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| CHFC > SEC Filings for CHFC > Form 10-K on 22-Feb-2013 | All Recent SEC Filings |
22-Feb-2013
Annual Report
Accounting for Loans Acquired in Business Combinations
Financial Accounting Standards Board (FASB) Accounting Standards Codification
(ASC) Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit
Quality (ASC 310-30), provides the GAAP guidance for accounting for loans
acquired in a business combination that have experienced a deterioration in
credit quality from origination to acquisition for which it is probable that the
investor will be unable to collect all contractually required payments
receivable, including both principal and interest.
Loans purchased with evidence of credit deterioration since origination and for
which it is probable that all contractually required payments will not be
collected are considered to be impaired. In the assessment of credit quality
deterioration, the Corporation must make numerous assumptions, interpretations
and judgments using internal and third-party credit quality information to
determine whether or not it is probable that the Corporation will be able to
collect all contractually required payments. This is a point in time assessment
and inherently subjective due to the nature of the available information and
judgment involved. Evidence of credit quality deterioration as of the
acquisition date may include statistics such as past due and nonaccrual status,
recent borrower credit scores and loan-to-value percentages. Those loans that
qualify under ASC 310-30 are recorded at fair value at acquisition, which
involves estimating the expected cash flows to be received. Accordingly, the
associated allowance for loan losses related to these loans is not carried over
at the acquisition date. ASC 310-30 also allows investors to aggregate acquired
loans into loan pools that have common risk characteristics and use a composite
interest rate and expectation of cash flows to be collected for the loan pools.
The Corporation understands, as outlined in the American Institute of Certified
Public Accountants' open letter to the Office of the Chief Accountant of the SEC
dated December 18, 2009, and pending further standard setting, that for acquired
loans that do not meet the scope criteria of ASC 310-30, a company may elect to
account for such acquired loans pursuant to the provisions of either ASC Topic
310-20, Nonrefundable Fees and Other Costs, or ASC 310-30. The Corporation
elected to apply ASC 310-30, by analogy, to loans acquired in the OAK
acquisition that were determined not to have deteriorated credit quality, and
therefore, did not meet the scope criteria of ASC 310-30. Accordingly, the
Corporation follows the accounting and disclosure guidance of ASC 310-30 for
these loans. Notes 1, 2 and 4 to the consolidated financial statements contain
additional information related to loans acquired in the OAK acquisition.
The excess of cash flows of a loan, or pool of loans, expected to be collected
over the estimated fair value is referred to as the "accretable yield" and is
recognized into interest income over the estimated remaining life of the loan,
or pool of loans, on a level-yield basis. The difference between the
contractually required payments of a loan, or pool of loans, and the cash flows
expected to be collected at acquisition, considering the impact of prepayments
and estimates of future credit losses expected to be incurred over the life of
the loan, or pool of loans, is referred to as the "nonaccretable difference."
The Corporation is required to quarterly evaluate its estimates of cash flows
expected to be collected from acquired loans. These evaluations require the
continued usage of key assumptions and estimates, similar to the initial
estimate of fair value. Given the current economic environment, the Corporation
must apply judgment to develop its estimates of cash flows for acquired loans
given the impact of changes in property values, default rates, loss severities
and prepayment speeds. Decreases in the estimates of expected cash flows will
generally result in a charge to the provision for loan losses and a resulting
increase to the allowance for loan losses. Increases in the estimates of
expected cash flows will generally result in adjustments to the accretable yield
which will increase amounts recognized in interest income in subsequent periods.
Dispositions of acquired loans, which may include sales of loans to third
parties, receipt of payments in full or in part by the borrower and foreclosure
of the collateral, result in removal of the loan from the acquired loan
portfolio at its carrying amount. As a result of the significant amount of
judgment involved in estimating future cash flows expected to be collected for
acquired loans, the adequacy of the allowance for loan losses could be
significantly impacted by changes in expected cash flows resulting from changes
in credit quality of acquired loans.
Acquired loans that were classified as nonperforming loans prior to being
acquired and acquired loans that are not performing in accordance with
contractual terms subsequent to acquisition are not classified as nonperforming
loans subsequent to acquisition because the loans are recorded in pools at net
realizable value based on the principal and interest the Corporation expects to
collect on such loans. Judgment is required to estimate the timing and amount of
cash flows expected to be collected when the loans are not performing in
accordance with the original contractual terms.
