As global and domestic economic activity continued to increase throughout the 2021, due to a multitude of factors including the easing of COVID-19 restrictions, availability of vaccines, and government stimulus, activity within the energy industry has experienced similar economic increases. In addition to commodity price rebounds from the lows of 2020, many aspects of the energy industry have also been evolving due to stakeholder and regulatory pressures on, and opportunities within, carbon reduction and increased focus on environmental, social, and governance (ESG) factors. As a result of these factors as well as the ramifications of entities hit hard during the commodity price downturns in 2020, the industry is experiencing consolidations and combinations as ownership groups and management teams strive to create operational and financial efficiencies.
Much of this activity has recently been within the oil and gas sector, as in recent years upstream entities have shifted their strategies from a “prove and move” acquisition and divestiture strategy to a cash flow distribution model wherein lowering operating costs and managing the entity using its own cash flows has reigned supreme. As entities work through the challenges created by the events of 2020, including resolving financing challenges, as well as shifting their strategy, acquisition and consolidation opportunities are present, which has resulted in a recent increase in acquisition and divestiture-related activity.
In addition to these transactions taking place in the form of asset and equity purchases, which were some of the more common transaction methods in recent years, due to the nature of the current environment, transactions are also materializing in the form of mergers, rollups, and transactions with related entities. The increase of these types of transactions can create a variety of accounting and financial reporting challenges that should be contemplated as the transactions are being negotiated in order to understand the impact that the resulting accounting will have on the entity and its financing plans prospectively. (The impacts of any income tax and tax-related accounting and financial reporting ramifications are beyond the scope of this article).
Acquisition accounting
Accounting Standards Update (ASU) 2017-01, which was issued in 2017, amended the definition of a business within Accounting Standards Codification (ASC) 805. As there are differing accounting models for business combinations and asset acquisitions, this change in definition may result in different accounting conclusions than under the previous definition. While this guidance has been applicable for numerous years, the increase in recent acquisition activity and the shift in the nature of the transactions in the current marketplace provides an opportunity to reexamine and refresh its impact in the current environment.
The most significant change provided by ASU 2017-01 was the creation of the “practical screen.” If a transaction meets the practical screen, it’s accounted for as an asset acquisition. If the practical screen is not met, while the transaction doesn’t always meet the definition of a business as there are other factors to analyze, in most common oil and gas transactions, it does generally result in accounting for as a business combination.
There are numerous differences between the accounting for business combinations and asset acquisitions, with some being more common and impactful than others. In a business combination, the potential for goodwill or bargain purchase gain is present and is the result of the differences between the fair value of the net assets acquired and that of the consideration transferred. These concepts are not present in asset acquisitions as the net assets are generally allocated the transaction consideration based on the relative fair value of the acquired net assets. Additionally, differences in the recognition of certain liabilities can occur between the two accounting models, such as contingent consideration and contingencies, including those associated with loss contracts or underwater or above-market throughput commitments. Lastly, the treatment of transaction costs is different under the two models as they are included as a part of the transaction consideration in an asset acquisition and expensed in a business combination.
To determine if the practical screen is met, the fair values of the gross assets acquired are analyzed to determine if substantially all of their fair value is concentrated in a single identifiable asset or a group of similar identifiable assets. If so, the screen is met. To determine if the assets are in effect a single identifiable asset, analysis should be performed to determine if the assets are physically attached together and can’t be removed or separated without incurring significant cost or diminution of value or utility. This can result in significant analysis and judgment for entities, especially those with gathering and transportation assets. To determine if the assets make up a group of similar assets, the nature and risks of each asset should be analyzed to determine if the risk characteristics associated with managing and creating outputs from each are similar. For oil and gas entities, this often results in analysis of the risk characteristics associated with each asset, including the reserve category, commodity type, geographic location, intent and timing for development, and type of ownership interest, to name a few.
The practical screen was added to potentially allow transactions that had the substance of an asset acquisition but met the previous definition of business to now potentially be accounted for as an asset acquisition. However, the insertion of the practical screen into ASC 805 has also created additional complexity and the need for significant judgment as the fair value estimates of the gross assets acquired as well as the risk characteristics of each are highly judgmental and subject to significant estimates.
Common control
Another increasingly common transaction in the current marketplace are transactions with related entities. As investors continue to focus on maximizing cash flows, rolling up multiple entities within an investor portfolio or group is occurring in order to take advantage of operational and financial efficiencies and other strategic plans. When transactions among entities occur that have the same, similar, or related ownership structures, the transactions need to be analyzed to determine if common control of the entities exist as the accounting model for common control transactions is dramatically different when there is a change in control.
Common control is generally deemed to exist when one entity or a group of shareholders/owners with an agreement to vote in concert, have the majority voting interest in the entities that are party to the transaction. Additionally, depending on the governance structure of the entities, there are other factors of control that should be considered, such as the presence of kick-out rights and which equity owner has such rights as their presence may be indicative of a controlling factor. All related agreements of the entities, such as operating agreements and organizational documents, should be analyzed to determine the controlling parties, including the parties with board of director representation, board of direction election and replacement rights, and what decisions require specific board of director voting thresholds. Common control transactions, historically present in the energy industry, are becoming increasingly common as consolidation occurs between entities with the same equity owners.
