Acquisition Due Diligence – Pro Forma Information

Thoughtware Article Published: Jan 01, 2018
Two bankers shaking hands

The number of annual bank acquisitions is on the decline after peaking in 2014. Interestingly, the number of deals declined during 2016, suggesting larger banks were being acquired, as compared to recent years. During 2017 the number of deals and aggregate deal values decreased while the average deal value per tangible common equity increased. Approximate average deal value to tangible common equity is 161 percent for 2017, based on 115 completed deals, as compared to 143 percent during 2016 at 227 deals. Average deal values to earnings are slightly lower—22.1 percent during 2017 as compared to 24.05 percent during 2016.

Acquisition Due Diligence – Pro Forma Information Chart

Various factors have contributed to the rise in bank acquisitions since 2012, including increased regulatory compliance, succession planning issues, increasing capital requirements, the need to leverage excess capital and uncertainty in operating risk associated with government regulations. However, under the Trump administration, these trends may not continue at the same pace due to recently enacted tax reform and promises for reduced regulatory burden. The reduction in corporate and individual tax rates likely will affect pricing strategies with considerations for regulatory capital related to reduced net deferred tax assets and longer term benefits of reduced income tax provisions and increases in net earnings. Many bank management teams are assessing their strategic plans to be either buyers or sellers based on the changing acquisition environment.

This article is primarily for those who buy banking organizations and relates to their due diligence in preparing pro forma financial information; however, sellers also may find the information useful.

One of the first considerations in the acquisition process is obtaining regulatory approval. The application process should include thorough due diligence of the target, a well-documented post-acquisition business plan and pro forma financial statements and disclosures with post-closing capital ratios. Capital ratios pre- and post-close will be an important area of emphasis for regulators to evaluate the viability of the transactions and will influence ultimate approval. Therefore, it’s important for the buyer to carefully evaluate the transaction and pro forma financial information recording.

A first step in preparing accurate pro forma financial information and disclosures is summarizing the deal contract, including the purchase price, contingencies, obligations and transactions occurring due to change in control provisions and transfer of assets acquired and liabilities assumed. Once a clear understanding of the transactions is obtained, the acquirer will need to apply Accounting Standards Codification 805, Business Combinations, to the transaction, which requires a thorough analysis and recording of assets acquired and liabilities assumed at fair value. The following are some high-level reminders when recording a target acquisition:

  • With limited exceptions, assets acquired and liabilities assumed, and noncontrolling interest, are recorded at fair value
  • Merger-related costs such as legal, accounting and consulting fees are no longer capitalized into the acquisition price
  • Currently, none of the target’s allowance for loan losses transfers to the acquirer. Instead, adjustments for credit risk are subsumed in the fair value of loans acquired
  • Any excess of net assets acquired over the purchase price (formerly negative goodwill) is recognized in earnings as a bargain purchase gain
  • The acquisition date is the date on which the acquirer obtains control of the target
  • Adjustments to fair value may be made post acquisition within one year after the acquisition date if better information is obtained

Estimating fair value can be challenging pre-acquisition and may require outside assistance, particularly with loan portfolios. Bankers generally instill good due diligence processes when evaluating loan credit quality; however, other fair value adjustments often are overlooked, such as those related to current interest rates and terms as compared to contractual agreements in place, liquidity premiums or estimation of prepayments, all of which can have a material effect on fair value measurements either individually or in the aggregate. The same is similar to other financial instruments, including deposit portfolios.

The effects on the financial statement may be long-lasting due to post-acquisition accretion or amortization of discounts or premiums applied to assets and liabilities to arrive at fair value. These subsequent adjustments and impairment considerations are important to the pro forma financial disclosures because they may have significant effects on results of operations and cash flows of the entity.

It also is important to understand Statement of Financial Accounting Concepts No. 6, Elements of FinancialStatements, regarding elements of financial statements and criteria for recording an asset or a liability. In some cases, assets or liabilities recorded on a target’s balance sheet may not qualify for an asset or liability on the acquirer’s books during the acquisition process, and vice versa. Items to carefully examine may include prepaid assets, unrecorded payables, employee relocation cost or terminations, payroll liabilities arising from stock-based compensation plans, equity method investments, favorable or unfavorable leases and assets and liabilities arising from contingencies.

In other cases, costs an acquirer expects but isn’t obligated to incur in the future aren’t liabilities at the acquisition date, but are costs that the acquirer will incur subsequent to the acquisition date. A common example includes the decision to terminate software contracts of the target post acquisition. In this circumstance, the buyer may have negotiated the termination cost into the acquisition price and cost to the selling shareholders, with a perception the cost will be recorded as a liability at the acquisition date. However, a liability or related expense isn’t incurred until the software is terminated—often post acquisition—resulting in an expense to the buyer.

Many purchase and assumption agreements include purchase price allocations based on a target’s capital, as stated in accordance with generally accepted accounting principles. Applying a thorough due diligence process with an understanding of the concepts described above can improve buyer and seller expectation related to deal values and pro forma information results, resulting in accurate pro forma information that can help with expedited regulatory approval and depiction of the transactions post close.

For more information on how issues in this article could affect your institution, contact Doug or your trusted BKD advisor.

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