimating what their company is worth. Aren’t insurance agencies worth 2.0x revenue? Or is it 7x EBITDA? A platform agency must be at least 10x EBITDA, right? A lack of knowledge regarding the value of your business could be costly, leading to missed opportunities or inadequate wealth planning.On a practical level, understanding how insurance agencies and brokerages are actually valued may help you understand how to increase the value of your business and maximize your return when it comes time to sell or perpetuate your agency.The purpose of this whitepaper is to provide an informative overview regarding the valuation of insurance brokerages and agencies.

The economic impact from the COVID-19 pandemic has been swift and unexpected. Just a few short weeks ago, the S&P 500 was at an all-time high and goodwill impairments were not a serious concern for most companies. However, between mid-February and the end of March, the S&P 500 declined by 25%. The Russell 2000 fell nearly 32% over the same period, and the negative shock to certain companies and sectors has been much worse.Most financial professionals understand that goodwill impairment testing is typically performed annually, usually near the end of a Company’s fiscal year. In fact, many companies just completed an impairment test as of year-end 2019. But the unprecedented events precipitated by the COVID-19 pandemic now raise questions about whether an interim goodwill impairment test is warranted.Do I Need an Impairment Test?The accounting guidance in ASC 350 prescribes that interim goodwill impairment tests may be necessary in the case of certain “triggering” events. For public companies, perhaps the most easily observable triggering event is a decline in stock price, but other factors may constitute a triggering event. Further, these factors apply to both public and private companies, even those private companies that have previously elected to amortize goodwill under ASU 2017-04.For interim goodwill impairment tests, ASC 350 notes that entities should assess relevant events and circumstances that might make it more likely than not that an impairment condition exists. The guidance provides several examples, including the following:Changes in the macroeconomic environment, such as a deterioration in general economic conditionsLimitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit marketsIndustry and market considerations such as a deterioration in the environment in which an entity operates or an increased competitive environmentDeclines in market-dependent multiples or metrics (consider in both absolute terms and relative to peers)Changes in the market for an entity’s products or services, or a regulatory or political developmentCost factor considerations such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flowsOverall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periodsEntity-specific events (changes in management or key customers, contemplation of bankruptcy, adverse litigation or regulatory events)Changes in the carrying amount of assets at the reporting unit including the expectation of selling or disposing certain assetsIf applicable, a sustained decrease in share price (considered both in absolute terms and relative to peers) The examples above are not all-inclusive and entities should consider other relevant events and circumstances that might affect the fair value or carrying amount of a reporting unit. An entity should place more weight on the events and circumstances that most affect a reporting unit’s fair value or the carrying amount of its net assets. The guidance notes that an entity should also consider positive and mitigating events and circumstances that may affect its conclusion. If a recent impairment test has been performed, the headroom between the recent fair value measurement and carrying amount could also be a factor to consider.How an Impairment Test WorksOnce an entity determines that an interim impairment test is appropriate, a quantitative “Step 1” impairment test is required. Under Step 1, the entity must measure the fair value of the relevant reporting units (or the entire company if the business is defined as a single reporting unit). The fair value of a reporting unit refers to “the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.”For companies that have already adopted ASU 2017-04, the legacy “Step 2” analysis has been eliminated, and the impairment charge is calculated as simply the difference between fair value and carrying amount. Under the old framework, an additional “Step 2” analysis was performed and the impairment charge was based on the amount by which carrying amount exceeded the implied value of goodwill.ASC 820 provides a framework for measuring fair value which recognizes the three traditional valuation approaches: the income approach, the market approach, and the cost approach. As with most valuation assignments, judgment is required to determine which approach or approaches are most appropriate given the facts and circumstances. In our experience, the income and market approaches are most commonly used in goodwill impairment testing. In the current environment, we offer the following thoughts on some areas that are likely to draw additional scrutiny from auditors and regulators.Are the financial projections used in a discounted cash flow analysis reflective of recent market conditions? What are the model’s sensitivities to changes in key inputs?Given developments in the market, do measures of risk (discount rates) need to be updated?If market multiples from comparable companies are used to support the valuation, are those multiples still applicable and meaningful in the current environment?If precedent M&A transactions are used to support the valuation, are those multiples still relevant in the current environment?If the subject company is public, how does its current market capitalization compare to the indicated fair value of the entity (or sum of the reporting units)? What is the implied control premium and is it reasonable in light of current market conditions? At a minimum, we anticipate that additional analyses and support will be necessary to address these questions. The documentation from an impairment test at December 31, 2019 might provide a starting point, but the reality is that the economic landscape has changed significantly in the last three months.Concluding ThoughtsNot all industries have been impacted in the same way and there will certainly be differences between companies. For public companies, it can be difficult to ignore the significant drop in stock prices and the implications that this might have on fair value. For private businesses, even if a triggering event has not arisen yet, the deteriorating economic environment may just push the triggering factors into the second or third quarter of the year.At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim goodwill impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Financial Statement Reporting Group.