While common control may not be present in a transaction among related owners or entities, common ownership may be present. When the transferring entity and the receiving entity have identical ownership interests, the accounting for the transaction is the same as if it was a common control transaction as the transaction is generally deemed to lack economic substance. However, when identical ownership interests are not present between the transferring entity and the receiving entity, the accounting for the transaction should follow the business combination and asset acquisition guidance within ASC 805.
The accounting model for common control transactions requires that transactions between entities under common control be recorded by the receiving entity at the carrying value of the net assets rather than at fair value. Any consideration transferred by the receiving entity in excess of the net asset’s carrying value is treated as an equity transaction, akin to a distribution. Additionally, gains and losses are not recognized by the transferring entity since there is no change in the party, which has the controlling financial interest.
Another important financial reporting consideration for the receiving entity when common control transactions occur is whether the net assets transferred constitute a business or an asset. If the transaction is determined to be a transfer of a business, which is defined based on the definition of a business per ASC 805 as discussed earlier, requiring significant judgment, it may cause a change in reporting entity for the receiving entity. If determined to be a change in reporting entity, the receiving entity’s financial statements are retrospectively adjusted to include the results of operations and financial position of the transferred net assets as if the transfer occurred at the beginning of the earliest period presented in the receiving entity’s financial statements. Certain adjustments may be required to the transferred net assets’ results of operations and financial position if differing accounting methods are utilized by the entities, and for eliminations of intercompany transactions.
Reverse acquisition
One way for private entities to access capital markets without following the often lengthy and costly initial public offering process is through reverse acquisition. These may take place through a variety of types of transactions, such as when a privately operating company purchases a publicly listed shell company, and in some cases through a special-purpose acquisition company (SPAC) when the SPAC acquires an operating company. SPAC transactions have experienced a recent resurgence in activity.
In a reverse acquisition, the (legal) acquirer may issue equity interests, in addition to cash consideration, to the (legal) acquiree in exchange for its net assets or equity. However, the legal acquirer, such as the SPAC or publicly listed shell company, is not automatically considered the accounting acquirer. When the controlling party is not clearly identifiable, which is determinative of who the accounting acquiror is, the factors to consider when determining such include relative voting rights in the combined entity, existence of large minority voting interest(s), the composition of the governing body and management of the combined entity, the terms of the exchange of equity interests including whether any party is paying a premium over the precombination fair value of the entities, and the relative size of each party, including asset value, revenue, and earnings.
When multiple parties are involved in a transaction, such as in the case of roll-ups, these factors should be considered for all involved entities, with a particular emphasis on the relative sizes of the combining entities in order to determine the accounting acquirer.
As a result of this determination of the controlling party, thus accounting acquirer, the legal acquiree may technically be the accounting acquirer. When this is the case, the historical accounting records of the accounting acquirer/legal acquiree may become the historical records of the combined entity, with the accounting acquiree/legal acquirer’s net assets recorded as a business combination, at fair value, or asset acquisition based on whether a business or an asset is purchased, as defined in ASC 805. The determination of which entity is the accounting acquirer can involve significant judgment and careful consideration should be given to all of the relevant facts.
Significant acquisitions: Publicly traded entities
Publicly traded entities have been actively involved in many of the current market transactions. These entities must also analyze whether the acquisitions of a business, which is based on the definition in Regulation S-X 11-01(d) not ASC 805, is “significant.” The acquisition of a “significant” business that has occurred or is probable to occur results in the requirements in Regulation S-X 3-05/8-04 to provide separately audited annual financial statements and certain unaudited financial statements of the acquired entity. Rule 1-02(w) of Regulation S-X defines significance based on three tests that compare certain metrics of the acquirer to the acquiree, including income and revenue, assets, and investments. In May 2020, the Securities and Exchange Commission (SEC) revised certain aspects to the financial disclosure requirements of acquired and disposed businesses as well as of income and investments tests within the “significance test.” These revisions took effect in January 2021; however, registrants were able to voluntarily comply with the revisions in 2020.
If the acquisition is deemed significant to the registrant, in addition to the previously discussed requirements to provide historical financial statements of the acquired business, certain pro forma financial information is also required per Regulation S-X Article 11. It’s common in energy industry transactions, particularly in oil and gas, to only acquire certain assets of, or less than substantially all, of an entity. In these cases, carve-out financial statements or abbreviated financial statements may be allowable, subject to SEC rules. Additional compliance challenges have been created by the nature of the recent turbulent marketplace as the number of businesses bought through bankruptcy court proceedings or out-of-court restructurings have been increasing. Preparation of carve-out or abbreviated financial statements, as well as the required audits, may be highly difficult and challenging without involvement from the prior business operator from both a recordkeeper and historic knowledge standpoint.
While there haven’t been any recent changes to the business combination accounting guidance, the nature of current acquisitions and divestiture transactions created by the unique present market conditions requires the use of some of the more complex and judgmental aspects of the accounting and SEC guidance. The specific transaction facts and circumstances will drive the accounting and financial reporting.
