Three pillars of M&A accounting
Successfully integrating an acquired bank requires careful attention to three core accounting challenges:
1. Day 1 valuation
The first step in the accounting process for an acquisition is establishing a fair value for the target institution’s assets and liabilities. This valuation impacts financial reporting for years to come, making accuracy essential. Key considerations include:
- Loans and assets: Banks must mark acquired loans and other financial instruments to fair value, distinguishing between performing and purchase credit deteriorated (PCD) assets.
- Fixed assets: ATMs, computers, and other equipment typically require full appraisals, with real estate valuation being particularly complex.
- Intangibles and goodwill: Core deposit intangibles (CDIs) represent the value of customer relationships and must be accounted for separately from goodwill.
Many banks make the mistake of relying on aggregate calculations that lack the necessary loan-level detail, which can lead to financial reporting challenges later on.
2. CECL transition
One of the biggest shifts in M&A accounting under CECL (current expected credit loss) rules is the need to integrate two institutions’ loss estimation models into a single framework.
Key steps in this process include:
- Determining whether the acquiring bank’s CECL model can accurately reflect the combined portfolio. Typically, the buyer’s CECL framework survives. However, if it’s a merger of equals or a smaller buyer acquiring a larger target, adjustments may need to be made.
- Evaluating the methods used by both banks – If one uses a forecast regression model and the other a warm-back model, they may not align. Similarly, if a target institution has auto or residential loans that the buyer doesn’t specialize in, the CECL framework may need modifications. Assess whether the target bank’s historical loss data should be incorporated or if separate modeling is necessary.
- Setting up appropriate segmentation for PCD assets, which require distinct calculations under CECL. Before CECL adoption, technical accounting dictated how to handle purchase marks. But Abrigo's VP of Advisory Services, Neekis Hammond, warned banks that purchase marks can't be thrown into the core system and accreted accordingly. "Under CECL, these marks can be material, and core processing systems don’t provide enough audit support to accrete them," he said on Ahead of the Curve podcast. "This is something often overlooked but critically important."
Banks must document their CECL transition process thoroughly to satisfy auditors and regulators. Simply folding the acquired bank’s portfolio into the existing CECL model without justification can lead to compliance issues.
3. Income recognition
Recognizing income on acquired assets is another critical component of M&A accounting. Banks must track and amortize purchase accounting adjustments over time, ensuring transparency and auditability.
Common pitfalls include:
- Using core systems that lack detailed tracking of purchase accounting marks.
- Failing to establish a process for recognizing interest income and accretion.
- Overlooking the impact of fair value adjustments on financial statements.
Given today’s interest rate environment, purchase accounting marks can be highly material, making a structured approach to income recognition essential.
