Understanding M&A Accounting: What to Watch For

9-29-14-Crowe.pngOne of the worst things for an acquirer to find out after the fact is that the target wasn’t worth what the acquirer thought it was. That egg is on the board’s face and can cause significant headaches. The following are key trends and issues we have found recently in merger and acquisition (M&A) due diligence reviews.

Asset Quality
There is no better indicator of credit quality than a thorough loan review. We have seen a significant rise in collateral values in areas that were the hardest hit and modest recovery in others. Once-troubled institutions are recovering and finally are beginning to move other real estate owned and problem loans that sat unmarketable for several years. While the cleanup might not lead to a recapitalization of a bank for a variety of financial and legacy reasons, it has positioned many institutions as attractive acquisition targets at reasonable franchise values.

However, the not-so-happy news is that weak loan demand and the need to deploy capital efficiently have led to easing credit standards in commercial and industrial (C&I) and commercial real estate loans. It is important to check for deficiencies such as borrower base certificate compliance, waived or reset covenants, and lack of field audits. Also, current underwriting with extended amortizations and lower debt service requirements can present long-run risk to an acquirer. Additionally, we see institutions engaging in new loan products, which can present long-term risk if lender qualifications and track records have not been tested through a variety of economic cycles.

Quality of Earnings and Balance Sheet
Tangible book value (TBV), a common metric within the financial services industry, is used as an anchor for pricing a potential acquisition. Understanding the ways in which improper accounting or one-time income or expense items may skew this figure is important in arriving at a proper value for the bank. In the private company setting, we often find the rigor applied to interim accounting records does not match that applied to the annual audited financials. As management teams are more focused on normalizing yearly results, non-operating expense items might level out over the course of the year to not dramatically affect monthly results. We’ve observed a number of improperly capitalized items buried in other assets and underaccrued liabilities that can significantly distort the net book value of a bank. When establishing a fair purchase price based on a multiple of TBV, a $1 million interim balance sheet misstatement could mean a $1.5 million to $2 million purchase price adjustment.

Similarly, a $100,000 overstatement of core earnings could be a $1.6 million to $2 million purchase price adjustment using current multiples. We continue to see earnings supported by reserve releases, investment security salesA, and various other anomalies that have to be deciphered in order to get a true picture of normalized earnings. Determining a bank’s core earnings potential is more difficult in the current landscape because many acquisition targets have completed bank acquisitions of their own in the past few years. Both open-bank and failed-bank acquisitions come with accounting complexities related to recognition of interest income on the loans acquired. It’s imperative to understand the difference between the accounting yields and the cash income created from these acquired assets in order to avoid overestimating core earnings.

If a target bank has completed a failed-bank acquisition with loss-share agreements in place, significant consideration should be given to the accounting and record keeping of the loss-share arrangement. Acquirers should focus on understanding the remaining terms of any loss sharing, the ability to collect under the loss-share terms, and the potential hole that might be created from overstatement of the indemnification asset. Many of these arrangements may not be completely settled with the Federal Deposit Insurance Corp. (FDIC) for several more years, and many agreements contain a “true-up” provision whereby the FDIC could be owed significant sums of money if the loans perform better than expected. Each loss-share contract is unique, and potential acquirers need to fully understand the complexities associated with these agreements during the due diligence phase.

The issues highlighted here are just a few of the more common issues we’re seeing in current due diligence findings. Execution of a well-conceived due diligence plan can help eliminate surprises from an accounting, operational and credit perspective and lead to a successful transaction.

How the New FASB Standard on Revenue Recognition May Impact Banks

revenue-maze.jpgThe Financial Accounting Standards Board (FASB) recently released its long-awaited standard addressing revenue recognition. Existing U.S. generally accepted accounting principles (GAAP) were largely developed on a piecemeal basis and are industry- or transactional-focused. Consequently, economically similar transactions sometimes resulted in different revenue recognition. Accounting Standards Update (ASU) 2014-09, “Revenue From Contracts With Customers (Topic 606),” adopts a standardized approach for revenue recognition. This was a joint effort with the International Accounting Standards Board (IASB), resulting in converged guidance under both GAAP and International Financial Reporting Standards (IFRS). Of course, companies will report the same total amount of revenue over time, but the timing of the recognition could be accelerated or delayed when compared with current practices. 