A new year brings new opportunities and challenges in the world of fair value accounting. The Wall Street Journal’s recent coverage of the potential changes coming to goodwill impairment testing and the increased scrutiny around private equity portfolio company valuations signals that fair value issues continue to be top of mind for investors, companies, and regulators. Here are four key areas worth watching in 2020.Goodwill Impairment TestingThe FASB convened a roundtable in late 2019 to hear comments from registrants, investors, and the practitioner community about whether to continue the current system of annual goodwill impairment tests or shift to an amortization model over a set period of time. The responses have been mixed thus far, with some advocating instead for a trigger-based approach, perhaps over an initial period of time following an acquisition. The FASB has indicated that it will continue to discuss the comments during 2020 and no timeline for any changes has been set.Read our latest thoughts on technical issues surrounding goodwill impairment testing. >>Click HerePortfolio ValuationThe AICPA issued final guidance in 2019 for the valuation of portfolio company investments held by venture capital and private equity funds and other investment companies. The new accounting and valuation guidance lays out best practices for preparers, independent auditors, and valuation specialists, and we anticipate that firms and their stakeholders will increasingly expect that their fair value measurements will be done in compliance with the guide.Read more about some of the new concepts. >>Click HereSign up for our portfolio valuation newsletter. >>Click HereBusiness CombinationsAnother robust year for M&A transactions in 2019 meant an increased need for purchase price allocations and contingent consideration valuations. What may have been overlooked is that The Appraisal Foundation has now issued final guidance on the valuation of contingent consideration (earn-outs). One message from the new guidance: scenario-based methods are now being discouraged in favor of more complex, alternative approaches.Equity-Based CompensationThe increased scrutiny on PE/VC portfolio company investments inevitably spills over into the realm of valuing private company shares for equity-based compensation purposes. Indeed, the AICPA is in the process of drafting an update to its 2013 accounting and valuation guide on the topic. Another trend we’ve noticed is the increasing prevalence of equity grants with market condition vesting (such as performance of the issuer’s stock relative to a benchmark index) and issuances of incentive units / profit interests. These frequently require specialized fair value measurements.Mercer Capital provides a full range of fair value measurement services and opinions that satisfy the scrutiny of auditors, the SEC, and other regulatory bodies. We have broad experience with fair value issues related to public and private companies, financial institutions, private equity firms, start-ups, and other closely held businesses. We also offer corporate finance consulting, financial due diligence, and quality of earnings analyses. National audit firms regularly refer financial reporting valuation assignments to Mercer Capital.

This guest post first appeared on Mercer Capital’s Financial Reporting Blog on January 18, 2016.  When performing a purchase price allocation for an Exploration and Production (E&P) company, careful attention must be paid to both the accounting rules and the specialty nuances of the oil and gas industry. E&P companies are unique entities compared to traditional businesses such as manufacturing, wholesale, services or retail. As unique entities, the accounting rules have both universal rules to adhere as well as industry specific. Our senior professionals bring significant experience in performing purchase price allocations in the E&P area where these two principles collide. For the most part, current assets, current liabilities are straight forward. The unique factors of an E&P are found in the fixed assets and intangibles: producing, probable and possible reserves, raw acreage rights, gathering systems, drill rigs, pipe, working interests, royalty interests, contracts, hedges, etc. Different accounting methods like the full cost method or the successful efforts method can create comparability issues between two E&P’s that utilize opposite methods. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards.Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh-hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General RulesWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).Assignment DefinitionA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:Objective. The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.Purpose. The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Company OverviewDiscussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.Intangible AssetsThe intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Historical Financial PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Fair Value DeterminationThe report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.The report should outline the three approaches to valuation, regardless of the approaches selected for use in the valuation.Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Something to RememberA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.

