During the past few years, business combinations have become increasingly complex due to Generally Accepted Accounting Principles (GAAP) changes, FDIC-assisted acquisitions, and bargain purchases. ASC Topic 805, Business Combinations (formerly FAS 141 R), replaced FAS 141, introducing significant changes in the accounting for and reporting of business acquisitions.1 In addition, during the past few years, FDIC-assisted transactions have increased, and due to their nature, structure, and timing, they have created a large number of bargain purchases.
Interagency Supervisory Guidance on Bargain Purchases and FDIC- and NCUA-Assisted Acquisitions was established on June 7, 2010. Although the guidance concentrates on bargain purchases, it is also pertinent to business combinations in general. The guidance does not add to or modify existing regulatory reporting requirements issued by the agencies or current accounting requirements under GAAP. This article will discuss some of the supervisory concerns around bargain purchases and business combinations.
A bargain purchase takes place when the fair value of acquired net assets in a business combination exceeds the consideration paid by the acquirer. Under current guidance, rather than recognizing this “bargain purchase” value as negative goodwill, companies now record a gain on the income statement. Bargain purchases are raising supervisory considerations related to the reliability of valuations and estimated purchase gains for certain institutions, especially during the period when provisional estimates are recorded.
ASC Topic 805 continued the movement toward the greater use of fair values in financial reporting and increased transparency through expanded disclosures. It changed how business acquisitions are accounted for and impact financial statements at the acquisition date and in subsequent periods. Further, certain changes introduce more volatility into earnings and thus may impact a company's acquisition strategy.
The movement toward the greater use of fair values in financial reporting for business combinations requires a high level of accounting and fair value measurement expertise. Acquirers should ensure that they have qualified personnel to perform due diligence. Management should establish strong corporate governance and internal controls to ensure compliance with complex accounting requirements and regulatory requirements related to a business combination. Management is encouraged to understand applicable regulatory reporting and supervisory factors, such as fair value, measurement period, and required applications prior to consummating a business combination.
Fair value and measurement period. Due to the significant impact that fair value estimates can have on goodwill, earnings, and capital, management should have the appropriate written fair value measurement policies and procedures to report fair values in accordance with ASC Topic 820, Fair Value Measurements and Disclosures. If management does not have the requisite expertise, it should seek an expert opinion.
The measurement period is the period after the acquisition date during which the acquirer may adjust the provisional amounts recognized for a business combination. The measurement period ends as soon as the acquirer either receives the information it was seeking about facts and circumstances that existed as of the acquisition date or learns that more information is not obtainable. However, the measurement period shall not exceed one year from the acquisition date.
Business combination applications. The acquiring institution must submit the appropriate application to its primary regulator and any appropriate state regulator for approval prior to consummating the transaction. The acquirer should submit one pro forma balance sheet with two sets of pro forma capital calculations when the business combination results in a bargain purchase. The first set of pro forma calculations should include the increase in capital due to the bargain purchase, while the second set should exclude any estimated gain from the proposed business combination and any bargain purchase gains from prior business combinations still within the measurement period.
Since there may be concerns about the quality and composition of capital for a bargain purchase during the measurement period, conditions may be imposed in regulatory approvals, such as excess capital requirements, dividend limitations, independent audits or agreed-upon procedures requirements, independent valuations, and legal lending limits.
FDIC-assisted transactions. FDIC-assisted transactions have extremely short time frames for bidding and closing acquisitions, while important information about the failing bank, such as examination ratings, board minutes, employee information, and employment contracts, may not be available to the prospective acquirer. The due diligence review is limited to 2 1/2 to 3 days and is usually performed by four to six individuals. The acquiring institution should carefully read the purchase and assumption agreement. On April 1, 2010, the FDIC lowered its loss-sharing coverage for purchases and assumptions from 95 to 80 percent, so the risk of losses has increased for an acquiring institution.
GAAP accounting. ASC Topic 805 has changed many well-established business combination accounting practices and significantly impacts how acquisition transactions are reflected in the financial statements. It affects the allowance for loan and lease losses (ALLL), capital, regulatory capital, goodwill, acquisition-related expenses, and earnings.
ASC Topic 805 requires that receivables, including loans, acquired in a business combination be recorded at fair value. Separate valuation allowances are not recognized on assets that are recorded at fair value as of the acquisition date. The determined fair value of the acquired loans and leases, as defined in ASC Topic 820, become the new book value, which is the basis to assess future reserve requirements. It is important to note that some acquiring institutions have found that the elimination of the ALLL for the loans at the acquired institution has a negative impact on the total risk-based capital of the newly combined entity, since the ALLL is a component of tier 2 capital.
Subsequent to the measurement period, a loan loss reserve should be established for these loans in accordance with existing ALLL guidance. Additional analysis, such as historical and peer group, may be required to determine the effect of acquisition-related loans on the historical loss rates, coverage ratios, and allowance ratios. Institutions may need to implement new systems to segregate acquisition-related loans from the originated portfolio.
The acquirer shall account for transaction or acquisition-related costs (e.g., finder's fees, advisory, legal, accounting, valuation, or other professional or consulting fees) as expenses, which differs from the treatment under previous GAAP. The acquirer would defer these costs under previous GAAP by adding them to the purchase price, which typically increased recorded goodwill. The expensing of transaction costs under ASC Topic 805 reduces an acquirer's earnings and capital, as the expenses are recognized.
ASC Topic 805 affects how companies negotiate and structure transactions, model financial projections of the acquisition, and communicate to stakeholders. For more information, Interagency Supervisory Guidance on Bargain Purchases and FDIC- and NCUA-Assisted Acquisitions is available online.
Business combinations during times of uncertainty and volatility can be extremely challenging, but rewarding in the long run for an astute acquirer. Novelist Louisa May Alcott once said "I am not afraid of storms, for I am learning to sail my ship." Before embarking on an acquisition, prospective acquirers should realize that there is a steep learning curve, and that it is challenging to navigate through the complexities of GAAP accounting, FDIC-assisted acquisitions, and bargain purchases.