Merger Accounting-The Facts You Need Before Executing a Voluntary Merger (part 2)

Part I of this article addressed the following questions:

1. How does the Acquisition method differ from the Pooling method?
2. What parts of the Acquiree will have to be recorded at fair value?
3. How is fair value defined, and how is fair value determined?
4. What are the most common intangible assets that will be identified in a credit union business combination?

The remainder of this article addresses the following most common questions asked about accounting for mergers in credit unions:

1. What are the impacts to total capital?
2. What are the impacts to Regulatory Net Worth?
3. What are the impacts to future reported earnings and retained earnings?
4. What level of documentation will be required by my CPA?
5. What are the most important practical considerations that we should consider as we pursue merger opportunities?

As we’ve discussed in the earlier questions, the acquisition method of accounting will result in fair value adjustments to various asset and liability accounts, the total of which will either increase total capital of the acquiree (assuming a netpositive impact of the fair value adjustments) or decrease total capital of the acquiree (assuming a net negative impact of the fair value adjustments). While each situation will have different facts and circumstances, let’s assume the acquireeis a $100million credit union with 10% retained earnings (ahh, the good old days). Also assume the net fair value adjustment is positive $1million. So, the acquiring credit union would record a total of $11million in GAAP capital from themerger, consisting of the original $10million of retained earnings, plus the $1million increase resulting from the fair value adjustment.

What are the impacts to net worth?

The entire $11million of capital would be classified as capital acquired from acquisition on the acquirer’s financial statements subsequent to the merger. Note: this will NOT be part of retained earnings-itwill be a separate component of total capital.

For regulatory reporting purposes, the original amount of retained earnings of the acquiree ($10million) would count towards net worth, while the $1million addition would be excluded from net worth. Preparers of call reports should be alert to the newcall report accounts that have been designated to capture the reporting of capital which results from the merger of two credit unions.

What are the impacts to future reported earnings and retained earnings?

This question is critical, and underscores the need to ensure proper ongoing monitoring of the financial reporting impacts discussed above. Let’s illustrate by discussing one of the possible categories that was adjusted to fair value, loans to membersof the acquiree. In the $100million example discussed above, assume that the book value of loans (excluding the ALLL) was $60million. Assume strong credit quality and favorable interest rates results in the fair value of these loans estimated to be$63million (a 5% increase). The acquirer would record loans at $63million, and the $3million gain is one of the components of our overall $1mllion net gain. The individual loans comprising the total portfolio would have to betracked prospectively, and the $3million gain would be amortized over the life of the portfolio in a manner that results in a constant yield to maturity.

The amortization of this amount will have a negative impact on earnings (and therefore retained earnings). However, this is theoretically offset by the positive impact of the strong credit and favorable rates that comprise the portfolio.

All balance sheet items that were impacted as a result of the initial fair value adjustment will have to be either amortized or evaluated for impairment subsequent to the acquisition depending on the nature of the item.

What level of documentation will be required by my CPA?

Assuming the business combination is considered to be material, your CPA is likely to require substantive documentation of all the calculations and assumptions that entered into the determination of fair value. Further, if a valuation expert was utilized,your CPA may be required to document the qualifications and expertise of this party in order to place reliance upon their work product. And in periods subsequent to the merger, your CPA will need to review the amortization assumptions utilized aswell as your calculations supporting the various intangible assets (for example, CDI and goodwill) to ensure they have not become impaired.

It is strongly advised that you consult with your CPA in advance of executing the merger to ensure a good understanding of the level of documentation that will be required upon the first and subsequent audits of the combined entity.

What are the most important practical considerations that we should consider as we pursue merger opportunities?

The following issues should be considered as part of the overall merger process:

1. Have we identified the appropriate accounting resources to ensure a good understanding of all GAAP related requirements? The CPA that performs your audit engagement might not be able to serve as your fair value expert either due to conflictswith the audit engagement, or lack of fair value expertise within their firm.
2. Have we identified a strong business valuation expert who can assist with determining the fair values of the individual tangible and intangible assets and liabilities of the acquiree? Of the entity fair value of the entity being acquired?
3. Are we prepared to provide the regulator with a high-level analysis of fair value to demonstrate the accounting impact at the early stages of seeking approval for the merger?
4. Have we discussed the future accounting requirements with the right team in the organization to ensure our ability to account for the merger prospectively (for example, tracking loan balances of the acquired portfolio to test reasonablenessof amortization of fair value adjustment)?
5. Do we have a plan for appropriate due-diligence prior to merger execution?
6. Have we sought appropriate legal counsel prior to merger execution?

I have advised my clients that accounting requirements, even if complex, should not stand in the way of good business decisions. This is true for whether considering a loan restructure, sale of assets, acquisition of derivatives, or merging two creditunions under the new accounting standards. Once you have properly analyzed the financial and operational characteristics of the opportunity, and you have assured an appropriate return on investment, the accounting complexities will bemanageable.

About Mike Sacher:
As a CPA with over 30 years experience providing services to credit unions, Mike Sacher has earned a national reputation for his expertise in areas such as accounting & finance, internal control, ALM and governance issuesof importance to credit unions. Mike stands ready to assist your credit union with practical and effective solutions to the complex merger accounting requirements imposed by GAAP.