A Core Principle and a Five-Step Approach

The new ASU is based on a core principle: “Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” To achieve this principle, the guidance spells out several steps that a company must take when determining when to recognize revenue on its financial statements.

  1. Identify the contract with a customer.
  2. Identify the separate performance obligations in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to the separate performance obligations.
  5. Recognize revenue when (or as) performance obligations are satisfied.

Is This a Big Deal for Banks? 

The new ASU could be a challenge from two perspectives. First, there are certain industries for which there will be wholesale changes, including the software, telecommunication and real estate industries. For the banking industry, wholesale changes are not expected—largely because much of a bank’s revenue comes from financial instruments (including debt securities, loans and derivatives), and many of those are scoped out. That is not to say that banks won’t be affected, because most will. But for most banks, the effect is not likely to be significant.

Second, the challenge for banks (as well as other industries) will be taking the core principle and accompanying steps and figuring out how the guidance applies. In other words, the five steps provided are not written with a specific industry in mind, so a shift in thinking will be necessary to evaluate how the accounting will change for those transactions that will apply to banks. A few areas of potential application for banks include:

  • Loyalty point programs
  • Asset management fees
  • Credit card interchange fees
  • Deposit account fees

Effective Dates

The boards provided a lengthy implementation time for the new rules, giving companies time to develop and put in place new controls and processes. The ASU is effective for public companies for annual reporting periods (including interim reporting periods within) beginning after Dec. 15, 2016; early implementation is not allowed. For nonpublic companies, the guidance is effective for annual reporting periods beginning after Dec. 15, 2017, and interim and annual reporting periods thereafter. Early adoption is permitted for nonpublic companies with certain caveats.

Help Is on the Way

In addition to establishing a revenue recognition working group to own the guidance, the American Institute of Certified Public Accountants (AICPA) created 16 different industry task forces charged with providing industry-specific guidance. One of those 16 task forces is the depository institutions revenue recognition task force. With the issuance of the standard, the work now can begin.

In addition, the FASB and the IASB are forming a joint transition resource group, which will consist of 15 to 20 specialists representing preparers, auditors, regulators, users, and other stakeholders. Its objective will be to promote effective implementation and transition.

At just more than 700 pages, the new standard is the longest the FASB has ever issued. This was a major undertaking by the boards, and given the girth of the standard and the fact that it is not industry specific, it’s safe to say it’s just going to take time to digest. 

Top Three Recommendations for Valuing and Accounting for Acquired Loans

bsns-man-binoculars.jpgAs acquisitions of troubled and failed institutions continue, understanding the accounting for acquired loans is more critical than ever. The most often overlooked area in any transaction is the alignment of internal and external resources with accounting systems to facilitate a smooth transition of recordkeeping for loans—the most significant asset class acquired.

Acquired loans are accounted for at fair value at the date of acquisition, and accounting for those loans going forward presents a multitude of complexities for accounting personnel and senior management responsible for asset quality and financial reporting. Highlighted here are three best practices an acquirer can use to efficiently manage through acquired loan accounting and limit surprises.

1. Valuation Due Diligence

Many acquirers apply generic rules of thumb when valuing an acquired balance sheet and make broad assumptions about how earnings will be affected by valuation adjustments during the due diligence phase. When time permits, as part of the due diligence process, acquirers should perform a preliminary valuation of the loan portfolio being acquired. In a failed-bank acquisition, however, there typically is not sufficient time to conduct this level of valuation. Given the recent slowdown in closings, though, potential acquirers are finding themselves with more time.

In a normal bank transaction, there typically is enough lead time to perform a preliminary valuation since the acquirer has more control over the timing of the transaction closing. By performing a preliminary valuation, management is able to work through vendor selection prior to closing and can align expectations on valuation methodologies and deliverables to eliminate surprises after an acquisition. Third-party audit firms can review overall methodologies and deliverables well in advance of closing.

