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Accounting and Regulatory Reporting for Mergers Presented by Wilary Winn Risk Management LLC June 21, 2012 PowerPoint Presentation
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Accounting and Regulatory Reporting for Mergers Presented by Wilary Winn Risk Management LLC June 21, 2012. ACUIA. ACUIA. Topics for the Session How to Record Transaction on “Day 1” “Day 2 Accounting” and ongoing requirements . ACUIA. New Accounting for Business Combinations

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Presentation Transcript
slide1
Accounting and Regulatory Reporting

for Mergers

Presented by Wilary Winn Risk Management LLC

June 21, 2012

ACUIA

slide2

ACUIA

Topics for the Session

  • How to Record Transaction on “Day 1”
  • “Day 2 Accounting” and ongoing requirements
slide3

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
slide4

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
slide5

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
slide6

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
slide7

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
slide8

ACUIA

Further Considerations of

Income-Based Approach

  • Historical review
  • Review of operating market
  • Discussion with management on operating issues specific to the credit union
slide9

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
slide10

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
slide11

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
slide12

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
slide13

ACUIA

Value of Financial

Assets and Liabilities

slide14

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
slide15

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
slide16

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
slide17

ACUIA

Core Deposits

  • Non-maturity shares are recorded at book value
  • A core deposit intangible is recorded as an intangible asset
slide18

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
slide19

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.

slide20

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
slide21

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

slide22

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
slide25

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
slide26

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
slide27

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
slide28

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)
slide29

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
slide30

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
slide31

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
slide32

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
slide33

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
slide34

ACUIA

Goodwill Impairment Testing

  • This is also complex – determination of reporting unit
  • Qualitative test – “Step 0”
  • Quantitative tests – “Step 1” and “Step 2”
slide35

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
slide36

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
slide37

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
slide38

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
slide39

ACUIA

Available Resources

  • Wilary Winn Risk Management Accounting White Paper and a companion Frequently Asked Questions
slide40

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

slide41

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