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 Background
A 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 Assets
According 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 Acquisition
In 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 Firm
Miller 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 Observations
The 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.
- A Buyer’s Market: Accounting for Bargain Purchases
- In the Eye of the Beholder: Increasing SEC Scrutiny of Public Company Fair Value Marks
- Misleading Purchase Accounting Results in SEC Complaint and Fines for CVS
- SEC Signals Increased Focus on Financial Reporting
- The Fair Market Value of Oil and Gas Reserves