February 29, 2008
Mr. John P. Nolan
Accounting Branch Chief
United States Securities and Exchange Commission
Division of Corporation Finance
450 Fifth Street, N.W.
Washington, D.C. 20549-0408
RE: First Federal of Northern Michigan Bancorp, Inc.
Form 10-KSB filed March 02, 2007
File No. 000-31957
Dear Mr. Nolan:
We are in receipt of the comments issued by the accounting staff of the
Securities and Exchange Commission in your comment letter dated December 19,
2007 regarding the 2006 Form 10-KSB and the Form 10-QSB for the period ended
September 30, 2007 for the above referenced company (the "Company"). We
appreciate the staff's verbal extension of time to respond to the staff's
comments. The Company's responses to the staff's comments follow:
Form 10-KSB for the period ended December 31, 2006
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Exhibit 13 - 2006 Annual Report
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Note 1 - Summary of Significant Accounting Policies
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Intangible Assets - page 13
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1. As requested in the comment, we have provided below our analysis
supporting our accounting for various branch acquisitions as
"businesses." First, however, we have summarized the applicable
authoritative accounting literature.
SFAS 141
SFAS 141, paragraph 4 states that "An entity shall determine whether a
transaction or other event is a business combination by applying the
definition of this Statement, which requires that the assets acquired
and liabilities assumed constitute a business. If the assets acquired
are not a business, the reporting entity shall account for the
transaction or other event as an asset acquisition."
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Paragraph A4 of Appendix A of SFAS 141 goes on to define a business as
"an integrated set of activities and assets that is capable of being
conducted and managed for the purpose of providing a return in the
form of dividends, lower costs, or other economic benefits directly to
investors or other owners, members or participants." The three
elements of a business, per paragraph A4 are:
a. Input: Any economic resource that creates, or has the ability to
create, outputs when one or more processes are applied to it.
Intangible assets are specifically listed as being an "input."
b. Process: Any system, standard, protocol, convention, or rule that
when applied to an input or inputs, creates or has the ability to
create outputs. Operational processes are specifically mentioned
as an example.
c. Output: The result of inputs and processes applied to those
inputs that provide or have the ability to provide a return in
the form of dividends, lower costs, or other economic benefits
directly to investors or other owners, members, or participants.
Paragraph A5 of SFAS 141 states that a business need not include
all of the inputs or processes that the seller used in operating
that business if market participants are capable of acquiring the
business and continuing to produce outputs, for example, by
integrating the business with their own inputs and processes.
Paragraph A8 of SFAS 141 states that determining whether a
particular set of assets and activities is a business should be
based on whether the integrated set is capable of being conducted
and managed as a business by a market participant.
EITF 98-3
EITF 98-3 discusses how exchanges of assets should be accounted
for at historical cost and how a "business" should be defined.
Paragraph 6 of EITF 98-3 defines a business as "a self-sustaining
set of activities and assets conducted and managed for the
purpose of providing a return to investors." A business consists
of: (a) inputs, (b) processes applied to those inputs, and (c)
resulting outputs that are used to generate revenues. For a
transferred set of activities and assets to be a business, it
must contain all of the inputs and processes necessary for it to
continue to conduct normal operations after the transferred set
is separated from the transferor, which includes the ability to
sustain a revenue stream by providing its outputs to customers."
Paragraph 6 of EITF 98-3 further evaluates the three components
of a business by indicating that inputs include:
o Long-lived assets, including intangible assets, or rights to
use long-lived assets;
o Intellectual property;
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o The ability to obtain access to necessary materials or
rights; and o Employees
Processes are defined as:
o The existence of systems, standards, protocols, conventions,
and rules that act to define the processes necessary for
normal, self-sustaining operations such as (i) strategic
processes, (ii) operational processes, and (ii) resource
management processes.
Outputs are defined as:
o The ability to obtain access to the customers that purchase the
outputs of the transferred set.
Paragraph 6 further states that a transferred set of activities
and assets fails the definition of a business if it excludes one
or more of the above items such that it is not possible for the
set to continue normal operations and sustain a revenue stream by
providing its products and/or services to customers. However, if
the excluded item or items are only minor (based on the degree of
difficulty and the level of investment necessary to obtain access
to or to acquire the missing items(s)), then the transferred set
is capable of continuing normal operations and is a business.
EITF 98-3 advises the reader to look at the transaction as a set
of transferred assets and activities and then apply the following
three-step approach:
o Identify the elements included in the transferred set.
o Compare the identified elements in the transferred set to
the complete set of elements necessary for the transferred
set to conduct normal operations in order to identify any
missing elements.
o If there are missing elements, make an assessment as to
whether the missing elements cause one to conclude that the
transferred set is not a business.
