The Impact of the Acquisition Method of Accounting on Corporate Credit Union Mergers

1. The Impact of the Acquisition Method of Accounting on Corporate Credit Union Mergers

2. Prepared by the following ACCU Committee John Cassidy, Southwest Corp Todd Adams, Members United Kathy Brick, US Central Laura Cloherty, WesCorp

3. Today’s Presentation Overview of Merger Accounting Comparison of Pooling vs. Acquisition Methods Acquisition Method Implementation Guidance NCUA Considerations Q & A

4. Overview of Merger Accounting Background APB16 (1970) for Business Combinations Pooling-of-interests method required if 12 criteria met Purchase method required for all other business combinations

5. Overview of Merger Accounting The Beginning of the End In 1996 FASB began a project to reconsider APB16 due to criticism that similar business transactions were accounted for using different methods that produced dramatically different results.

6. Overview of Merger Accounting New FASB eventually issued FASB 141 on Business Combinations issued in 2001 Required all business combinations within scope to be accounted for using the purchase method Eliminated the pooling method

7. Overview of Merger Accounting However, credit unions not within the scope of FASB 141 “This statement does not apply, however, to combinations of two or more not-for-profit organizations, the acquisitions of a for-profit business entity by a not-for-profit organization, and combinations of two or more mutual enterprises.” Credit union mergers remained under APB 16

8. Overview of Merger Accounting FASB finally to address credit union mergers Exposure draft issued by FASB in 2005 on business combination Scope includes credit unions

9. Overview of Merger Accounting Paragraph 53 of FASB exposure draft “In a business combination involving only mutual entities in which the only consideration exchanged is the member interests of the acquiree for the member interests of the acquirer…, the amount equal to the fair value of the acquiree shall be recognized as a direct addition to capital or equity, not retained earnings.”

10. Overview of Merger Accounting Current status FASB has discussed the Exposure Draft at 20 meetings and expects to issue a final statement (FAS 141R) in early October Credit unions will be required to use the acquisition method of accounting for mergers

11. Comparison of Pooling vs. Acquisition Methods Two methods = Pooling or Acquisition Pooling method may be available for mergers through 2008 Acquisition method will most likely be effective for mergers beginning on or after January 1, 2009

12. Comparison of Pooling vs. Acquisition Methods Pooling Method Combine the balance sheets No consolidation adjustments “Retained Earnings” (before) equals “Retained Earnings” (after)

13. Pooling Method Illustration

14. Comparison of Pooling vs. Acquisition Methods Acquisition method Fair value the acquired credit union Fair value each individual asset and liability Identify and fair value intangible assets Goodwill is the balancing entry “Retained Earnings” (before) equals “Capital Acquired in a Merger” (after)

15. Acquisition Method Illustration

16. Comparison of Pooling vs. Acquisition Methods Acquisition Method Notes A. Value the entity as a whole first (this is your credit to equity). The example assumes a book value multiple of 1.30 (banks average 1.70). B. Determine a fair value of each investment, loan, certificate or borrowing with a maturity greater than 1 year. C. Buildings, equipment and other fixed assets would require an appraisal market valuation.

17. Comparison of Pooling vs. Acquisition Methods Acquisition Method Notes D. Identify and value intangible assets. These may include customer lists or contracts to provide services (ie, item processing agreements, advisory contracts, employment agreements, etc). E. Eliminate retained earnings of the acquired credit union for GAAP purposes (however, maintain this number for regulatory capital ratios). F. Goodwill represents the balancing entry.

18. Comparison of Pooling vs. Acquisition Methods Capital Ratio Considerations Current retained earnings ratio declines AAP equity ratio most likely increases as intangible assets and goodwill are recorded NCUA regulatory ratio is consistent with the ratio derived under pooling. However, this would require a complex reconciliation between Regulatory and GAAP Equity.

19. Acquisition Method Implementation Guidance Overall premise of purchase accounting: Acquirer measures and recognizes the target as a whole, and the assets acquired and liabilities assumed at their fair values as of the acquisition date.

20. Acquisition Method Implementation Guidance Step one: Determine Fair Value of Entity as a Whole Determine the fair value of the target entity as a whole. Generally, the “consideration” or purchase price is considered the best evidence of fair value. However, in mutual combinations (credit union combinations), there is generally no consideration, thus the fair value of the target entity as a whole becomes a proxy for the consideration, or purchase price.

