1. Accounting and Regulatory Reporting
ACUIA
Accounting and Regulatory Reporting
for Mergers
Presented by Wilary Winn Risk Management LLC
June 21, 2012

2. ACUIA Topics for the Session How to Record Transaction on “Day 1”
“Day 2 Accounting” and ongoing requirements
Doug

3. Business Combinations
ACUIA
New Accounting for
Business Combinations
A combination of mutual entities, including credit unions, is treated as a “purchase” and must be accounted for under FASB ASC Topic 805 – Business Combinations (FAS 141R)
The fair value of the credit union to be merged in and its assets and liabilities must be accounted for at fair value in accordance with FAS ASC 820 – Fair Value Measurements and Disclosures
Doug

4. Value of Acquired Credit Union is a
ACUIA
Value of Acquired Credit Union is a
Two Step Process
Step 1 – Value the entity as whole – the result is accounted for as a direct addition to equity
Step 2 – Determine the fair value of the acquired credit union’s assets and liabilities
Doug

5. Value of the Entity as a Whole
ACUIA
Value of the Entity as a Whole
Rules regarding valuing a business are set forth in the Statement of Standards for Valuation Services of the American Institute of Certified Public Accountants
Experts generally use income-based and market-based approaches to determine fair value
Values derived using the different methods must be reconciled to reach an overall fair value conclusion
Entity value of credit union acquired in a bid transaction is the purchase price
Doug

6. Income-Based Approaches
ACUIA
Income-Based Approaches
Estimated future cash flows are discounted to derive an estimate of fair value
Generally involves the use of a CAPM pricing model using an after-tax discount rate
Estimate of terminal value is generally included – Gordon Growth model
Doug

7. Further Considerations of Income-Based Approach
ACUIA
Further Considerations of
Income-Based Approach
Most experts use income versus cash flow to value financial institutions
Need to adjust for the amount of income that must be retained in order to remain well capitalized
A key assumption is the future rate of growth
Doug

8. Further Considerations of Income-Based Approach
ACUIA
Further Considerations of
Income-Based Approach
Historical review
Review of operating market
Discussion with management on operating issues specific to the credit union
Doug

9. Income-Based Approach
ACUIA
Key Metrics for
Income-Based Approach
Discount rate - Ibbotson Cost of Capital
Profitability - NIM, non-interest income and expense
Asset Quality - ALLL
Liquidity - Loans to Deposits ratio
Doug

10. Market-Based Approaches
ACUIA
Market-Based Approaches
Generally involve the price to earnings ratio or price to book value for publicly traded community banks with similar size, asset composition, operating strategies and geography
Need to adjust for differences in return and growth
Commercial lending
Market-based approach is not a sufficient valuation on its own
Doug

11. ACUIA
Overall Value
Need to reconcile income and marketplace valuations
The result is the equity amount to be recorded on Day 1
Generally no overall entity value for distressed credit unions
We often see equity values equal to the fair value of the assets and liabilities – value is equal to liquidation amount
Doug

12. Assets and Liabilities
ACUIA
Value of Financial
Assets and Liabilities
The valuation for loans is not as simple as comparing the interest rate on the loan to current market interest rates using an ALM model – the fair value must include the estimated credit losses
The value derived should be an “exit price” according to FAS ASC Topic 820
Because the credit losses are included in the loans’ fair value, the allowance for loan losses is brought over at zero
Doug

13. Value of Financial Assets and Liabilities
ACUIA
Value of Financial Assets and Liabilities
Doug

14. Assets and Liabilities
ACUIA
Value of Financial
Assets and Liabilities
We generally see required adjustments for HTM investments and share certificates
Prepaid expenses may have to be adjusted down if there is no benefit to an acquirer
For example, a multi-year prepaid contract for a service that cannot be used after the merger has no “fair value”
Accrued expenses should not include merger-related costs
Doug