Equity-based compensation has been a key part of compensation plans for years.  When the equity compensation involves a publicly traded company, the current value of the stock is known and so the valuation of share-based payments is relatively straightforward.  However, for private companies, the valuation of the enterprise and associated share-based compensation can be quite complex.The AICPA Accounting & Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, describes four criteria that should be considered when selecting a method for valuing equity securities:Going Concern.  The method should align with the going-concern status of the company, including expectations about future events and the timing of cash flows.  For example, if acquisition of the company is imminent, then expectations regarding the future of the enterprise as a going concern are not particularly relevant.Common Share Value.  The method should assign some value to the common shares, unless the company is in liquidation with no expected distributions to common shareholders.Independent Replication.  It is important that the results of the method used by a valuation specialist can be independently replicated or approximated using the same underlying data and assumptions.  When completing the valuation, proprietary practices and models should not be the primary method of determining value.Complexity and Stage of Development.  The complexity of the method selected should be appropriate to the company’s stage of development. In other words, a simpler valuation method (like an OPM) with fewer underlying assumptions may be more appropriate for an early-stage entity with few employees than a highly complex method (like a PWERM). With these considerations in mind, let’s take a closer look at the four most common methods used to value private company equity securities.Current Value Method (CVM)The Current Value Method estimates the total equity value of the company on a controlling basis (assuming an immediate sale) and subtracts the value of the preferred classes based on their liquidation preferences or conversion values.  The residual is then allocated to common shareholders. Because the CVM is concerned only with the value of the company on the valuation date, assumptions about future exit events and their timing are not needed. The advantage of this method is that it is easy to implement and does not require a significant number of assumptions or complex modeling.However, because the CVM is not forward looking and does not consider the option-like payoffs of the share classes, its use is generally limited to two circumstances. First, the CVM could be employed when a liquidity event is imminent (such as a dissolution or an acquisition). The second situation might be when an early-stage company has made no material progress on its business plan, has had no significant common equity value created above the liquidation preference of the preferred shares, and for which no reasonable basis exists to estimate the amount or timing of when such value might be created in the future.Generally speaking, once a company has raised an arm’s-length financing round (such as venture capital financing), the CVM is no longer an appropriate method.Probability-Weighted Expected Return Method (PWERM)The Probability-Weighted Expected Return Method is a multi-step process in which value is estimated based on the probability-weighted present value of various future outcomes.  First, the valuation specialist works with management to determine the range of potential future outcomes for the company, such as IPO, sale, dissolution, or continued operation until a later exit date.  Next, future equity value under each scenario is estimated and allocated to each share class.  Each outcome and its related share values are then weighted based on the probability of the outcome occurring.  The value for each share class is discounted back to the valuation date using an appropriate discount rate and divided by the number of shares outstanding in the respective class.The primary benefit of the PWERM is its ability to directly consider the various terms of shareholder agreements, rights of each class, and the timing when those rights will be exercised. The method allows the valuation specialist to make specific assumptions about the range, timing, and outcomes from specific future events, such as higher or lower values for a strategic sale versus an IPO.  The PWERM is most appropriate to use when the period of time between the valuation date and a potential liquidity event is expected to be short.Of course, the PWERM also has limitations.  PWERM models can be difficult to implement because they require detailed assumptions about future exit events and cash flows.  