By Al Nolte
September 25, 2015
Mergers and acquisitions among community banks are continuing at a rapid pace. There are many reasons for these transactions: to increase market share, to complete part of a growth strategy, to gain economies of scale, and to attempt to better manage the ever-increasing regulatory burden. However, these transactions bring challenges and complexities with the related purchase accounting.
Mergers and acquisitions are accounted for under FASB ASC 805 – Business Combinations. Some of the key accounting requirements under ASC 805 are as follows:
Initially, all assets of the acquired bank, both financial and non-financial, will be recorded at fair value. The loan portfolio is generally the largest asset on the acquired bank and requires the most attention for purchase accounting.
Fair Value of the Loan Portfolio
Determining the fair value of the loan portfolio is the most difficult and complex, and many times requires the assistance of a third party. There are two main components of the loan portfolio that require analysis in the fair value determination: impaired loans and performing loans. An initial assessment is required to identify any loans with evidence of credit deterioration since origination. These loans will be accounted for using FASB ASC 310-30 and are commonly referred to as purchased credit impaired (PCI) loans. Fair value of PCI loans is determined by estimating the present value expected cash flows of the individual loans. Once that is determined, the discount is divided into an accretable and nonaccretable portion. The accretable portion of the discount will be accreted into interest income based on the expected cash flows. Should the actual cash flows be better than the original estimated cash flows, the bank may increase the accretable discount and recognize a higher rate of accretable yield. On the other hand, if the actual cash flows are less than original estimated cash flows, the bank will have to reduce the accretable discount and recognize a lower rate of accretable yield. The accounting for PCI loans is some of the most complex related to acquisitions.
The fair value of the performing loan portfolio is estimated using a discounted cash flow method. There are numerous assumptions that are considered when estimating the discounted cash flows, including principal maturities, prepayments, probability of default, loss given default, current market rates and proper discount rates. Generally, a fair value discount is recognized on the loan portfolio at acquisition date. However, if the acquired loan portfolio has a greater yield than current market rates, a premium may be recorded. It should also be noted the fair value of the loan portfolio should be determined on a loan-by-loan basis as of the acquisition date. The related discount or premium recorded will be accreted or amortized through interest income on level yield basis over the remaining life of the loans.
Available-for-sale securities are already carried at fair value. However, if the acquired bank has any held-to-maturity securities or longer term certificates of deposits in other banks, a fair value adjustment will be required. The related fair value premium or discounts will be amortized or accreted through interest income over the life of the respective securities or certificates of deposits in other banks.
Buildings and Equipment
Premises and equipment will also be required to be recorded at fair value. Generally the greatest impact is related to the buildings and land for the acquired banks locations. The fair value should be supported by appraisals, and many times there can be a significant difference in the fair value versus the current carrying value. The fair value establishes a new cost basis and depreciable lives.
Fair value adjustments for liabilities focus on certificates of deposit and long-term borrowings. A fair value adjustment may be required, if the rates the acquired bank was paying on its CDs and borrowings differs from current market interest rates. The fair value adjustment, whether a premium or discount, should be accreted or amortized through interest expense over the expected maturity of the related CDs or borrowings.
Intangible assets, of which the most common is a core deposit intangible (CDI), will need to be recognized at fair value at acquisition date as well. The CDI does not represent the value of the overall deposits derived by comparing rates paid on deposits by the acquired bank to current rates. Rather, a CDI represents the estimated value of the core deposits, based on costs to maintain core deposits versus the costs of an alternative source of funding. Again, the fair value is determined using a discounted cash flow method. The important assumptions used to determine the fair value include deposit decay rates, estimated fees, maintenance costs, and alternative costs of funding. The CDI should be amortized over its useful life using a method that reflects the pattern of economic benefit. This will usually result in an accelerated method of amortization.
There are a number of items to address and work through when it is time to record the acquisition transaction for accounting purposes. The items above are not all inclusive; you may need to determine the fair value of mortgage servicing rights, contingent consideration, operating leases, and non-compete agreements. If you are contemplating an acquisition, be aware of the accounting impacts and contact your accountant if you have any questions.