By doing this dry-run valuation work ahead of time, accounting personnel can start formulating the appropriate accounting policies and gain a deeper understanding of the financial reporting effect of yet-to-be-made accounting policy elections. Well in advance of closing, the bank should determine how best to construct pools of performing and problem loans for efficient accounting going forward, how to effectively align acquired loans into the existing credit monitoring and allowance methodologies, and which loans are most effectively valued and accounted for individually as opposed to pooled.

2. Early Assessment of Capabilities

Acquirers should identify resources that will be needed within the accounting, loan operations and credit administration functions in order to support the appropriate day-to-day application of accounting for the acquired loan. In addition to assessing personnel, acquirers should evaluate existing accounting systems to identify potential weaknesses in facilitating acquired loan accounting going forward. The acquiring institution’s current software vendor should know its system limitations in applying acquired loan accounting, and these discussions should start early in the process.

Acquirers should also address conversion protocols and timelines for a particular acquisition while discussing system capabilities. This assessment and education process should help determine resources and systems needed to perform the accounting going forward. It also will result in more accurate projections of the value of any particular acquisition since information systems and personnel costs can be more accurately forecast by assessing these areas early.

3. Post-Closing Valuation

Acquirers should perform another review of the acquired portfolio prior to providing final data for the loan valuations. This review should allow acquirers to revisit loan grades and take into account changes in collateral value and credit scores following the initial due diligence. Loan grading and collateral values change over time, and given the limited scope for review under due diligence timelines and the potential for credit deterioration or improvement, acquirers should strive to provide the most up-to-date information to be used in valuing the portfolio. Starting off with an accurate set of assumptions will help minimize surprises going forward.

Originally published on April 23, 2012.

Handling One of the Biggest Headaches in Acquisitions: Data Integration

knot.jpgWe have seen more than 400 bank and thrift closures since the beginning of 2008. We have also seen an increase in the number of “good bank” acquisitions. These acquisitions have presented healthy banks with a significant opportunity to expand their banking footprint and their asset base.

Unfortunately, it is easy to underestimate the data integration challenges involved in a bank acquisition, even if both institutions are sound.

Fortunately, however, there is a better alternative—an approach that allows acquiring institutions to take advantage of the benefits offered through acquisitions. By employing a systematic, methodical approach to data integration and reporting challenges, the complexity of any type of merger or acquisition can be greatly reduced. For its part, the board should ask for an overall data integration plan for each department’s main systems prior to agreeing to an acquisition. The board should receive an inventory of all applicable systems being acquired and the corresponding system needed for integration within the acquiring bank.

Loans acquired as part of any transaction are subject to various additional recordkeeping and reporting requirements, including:

Internal loan accounting. Each loan must be accounted for, rated for risk, and tracked for regular servicing and transactions. Although the acquiring institution will have its own systems for handling these tasks, the historical loan accounting data must be left intact in order to support loss recognition and accurate reporting.

GAAP accounting. Loan data must be structured in accordance with U.S. generally accepted accounting principles (GAAP), as spelled out in the Financial Accounting Standards Board’s Accounting Standards Codification. Verifying the fair valuation of loans and other assets often entails significant data requirements and complex cash flow estimates, which might not be included with the original loan contract and documentation.

Tax accounting. Acquired loans are handled differently for tax purposes and GAAP accounting. Examples include accounting for charge-offs, other real estate owned (OREO), appraisals, expenses and taxes. Despite the differences, however, the two accounting approaches must rely on standardized and consistent data to satisfy auditors’ and regulators’ tracking and accounting requirements.

Complicating Factors: What Acquiring Banks Need to Address

Institutions also face a number of broader data integration and reporting issues when acquiring a bank or a bank’s loan portfolio. Following are some of the most common concerns they encounter:

As banks have grown, so has the number of information systems they rely on to manage their assets. Even before an acquisition, most institutions already are struggling with loan data being stored in several different systems that do not adequately talk to each other. Integrating systems from an acquired institution only adds to the challenge.