Such assumptions may be difficult to support objectively. Further, because it considers only a specific set of outcomes (rather than a full distribution of possible outcomes), the PWERM may not be appropriate for valuing option-like payoffs like profit interests or warrants. In certain cases, analysts may also need to consider interim cash flows or the impact of future rounds of financing.Option Pricing Model (OPM)The Option Pricing Model treats each class of shares as call options on the total equity value of the company, with exercise prices based on the liquidation preferences of the preferred stock. Under this method, common shares would have material value only to the extent that residual equity value remains after satisfaction of the preferred stock’s liquidation preference at the time of a liquidity event. The OPM typically uses the Black-Scholes Option Pricing Model to price the various call options.In contrast to the PWERM, the OPM begins with the current total equity value of the company and estimates the future distribution of outcomes using a lognormal distribution around that current value. This means that two of the critical inputs to the OPM are the current value of the firm and a volatility assumption. Current value of the firm might be estimated with a discounted cash flow method or market methods (for later-stage firms) or inferred from a recent financing transaction using the backsolve method (for early-stage firms). The volatility assumption is usually based upon the observed volatilities of comparable public companies, with potential adjustment for the subject entity’s financial leverage.The OPM is most appropriate for situations in which specific future liquidity events are difficult to forecast.  It can accommodate various terms of stockholder agreements that affect the distributions to each class of equity upon a liquidity event, such as conversion ratios, cash allocations, and dividend policy. Further, the OPM considers these factors as of the future liquidity date, rather than as of the valuation date.The primary limitations of the OPM are its assumption that future outcomes can be modeled using a lognormal distribution and its reliance on (and sensitivity to) key assumptions like assumed volatility. The OPM also does not explicitly allow for dilution caused by additional financings or the issuance of options or warrants.  The OPM can only consider a single liquidity event. As such, the method does not readily accommodate the right or ability of preferred shareholders to early-exercise (which would limit the upside for common shareholders). The potential for early-exercise might be better captured with a lattice or simulation model.  For an in-depth discussion on the OPM, see our whitepaper A Layperson’s Guide to the Option Pricing Model at mer.cr/2azLnB.Hybrid MethodThe Hybrid Method is a combination of the PWERM and the OPM.  It uses probability-weighted scenarios, but with an OPM to allocate value in one or more of the scenarios.The Hybrid Method might be employed when a company has visibility regarding a particular exit path (such as a strategic sale) but uncertainties remain if that scenario falls through. In this case, a PWERM might be used to estimate the value of the shares under the strategic sale scenario, along with a probability assumption that the sale goes through. For the scenario in which the transaction does not happen, an OPM would be used to estimate the value of the shares assuming a more uncertain liquidity event at some point in the future.The primary advantage of the Hybrid Method is that it allows for consideration of discrete future liquidity scenarios while also capturing the option-like payoffs of the various share classes. However, this method typically requires a large number of assumptions and can be difficult to implement in practice.ConclusionThe methods for valuing private company equity-based compensation range from simplistic (like the CVM) to complex (like the Hybrid Method). In addition to the factors discussed above, the facts and circumstances of a particular company’s stage of development and capital structure can influence the complexity of the valuation method selected. In certain instances, a recent financing round or secondary sale of stock becomes a datapoint that needs to be reconciled to the current valuation analysis and may even prove to be indicative of the value for a particular security in the capital stack (see “Calibrating or Reconciling Valuation Models to Transactions in a Company’s Equity” on page 6). At Mercer Capital, we recommend a conversation early in the process between company management, the company’s auditors, and the valuation specialist to discuss these issues and select an appropriate methodology. Originally published in the Financial Reporting Update: Equity Compensation, June 2019.