21. Acquisition Method Implementation Guidance Measuring Fair Value In the absence of “consideration”, two measurement options available: FV entire value (100% ownership) of the target (best method) FV of an ownership interest in the buyer (less reliable and more difficult to determine)

22. Acquisition Method Implementation Guidance Valuation Hierarchy Look to market value of equity interest (does not apply to credit unions as equity is not publicly traded) Look to similar transactions with consideration (not available in CU market) When no other market information exists then default to: Cost method (rarely used in this type of evaluation) Market (comparable transactions) Income method (discounted cash flows)

23. Acquisition Method Implementation Guidance Market and Income Valuation Methods Market - Look to similar transactions for other financial institutions (thrifts and banks) Income – Converts future cash flows into a present value indicator of value of target May need to use both approaches in determining a final value Valuations are typically performed by outside third party specialists ($$) and methodology needs to be acceptable and auditable by outside audit firm

24. Acquisition Method Implementation Guidance Step two: Determine Fair Value of assets and liabilities Determine the fair values of the individual assets and liabilities of the target Independent appraisals, actuarial, or other valuations may be used as an aid to determine the estimated fair values of assets acquired and liabilities assumed Consider value of intangible assets not on target’s books Outside valuation specialist ($$)

25. Acquisition Method Implementation Guidance Step three: Calculate goodwill Compare consideration (or value of entire entity) determined in Step One to fair value of assets and liabilities determined in Step Two (net assets) to calculate amount of goodwill.

26. Acquisition Method Implementation Guidance Goodwill Consideration (value of entire entity) greater than fair value of net assets, then goodwill created Consideration (value of entire entity) less than fair value of net assets, then bargain purchase If bargain purchase, then value of certain assets reduced until negative goodwill reduced to zero, or extraordinary gain recognized

27. Acquisition Method Implementation Guidance Goodwill Once created, goodwill measured periodically for impairment (no more systematic amortization over fixed period of time) If deemed to be impaired, immediate write down to new reduced value

28. Acquisition Method Implementation Guidance Increased bookkeeping requirements Will require that the original cost basis be retained separate from the fair market values at acquisition at a detailed level Example: Above- or below-market rates on member share accounts would be recorded at a different acquisition amount than actual cash flows that will be paid to members and must be tracked separately. As accounts pay down and mature, associated purchase adjustments must be relieved

29. Acquisition Method Implementation Guidance Disclosure Requirements Increased financial statement disclosure requirements that enable users of financial statements to evaluate the nature and financial effect of the business combination

30. NCUA Considerations Overview Move to Acquisition Method of Accounting would require some revisions to Part 704 Main issue concerns creation of new line item under capital for retained earning obtained through merger Some revision to definitions to include “acquired” retained earnings or capital ratios would be understated

31. NCUA Considerations Background NCUA commented in 12/05 regarding their disagreement with the replacement of the Pooling Method with the Acquisition Method Federal Credit Union Act amended as part of FSRRA of ’06 to revise the definition of net worth for PCA purposes to include “retained earning of any other credit union with which the credit union has combined”

32. NCUA Considerations Outlook The following represents the “tentative” thoughts of the OCCU, no actions have yet been taken An OCCU recommendation was drafted but held at the request of the OE&I until the final statement is issued by FASB

33. NCUA Considerations Outlook OCCU recommendation is to revise Part 704 to state that corporate credit union mergers are to be accounted for under the Pooling Method OCCU recommendation would create a significant GAAP/RAP difference This approach will apparently also apply to natural person credit unions

34. NCUA Considerations Impact on Corporate Credit Unions Even if the Pooling Method is more appropriate, the creation of a GAAP/RAP difference is not warranted The GAAP/RAP difference will create additional work as the merging corporate will need to maintain two sets of books The GAAP/RAP difference will create confusion among users of corporate financial statements

35. NCUA Considerations Possible Next Steps for Corporate Credit Unions Determine if OCCU’s tentative stance on Pooling is shared within NCUA & other regulators Active dialogue between OCCU and ACCU to influence OCCU’s stance on the Pooling Method ACCU coordination with other credit unions trade associations to influence NCUA’s stance on Pooling Comment letters from ACCU and individual corporates if/when OCCU issues an ANPR