National Bank Appeals Process:
Appeal of Denial of Request to Record a Core Deposit Intangible and Include it in Regulatory Capital (Second Quarter 1996)
Background
A bank appealed the OCC chief accountant's denial
of its request to record a core deposit intangible, and to include
it in the calculation of regulatory capital. The bank went through a
change in control in 1984, accompanied by replacement of the
management team. The
core deposit intangible originated through a proposed
quasi-reorganization in 1995.
After mailing the associated proxy statement seeking
shareholder approval, the bank requested the OCC's opinion regarding
the appropriate regulatory capital treatment and call report
presentation for the core deposit intangible. The chief accountant advised
the bank that it was not appropriate to recognize the fair value of
the core deposit intangible in a quasi-reorganization, unless the
intangible had previously existed through a prior purchase
transaction. The chief
accountant also advised the bank that core deposit intangibles are
not included in regulatory capital.
The bank's appeal argues that the inability to
record the core deposit intangible significantly reduces the bank's
regulatory capital ratios.
Bank management further argues that the "fresh start" concept
of a quasi-reorganization only applies to the capital accounts and
not the entire balance sheet.
Because its risk components did not change, its regulatory
capital should not change.
Discussion
A quasi-reorganization is an accounting procedure
that allows a bank to restructure its capital accounts to remove a
deficit in undivided profits without undergoing a legal
reorganization. It is
based on the concept that when a bank has previously suffered loses,
but has subsequently corrected its problems; it should be allowed to
restate its records as if it had been reorganized.
The American
Institute of
Certified Public Accountants'
(AICPA) Accounting Research Bulletin No. 43 (ARB 43) requires that
the reorganized company's accounting "be substantially similar to
that appropriate for a new company." The "new company" or "fresh
start" concept is also discussed in the Securities and Exchange
Commission's (SEC) Accounting Series Release 25 and Staff Accounting
Bulletin 78. This
requires that all existing assets be recorded at fair value. It is not appropriate to
place new assets on the books that would not otherwise have been
recorded. Core deposit
intangibles result from a purchase transaction and are not present
in a newly chartered or "freshly started" bank. Therefore, the fair value of
a core deposit intangible cannot be recognized in a
quasi-reorganization unless the intangible had previously existed as
a result of a prior purchase transaction.
OCC Bulletin 95-27 states that, in a
quasi-reorganization, the bank's financial records should reflect
the fair value of all assets and liabilities. Additionally, the bank's
undivided profits account must be adjusted to a zero balance. Some other requirements for
accomplishing a quasi-reorganization are as follows:
- The bank
must first restate the recorded value of each of its identifiable
assets and liabilities to the current fair value based on an
appropriate appraisal process. In no circumstances should
a bank record goodwill because of a quasi-reorganization.
- If the net
effect of the fair value adjustments results in decreased capital,
the bank must charge this amount to the existing deficit in
undivided profits.
- Total
capital cannot be increased as the result of a
quasi-reorganization.
If the fair value adjustment would result in increased
capital, the bank must proportionately reduce the fair value of
any non-current, non-marketable asset so that capital is not
increased. Following
the quasi-reorganization, the bank should be accounted for like a
new entity.
The "fresh start" concept in paragraph 9 of ARB
43 also refers to the company's total financial reporting. By electing a
quasi-reorganization, a new basis of accounting is established and
regulatory capital is measured based on the adjusted value of the
assets. However, the
linkage by the bank of the regulatory capital treatment is
inappropriate. Section
2(c)(2) of appendix A to 12 CFR 3 specifically limits the intangible
assets that may be included in regulatory capital to mortgage
servicing rights and purchased credit card relationships. Therefore, regardless of the
accounting treatment afforded the transaction, part 3 requires the
exclusion of core deposit intangibles from regulatory capital
computations.
Conclusion
The Ombudsman denied the bank's appeal. Before the appeal decision
was issued, bank management notified the Ombudsman of its intent to
unwind the proposed quasi-reorganization. This decision was based on
management's projections that positive earnings trend would be
sufficient to eliminate the deficit undivided profits account within
12 to 18 months. Thus,
the bank could achieve the objective of the quasi-reorganization
through earnings retention.
Although the shareholders approved the quasi-reorganization,
subject to OCC approval, management never reflected its impact in
the bank's financial reports because of the pending appeal.
Unwinding the quasi-reorganization effectively
nullified the bank's request to record the core deposit intangible
on its books and include it in regulatory capital. The bank was instructed to
officially notify its shareholders of management's decision not to
implement the quasi-reorganization. Management was also asked to
apprise the bank's OCC district office of its current plans and
their impact on the banks financial performance. The bank is not subject to
SEC reporting requirements and none of its financial or regulatory
reports needed to be refiled.
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