15. Assets and Liabilities
ACUIA
Value of Financial
Assets and Liabilities
Need to identify liabilities that have not been recorded that will be triggered indirectly by the merger – some forms of compensation, buy-outs of lease agreements, etc.
Need to consider whether operating leases are favorable (asset), unfavorable (liability) or at market
Doug

16. Value of Non-Financial Assets and Liabilities
ACUIA
Value of Non-Financial
Assets and Liabilities
The largest non-financial assets are generally land and buildings – we generally have our clients obtain a commercial real estate appraisal(s) if they are material
Doug

17. ACUIA Core Deposits Non-maturity shares are recorded at book value
A core deposit intangible is recorded as an intangible asset
Doug

18. ACUIA Intangible Assets
The most common intangible assets are the core deposit intangible, mortgage servicing rights and customer relationships
Trade name – need to consider defensive value as well
Recognition of an intangible asset requires that the asset be separable or have a contractual or legal benefit
Doug

19. Core Deposit Intangible
ACUIA
Core Deposit Intangible
Benefit of low cost deposits:
It is not the value of the overall deposit derived by comparing the interest rate on the deposit to rates at the time of the merger.
Instead, it is the estimated value of the deposits based on the fees they generate and the costs to maintain them compared to an alternative source of funding such as the Federal Home Loan Bank or Wholesale Share Certifcates – SimpliCD.
Doug

20. Other “Day 1” Accounting Considerations
ACUIA
Other “Day 1” Accounting Considerations
Merger-related expenses must be expensed
Restructuring costs of acquirer are recorded as “post-transaction” expenses – ‘Compensation’ vs. ‘Consideration’
Costs that benefit buyer or combined entity are compensation
Assets that an acquirer does not intend to use should still be valued at their “highest and best use”
Example: defensive value of a trade name or unused leased space
The accounting for contingent consideration is complex
Doug

21. Goodwill or Bargain Purchase
ACUIA
Goodwill or Bargain Purchase
The balancing amount to the Day 1 journal entry is goodwill or bargain purchase
We believe a bargain purchase is a relatively rare event
Example of bargain purchase:
NCUA-assisted transaction where the value of the net assets received, including the consideration from the NCUA, is greater than the amount of liabilities assumed
Doug

22. ACUIA Regulatory Reporting
The equity acquired in the merger (the overall value of the acquired credit union) is not included in the calculation of regulatory capital
The acquired credit union’s book equity as of the merger date is recorded instead
In the case of regulatory-assisted transactions – the book value of equity is not recorded and any consideration received is a dollar for dollar reduction of goodwill
Doug

23. ACUIA
Doug

24. ACUIA
Doug

25. Day 2 Accounting for Items
ACUIA
Day 2 Accounting for Items
Other than Loans
Amortize discount on investments - increase to interest income
Accrete premium on investment - reduce to interest income
Amortize discount on share certificates - increase to interest expense
Doug

26. Day 2 Accounting for Items
ACUIA
Day 2 Accounting for Items
Other than Loans
Accrete premium on share certificates - decrease to interest expense
Amortize core deposit intangible - increase to non-interest expense
Depreciate new basis of fixed assets over expected remaining life
Doug

27. Amortization of Intangibles
ACUIA
Amortization of Intangibles
A recognized intangible asset shall be amortized over its useful life unless that life is determined to be indefinite
The method of amortization should reflect the pattern of economic benefit (i.e. match amortization rate to attrition rate on core deposit intangibles)
Ten year straight line has been accepted by accounting firms and regulators
Doug

28. Day 2 Accounting for Loans
ACUIA
Day 2 Accounting for Loans
Need to determine loan or group level and FAS ASC or (SOP 03-3) – the determination can be quite complex
FAS ASC – expect to receive all contractual cash flows
FAS ASC – accounting based on expected cash flows
Do not include the loans acquired in the combined entity’s allowance for loan losses (except for open-ended loans)
Doug

29. Day 2 Accounting for Loans
ACUIA
Day 2 Accounting for Loans
Accounting for high credit quality loans under FAS ASC
Amortize purchase discount on level yield basis
May have to establish post-acquisition ALLL
Doug

