Two railroad tracks merge en route

Increasing regulatory compliance costs, decreasing margins, and intensifying competition from both traditional and emerging providers of financial services have spurred significant merger and acquisition (M&A) activity throughout the community banking industry. According to SNL Financial, nearly 300 bank acquisitions occurred in each of the last two years and 2016 is on pace to match or exceed that number. Within all of the M&A-related activity banking executives must focus on, key financial and regulatory compliance items typically fall into three stages.

Stage 1 – Readiness

In this first stage, buyers of community banks need to identify candidates aligned with their growth goals and uncover any potential issues early. Sellers need a thorough understanding of how to attract buyers and maximize value. Items to focus on within the readiness stage include:

  • Quality of earnings. Validate net interest margin, sustainability of non-interest income, and ability to achieve cost/expense savings, and quality of assets.
  • Purchase accounting. Include posting and disclosures, documentation of inputs and assumptions, and contingent considerations for pro forma financial statements.
  • Loan acquisition accounting. Understand inputs/drivers in the loan portfolio initial valuation and the impact going forward, include consideration of accounting for purchase credit impaired (PCI) loans vs. non-PCI loans.
  • Regulatory impact. Interpret bank regulatory matters that may affect the transaction or future operations, such as the effect the current expected credit loss (CECL) standard has on capital planning.
  • Compliance. Review regulatory compliance structure for potential violations that may result in operating restrictions, penalties, and fines. Include high risk areas such as affiliate transactions (Regulation W) and insider lending (Regulation O).
  • Internal controls. Evaluate internal controls, gaps and weaknesses, remediation analysis, and sufficiency of internal control environment.
  • Internal audit structure. Identify internal audit structure deficiencies and provide a method for testing the internal control environment.
  • Vendor management process. Identify potential issues in vendor contracts and consider any control issues.
  • Regulatory exam reports. Analyze reports for any safety, soundness, or compliance areas of concern. Consider management’s response and implementation of recommendations.
  • Taxes. Include accounting methods, state filings, compensation plans, deferred tax analysis, change in control payments/liabilities and related tax consequences, and tax attributes such as net operating losses (NOL) and tax credits.

Stage 2 – Structuring and getting the deal done

In this stage, buyers are working to gain an understanding of the community bank as a whole, reducing risks of post-acquisition issues, and determining accurate purchase prices. Sellers must consider the letter of intent (LOI), cooperate with buyer due-diligence efforts, and fully understand the financial impact of the transaction. In this stage, banking executives must pay attention to the following:

  • Personnel quality and exit costs. Analyze capacity and skills of acquired personnel to be retained and determine severance costs where personnel are not required for post-transaction operations.
  • Vendor relationships. Identify aspects of vendor relationships that may have operational and accounting consequences, including severance costs.
  • Data and information reliability. Gain an appropriate level of confidence that the transaction analysis and decisions are based on complete and accurate information.
  • Buyer due diligence. Review information supporting the financial statements, such as loan files, and reconciliations. Conduct interviews of the seller to identify any hidden risks.
  • Material contracts. Uncover any financial risks not evident on the financial statements including potential liabilities such as change of control, technology (IT), and major leases.
  • Purchase accounting tax entries. Understand the tax treatment of various purchase accounting (fair value) adjustment entries to record the proper amount of deferred income tax asset/liability as a result of the transaction.
  • Tax-specific due diligence. Include tax accounts, accounting methods, state filings, tax exposures, compensation plans, deferred tax analysis, change in control payments/liabilities and related tax consequences, net operating losses and other carryforwards, and sales price. Analyze the transaction structuring and tax consequences as well as the financial statement impact of the transaction. Mitigate tax exposure by understanding tax positions of the other party in the transaction from a generally accepted accounting principles (GAAP) and tax return perspective.
  • Technology risk/cybersecurity. Analyze IT risks, including cybersecurity, and the financial impact of remediation activities. Consider various perspectives including people, process/controls, technology, and governance. Identify gaps and cost estimates to address any problem areas.

Stage 3 – Ongoing compliance and post-transaction

In the post-transaction stage, the resulting financial institution must effectively manage accounting, tax, and regulatory compliance requirements to gain all the expected transaction benefits. The most important areas in this stage include:

  • Purchase accounting. Ensure financial statements are accurately presented including posting and disclosures, input and assumption documentation, purchase accounting, and contingent considerations.
  • Loan acquisition accounting. Develop and maintain an accurate and reliable framework for the identification of purchased loans and the application of accounting entries related to credit performance for purchase credit impaired (PCI) loans and non-PCI loans.
  • Post-acquisition performance. Review activity post-transaction for items that may affect pricing, such as claw-back provisions, to maximize purchase value.
  • Impairment accounting. Address impairment of long lived assets, intangibles, and goodwill to ensure financial statements are accurately presented.
  • Transaction cost study. Evaluate which costs related to the transaction are tax deductible. Assess the impact on financial statements. Support capitalized amounts and expense deductions on the tax return.
  • Tax returns. Analyze tax return election and information statements related to the transaction, including tax estimate due dates and short year return due dates. Understand the tax return consequences and special findings related to the transaction. Ensure accuracy in the seller’s final tax return and the purchaser’s first post-transaction return.
  • Estate/financial planning. Prepare executives for tax obligations resulting from the transaction and mitigate future taxes.
  • Board expertise. Ensure IT risk and cybersecurity expertise is available at the board level, either through a director with specialized experience or a third-party advisor. Regulators are now expecting financial institutions to have subject-matter expertise available to advise their boards on technology and cyber risks on an ongoing basis.

With effective project management and focused attention on the key areas in each M&A stage, bank executives will be able to appropriately account for myriad costs and risks to support a successful integration.\

For more information or to learn how Baker Tilly’s specialists can help, contact our team.

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