Originally published on Mercer Capital's Financial Reporting Blog, Lucas Parris analyzed the SEC’s $6.2 million settlement with a Big 4 audit firm relating to auditing failures associated with Miller Energy Resources, an oil and gas company with activities in the Appalachian region of Tennessee and in Alaska.In late 2009, Miller acquired certain Alaskan oil and gas interests for an amount the company estimated at $4.5 million. The company subsequently assigned a value of $480 million to the acquired assets, resulting in a one-time after-tax bargain purchase gain of $277 million. Following the deal, the newly acquired assets comprised more than 95% of Miller’s total reported assets. Was it a bargain purchase or not?Paris’ post examines the particulars of the case and provides some observations on fair value accounting that can be gleaned from the SEC settlement order.Bargain Purchase BackgroundA bargain purchase results when the fair value of the assets acquired exceeds the purchase price. If a transaction is determined to be a bargain purchase, the acquirer must recognize a gain on its income statement. Bargain purchases can be the result of a distressed seller or the lack of recognition of a contingent liability. In practice, bargain purchases are uncommon, and typically require a reassessment of the identifiable assets acquired, liabilities assumed, and consideration transferred to confirm that such a transaction has occurred.Miller’s Acquisition of the AssetsAccording to the SEC Order, Miller went public via a reverse merger in 1996. Between 2002 and 2009, its stock price regularly traded below one dollar per share and the firm reported net losses in all years. In late 2009, Miller learned that certain oil and gas interests located in Alaska (the “Alaska Assets”) were in the process of being legally “abandoned” in connection with a bankruptcy proceeding. The Alaska Assets included leases covering 602,000 acres of mostly unproven exploratory oil and gas prospects, five operative oil and gas wells located mainly on two fields, two major facilities, and an offshore platform.The prior owner had marketed the assets for nearly a year, culminating in a court-sponsored auction that produced bids of $7.0 million and $8.1 million. However, neither bidder closed on the bids. A second competitive auction occurred, in which Miller outbid a competing entity whose parent company was, at the time, the largest land drilling contractor in the world. Miller’s winning bid was $2.25 million in cash plus the assumption of $2.2 million in liabilities. The transaction closed December 10, 2009.Accounting for the AcquisitionIn its quarterly SEC filing following the transaction, Miller assigned a fair value of $480 million to the acquired assets. The primary assets were the oil and gas properties ($368 million) and fixed assets ($110 million).Oil and Gas Properties – To establish the fair value of the oil and gas assets, Miller relied upon a reserve report prepared by a third-party petroleum engineering firm under the guidelines for supplemental oil and gas disclosures (ASC 932). The SEC Order stipulated that this was improper because the report itself expressly disclaimed that any of its estimates were estimates of fair value. In other words, the report was prepared for another purpose and with a different accounting/valuation premise than is required under the fair value guidance of ASC 820 and ASC 805. The SEC Order noted that the reserve report estimates were improper from a fair value perspective because the report failed to incorporate an appropriate discount rate and risk adjustments for certain speculative reserve categories. The report was also alleged to contain understated and unsubstantiated cost forecasts, which had been originally provided to the engineering firm by Miller.Fixed Assets – Miller valued the acquired fixed assets (facilities and ancillary pipelines) at $110 million. However, the SEC Order noted that the basis for the $110 million figure was an insurance report that actually contained no third-party analysis – the figure was actually provided to the insurance broker by Miller and then referenced as if it was independently derived by the broker. Furthermore, the SEC indicated that the recording of a separate $110 million fixed asset was double-counting, because these assets were necessary to produce the oil and gas reserves and were already included in the $368 million reserve report value.Role of the Audit FirmMiller Energy replaced its prior independent audit firm in February 2011 (about a year after the acquisition of the Alaska Assets). The new Big 4 firm provided audit reports for Miller, with unqualified opinions, for fiscal 2011 through 2014. The SEC Order states that the firm failed to comply with certain auditing standards, including the requirement to analyze the impact of Miller’s opening account balances (including the value of its oil and gas properties) on the current year financial statements.The SEC Order alleges that the auditors failed to obtain sufficient competent evidence regarding the impact of the opening balances on the current year financial statements, despite knowing that no proper fair value assessment had been performed by management in the prior year. While the audit firm did undertake some audit procedures, it failed to appropriately consider the facts leading up to the acquisition including the competitive bidding process and the “abandonment” of the assets by the prior owner. The SEC Order also noted that the auditor failed to detect the double-counting of fixed assets in the opening balances.Fair Value ObservationsThe SEC Order contains extensive discussion of the auditing and review process as it relates to Miller’s Alaska Assets, which we will not attempt to summarize here. Instead, we will discuss a few of the key themes that emerge from our reading.Bargain Purchases Should Require Additional Scrutiny – It should go without saying, but if a $4.5 million purchase results in a $472 million gain on the income statement (over 100x), there should be a