With the market for financial services organizations’ mergers and acquisitions (M&A) showing signs of picking up, it’s time for organizations to prepare. In our last article, we covered strategies for due diligence and integration planning. In this article, our team highlights key areas of focus that can help lead to a successful close.
As financial services organizations approach the various phases of M&A, a critical step is to create a closing plan. The objective of the closing plan should focus on ensuring proper accounting and financial reporting to enable users of the financial statements to make informed decisions about the reporting entity. The closing plan should identify the necessary resources and timing needed for the key areas of focus that follow.
A thorough review of the merger agreement is critical for identifying any provisions that could have accounting implications or tax ramifications. Involving the accounting team early in this process, ideally in the drafting phase, allows for real-time feedback and proactive planning, and it can help avoid unintended ramifications further along in the process.
One key area to examine is the consideration outlined in the agreement. While a stock exchange or mix of cash and stock is typical, organizations need to be aware of any other forms of consideration that should be evaluated, such as settling warrants or similar awards, awards to executives on the successful closing of the merger, or earnouts and contingent consideration. Compensation agreements should also be scrutinized. Terms related to change-in-control payments, bonuses, or other compensation triggered by the transaction are examples of items that might require special accounting considerations.
It’s also important to assess the broader financial reporting implications of the deal structure and timing. One aspect to consider is determining the accounting acquirer, which is the entity that is required to apply purchase accounting. Depending on the transaction, this determination can be straightforward, or it can be a complex procedure. If it’s not clear which party is the accounting acquirer, organizations should perform their own analysis based on the specific facts and circumstances of their transaction and consult with their accountants and auditors if needed. If the deal is expected to be accounted for as a reverse merger, there could be unique nuances to work through with the help of technical accounting specialists. Another factor to consider is determining whether the transaction will be accounted for as a business combination or an asset acquisition. While most deals in the financial services industry going through the M&A life cycle will meet the definition of a business combination, some deals might require consideration of treatment as an asset acquisition.
In addition to evaluating the purchase agreement and transaction structure for accounting implications, organizations should also evaluate the disclosure schedules, seller business operations, and seller financials for consideration of tangible and intangible assets and liabilities that need to be reported at fair value for purchase accounting in accordance with the Financial Accounting Standards Board’s Accounting Standards Codification (ASC) 805, “Business Combinations.” This process might include evaluating business lines for potential customer relationship intangible assets or other aspects that might give rise to assets not recorded in the seller financial statements but should be recognized in a business combination. Working through a checklist of potential opening balance sheet considerations and documenting consideration and planned accounting treatment of each line item can help enable complete and accurate purchase accounting adjustments.
During this time, engaging with a third-party team that offers both technical accounting and audit expertise to answer questions and pull together necessary documents can help facilitate a smoother audit process for the accounting for the business combination.
Once organizations have identified the assets and liabilities to be valued for purchase accounting treatment, obtaining valuations as of the closing date of the transaction is the next critical step for financial reporting. Many organizations obtain preliminary valuation estimates of the material assets and liabilities to both better inform pro forma modeling and prepare for closing, which can help streamline the valuation process at closing. For financial services organizations, the most common significant assets and liabilities to be valued are the loan portfolio, securities, core deposit intangible (CDI) assets, time deposits, debt, mortgage servicing rights, and real estate. When there are business lines at the seller such as wealth management, fintech, payment processing, or insurance, there can often be other customer relationship intangible assets, technology, or trade names that need to be valued as well. These valuations should flow into the opening balance sheet and a purchase accounting workbook, accompanied by Day 2 accretion and amortization projections.
For each of these valuations, organizations must understand the key assumptions that drive their value. Detailed support and clear rationale for these assumptions can help organizations be comfortable with the valuation results and provide appropriate evidence to auditors. Understanding the drivers of the valuation, particularly during the preliminary stage, can help organizations plan for the impact at closing as well. For example, the loan portfolio fair value, typically estimated through loan-level discounted cash flow analysis, will be influenced by the credit risk in the portfolio; the rates, terms, and structures of the portfolio; and market participant required rates of return from an exit price perspective. The credit component is based on market participant credit expectations and is often also informed in part by credit due diligence. Beyond credit improving or deteriorating, movement in rates after loans in the portfolio were originated and favorable or unfavorable structures and rate pricing can also influence the fair value. The value of the CDI will be heavily driven by the separation between the costs of core deposits and the alternative funding sources available at the valuation date.
Along with the valuation, estimating the initial allowance for credit losses (ACL) in accordance with ASC 326, “Financial Instruments – Credit Losses,” or the current expected credit loss (CECL) model, for the acquired loan portfolio is a critical step in the M&A process for organizations. Unlike traditional purchase accounting, organizations apply the CECL estimate postclose, not as part of the opening balance sheet, and do not have a measurement period of up to one year from the acquisition date to adjust ACL estimates for new information, which heightens the importance of accurately estimating expected credit losses following transaction closing. As the acquisition date approaches, organizations need to plan for how they will align the acquired loan portfolio with their ACL approach and verify that proper controls are in place over the CECL estimation process. This preparation includes robust documentation, data integrity checks, and alignment among the valuation, accounting, and financial reporting workstreams. Following are several steps to consider when estimating CECL:
Throughout the preparation of valuation and CECL estimates related to the transaction, getting auditors involved early can facilitate a smoother closing process.
