Accounting and Regulatory Reporting for Mergers

Presented by Wilary Winn Risk Management LLCJune 21, 2012

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

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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

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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

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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

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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

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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

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Further Considerations of Income-Based Approach

• Historical review• Review of operating market• Discussion with management on operating issues

specific to the credit union

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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

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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

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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

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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

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Value of Financial Assets and Liabilities

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Credit Discount Non-Principal # of Avg Avg Avg Future Discount Fair Fair Only Rate Contractual AccretableBalance Loans FICO LTV* WAC Age WAM Life CPR % CRR % CDR % Severity% Loss % Rate Value % Value $ Difference Difference1 Difference2 Cash Flows Cash Flows

Fixed Rate Mortgage 7,500,000 46 747 68% 5.9% 54 277 4.0 18.0% 13.9% 4.0% 22.2% 2.9% 6.4% 96.0% 7,200,000 (300,000) (215,000) (85,000) 11,866,223 2,699,491 Home Equity 2,500,000 76 726 71% 6.9% 37 161 3.7 9.3% 6.2% 3.2% 61.4% 3.8% 6.8% 96.5% 2,412,500 (87,500) (94,000) 6,500 3,741,895 552,208 HELOC 5,600,000 133 743 68% 2.9% 26 209 5.4 15.5% 12.8% 2.7% 48.2% 4.5% 5.9% 83.5% 4,676,000 (924,000) (235,000) (689,000) 7,054,554 847,341 New Vehicle - Direct 3,400,000 370 679 n/a 6.7% 26 40 1.3 25.3% 18.1% 7.2% 58.8% 5.5% 6.9% 95.0% 3,228,300 (171,700) (164,700) (7,000) 3,720,251 233,824 Used Vehicle - Direct 4,500,000 532 664 n/a 7.6% 22 33 1.4 22.7% 17.9% 4.8% 53.4% 3.3% 7.6% 96.5% 4,342,500 (157,500) (150,000) (7,500) 5,142,877 294,237 Motorcycle 60,000 12 711 n/a 6.5% 18 41 1.3 18.9% 17.6% 1.3% 35.0% 0.6% 9.5% 96.0% 57,600 (2,400) (300) (2,100) 62,121 1,519 RV 75,000 6 635 n/a 9.9% 21 81 2.3 23.7% 16.6% 7.1% 61.1% 10.9% 12.9% 85.0% 63,750 (11,250) (6,600) (4,650) 98,585 20,340 Boat 250,000 6 745 n/a 6.1% 10 101 2.4 25.1% 21.0% 4.0% 61.1% 5.8% 8.5% 90.0% 225,000 (25,000) (11,000) (14,000) 263,269 39,551 Signature 12,500,000 2,752 655 n/a 12.8% 27 52 2.0 17.0% 8.2% 8.8% 100.0% 16.2% 15.8% 82.0% 10,250,000 (2,250,000) (1,740,000) (510,000) 16,293,567 2,895,180 Share Secured 170,000 33 714 n/a 2.5% 13 34 1.2 19.7% 19.7% 0.1% 0.0% 0.0% 4.0% 98.0% 166,600 (3,400) (10) (3,390) 173,365 1,001 Consolidation Loan 5,500 4 656 n/a 13.8% 44 16 0.5 16.3% 9.0% 7.3% 100.0% 3.4% 16.2% 92.0% 5,060 (440) (200) (240) 5,690 203 Student Loan 350,000 38 n/a n/a 6.2% 3 73 1.3 14.0% 12.8% 1.2% 2.5% 0.0% 8.6% 97.0% 339,500 (10,500) (400) (10,100) 399,110 3,953 Total 36,910,500 4,008 698 69% 8.1% 32 126 2.9 18.0% 12.3% 5.7% 68.1% 8.0% 9.8% 89.3% 32,966,810 (3,943,690) (2,617,210) (1,326,480) 48,821,507 7,588,848

1 Credit Only Difference is referred to as the Credit Valuation Allowance2 Discount Rate Difference is referred to as the Discount Rate Valuation Allowance

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

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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

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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

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

asset

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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

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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.

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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

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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

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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

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Balance Coupon

Market Pricing at Valuation

Date

Remaining Term in Months

Estimated Fair

Value %

Estimated Fair

Value $ Difference

ASSETSCash 2,500,000 100.0% 2,500,000 - Available for Sale Securities 14,500,000 100.0% 14,500,000 - Investments 4,500,000 1.2% 0.7% 8.0 100.5% 4,522,500 22,500 Total Membership and Paid In Capital 80,000 100.0% 80,000 - All Other Investments in Corporate Credit Unions 150,000 100.0% 150,000 - Total Loans and Leases 36,910,500 89.3% 32,966,810 (3,943,690) Total Loans and Leases - Loss Allowance (700,000) 0.0% - 700,000 Foreclosed and Repossessed Assets 235,000 100.0% 235,000 - Land and Building 600,000 105.0% 630,000 30,000 Other Fixed Assets 90,000 100.0% 90,000 - All Other Assets 710,000 100.0% 710,000 - Total Assets 59,575,500 94.6% 56,384,310 (3,191,190)

LIABILITIESAccounts Payable and Other Liabilities 490,000 100.0% 490,000 - Share Drafts, Regular Shares, Money Market, & IRA Shares 42,170,000 100.0% 42,170,000 - Share & IRA Certificates 13,300,000 2.9% 1.2% 20.0 102.9% 13,687,500 387,500 Total Liabilities 55,960,000 100.7% 56,347,500 387,500

EQUITY 3,615,500 36,810 (3,578,690)

Base WeightedValue Weighting Value

Overall Value of XYZ Credit Union - Income Projected 3,650,000 80% 2,920,000 Overall Value of XYZ Credit Union - Market Valuation 3,100,000 20% 620,000 Overall Value of XYZ Credit Union - Total Wtd Avg 100% 3,540,000

Value of Financial Assets and Liabilities (918,190) Value of Non-Financial Assets and Liabilities 955,000 Value of Core Deposits 275,000 Goodwill (Bargain Purchase) 3,228,190

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Opening Journal EntryDebit Credit

Investments 22,500 Loans - Credit Adjustment 2,617,210 Loans - Discount Rate Adjustment 6,500 1,332,980 Loans - Loss Allowance 700,000 - Land and Building 30,000 - Core Deposit Intangible 275,000 - Share & IRA Certificates 387,500 Equity (removal of existing equity accounts) 3,615,500 - Equity (record equity acquired in merger (franchise value)) - 3,540,000 Goodwill 3,228,190 -

7,877,690 7,877,690

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

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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

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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

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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)

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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

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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

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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

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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

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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

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

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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

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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

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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

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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

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Available Resources• Wilary Winn Risk Management Accounting White Paper

and a companion Frequently Asked Questions

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Wilary Winn Risk Management LLCAlliance Bank Center

55 East 5th Street, Suite 1020St. Paul, MN 55101

651-224-1200

www.wilwinn.com

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Services and Contact InformationPrivate 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

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