healthy dose of professional skepticism from all sides (management, auditors, and valuation specialists). Every transaction is unique, and perhaps the facts and circumstances support it, but one should be wary if the magnitude of the bargain is large. As an aside, one would think that potential investors would be wary of such an accounting treatment as well, without adequate and supportable disclosures.Proper use of valuation reports – The reserve reports relied upon by Miller management did not contain fair value measurements. Perhaps they were entirely appropriate for the purpose for which they were prepared, but that purpose was not fair value for ASC 805 compliance.Industry Expertise – The partner-in-charge and senior manager on the Miller engagement had no prior experience with oil and gas companies, which the SEC Order indicates resulted in departures from professional standards during the audit process. The SEC Order, citing an AICPA Auditing & Accounting Guide, states that when a client’s business involves unique and complex accounting, as in the case of the oil and gas industry, the need for the engagement partner to understand the client’s industry is even more important. In our opinion, the importance and benefit of industry expertise extends to the valuation specialist as well. Mercer Capital has performed purchase price allocations for clients across a variety of industries and transaction structures, including those giving rise to bargain purchases. We also have significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Related LinksA Buyer’s Market: Accounting for Bargain PurchasesIn the Eye of the Beholder: Increasing SEC Scrutiny of Public Company Fair Value MarksMisleading Purchase Accounting Results in SEC Complaint and Fines for CVSSEC Signals Increased Focus on Financial ReportingThe Fair Market Value of Oil and Gas Reserves

This guest post first appeared on Mercer Capital’s Financial Reporting Blog on January 18, 2016. When performing a purchase price allocation for an Exploration and Production (E&P) company, careful attention must be paid to both the accounting rules and the specialty nuances of the oil and gas industry. E&P companies are unique entities compared to traditional businesses such as manufacturing, wholesale, services or retail. As unique entities, the accounting rules have both universal rules to adhere as well as industry specific. Our senior professionals bring significant experience in performing purchase price allocations in the E&P area where these two principles collide. For the most part, current assets, current liabilities are straight forward. The unique factors of an E&P are found in the fixed assets and intangibles: producing, probable and possible reserves, raw acreage rights, gathering systems, drill rigs, pipe, working interests, royalty interests, contracts, hedges, etc. Different accounting methods like the full cost method or the successful efforts method can create comparability issues between two E&P’s that utilize opposite methods. We will explore the unique factors in future entries. In this blog post, we discuss the guidelines for purchase price allocations that all companies must adhere. Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles. Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.General RulesWhile every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:The report should be well-documented. As a general rule, the reviewer of the purchase price allocation should be able to follow the allocation process step-by-step. Supporting documentation used by the valuation specialist in the determination of value should be clearly listed and the report narrative should be sufficiently detailed so that the methods used in the allocation can be understood.The report should demonstrate that the valuation specialist is knowledgeable of all relevant facts and circumstances pertaining to the acquisition. If a valuation specialist is not aware of pertinent facts related to the company or transaction, he or she will be unable to provide a reasonable purchase price allocation. If the report does not demonstrate this knowledge, the reviewer of the report will be unable to rely on the allocation.The report should make sense. A purchase price allocation report will not make sense if it describes an unsound valuation process or if it describes a reasonable valuation process in an abbreviated, ambiguous, or dense manner. Rather, the report should be written in clear language and reflect the economic reality of the acquisition (within the bounds of fair value accounting rules).Assignment DefinitionA purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:Objective. The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.Purpose. The purpose explains why the valuation specialist was retained. Typically, a purchase price allocation is completed to comply with GAAP financial reporting rules.Effective Date. The effective date of the purchase price allocation is typically the closing date of the acquisition.Standard of Value. The standard of value specifies the definition of value used in the purchase price allocation. If the valuation is being conducted for financial reporting purposes, the standard of value will generally be fair value as defined in ASC 820.Statement of Scope and Limitations. Most valuation standards of practice require such statements that clearly delineate the information relied upon and specify what the valuation does and does not purport to do.Background InformationThe purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.Company OverviewDiscussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.Intangible AssetsThe intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).Historical Financial PerformanceThe historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).Transaction OverviewTransaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.Fair Value DeterminationThe report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”Something to RememberA purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.

