Acquisition Due Diligence – Pro Forma Information

Thoughtware Article Published: Dec 05, 2019
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The number of annual bank acquisitions is on the decline after peaking in 2015. Interestingly, the number of deals and pricing matrix per transaction have decreased, while the average deal value per transaction has increased, suggesting that larger banks are being acquired as compared to previous periods. Approximate average deal value to tangible common equity is 154 percent for 2019, based on 272 completed deals, as compared to 169 percent during 2018 at 346 deals. Average deal values to earnings are slightly lower—18.8 percent during 2019 as compared to 24.3 percent during 2018.

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 Various factors have contributed to the steady pace of bank acquisitions since 2014, including increased regulatory compliance cost, succession planning issues, increasing capital requirements, the need to leverage excess capital and uncertainty in operating risk associated with government regulations. However, under the current regulatory environment, these trends may not continue at the same pace due to recently enacted tax reform and promises for reduced regulatory burden. Reduced corporate and individual tax rates and upcoming accounting changes will likely continue to affect pricing strategies with considerations on regulatory capital related to adopting an expected credit loss model and reduced net deferred tax assets and longer-term benefits of reduced income tax provisions. Many bank management teams are assessing their strategic plans to be either buyers or sellers based on the changing acquisition environment.

This article aims to help banking organizations’ buyers with 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 a thorough due diligence of the target, a well-documented business plan post-acquisition and pro forma financial statements and disclosures with post-closing capital ratios. Capital ratios pre- and post-close are an important area for regulators to evaluate the viability of the transactions and will influence ultimate approval. Therefore, the buyer should 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 should 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. Here are some high-level reminders when recording a target acquisition:

  • With limited exceptions, assets acquired, 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
  • Goodwill can no longer be adjusted after one year post-acquisition
  • 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 assets are acquired and/or liabilities are assumed
  • Adjustments to fair value may be made post-acquisition within one year after the acquisition date

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 are often 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 the entity’s operations and cash flows. 

It’s also important to understand Statements of Financial Accounting Concepts No. 6, Elements of Financial Statements, 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 the acquirer will incur subsequent to the acquisition date. A common example is 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, reach out to your BKD trusted advisor or use the Contact Us form below.

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