The current FASB accounting standards codification associated with Business Combinations (Topic 805) defines a business as,
- An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits to investors or other owners, members, or participants.
This definition left considerable uncertainty as to what qualifies as a business, which resulted in most acquisitions being accounted for as a business rather than an asset, thus making the accounting costlier and more complicated. In response, the FASB released Accounting Standards Update (ASU) 2017-01 in January 2017 to clarify the definition of business. We expect this revision will result in some acquisitions that were previously being accounted for as a business to now be accounted for as an asset acquisition.
Implications to oil & gas accounting
The primary difference between the current and updated standards are that ASU 2017-01 provides a practical screen to help determine when a set of acquired inputs and processes should not be considered a business. We believe that this standard will make the accounting for certain acquisitions of upstream oil and gas properties simpler by allowing some of them to be accounted for as an asset purchase instead of the purchase of a business.
ASU 2017-01 provides a screen to determine when a set (acquired inputs, processes, and outputs) is not a business.
As noted previously, ASU 2017-01 provides a screen to determine when a set (acquired inputs, processes, and outputs) is not considered to be a business. Paragraph 805-10-55-5A, which will be codified with the implementation of the ASU states, “if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not considered a business.” Under this basis for conclusion, the FASB clarifies assessing the risk associated with managing a group of assets and creating outputs should be an integral process in evaluating whether a group of assets should be considered to be a single group of similar units.
In practice, upstream oil and gas companies making an acquisition will need to evaluate the risk characteristics of each reserve category to determine if a group of similar identifiable assets has been purchased. In a typical acquisition, there are different types of reserve categories being acquired. These reserve categories will likely link to different risks associated with creating outputs for the company, and therefore each will need to be treated as a different set of assets for the screening process. In certain circumstances, acquired Proved Developed Producing (PDP) and Proved Undeveloped Reserves (PUD), or other categories of reserves can be treated as a group of similar identifiable assets, if the company can prove these groups of reserves have similar risk characteristics.
The following circumstances are instances where companies are able to group different type of reserves into a single group:
- Reserves located in the same geological area;
- Preliminary study of the PUD, or unproven reserves indicate success rate of high development/production; or
- Acquiring a company that has a proven record of success in development/production in the area.
Another factor that upstream oil and gas companies should consider in this screening process is whether they are acquiring tangible assets attached to other tangible or intangible assets that are inseparable or will incur significant cost to remove or detach. For example, production equipment or tangible drilling costs incurred to bring the well into production are generally inseparable from working-interest rights, or other mineral rights, without significant cost. In these circumstances, companies should treat the underlying group of assets as a single identifiable asset group and perform the screen as defined by ASU 2017-01.
ASU 2017-01 provides a framework for companies to evaluate if they have an input and a substantive process present with the acquisition.
The primary intent of the FASB in issuing ASU 2017-01 is to clarify the definition of business, and the Board has done this by providing a framework for companies to evaluate whether they have acquired a business, or an asset. Under the updated framework, “a business consists of inputs and processes applied to those inputs that have the ability to contribute to the creation of outputs” (amended Paragraph 805-10-55-4). While outputs are not required for a set to be considered a business, they are usually a key element of a business; therefore, the FASB has developed more detailed criteria for sets without outputs.
A purchase which fails the initial business/asset screening is not automatically considered a business. Instead, the purchaser must perform additional assessments based on other criteria. First, is to determine if a business has been purchased based on other criteria. The first evaluation determines whether an acquired set includes any outputs. Amended paragraph 805-10-55-5E states that:
- When the set has outputs (that is, there is a continuation of revenue before and after the transaction), the set will have both an input and a substantive process that together significantly contribute to the ability to create outputs when any of the following are present:
- I. Employees that form an organized workforce that have the necessary skills, knowledge, or experience to perform an acquired process (or group of processes) that when applied to an acquired input or inputs is critical to the ability to continue producing outputs. A process (or group of processes) is not critical if, for example, it is considered ancillary or minor in the context of all of the processes required to continue producing outputs.
- II. An acquired contract that provides access to an organized workforce that has the necessary skills, knowledge, or experience to perform an acquired process (or group of processes) that when applied to an acquired input or inputs is critical to the ability to continue producing outputs. An entity should assess the substance of an acquired contract and whether it has effectively acquired an organized workforce that performs a substantive process (for example, considering the duration and the renewal terms of the contract).
- III. The acquired process (or group of processes) when applied to an acquired input or inputs significantly contributes to the ability to continue producing outputs and cannot be replaced without significant cost, effort, or delay in the ability to continue producing outputs.
- IV. The acquired process (or group of processes) when applied to an acquired input or inputs significantly contributes to the ability to continue producing outputs and is considered unique or scarce.
When a company acquires a number of PDPs within the same geographic area, it likely will be determined that the properties are a single identifiable asset, and therefore not considered a business. What is more typical, however is that a company acquires interests in PUDs, PDP, and unproved acreage. At the same time, and without employees coming over. In this situation, substantially all of the fair value of the gross assets acquired is NOT concentrated in a single identifiable asset or group of similar identifiable assets. If the value of the PDP properties are significant, then the acquired asset has inputs, a process, and outputs and the acquisition should be accounted for as a business. The risk categories for the PUDs, PDPs, and unproved acreage are all different, though. If a company acquires mainly unproved or PUDs, then it would likely not have outputs. Therefore the acquisition would be treated as an asset purchase, as long as it did not include an organized workforce.
When output does not exist upon acquisition, the ASU places more stringent rulings on how the transaction can be perceived as a business. Not only should the acquired set include inputs and processes that will lead to creating outputs, companies have to acquire “employees that form an organized workforce and an input that the workforce could develop or convert into output” (amended paragraph 805-10-55-5D). Companies may acquire a number of PUDs and unproven reserves with different risk characteristics that are not considered to be a group of similar assets in an acquisition package which includes a joint operating agreement (JOA), but does not include any employees. Under the interpretation of ASU 2017-01, companies would consider transactions like this to be acquisitions of assets, as no labor force was acquired.
ASU 2017-01 is effective for all non-public entities with annual periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. Early adoption is permitted, and companies should apply the new standard prospectively.
Click here for guidance on applying the new ASU. Included are considerations to be made in different acquisition circumstances.
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