Golden parachute payments have long been a controversial topic. These payments, typically occurring when a public company undergoes a change-in-control, can result in huge windfalls for senior executives and in some cases draw the ire of political activists and shareholder advisory groups. Golden parachute payments can also lead to significant tax consequences for both the company and the individual. Strategies to mitigate these tax risks include careful design of compensation agreements and consideration of noncompete agreements to reduce the likelihood of additional excise taxes.When planning for and structuring an acquisition, companies and their advisors should be aware of potential tax consequences associated with the golden parachute rules of Sections 280G and 4999 of the Internal Revenue Code. A change-in-control (CIC) can trigger the application of IRC Section 280G, which applies specifically to executive compensation agreements. Proper tax planning can help companies comply with Section 280G and avoid significant tax penalties.Golden parachute payments usually consist of items like cash severance payments, accelerated equity-based compensation, pension benefits, special bonuses, or other types of payments made in the nature of compensation. In a CIC, these payments are often made to the CEO and other named executive officers (NEOs) based on agreements negotiated and structured well before the transaction event. In a single-trigger structure, only a CIC is required to activate the award and trigger accelerated vesting on equity-based compensation. In this case, the executive’s employment need not be terminated for a payment to be made. In a double-trigger structure, both a CIC and termination of the executive’s employment are necessary to trigger a payout.Adverse tax consequences may apply if the total amount of parachute payments to an individual exceeds three times (3x) that individual’s “Base Amount.” The Base Amount is generally calculated as the individual’s average annual W2 compensation over the preceding five years.As shown in Figure 1 below, if the (3x) threshold is met or crossed, the excess of the CIC Payments over the Base Amount is referred to as the Excess Parachute Payment. The individual is then liable for a 20% excise tax on the Excess Parachute Payment, and the employer loses the ability to deduct the Excess Parachute Payment for federal income tax purposes. Several options exist to help mitigate the impact of the Section 280G penalties. One option is to design (or revise) executive compensation agreements to include “best after-tax” provisions, in which the CIC payments are reduced to just below the threshold only if the executive is better off on an after-tax basis. Another strategy that can lessen or mitigate the impact of golden parachute taxes is to consider the value of noncompete provisions that relate to services rendered after a CIC. If the amount paid to an executive for abiding by certain noncompete covenants is determined to be reasonable, then the amount paid in exchange for these services can reduce the total parachute payment. According to Section 1.280G-1 of the Code, the parachute payment “does not include any payment (or portion thereof) which the taxpayer establishes by clear and convincing evidence is reasonable compensation for personal services to be rendered by the disqualified individual on or after the date of the change in ownership or control.” Further, the Code goes on to state that “the performance of services includes holding oneself out as available to perform services and refraining from performing services (such as under a covenant not to compete or similar arrangement).” Figure 2 below illustrates the impact of a noncompete agreement exemption on the calculation of Section 280G excise taxes. How can the value of a noncompete agreement be reasonably and defensibly calculated? Revenue Ruling 77-403 states the following: “In determining whether the covenant [not to compete] has any demonstrable value, the facts and circumstances in the particular case must be considered. The relevant factors include: (1) whether in the absence of the covenant the covenantor would desire to compete with the covenantee; (2) the ability of the covenantor to compete effectively with the covenantee in the activity in question; and (3) the feasibility, in view of the activity and market in question, of effective competition by the covenantor within the time and area specified in the covenant.”A common method to value noncompete agreements is the “with or without” method. Fundamentally, a noncompete agreement is only as valuable as the stream of cash flows the firm protects “with” an agreement compared to “without” one. Cash flow models can be used to assess the impact of competition on the firm based on the desire, ability, and feasibility of the executive to compete. Valuation professionals should consider factors such as revenue reductions, increases in expenses and competition, and the impact of employee solicitation and recruitment.Mercer Capital provides independent valuation opinions to assist public companies with IRC Section 280G compliance. Our opinions are well-reasoned and well-documented, and have been accepted by the largest U.S. accounting firms and various regulatory bodies, including the SEC and the IRS.