We provide true-ups for the purchase accounting adjustments arising from mergers and acquisitions.
Why Choose Us
We perform true-up adjustments by revaluing the loan portfolio as of the valuation date using the fair value discount rate as of the date of the merger or acquisition. Many valuation firms will produce a single contra-account as of the original transaction that combines the effect of estimated credit losses, prepayments, and the note rate in comparison to market rates. They do this by using an all-in fair value discount rate. This greatly complicates the ongoing accounting because it is difficult to separate the effects that interest rate related items such as prepayments have had on the value versus credit losses. Thus, when determining the updated fair value, we use a discount rate that excludes credit spread. We apply this discount rate to expected future cash flows net of prepayments and credit losses. We can then divide the present value adjustments into separate discount rate contra and credit loss contra accounts so our clients can better understand the historical and projected performance of the portfolio.
Our ALM work provides us with robust input assumptions for loan prepayments, curtailments, and extensions, as well as deposit attrition. This knowledge informs our discount rate portion of the fair value adjustments. Similarly, our CECL work provides us with insights regarding life-of-loan credit losses to use when estimating the required contra account related to potential credit losses. We believe our knowledge in these areas combined with our extensive work in mergers and acquisitions and overall approach results in a superior product.
We begin by obtaining the attributes of the loan portfolio at the loan level to determine contractual cash flows. Our next step in the process is to determine input assumptions for voluntary repayment, involuntary repayment and loss severity to derive expected cash flows. To develop our input assumptions, we stratify the portfolio by loan attributes. For example, we separate first lien residential real estate loans from junior lien. We further divide the first liens into fixed and variable, and junior liens between closed and open-ended. For auto loans, we separate new from used, and further segment by direct and indirect. We do this because our modeling experience has shown that these loan types perform differently even with similar credit indicators.
We then segment the loan categories by predictive credit indicators. For residential real estate loans, we use FICO and combined loan to value. For other consumer loans, we rely primarily on FICO. For commercial loans, we typically apply the credit assumptions by risk rating, debt service coverage and NAICS code. We do this based on our analysis of the historical performance of billions of dollars of loans across the most recent ten-year business cycle.
For a given loan or loan cohort, we develop model input estimates for:
- Voluntary prepayment – conditional repayment rate (“CRR”)
- Involuntary prepayment – conditional default rate (“CDR”)
- Loss severity if a default occurs
We adjust the contractual cash flows based on these input assumptions and discount the resulting cash flows back to the valuation date at the discount rate used to originally determine fair value net of credit spread.
Finally, after recalculating the expected cash flows to be received from the loan portfolio, we identify if the carrying values of the contra accounts should be adjusted and provide the journal entries to do so.