Over 12 years ago, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) started a joint project to provide broad accounting principles that can be applied to any business combination, no matter what industry or type of business. Although, many CPAs, including myself, do not believe that an “acquisition” occurs when two credit unions merge, our accounting standard setters have determined that acquisition accounting does apply to credit union mergers.
It is no longer acceptable to use the pooling of interests method of accounting, which was traditionally used for credit union mergers. Pooling essentially added all accounts of the two credit unions together to achieve the accounts of the merged credit unions.
Acquisition accounting is very similar to the previously known purchase accounting method, with some changes. The standard also provides guidance when a business combination does not have an exchange of cash or stock. This is the guidance that is important for credit union mergers.
Under acquisition accounting, the acquirer must be identified. The acquirer is the credit union that is ultimately in control of the combined unit. To identify the acquirer, fair value of total assets, majority of board of director votes or the ability to appoint board members or management of the combined entity should be analyzed. In the credit union context, the acquirer will typically be the surviving charter. Essentially, there is a legal question that needs to be answered – Which credit union becomes responsible for the acquiree’s assets, liabilities and activities?
The surviving credit union must then determine the fair value of the merging credit union’s assets acquired and liabilities assumed as of the acquisition (merger) date. In most cases, assets and liabilities with variable rates that are market driven have a book value that equals fair value. Generally, cash and cash equivalents, prepaid expenses, accounts payable, accrued expenses and member share accounts without maturity dates, also have a book value that equals fair value. Marketable securities would be recorded at quoted market prices, regardless as to whether they were previously classified as available-for-sale or held-to-maturity securities. The fair values of nonmarketable investments, such as certificates of deposits, fixed rate loans and long term share certificates or IRA accounts, are estimated by performing present value calculations, by comparing the actual book interest rates versus the current market interest rates. However, for loans receivable, the allowance for loan losses does not carryover as a separate account. Rather, the fair value of the loan portfolio should take into account all credit risk, as well as interest rate risk evaluations. Essentially, uncertainty about collections and future cash flows must be considered in the fair value measurement for the loan portfolio. Negative share accounts would also be treated as loans and evaluated for collectability when calculating their fair value.
That was the easy stuff. Contingent assets and/or contingent liabilities must also be analyzed under a much broader concept than under current generally accepted accounting principles (GAAP), to determine if they must be recorded at the merger date. Therefore, it is possible that more contingencies (asset or liability) will actually appear on the post-merger balance sheet. Long-term operating leases must also be analyzed to determine if there are existing favorable or unfavorable lease agreements as compared to current market lease terms available. Favorable lease terms would result in an intangible asset and unfavorable lease terms would result in a liability. If the acquiree has a defined benefit pension plan, all unamortized actuarial gains and losses must also be recognized.
The new standard describes a host of possible intangible assets that could appear at fair value on the balance sheet such as noncompete agreements, internet domain names, loan servicing contracts, computer software agreements and the core membership (deposit) base. However, the standard does not allow recording an assembled workforce or executive expertise at fair value.
The most difficult to measure intangible asset noted above will be the core membership (deposit) base. The theory behind recording this intangible asset is that considerations such as service, convenience and long-standing relationships are important in the eyes of credit union members. It is after all, these relationships that give rise to a stable source of investable funds for a credit union. Typically, core deposits are all deposits on the balance sheet except brokered deposits and share certificates over $100,000. Because merged-in members will eventually die, relocate, move their accounts or otherwise terminate their relationship with a credit union, the core deposit base is presumed to have a finite life. Therefore the resulting intangible asset will be amortized over its estimated life. A rule of thumb is that half of the core membership will terminate over 7-9 years.
The earnings method is generally used to calculate a fair value of the intangible asset for the core membership base. There are two approaches to the earnings method. The first approach, referred to as the gross earnings approach, recognizes that the core membership provides a stream of net revenue to the credit union. The future earnings benefit is the “spread” between the expected annual expense for the core membership base (dividends and operating expenses) and the expected yield on earning assets. The second approach, referred to as the cost savings approach, recognizes that the core membership base provides a stream of cost savings verses other alternatives for financing loans. This approach takes into account the expected dividend expense on the core membership base versus the cost of an alternative funding source like brokered certificates or debt.
The gross earnings approach (net revenue provided by the core membership base) is frequently the most appropriate valuation method because it recognizes the entire future earnings stream supported by the core membership base and thus implicitly includes the economic benefit of the lower risk profile of a base of core members. Under either earnings approach to valuing this intangible asset, the net earnings or net cost savings stream of amounts calculated would be present valued using a current risk free investing rate.
Once all of the fair values of assets acquired and liabilities assumed have been determined, the residual will be a new account called acquired equity. Acquired equity is a separate account that is part of members’ equity, but not included in retained earnings. However, the amount of retained earnings previously recorded by the merged-in credit union would be included in the net worth calculation of the combined credit union under PCA requirements of the NCUA.
Acquisition accounting can be extremely complex. If you need assistance in analyzing the accounting effects of potential merger candidates for your credit union, please call Sharon Gregor.