When performing a purchase price allocation for an oilfield services company, careful attention must be given to both the relevant accounting rules and the specific nuances of the oil and gas industry. Oilfield services companies can entail many unique characteristics that are not present in non-oilfield related businesses such as manufacturing, wholesale, non-energy related services, or retail. Our senior professionals bring significant experience in performing purchase price allocations in the oilfield services area where knowledge of these characteristics is crucial to determining the proper allocation among the subject company’s assets.
For the most part, current assets and current liabilities are relatively straight forward. The unique factors of an oilfield services company are found in the fixed assets and intangibles: specialized drilling and production equipment, service contracts, proprietary technology (patented, or unpatented), methods, or software, in-process research and development assets (IPR&D), etc. In addition, the proper consideration of contributory asset charges in the appraisal of existing customer relationships or technology in the context of oilfield services companies requires a thorough understanding of how such contributory assets are utilized in generating the subject company’s expected operating results. 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.
The unique factors of an oilfield services company are found in the fixed assets and intangibles.
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.
It should be noted 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.
While 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).
This can be particularly daunting if the reviewer of the purchase price allocation report does not have significant experience in working with oilfield services industry participants. The oilfield services industry is particularly strong in industry-specific terminology and jargon that can lead to a lack of understanding among purchase price allocation report reviewers that lack a deep industry background.
Definition of Assignment
A purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:
- The definition of the valuation objective should specify the client, the acquired business, and the intangible assets to be valued.
- 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.
The 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.
Understanding of the Business
The purchase price allocation report should include a discussion related to the acquired company which demonstrates 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 plays 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.
In the case of acquisitions within the oilfield services industry, the pertinent facts include a thorough understanding as to the demand for the subject company’s services across the various basins within the target market. Unlike many other industries, oilfield services businesses may provide services that are specific to certain basins. Therefore, expectations regarding the specific basins served may be of much greater importance than expectations for the overall oil and gas industry.
The discussion of the subject intangible assets should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the assets 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.
Upon 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).
Within the oilfield services industry, in particular, one may have to spend a significant amount of time in the determination of what intangible assets were acquired, what intangible assets should recognized as a separate asset from goodwill (based on the legal/contractual rights and separability considerations) and what intangible assets are likely to have a material value. These can differ markedly across industries and such considerations can be somewhat unique in the oilfield services industry.
The 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.
The historical financial performance of the acquired company provides important context to the story.
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).
Understanding an oilfield services company’s past financial performance requires knowledge of industry-specific trends that can impact activity levels, pricing for particular services, competing service providers, and profit margins. The oilfield services industry is subject to potentially wide fluctuations in activity that can be driven by commodity prices and technological changes. A thorough understanding of these dynamics is necessary in order to correctly interpret past performance among industry participants.
Transaction 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.
Determination of Value
The purchase price allocation report should provide an adequate description of the valuation approaches and methods relevant to the project. 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.
Any of a number of valuation methods could be appropriate for a given intangible asset depending on the specific situation. 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.
In the closing discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This part of the purchase price allocation report 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.”
Within the oilfield services industry determination as to the reasonableness of the indicated allocation of value (purchase price) is often a factor of whether the subject company’s services are subject to proprietary technology, the level of fixed assets required to provide the subject company’s services and the level of personal interaction with customers. Based on such factors, the allocation of value might be reasonably expected to be skewed to particular types of assets, with higher, or lower, expected levels of goodwill.
Keep in Mind, it’s Not a Blackbox
A 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.