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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

ACUIA Doug

ACUIA Doug

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

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

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

Day 2 Accounting for Loans ACUIA Day 2 Accounting for Loans Need to determine loan or group level and FAS ASC 310- 20 or 310-30 (SOP 03-3) – the determination can be quite complex FAS ASC 310-20 – expect to receive all contractual cash flows FAS ASC 310-30 – 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

Day 2 Accounting for Loans ACUIA Day 2 Accounting for Loans Accounting for high credit quality loans under FAS ASC 310-20 Amortize purchase discount on level yield basis May have to establish post-acquisition ALLL Doug

Day 2 Accounting for Loans ACUIA Day 2 Accounting for Loans Accounting for loans with deteriorated credit quality under FAS ASC 310-30 Amortize purchase discount on level yield basis Foreclosure losses are charged against credit valuation allowance – non-accretable portion Doug

Day 2 Accounting for Loans ACUIA Day 2 Accounting for Loans Under FAS ASC 310-30, 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

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 310-30, 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

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 310-30, then TDR accounting and disclosure is not applicable Revolving loans (HELOCs, credit cards, etc.) cannot be accounted for under FAS ASC 310-30 Doug

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

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

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

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

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

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

Wilary Winn Risk Management LLC ACUIA Wilary Winn Risk Management LLC Alliance Bank Center 55 East 5th Street, Suite 1020 St. Paul, MN 55101 651-224-1200 www.wilwinn.com Doug

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