As banking M&A heats up, it pays to know acquisition accounting

Aug 18, 2015

Since 1980, more than 10,000 mergers involving more than $7 trillion in acquired assets have taken place in the U.S. banking industry, according to a 2012 Federal Reserve working paper. And with regulators recently approving some mergers between regional banks, and the Federal Reserve finalizing a rule that makes it easier for small banks to pursue mergers, some banking industry experts expect M&A activity will pick up in the coming months.

This expected activity makes it critical that financial institutions have a solid grasp of acquisition accounting, according to David Heneke, principal in CliftonLarsonAllen LLP’s financial institutions practice.

“The industry’s in a state of consolidation, and with consolidation comes these accounting rules, so this affects anybody who’s thinking about an acquisition – either looking at making an acquisition or considering becoming a seller,” he said.

Heneke, who will lead a presentation on loan acquisition accounting at the 2015 Risk Management Summit presented by Sageworks on Sept. 23-25, says one of the most vexing areas of acquisition accounting is the process of dividing the acquired loan portfolio into “buckets” of impaired loans and performing loans.

Decisions about which of these loans get labeled purchased performing and which get labeled purchased impaired are important, because all assets and liabilities need to be recorded at fair value on the acquisition date. As loans are marked to fair value, the acquiree’s allowance doesn’t carry over; instead, the allowance takes shape as a discount to loans, according to Heneke. Those discounts are treated differently depending on the type of loan.

The accounting for purchased loans can impact pricing, Heneke noted. For example, the buyer of a financial institution can end up with an especially good deal if the seller agrees to retain a group of bad loans but doesn’t stipulate in the merger agreement that it will receive an amount equal to the reserve that had been set up for the loans (and which won’t carry over when the loans are marked to fair value).

Heneke advises that banks should only identify as purchased impaired those loans that absolutely have to be categorized that way. Data related to purchased performing loans can be integrated somewhat from the core system, he said, “so the accounting handles itself.” That’s not the case with purchased impaired loans, which require a lot of manual accounting, he said.

In addition, once loans are labeled as either purchased performing or purchased impaired, the financial institution is stuck with that label until the loan is off the books, with limited exceptions.

He said only a couple of types of loans must be labeled as purchased impaired: Loans that are on nonaccrual status and loans that are 90 days past due. “That’s your starting point,” he said. “But outside of those two types, it comes down to the individual circumstances of an individual credit,” and financial institutions need more information about the loan to make the determination.

It’s these “tweener’’ loans– those that are current now but where there is a lot of doubt — that are the most challenging for banks as they try to bifurcate the loan portfolio, Heneke noted.

“For example, some banks call loans impaired because there’s a collateral shortfall, but it’s not an impaired loan by the pure definition, because there’s nothing to indicate it is probable they are going to stop paying,” he said. The theory of labeling a loan purchased impaired is based on whether the borrower can make payments.

Loans rated as substandard but not 90 days past due and not on nonaccrual status are tricky. Heneke recommends considering whether the borrower is current, and whether the borrower is expected to remain current into the foreseeable future. If the answer to those questions is yes, a case can be made to label this loan purchased performing. “But if the answer is no to either one, it’s a little harder to make the case for purchased performing treatment,” he said.

To learn more from Heneke about accounting for purchased loans, attend the 2015 Risk Management Summit. You can also download the whitepaper, “Accounting for Purchased Loans: Easier Said Than Done.”