Regulation S-X Paragraph 210.11.01(d)
This paragraph states that the evaluation of whether an acquired
entity constitutes a business should be evaluated in terms of the
facts and circumstances and whether there is sufficient
continuity of the acquired entity's operations prior to and after
the transaction. This paragraph also states that a presumption
exists that a separate entity, subsidiary or a division is a
business but that a lesser component of an entity may also
constitute a business. The facts and circumstances to be reviewed
in evaluating whether a lesser component of an entity constitutes
a business are the following:
o Whether the nature of the revenue-producing activity of the
component will remain generally the same as before the
transaction; or
o Whether any of the following attributes remain with the
component after the transaction:
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o Physical facilities;
o Employee base;
o Market distribution system;
o Sales force;
o Customer base;
o Operating rights;
o Production techniques, or
o Trade names
Response
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In each case, the guidance discussed above (SFAS 141, EITF 98-3,
and Paragraph 210.11.01(d) of Regulation S-X) conveys the same
basic message: the inputs, processes and outputs associated with
the asset acquisition must be capable of performing as a
stand-alone entity in order for that set of assets to be
classified as a business acquisition and be recorded at fair
value. If the asset acquisition is not a business then the
acquisition must be recorded at historical cost. We applied the
three-step approach described above in EITF 98-3 to our branch
acquisitions:
Step 1 - Identification of the elements included in the
transferred set(s):
o Long-lived assets
|X| Facilities (buildings & equipment)
|X| Intangible assets in the form of a core
deposit intangible
o Operational Employees (branch and, where applicable, lending
staff)
o Certain processes (an understanding of the daily tasks
required to run a branch office, administration of personnel
at the branch level by the branch manager, basic knowledge
of how to process customer transactions, and essential basic
knowledge of banking rules and regulations). The processes
in place at each branch included:
a. Customer transactions:
|X| Deposits
|X| Withdrawals
|X| Check cashing
|X| Loans
b. Teller duties
|X| Branch opening and closing processes
|X| Daily drawer balancing
c. Basic branch operations
|X| Ordering cash from the Federal Reserve
o Access to customers through continuity of location - the
customer base remained largely the same after the
acquisition as it was before the acquisition.
Step 2 - The acquired set did not include:
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o Certain processes - accounting, loan processing (where
applicable), strategic processes
o Certain employees - senior management
o Trade names
Step 3 - The set(s) acquired lacked certain processes such as
accounting and loan processing (for those branches acquired with
loan origination personnel). The acquired set also lacked senior
management; however we concluded that the daily business of
running a bank branch did not require senior management
involvement. For the most part, these branches run independently
of the main office on a daily basis. The branch manager is
responsible for hiring and managing branch staff, and acquiring
necessary materials and services to run the branch.
In addition, although the trade name (i.e., the name of the bank
from which the branch was acquired) was not transferred in the
transaction, for the most part the transaction was seamless to
customers who received the same level of service from the same
branch employees the day after the asset transfer as they did the
day before the asset transfer. These customers have continued to
bank with us after the acquisition, despite the name change,
because of their level of comfort and familiarity with the local
branch staff.
In terms of processes, each branch was capable of functioning as
a stand-alone business when we acquired it. There were
undoubtedly a few minor changes to the policies and procedures
(different forms used, etc.) but, in general, bank branch
policies and procedures do not vary much from bank to bank. We
acquired a well-trained set of employees who knew the basics of
running a bank branch. Each employee understood and was capable
of operating under commonly known banking standards, protocols
and conventions and rules. Strategic management processes come
from our executive office, but basic operational processes and
resource management processes remained in place and functional at
each branch we acquired.
Conclusion
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Our conclusion on staff comment #1 is that in all of our branch
acquisitions we acquired a "business" and have properly accounted
for the acquisitions. However, in the interest of providing
investors with more complete information, we will expand our
disclosure on core deposit intangibles in future filings. Our new
disclosure will state the following:
We have in the past purchased a branch or branches from other
financial institutions. Our analysis of these branch acquisitions
led us to conclude that in each case, we acquired a business and
therefore, the excess of purchase price over fair value of net
assets acquired has been allocated to core deposit intangible
assets. Our conclusion was based on the fact that, in each case,
we acquired employees, customers and branch facilities. The
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expected life for core deposit intangibles is based on the type
of products acquired in an acquisition. The amortization periods
range from 10 to 15 years and are based on the expected life of
the products. The expected life was determined based on an
analysis of the life of similar products within the Company and
local competition in the markets where the branches were
acquired. The core deposit intangibles are amortized on a
straight line basis. The core deposit intangible is analyzed
quarterly for impairment.
2. The staff's comment refers to the exclusive contract with BCBS with an
assigned value of $579,000 recorded as intangible assets as a result
of the Company's acquisition of ICA in 2003. In the comment, the staff
requests the following specific information:
o The analysis that supports our conclusion that the decrease
in future cash flows related to the retirement of the former
owner of ICA and the termination of the exclusive BCSB
contract warranted a 75% reduction in the amortization
period during a seven-month period under paragraph 14 of
SFAS 142.