Pension Plan Accounting
The Corporation has a defined benefit pension plan for certain salaried
employees. Effective June 30, 2006, benefits under the defined benefit pension
plan were frozen for approximately two-thirds of the Corporation's salaried
employees as of that date. Pension benefits continued unchanged for the
remaining salaried employees. At December 31, 2012, 214 employees, or 12% of
total employees on a full-time equivalent basis, were earning pension benefits
under the defined benefit pension plan. The Corporation's pension benefit
obligations and related costs are calculated using actuarial concepts and
measurements. Benefits under the plan are based on years of vested service, age
and amount of compensation. Assumptions are made concerning future events that
will determine the amount and timing of required benefit payments, funding
requirements and pension expense.
The key actuarial assumptions used in the pension plan are the discount rate and
long-term rate of return on plan assets. These assumptions have a significant
effect on the amounts reported for net periodic pension expense, as well as the
respective benefit obligation amounts. The Corporation evaluates these critical
assumptions annually. At December 31, 2012, 2011 and 2010, the Corporation
calculated a discount rate of 4.08%, 4.90% and 5.65%, respectively, for the
pension plan using the results from a bond matching technique, which matched the
future estimated annual benefit payments of the pension plan against a portfolio
of bonds of Aa quality to determine the discount rate.
The assumed long-term rate of return on pension plan assets represents an
estimate of long-term returns on an investment portfolio consisting primarily of
equity and fixed income investments. When determining the expected long-term
return on pension plan assets, the Corporation considers long-term rates of
return on the asset classes in which the Corporation expects the pension funds
to be invested. The expected long-term rate of return is based on both
historical and forecasted returns of the overall stock and bond markets and the
actual portfolio. The following rates of return by asset class were considered
in setting the assumptions for long-term return on pension plan assets:
The assumed long-term return on pension plan assets is developed through an
analysis of forecasted rates of return by asset class and forecasted asset
allocations. It is used to compute the subsequent year's expected return on
assets, using the "market-related value" of pension plan assets. The difference
between the expected return and the actual return on pension plan assets during
the year is either an asset gain or loss, which is deferred and amortized over
future periods when determining net periodic pension expense. The Corporation's
projection of the long-term return on pension plan assets was 7% in 2012, 2011
and 2010, while the actual return on pension plan assets was 8.6%, (0.9)% and
8.7% in 2012, 2011 and 2010, respectively.
Other assumptions made in the pension plan calculations involve employee
demographic factors, such as retirement patterns, mortality, turnover and the
rate of compensation increase.
The key actuarial assumptions that will be used to calculate pension expense in
2013 for the defined benefit pension plan are a discount rate of 4.08%, a
long-term rate of return on pension plan assets of 7.0% and a rate of
compensation increase of 3.5%. Pension expense in 2013 is estimated to be
approximately $1.7 million, an increase of approximately $0.3 million, or 21%,
from 2012. The increase in pension expense in 2013, as compared to 2012, is
primarily attributable to the decrease in the discount rate, which has been
largely mitigated by an additional contribution to the pension plan, as
discussed further below. In 2013, a decrease in the discount rate of 50 basis
points and 100 basis points is estimated to increase pension expense by
$0.45 million and $0.9 million, respectively, while an increase of 50 basis
points and 100 basis points is estimated to decrease pension expense by
approximately the same amounts. The discount rate used to value the projected
benefit obligation and estimated pension expense of the Corporation's defined
benefit pension plan has averaged 6.38% over the last fifteen years. However,
the discount rate used to estimate the projected benefit obligation and pension
expense in 2012, 2011 and 2010 was significantly below this historical average
due to the historically low interest rate environment. The Corporation was not
required to make contributions to the pension plan during 2012, 2011 or 2010;
however, in order to mitigate the increases in the projected benefit obligation
and pension expense resulting from the lower discount rates, the Corporation
made a $10 million contribution to the pension plan in 2010, a $12 million
contribution to the pension plan in January 2012 related to the 2011 plan year,
and a $15 million contribution in February 2013 related to the 2012 plan year.
There are uncertainties associated with the underlying key actuarial
assumptions, and the potential exists for significant, and possibly material,
impacts on either or both the results of operations and cash flows (e.g.,
additional pension expense and/or additional pension plan funding, whether
expected or required) from changes in the key actuarial assumptions. If the
Corporation were to determine that more conservative assumptions are necessary,
pension expense would increase and have a negative impact on results of
operations in the period in which the increase occurs.