A purchase accounting workbook includes a variety of items to properly apply purchase accounting in accordance with ASC 805. Some of the key aspects are determining the purchase consideration, evaluating proper treatment for purchase price allocation, and establishing an opening balance sheet. These steps are necessary for postclose financial reporting and in the lead-up to closing as part of the regulatory approval process and Securities and Exchange Commission (SEC) reporting requirements, if applicable. As part of the regulatory application for merger approval, organizations are typically required to submit a pro forma opening balance sheet and detailed projections reflecting the anticipated effect of the transaction on the combined organization. Detailed coordination among the valuation team, accounting advisers, and the bank’s finance team is essential to help provide consistency and accuracy in these submissions and reporting requirements. The purchase accounting workbook should build on the pro forma modeling conducted earlier in the deal life cycle, as outlined in our M&A strategy and due diligence and integration planning articles, to move from preliminary estimations in the pro forma model to the final opening balance and related journal entries for financial reporting.
As part of the purchase accounting workbook, organizations should prepare an opening balance sheet reconciliation, often called an “accounting bridge.” This reconciliation bridges the seller’s final preacquisition balance sheet with the opening balance sheet reflecting all purchase accounting adjustments. It itemizes each fair value adjustment ascertained by third-party valuation specialists and reconciles the total goodwill or bargain purchase amount recognized. In addition, it should incorporate insights from the organization’s tax team to identify the correct tax treatment of the transaction and any tax assets or liabilities associated with the transaction. This multidisciplinary approach enables proper financial reporting and provides regulators with a comprehensive picture of the combined entity’s financial position immediately after the transaction closes.
Acquisitions are not a regular occurrence for most organizations, so it’s important for organizations to prepare audit-ready documentation and maintain effective internal controls over a transaction during the closing phase. Documentation should include an accounting policy related to merger activities and a purchase accounting memo detailing the purchase price allocation and subsequent accounting components, assumptions, estimates, and calculations.
From an internal controls perspective, organizations should first establish internal controls to address the existence, completeness, and accuracy of acquired historical balances. This process includes implementing controls, such as reconciling loan and deposit trial balances and tracing key attributes to source documents; sending confirmations to acquired loan and deposit customers and other third parties, such as correspondent banks and security safekeeping agents; and reviewing the System and Organization Controls reports of the acquired entity’s key systems. Organizations should also identify and implement key controls specific to the purchase accounting and fair value processes. This process includes maintaining documentation to substantiate procedures performed, reviews, and decisions made regarding opening balance sheet adjustments, valuations, and purchase price allocation. Developing a checklist and methodology for validating the accuracy of the key inputs used for the valuation, as well as other critical financial reporting purposes, is also helpful.
As the deal is announced, organizations typically file a press release, prepare an investor presentation, and submit regulatory applications with preliminary estimates, projections, and key information on the transaction. Controls should be in place over the preparation of these materials to help manage the completeness and accuracy of the information being publicly disseminated or provided to regulators. Looking ahead, the combined entity will need to assess its overall control environment postclose. New controls might be required to address additional risks, complexities, and changes in the business stemming from the transaction.
Organizations will also need to draft acquisition footnote disclosures to meet financial reporting requirements. If organizations are subject to SEC requirements, they should work with their team to comply with all disclosure requirements, including pro forma disclosures and filings leading up to closing, along with quarterly financial reporting requirements postclose.
Organizations need to take a proactive approach to be able to effectively navigate the regulatory approval process in the banking sector. Knowing the rules and understanding potential regulatory concerns with the merger is crucial, especially with updated merger application policies the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency issued in 2024 and given the heightened scrutiny for regulatory approval.
Diligence in providing the required information up front can enable a shorter approval process. Larger transactions usually receive heightened scrutiny, which can divert resources from processing approvals on smaller transactions and cast a shadow on all mergers. These factors further emphasize the importance of a diligently prepared merger application, no matter the size of the transaction. Poorly prepared applications can significantly delay approval or even lead to denial or request for withdrawal of a prospective transaction. At the start, organizations need to be realistic about where their proposed merger is on the spectrum of risk from a regulatory perspective and proactively address any significant issues head-on. Regulators typically value self-identification and realism. Attempts to superficially address or downplay deficiencies and concerns are ill-advised and typically ineffective. Rather, conducting robust due diligence in areas of concern and devising a strategy to address vulnerabilities can best position organizations for the regulatory approval process.
