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Other Than Temporary Impairment (OTTI)

FAS 157 – Fair Value

Troubled Debt Restructurings (TDRs)

FAS 141R Purchase Accounting

Presentation to Credit Union Audit Team

by Douglas Winn

January 30, 2010

OTTI – Presentation done 5/12/2009• WW Risk Management High Level Test will identify bonds

with potential OTTI• WW Risk Management can provide OTTI Policy• Watch subordinate bonds, senior support bonds and

mezzanines in all years• Watch 2006 and 2007 all levels • Watch ReRMICs

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Fair Value Footnotes • Must include credit and interest rate calculations• Work is similar to mergers but more limited in scope – no

calculations of the value of the franchise or the core deposit intangible

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Fair Value Footnote Clients Referred By McGladrey

AltaOne

Farmers Insurance Group

Los Angeles Police FCU

Metro 1

Mocse Federal Credit Union

National 1st CU

North Island FCU

Pacific Oaks FCU

San Francisco FCU

San Mateo CU

TAPCO Credit Union

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Troubled Debt Restructurings • TDR results when lender makes a concession in response to

borrower’s financial distress• Must include credit and interest rate calculations – interest

based on the rate before modification• Accounting for consumer loans included the Center for Audit

Quality guidance on TDRs of residential mortgage loans – December 2008

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New Accounting for Business Combinations

• Combination of mutual entities including credit unions is treated as a “purchase” and must be accounted for under FAS 141R and FASB Accounting Standards Codification (“FASB ASC”) Topic 805 – Business Combinations

• Credit union to be merged in must be accounted for at fair value

• Effective for transactions consummated in fiscal years beginning after December 15, 2008

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Value of Acquired Credit Union is Two Step Process

• Step 1 – Value the entity as whole – the result is a accounted for as a direct addition to equity

• Step 2 – Determine the fair value of the acquired credit union’s assets and liabilities

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Value of the Entity as a Whole• Conclusion of “fair value” in accordance with FAS 157 and

FASB ASC Topic 820 – Fair Value Measurements and Disclosures

• Rules regarding valuing a business are set forth in the Statement of Standards for Valuation Services of the American Institute of Certified Public Accountants

• Experts generally use income-based and market-based approaches to determine fair value

• Values derived using the different methods must be reconciled to reach an overall fair value conclusion

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Income-based Approaches• Estimated future cash flows are discounted to derive an

estimate of fair value• Generally involves the use of a Cap M pricing model using an

after-tax discount rate• Estimate of terminal value is generally included• Need to consider adjustments for control premiums

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Market-Based Approaches• Generally involve the price to earnings ratio or price to book

value for publicly traded community banks with similar size, asset composition, operating strategies and geography

• Need to adjust for tax equalization

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Value of Financial Assets and Liabilities

• The valuation for loans and investments is not as simple as comparing the interest rate on the item to current interest rates using an Asset Liability Management model – the fair value must include the estimated credit losses

• The value derived should be an “exit price” according to FAS 157 and FASB ASC Topic 820

• Because the credit losses are included in the loans’ fair value – the allowance for loan losses is brought over at zero

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Value of Non-Financial Assets and Liabilities

• The largest non-financial assets are generally land and buildings – we generally have our clients obtain a commercial real estate appraisal(s) if they are material

• Need to consider whether the assets would have value to market participants after the merger – for example a multi-year prepaid contract for a service that cannot be used after the merger has no “fair value”

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Value of Non-Financial Assets and Liabilities, cont.

• Need to identify liabilities that have not been recorded that will be triggered by the merger – some forms of compensation, buy-outs of lease agreements, etc.

• Need to consider whether operating leases are favorable (asset), unfavorable (liability) or at market

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Intangible Assets• The most common intangible assets are the core deposit

intangible, mortgage servicing rights and customer relationships• Trade name – need to consider defensive value as well • Recognition of an intangible asset requires that the asset be

separable or have a contractual or legal benefit

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Core Deposit Intangible• Benefit of low cost deposits – it is not the value of the overall

deposit derived by comparing the interest rate on the deposit to rates at the time of the merger

• It is instead the estimated value of the deposits based on the fees they generate and the costs to maintain them compared to alternative source of funding such as the Federal Home Loan Bank

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Other “Day 1” Accounting Considerations

• Merger related expenses must be expensed• Restructuring costs of acquirer are recorded as “post-

transaction” expenses• Assets that an acquirer does not intend to use should still be

valued at their “highest and best use” – example defensive value of a trade name

• The accounting for contingent consideration is complex

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Accounting on Day 2• Accretion of interest income and interest expense• Adjustment of credit reserve• Do not include the loans acquired on day 1 in the combined

entity’s allowance for loan losses• Amortization of intangibles• Testing for impairment

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Amortization of Intangibles• A recognized intangible asset shall be amortized over its useful

life unless that life is determined to be indefinite• The method of amortization should reflect the pattern of

economic benefit (i.e. match amortization rate to attrition rate on core deposit intangibles) (10 year straight line has been accepted by accounting firms and regulators)

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Impairment Testing• Impairment testing for intangible assets with a finite life is based

on undiscounted cash flows according to FAS 144 and FASB ASC Topic 360 – Property, Plant, and Equipment and must be done if there is evidence that the asset could be impaired

• Impairment testing for intangible assets with indefinite lives must be done at least annually

• Impairment testing for goodwill must be done at least annually

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Goodwill Impairment Testing• Determine estimated goodwill by repeating Day 1 process• If the goodwill determined is greater than the carrying amount –

no entry need by recorded• If the goodwill determined is less than the carrying amount –

write the carrying amount down of the goodwill• Do not adjust the carrying amount of the assets and liabilities –

the revaluation is done to test for goodwill impairment only

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Wilary Winn LLCFirst National Bank Building

332 Minnesota Street, Suite W-2062St. Paul, MN 55101

651-224-1200

Douglas Winn dwinn@wilwinn.comFrank Wilary fwilary@wilwinn.com