The Corporation accounts for its defined benefit pension and other
postretirement plans in accordance with ASC Topic 715, Compensation-Retirement
Benefits, which requires companies to recognize the over- or under-funded status
of a plan as an asset or liability as measured by the difference between the
fair value of the plan assets and the projected benefit obligation and requires
any unrecognized prior service costs and actuarial gains and losses to be
recognized as a component of accumulated other comprehensive income (loss). The
impact of pension plan accounting on the statements of financial position at
December 31, 2012 and 2011 is further discussed in Note 16 to the consolidated
financial statements.
Income and Other Taxes
The Corporation is subject to the income and other tax laws of the United
States, the State of Michigan and other states where nexus has been created.
These laws are complex and are subject to different interpretations by the
taxpayer and the various taxing authorities. In determining the provisions for
income and other taxes, management must make judgments and estimates about the
application of these inherently complex laws, related regulations and case law.
In the process of preparing the Corporation's tax returns, management attempts
to make reasonable interpretations of applicable tax laws. These interpretations
are subject to challenge by the taxing authorities upon audit or to
reinterpretation based on management's ongoing assessment of facts and evolving
regulations and case law.
The Corporation and its subsidiaries file a consolidated federal income tax
return. The provision for federal income taxes is based on income and expenses,
as reported in the consolidated financial statements, rather than amounts
reported on the Corporation's federal income tax return. When income and
expenses are recognized in different periods for tax purposes than for book
purposes, applicable deferred tax assets and liabilities are recognized for the
future tax consequences attributable to the differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized as
income or expense in the period that includes the enactment date.
On a quarterly basis, management assesses the reasonableness of its effective
federal income tax rate based upon its current best estimate of net income and
the applicable taxes expected for the full year, including the impact of any
discrete items that have occurred. Deferred tax assets and liabilities are
reassessed on a quarterly basis, including the need for a valuation allowance
for deferred tax assets. Reserves for uncertain tax positions are reviewed
quarterly for adequacy based upon developments in tax law and the status of
examinations or audits. As of December 31, 2012 and 2011, there were no federal
income tax reserves recorded for uncertain tax positions.
Goodwill
At December 31, 2012, the Corporation had $120.2 million of goodwill, which was
originated through the acquisition of various banks and bank branches, recorded
on the consolidated statement of financial position. Goodwill is not amortized,
but rather is tested by management annually for impairment, or more frequently
if triggering events occur and indicate potential impairment, in accordance with
ASC Topic 350-20, Goodwill (ASC 350-20). The Corporation's goodwill impairment
assessment utilizes the methodology and guidelines established in GAAP,
including assumptions regarding the valuation of Chemical Bank.
The Corporation performed its 2012 annual goodwill impairment assessment at
October 31, 2012 utilizing the quantitative assessment approach to perform a
Step 1 valuation of its goodwill as of that date. The fair value of Chemical
Bank as of October 31, 2012 was measured utilizing the income and market
approaches as prescribed in ASC Topic 820, Fair Value Measurements and
Disclosures (ASC 820). GAAP identifies the cost approach as another acceptable
method; however, the cost approach was not deemed an effective method to value a
financial institution. The cost approach estimates a company's value by
adjusting the reported values of assets and liabilities to their fair values. It
is the Corporation's opinion that financial institutions cannot be liquidated in
an efficient manner. Estimating the fair value of loans is a very difficult
process and subject to a wide margin of error unless done on a loan by loan
basis. Voluntary liquidations of financial institutions are not typical. More
commonly, if a financial institution is liquidated, it is due to being taken
over by the Federal Deposit Insurance Corporation (FDIC). The value of Chemical
Bank was based as a going concern and not as a liquidation.
The income approach uses valuation techniques to convert future amounts (cash
flows or earnings) to a single, discounted amount. The income approach includes
present value techniques, option-pricing models, such as the Black-Scholes
formula and lattice models, and the multi-period excess-earnings method. In the
valuation of Chemical Bank, the income approach utilized the discounted cash
flow method based upon a forecast of growth and earnings. Cash flows are
measured by using projected earnings, projected dividends and dividend paying
capacity over a five-year period. In addition to estimating periodic cash flows,
an estimate of residual value is determined through the capitalization of
earnings. The income approach assumed cost savings and earnings enhancements
that a strategic acquiror would likely implement based upon typical participant
assumptions of market transactions. The discount rate is critical to the
discounted cash flow analysis. The discount rate reflects the risk of
uncertainty associated with the cash flows and a rate of return that investors
. . .
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