30. Day 2 Accounting for Loans
ACUIA
Day 2 Accounting for Loans
Accounting for loans with deteriorated credit quality under FAS ASC
Amortize purchase discount on level yield basis
Foreclosure losses are charged against credit valuation allowance – non-accretable portion
Doug

31. Day 2 Accounting for Loans
ACUIA
Day 2 Accounting for Loans
Under FAS ASC , increases in expected cash flows result in a higher rate of accretion – catch up over the expected life of the loan
If cash flows have decreased, then an additional ALLL should be recorded – immediate P & L effect
Should periodically reevaluate cash flows
Doug

32. Day 2 Accounting for Loans
ACUIA
Day 2 Accounting for Loans
To avoid tedious determination of whether or not the loan is “scoped in” to FAS ASC , one can elect to account for the loans at the group level
We note that the integrity of the pool must be maintained and that loans can only be removed through foreclosures, write-offs or sales of the loans – not refinancings
Doug

33. Day 2 Accounting for Loans
ACUIA
Day 2 Accounting for Loans
If the credit union is accounting for loans at the group level under FAS ASC , then TDR accounting and disclosure is not applicable
Revolving loans (HELOCs, credit cards, etc.) cannot be accounted for under FAS ASC
Doug

34. Goodwill Impairment Testing
ACUIA
Goodwill Impairment Testing
This is also complex – determination of reporting unit
Qualitative test – “Step 0”
Quantitative tests – “Step 1” and “Step 2”
Doug

35. Goodwill Impairment Testing – Step 0
ACUIA
Goodwill Impairment Testing – Step 0
Based on a comparison of circumstances – compare conditions at test date to conditions at merger, or previous test – requires Step 1 only if it is more likely than not, that the fair value of the reporting unit is less than its carrying amount – including goodwill
Macroeconomic conditions, industry and market considerations, cost factors, overall financial performance of the reporting unit, other relevant entity-specific events, events affecting a reporting unit
Doug

36. Goodwill Impairment Testing – Step 0
ACUIA
Goodwill Impairment Testing – Step 0
Diversity in practice – some external auditors allow immediate Step 0
Other firms say Step 0 is not appropriate unless a credit union meets all of the qualitative factors and passed a previous quantitative test with a substantial cushion
Doug

37. Quantitative Goodwill Impairment Testing
ACUIA
Quantitative Goodwill Impairment Testing
Step 1 – determine overall value of the reporting unit. If fair value is greater than the book value of equity (price to book greater than one), the credit union has passed Step 1 and no further testing is required
If the reporting unit fails Step 1, then a Step 2 test must be performed
Doug

38. Quantitative Goodwill Impairment Testing
ACUIA
Quantitative Goodwill Impairment Testing
In Step 2, determine estimated goodwill by repeating Day 1 valuation process
Determine fair value of entity and of the assets and liabilities
If the implied goodwill determined is greater than the carrying amount, no entry need be recorded
If the goodwill determined is less than the carrying amount, write the carrying amount down to the value of the goodwill
Do not adjust the carrying amount of the assets and liabilities – the revaluation is done to test for goodwill impairment only
Doug

39. ACUIA Available Resources
Wilary Winn Risk Management Accounting White Paper and a companion Frequently Asked Questions
Doug

40. Wilary Winn Risk Management LLC
ACUIA
Wilary Winn Risk Management LLC
Alliance Bank Center
55 East 5th Street, Suite 1020
St. Paul, MN 55101
Doug

41. ACUIA
Services and Contact Information
Private Label MBS/CMOs and Asset Liability Management:
Frank Wilary
Mergers and Acquisitions, Fair Value Footnotes, and TDRs:
Brenda Lidke
Mortgage Servicing Rights and Mortgage Banking Derivatives:
Eric Nokken
Pooled Trust Preferred CDOs:
Gregg Johnson
Doug