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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 re-filed.