An acquiring bank also needs to understand the acquired bank’s credit and risk review rating structure and identify where that information is kept. It then needs to incorporate the acquired loan portfolio into its own internal reporting systems for credit risk, financial and operational reporting. This step requires gathering data from new systems and transforming it into a normalized form that the organization can use.

In the case of older loans, some important data elements might be stored in paper files and not reflected in any electronic storage systems. Often, banks attempt to retrieve this information manually and store it in a spreadsheet format, only to encounter even more demands on their resources as they attempt to integrate this information with the rest of their data. In some instances, data also might be stored on outsourced systems.

Customer retention is always a critical concern. As such, the data used for managing customer interactions must be accurate and timely to demonstrate strong customer service and establish acquired customers’ confidence with the new bank.

Transparency is a critical requirement in all acquisition reporting. After several years of controversy, regulators are especially sensitive about verifying the institutions they monitor have systems with auditable processes. Those systems have to aggregate data from multiple sources and present reports quickly, cleanly and on demand.

One of the first criteria for a healthy bank considering acquisitions is to become a great steward of its own data. Doing so requires the bank to implement projects in six strategic information management areas.

  • Inventory and assessment. What information do we have? What is the true source of the information? How was it created?
  • Consolidation. What mechanisms will we need to get all of the disparate data normalized and consistent?
  • Quality. How will we facilitate accuracy, integrity and trust in the data? How will we improve data quality over time?
  • Speed and responsiveness. How will we deliver required information in a timely fashion?
  • Integration. In the long term, how will we establish smooth integration between legacy systems and new systems in the event of another acquisition?
  • Adaptability. How will we respond to a very dynamic environment in which data reporting requirements are certain to change over the five- or 10-year duration of a typical loss-sharing agreement?

Boards and executive management should keep a close eye on the system and data integration that will be driven by an acquisition. Systems and data integration issues can create spiraling costs in an acquisition. A solid review of all data integration plans should be in place prior to the actual acquisition. This would include an overall data integration plan agreed to by all IT management. Although the challenges can be considerable, the potential upside—including the opportunity to gain a foothold in new markets and establish new customer relationships—can make the effort worthwhile.

Audit Committee Members Face New Challenges

Audit committee members who participated in two separate roundtable discussions for public community banks at the Bank Director Peer Group sessions, held as part of the Bank Director Audit Committee Conference in Chicago on June 13, were able to let down their guard and share with their counterparts their experiences, uncertainties and pearls of wisdom. Despite being separated by thousands of miles, participants in both roundtable discussions shared their views on similar issues as if they were next-door neighbors.


It quickly became clear that the institutions represented in both groups are very focused on responding to an increase in regulatory scrutiny of how audit committees oversee the management of certain risks. This increasing level of scrutiny is being experienced now and is expected only to increase further in the foreseeable future.

Historically, audit committee members have focused primarily on their institutions’ higher-level financial measures and performance against budgets. In addition, audit committees have devoted a significant amount of attention to the results of exams such as internal audit, regulatory safety and soundness, and external audit findings.

In response to the expected increase in the level of regulatory oversight, however, additional areas of focus are now becoming part of the regular responsibilities of audit committees over and above their past approach. These include:

  • Monitoring credit concentrations
  • Monitoring classified loans
  • Compliance-related issues
  • Monitoring the remediation of exceptions noted by regulatory examiners, as well as internal and external audit
  • Understanding new initiatives and their related risks

Furthermore, to remain current on new issues, audit committee members are using tools such as self-assessment checklists, while also seeking out educational opportunities about new and emerging regulatory and accounting matters. Clearly, expectations are rising regarding engaging in and documenting participation in learning activities.


The members also discussed their interactions with and expectations of management. Because their relationships with management are generally collegial, it can be challenging at times to maintain the fierce independence that is expected of audit committees. Members agreed that reminding each other on a regular basis of their responsibilities helps them meet this challenge.

In addition, roundtable participants considered other approaches to holding their colleagues accountable for being productive committee members including attendance and participation requirements and peer evaluations. They also agreed that maintaining a culture of open and frank communication is vital in maintaining effective audit committee performance.

