Interactive 2009 Annual Report (PDF 7.56 MB) - Denbury Resources ...

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64 Denbury Resources Inc. 2009 Annual Reportcarryforwards). If recovery is not likely, we must record a valuation allowance against such deferred tax assets for theamount we would not expect to recover, which would result in an increase to our income tax expense. As ofDecember 31, 2009, we believe that all of our deferred tax assets recorded on our Consolidated Balance Sheet willultimately be recovered. If our estimates and judgments change regarding our ability to utilize our deferred tax assets,our tax provision would increase in the period it is determined that recovery is not likely. A 1% increase in our effectivetax rate would have increased our calculated income tax expense (benefit) by approximately $(1.2) million, $6.2 million,and $3.9 million for the years ended December 31, 2009, 2008 and 2007, respectively. See Note 7 to theConsolidated Financial Statements and see “Income Taxes” above for further information concerning our income taxes.Fair Value EstimatesThe FASC defines fair value, establishes a framework for measuring fair value and expands disclosures about fairvalue measurements. It does not require us to make any new fair value measurements, but rather establishes a fairvalue hierarchy that prioritizes the inputs to the valuation techniques used to measure fair value. Level 1 inputs are giventhe highest priority in the fair value hierarchy, as they represent observable inputs that reflect unadjusted quotedprices for identical assets or liabilities in active markets as of the reporting date, while Level 3 inputs are given thelowest priority, as they represent unobservable inputs that are not corroborated by market data. Valuation techniquesthat maximize the use of observable inputs are favored. See Note 11 to the Consolidated Financial Statements fordisclosures regarding our recurring fair value measurements.Significant uses of fair value measurements include:• allocation of the purchase price paid to acquire businesses to the assets acquired and liabilities assumed inthose acquisitions,• assessment of impairment of long-lived assets,• assessment of impairment of goodwill, and• recorded value of derivative instruments.AcquisitionsUnder the acquisition method of accounting for business combinations, the purchase price paid to acquire abusiness is allocated to its assets and liabilities based on the estimated fair values of the assets acquired and liabilitiesassumed as of the date of acquisition. FASC “Business Combinations” topic defines the acquisition date as the dateon which the acquirer obtains control of the acquiree, which is usually a date different than the date the economics of theacquisition are established between the acquirer and the acquiree. FASC “Fair Value Measurements and Disclosures”topic defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderlytransaction between market participants at the measurement date (often referred to as the “exit price”). A fair valuemeasurement is based on the assumptions of market participants and not those of the reporting entity. Therefore,entity-specific intentions do not impact the measurement of fair value unless those assumptions are consistent withmarket participant views.The excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired isrecorded as goodwill. A significant amount of judgment is involved in estimating the individual fair values involvingproperty, plant and equipment and identifiable intangible assets. This is even more difficult due to the nature of our corebusiness, enhanced oil recovery operations. In order to appropriately apply the FASC standard, we must estimate whatvalue a third party market participant would place on the acquired property. This is extremely difficult as we are oneof few industry entities that perform EOR operations and in our current operating area, the Gulf Coast, we are the onlyentity that we know of that currently has a significant source of CO 2 available to them. Therefore, it is very subjectiveas to what value another entity would place on the potential barrels recoverable with CO 2 , which impacts our allocationof the purchase price to goodwill, unevaluated properties and proved properties. Although we find that this standardis difficult to apply in our circumstance, we use all available information to make these fair value determinations and, forcertain acquisitions, engage third-party consultants for assistance.Form 10-K Part IIManagement’s Discussion and Analysis of Financial Condition and Results of Operations
Denbury Resources Inc. 2009 Annual Report 65The fair values used to allocate the purchase price of an acquisition are often estimated using the expected presentvalue of future cash flows method, which requires us to project related future cash inflows and outflows and apply anappropriate discount rate. The estimates used in determining fair values are based on assumptions believed to bereasonable but which are inherently uncertain. Accordingly, actual results may differ from the projected results used todetermine fair value.Impairment Assessment of GoodwillWe test goodwill for impairment annually during the fourth quarter, or between annual tests if an event occurs orcircumstances change that would more likely than not reduce the fair value of a reporting unit below its carryingamount. The need to test for impairment can be based on several indicators, including a significant reduction in pricesof oil or natural gas, a full-cost ceiling write-down of oil and natural gas properties, unfavorable adjustments to reserves,significant changes in the expected timing of production, other changes to contracts or changes in the regulatoryenvironment. The pending Merger, if approved, will likely result in a significant increase to our existing goodwill.Goodwill is tested for impairment at the reporting unit level. Denbury applies SEC full-cost accounting rules, underwhich the acquisition cost of oil and gas properties is recognized on a cost center basis (country), of which Denburyhas only one cost center (United States). Goodwill is assigned to this single reporting unit.Fair value calculated for the purpose of testing for impairment of our goodwill is estimated using the expected presentvalue of future cash flows method and comparative market prices when appropriate. A significant amount of judgmentis involved performing these fair value estimates for goodwill since the results are based on forecasted assumptions.Significant assumptions include projections of future oil and natural gas prices, projections of estimated quantities of oiland natural gas reserves, projections of future rates of production, timing and amount of future development andoperating costs, projected availability and cost of CO 2 , projected recovery factors of tertiary reserves, and risk-adjusteddiscount rates. We base our fair value estimates on projected financial information which we believe to be reasonable.However, actual results may differ from those projections.Oil and Natural Gas Derivative ContractsWe enter into oil and natural gas derivative contracts to mitigate our exposure to commodity price risk associatedwith future oil and natural gas production. These contracts have historically consisted of options, in the form of pricefloors or collars, and fixed price swaps. We do not designate these derivative commodity contracts as hedgeinstruments for accounting purposes under the FASC hedge accounting topic. This means that any changes in thefuture fair value of these derivative contracts will be charged to earnings on a quarterly basis instead of charging theeffective portion to other comprehensive income and the balance to earnings. While we may experience more volatilityin our net income than if we were to apply hedge accounting treatment as permitted by the FASC hedge accountingtopic, we believe that for us the benefits associated with applying hedge accounting do not outweigh the cost, time andeffort to comply with hedge accounting. During 2009, 2008 and 2007, we recognized expense (income) of $383.0million, $(257.6) million, and $39.1 million, respectively, related to non-cash changes in the fair market value of ourderivative contracts.Stock Compensation PlansThe FASB guidance under the “Share-Based Payment” topic of the FASC, requires that we recognize the cost ofemployee services received in exchange for awards of equity instruments, based on the grant date fair value of thoseawards, in the financial statements. We estimate the fair value of stock option or stock appreciation right (“SAR”)awards on the date of grant using the Black-Scholes option pricing model. The Black-Scholes option valuation modelrequires the input of somewhat subjective assumptions, including expected stock price volatility and expected term.Other assumptions required for estimating fair value with the Black-Scholes model are the expected risk-free interestrate and expected dividend yield of the Company’s stock. The risk-free interest rates used are the U.S. Treasury yieldfor bonds matching the expected term of the option on the date of grant. Our dividend yield is zero, as Denbury doesnot pay a dividend. We utilize historical experience in arriving at our assumptions for volatility and expected term inputs.Management’s Discussion and Analysis of Financial Condition and Results of OperationsForm 10-K Part II
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