From a financial and transaction structuring perspective, reliable and robust pro forma financials can help demonstrate the financial soundness and outlook of the combined organization and minimize related inquiries if done diligently. As the economic environment shifts and regulatory expectations change, organizations might need to deploy different tactics for strategy and transaction structuring to bridge gaps in pricing and the financial outlook of the combined organization. Traditional concentration assessment has also evolved to incorporate broader loan and deposit diversification, which is another factor to consider when aligning the portfolios of the two organizations.
The combined organization must be financially sound, but regulatory approval is not just focused on whether the combined organization is stronger from a financial perspective. Regulators are increasingly focused on consumer compliance, convenience, meeting the needs of the community, and competition beyond traditional safety and soundness. With the focus on the community in merger approval, emboldened community groups can sometimes protest proposed mergers, meaning buyers might be inclined to proactively work with those groups to avoid objections to the agencies’ decision-makers.
In today’s environment, the presence of any fair lending, Community Reinvestment Act, Bank Secrecy Act, or anti-money laundering concerns, any recent instances of noncompliance (particularly unresolved matters requiring attention or other regulatory criticisms), or involvement in fintech or crypto and digital asset activities by either party in a transaction can trigger significant scrutiny and potentially derail the approval process. Regulatory agencies might require a remediation plan – one that could surpass demands already imposed on the seller organization and include remediation for certain issues before closing – to address compliance concerns and map out exit strategies for undesirable activities. However, some activities might be profitable and legally permissible, so establishing a plan to mitigate and manage risk might be more advisable than conceding to exit those activities. Additionally, organizations should understand the impact of any written conditions that could limit their growth plans and strategy. Organizations should plan how to manage how any imposed conditions to maintain strategic flexibility, such as evaluating how they might be converted to informal or formal actions, minimizing the time subject to the conditions, or minimizing the breadth and depth of the conditions.
Beyond specific compliance concerns, strong management teams are imperative to a successful transaction. Thoroughly vetting the target’s management team and board members is critical, as is disclosing any identified financial, legal, or ethical issues. Organizations should also evaluate the seller’s compliance management systems and enterprise risk management processes, including competent staffing, comprehensive risk management capabilities, and effective oversight by management and the board.
The timeline from deal announcement to legal close can be an extended process. Regulatory approval must be obtained before the transaction can officially close, and the approval process often takes several months. During the interim period between signing and closing, the two organizations legally remain separate entities and generally cannot integrate operations or combine into a single entity until after the deal officially closes. However, leaders at each organization should still be proactively planning and preparing for the eventual integration. Both parties of the transaction should also be cognizant of any transition constraints or restrictions during this interim period, such as limitations on lending activities or capital levels to be maintained.
Certain integration workstreams and activities can and should take place prior to close. With an integration plan and integration management office (IMO) established to run the integration planning process, organizations can continue building the integration blueprint and road map to align with the expected timing and milestones while identifying integration work that can be completed ahead of closing. This process, facilitated by the IMO, might include assessing talent and resource needs, requesting more detailed information from the partner bank, and creating a timeline – all while balancing level of work and effort with likelihood of closing. Overall, organizations should assess their readiness for transaction close and understand which responsibilities will transition at the transaction close date.
As the anticipated closing date approaches, planning for core conversion, system selections, and data migration becomes paramount. It’s crucial to verify that all required data can be extracted, mapped, and migrated over as of the anticipated conversion date after closing, and going through planning and mapping activities for system conversions is an important part of what can be done ahead of closing. Recreating historical data after the fact might not be possible with legacy platforms; therefore, having a comprehensive plan for transitioning data is essential for system conversion readiness. Additionally, organizations can plan for the target operating model of the combined organization, define a unified regulatory compliance program, begin contract negotiations, review vendor assessments, align procedures, policies, and products, and work on cultural and employee alignment in the period leading up to close. As part of assessing process and product alignment, organizations can conduct gap analyses of departments and products to identify differences in processes, differences or similarities in products, and solutions for resolving process gaps or solutions for integrating products.
Organizations should develop and execute a comprehensive communication strategy during every phase of the M&A process, especially once the transaction is publicly announced. Regularly communicating with stakeholders, including employees, customers, the community, and board members, can help retain key personnel, maintain customer confidence, address any community groups’ concerns, and facilitate a smooth transition.
A well-designed employee communication plan can help retain top talent and maintain morale, especially during the closing process and the transition period. By keeping employees informed and engaged throughout the process, organizations can help mitigate uncertainty and potentially reduce the risk of losing valuable personnel.
Maintaining customer confidence and loyalty is also paramount during an M&A, which is why it’s important to maintain frequent and consistent communication throughout the process. Organizations should determine how customers might be affected and determine the best approach to communication to help alleviate customer concerns and reinforce the organization’s dedication to their needs.
Crowe frequently supports organizations in managing the more technical and cumbersome transaction elements, especially in the areas of accounting and valuation needs, integration, audit considerations, and regulatory or compliance concerns. Focusing on these key areas can go a long way to help you have a smooth and successful close process.
FASB materials reprinted with permission. Copyright 2024 by Financial Accounting Foundation, Norwalk, Connecticut. Copyright 1974-1980 by American Institute of Certified Public Accountants.
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