A few distinctions emerged between the two community bank roundtable groups, which were divided by size of institution. For example, members representing larger institutions (generally with more than $1 billion in total assets) have heard more from their regulators about formally documenting the identification and measurement of risks their institutions face as well as the mitigation of those risks – in other words, enterprisewide risk management. Members from smaller institutions indicated that risk identification, measurement, and mitigation were being documented less formally and generally their regulators have not asked them to do more.


A CPA’s Perspective on Managing Outside Consultants

puzzle-piece.jpgAll financial institutions must hire an outside CPA firm to audit their financial statements as well as the accounting information system and controls that affect those statements. The relationship between the bank and the external consultant can be mutually beneficial–but only if the bank goes about selecting, hiring and working with the CPA firm in a systematic and effective way.

What You Should Expect–and Receive–From Your CPA

The CPA firm you hire should have industry expertise that is specifically targeted to financial institutions the size and complexity of yours, and the firm should have experience and expertise in your major lines of business. You should also expect the firm’s CPAs to have a deep knowledge of SEC regulations and professional standards such as those issued by the PCAOB.

In addition, you need to be confident that your CPA firm understands the broad spectrum of risks facing your bank, including the potential exposure and return of each. An understanding and audit of the tools that management uses to monitor the bank’s performance results is also essential.

It’s important for you to recognize the difference between your bank’s problems and the auditor’s problems. Don’t expect the auditors to take responsibility for problems that are actually management’s issues to deal with. Doing so only invites delays and a loss of independence on the part of the auditor.

The ideal CPA firm focuses on relationships. The external audit team needs to communicate and work well with the bank’s team. On both sides, clear and informative discussions upfront about roles, timelines, methodologies, controls testing, documentation and the like will go a long way toward ensuring smooth and efficient planning, auditing and reporting process. The audit team also needs to be able to communicate effectively with the bank’s audit committee as well as management.

The Match Game

When contemplating hiring a CPA firm, you must first define your objectives. Understand and communicate the scope of what you expect the firm to do. You can select the appropriate firm only if you know your own organization well–its business, community, management strategy, performance and risks. Think long and hard about the nature of your institution’s risks, and then seek a consultant whose strengths match up with those risks.

Meet face to face with representatives of firms you are considering hiring. Read reports, ask penetrating questions and compare what they say with your understanding of the CPA firm’s reputation, skill set, and culture. Provide input and a balanced approach. Follow through in providing direction to the organization. Think through the cause and effect of problems your institution faces and use the consultants you interview to confirm your conclusions. Act on the recommendations.

You Have Rights

You have the right to continue to be involved and receive clear communication from the consultants throughout the audit and reporting process. You also have the right to receive advance warning from the CPA firm of possible problems.

Take the time to understand the auditors’ perception of the risk profile of your bank and their conclusions about management, and ask questions if you don’t.

Changing Standards, Changing Role

The best-in-class banks anticipate tomorrow’s standards by which today’s actions will be judged. The ubiquitous implementation of enterprise risk management programs in recent years should not have been a surprise given all the chatter of the past several years. And in the near future? Our crystal ball says that “stress testing” will be required soon, so now is the time to embrace it.

The Center for Audit Quality and other groups are looking into the auditor’s role, which we expect to change just as it has done before–particularly in the aftermath of the thrift industry crisis (which led to the Federal Deposit Insurance Corporation Improvement Act) and the major corporate and accounting scandals of the 1990s (which led to Sarbanes-Oxley). Look for greater CPA involvement in10-Ks, and in risk factor disclosure in 10-Ks/Qs and MD&A.

More big changes might be on the horizon, particularly for privately held companies, in light of the analysis of the report of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committee, an analysis indicating that audit committee effectiveness depends on independence and the number of meetings.

Collaboration, Not Confrontation

A good working relationship between your team and the external audit team will enhance the financial reporting process, reduce surprises and generally make everyone’s life easier.

Fair Value and the Allowance for Credit Losses: What Does the Future Hold?

These two topics, near and dear to bankers, are in the process of being addressed by the Financial Accounting Standards Board’s (FASB) financial instruments project. The financial instruments proposal, issued in May 2010, was a monster–fair value, impairment and hedging all rolled into one.

Adding to the complexity, remember that FASB is trying to converge with the International Accounting Standards Board (IASB)–but IASB is using timetables that differ from FASB’s. In this post, I’m setting aside hedging to focus on the two areas that affect everyone: fair value and the allowance for credit losses.

Fair Value

red-pin-finances.jpgFASB’s past proposal to carry most financial instruments (loans, securities and deposits) on the balance sheet at fair value was received with little enthusiasm, for two primary reasons. First, robust market data doesn’t exist for many of those instruments, raising concerns about the reliability of the fair values that would be used. Second, the proposal did not take into account management’s intent–when management does not intend to ever sell most of those instruments, what is the point in recording them at fair value?
The good news is that FASB has reconsidered its initial proposal. The board has moved away from broadly requiring fair value for most financial instruments. Instead, the determination of whether an instrument is carried at fair value will depend on (1) the characteristics of the financial asset and (2) the business strategy. The result is three categories:

Fair Value–Net Income: Measured at fair value with all changes in fair value recognized in net income. It includes items held in trading or for sale.

  1. Fair Value–Other Comprehensive Income: Measured at fair value with qualifying changes in fair value recognized in other comprehensive income. It includes financial assets for which the business objective is investing with a focus on managing risk exposures and maximizing total return, typically characteristics of an investment portfolio category.
  2. Amortized Cost: Measured at historical cost and for assets, evaluated for impairment. It includes financial instruments for which the business strategy is managing the instruments through a lending, borrowing or customer financing activity, typically characteristics of a loan portfolio category. This category would also include those liabilities (deposits) that the bank intends to hold.

If you think this overall model looks similar to what we have today, you are correct. However, there is an important shift. Today, the accounting model is driven primarily by the form of the instrument. That is, we follow one model if the asset is deemed to be a loan and another model if the asset is deemed to be a security. The shift is really toward one model, but then drivers are the marketability of the instrument (Is there a readily available market for the asset?) and management’s intent (What is the plan for the asset? Is the intent to hold the asset and collect the cash flows the typical intent for a loan? Or is the intent to manage interest rate risk and liquidity, which is typical for an investment portfolio?).
While there are many nuances with this area of the project, the key point is that FASB has moved away from essentially requiring fair value for the majority of the balance sheet. Stay tuned–FASB plans to make its final decisions in the third quarter of 2011.

Allowance for Credit Losses

Near and dear to bankers is the allowance for loan and leases losses (ALLL), an area in which FASB’s financial instruments project seeks to make some changes. For decades, we have struggled with the accounting in this area in large measure because of the confusion about what the allowance does and doesn’t represent. Today, losses cannot be recorded until they are probable and incurred. Those are words of art meaning that a loss has indeed happened and that a future event will likely confirm the loss. In other words, the allowance does not represent all possible or expected losses in the portfolio.

However, these concepts are being reevaluated. In late January, FASB and the IASB published a joint proposal for comment that is focused primarily on loans evaluated on a pool basis. Think about that in the context of loans that are not individually flagged being problematic. The proposal seeks to change the allowance from a probable and incurred loss model to a more forward-looking model–that is, closer to an expected loss model.

However, the two boards differ. FASB favors an approach that looks to the foreseeable future but not one that includes losses over the life of the portfolio. IASB favors an approach that takes expected losses over the portfolio and records those losses over time. The new proposal is really a hybrid of the two approaches. Essentially, bankers would have to determine the outcome of both approaches and record the lesser of the two amounts. So, for pools, the allowance for credit losses would be calculated based on the lower of a time-proportional amount (the IASB model) or losses expected to occur in the foreseeable future, which can’t be less than 12 months (the FASB model).

Unsurprisingly, the comment letters did not yield a consensus of opinion. So, with a goal of reaching a consensus by late June, the boards are back to the drawing board. Depending on the outcome, we may see yet another exposure draft. Stay tuned–more fun to come!

Can You See ThiS????