Response: When the former owner of ICA retired in May 2005
before the end of his employment contract, we evaluated the
potential impact that could have on the BCBS exclusive
third-party contract, since the contract was between the
former owner and BCBS. We determined that his retirement
opened the door for BCBS to re-negotiate this contract,
including the possibility that the contract could be
terminated. We made assumptions based on the uncertainty
involved in the future of the BCBS contract and estimated
the impact this could have on long-term cash flows. We did
not believe there was an uncertainty with respect to
near-term cash flows. Based on the guidance of SFAS 142, we
prospectively adjusted the amortization for this asset based
on our new expectations. Because of the uncertainty
surrounding the contract, we reassessed the remaining useful
life of the intangible asset. We determined that the
remaining useful life was 10 years and we re-amortized the
remaining book value over 10 years. Since we had already
amortized the asset for 2 years, the total useful life of
the asset was reduced from 20 years to 12 years.
Later in 2005 we were notified that BCBS was terminating the
contract and that effective January 1, 2006 there would be
no new insurance contracts added. We would, however,
continue to earn the override commission on any contracts
that remained active. At that point, due to the uncertainty
of potential run-off of customer accounts, we decreased the
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estimated useful life of this intangible asset. However,
given the amount of actual cash received over the life of
this asset to date, we did not anticipate a decrease in cash
flows in the near term. Effective January 1, 2005, we
re-amortized the remaining book value of the intangible
asset over 5 years. At this point we had amortized the asset
for 2 3/4 years, so the total useful life of the asset was
now reduced from our original estimate of 20 years to 7 3/4
years.
Our analysis of the actual cash flows from this asset
indicated that our original analysis of the total cash flows
over the estimated 20 year life of this asset indicated a
net present value of $890,000. We have re-evaluated the net
present value of the remaining future cash flows for this
asset based on what we have actually experienced for 2003 -
2007 and what we anticipate over the remaining useful life
(to end on December 31, 2010, five years from January 1,
2006). That re-evaluation indicates that the asset has total
value of approximately the original value of $890,000.
Further, actual cash flows for 2005, 2006 and 2007 have
approximated our original projections. This indicates to us
that there has been no impairment of this asset, nor is
there expected to be over the remaining useful life.
Our reduction of the remaining useful life was done in an
effort to be prudent, but in reality there has been no
impairment to this asset based on the retirement of the
former owner.
In future filings, our MD&A disclosure and/or our footnote
disclosure will state the following:
Using historical cash flows the customer list was assigned a
value of $890,000 and the exclusive contract was valued at
$597,000. Both assigned values were arrived at based on a
discounted cash flow (DCF) analysis that assumed a 20 year
life or 5% runoff of revenue each year. The analysis
projected net income which was discounted back to present
with a discount rate of 12%. The expected life was
determined using historical runoff rates experienced by ICA
before acquisition which were less than 5% per year.
Effective May 1, 2005, one of the former owners of ICA
retired, requiring an evaluation of the impact that this
retirement could have on both the customer list intangible
and the exclusive BCBS contract. Management determined that
the retirement could open the door for BCBS to re-negotiate
the exclusive contract, including the possibility that the
contract could be terminated. In addition, management
considered the possibility that the customer base could
deteriorate as a result of the retirement. Management made
assumptions based on this uncertainty and estimated the
impact this could have on long-term cash flows. Management
did not believe there was uncertainty with respect to
near-term cash flows. Based on the guidance of SFAS 142,
Management prospectively changed the amortization for these
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assets based on our new expectations. At that point, the
remaining useful life of the assets was determined to be 10
years. Despite the decrease in estimated useful lives, cash
flows from these assets have not deteriorated.
Effective January 1, 2006 the exclusive third-party contract
with BCBS was terminated. Prior to January 1, 2006, the ICA
exclusive agent contract with BCBS entitled ICA to an
override commission of 1.9% on all health premiums written
through local Chambers of Commerce in Northeast Michigan. On
any health insurance contracts in place as of December 31,
2005, ICA will continue to receive the 1.9% commission;
however, there will be no new groups added to this program
effective January 1, 2006. At that point, due to the
uncertainty of potential run-off of customer accounts,
management decreased the estimated useful life to 5 years
beginning January 1, 2006. However, given the amount of
actual override commissions received, management did not
anticipate a decrease in cash flows in the near term.
o A discussion of why these material reductions in expected
future cash flows were not considered permanent impairments
to the intangible asset based on the recognition and
measurement provisions for recording impairment losses in
paragraphs 7 to 24 of SFAS 144.
Response: Due to the increased uncertainty surrounding the
exclusive BCBS contract, management made the decision to
shorten the useful life of this asset. However, cash flows
associated with this asset have not diminished to the point
that required an impairment charge.
o A discussion of why the retirement of the former owners of
ICA and the termination of the exclusive contract with BCBS
has not resulted in impairment to the customer lists
intangibles with a carrying amount of $1.102 million that
were recorded as a result of the acquisition of ICA.
Response: The $1.102 million carrying amount of customer
lists intangibles recorded at December 31, 2006 is made up
of two components: $442,000 which relates to a customer list
acquisition by ICA in 2006 (after the retirement of the
former owner, so it is unrelated to the issues noted above)
and $660,000 which relates to the customer lists intangibles
for both Property & Casualty customers and Blue Cross
customers directly related to the acquisition if ICA in
2003. It should be noted that this Blue Cross customer list
relates to Blue Cross contracts written directly by ICA
agents and is unrelated to the BCBS exclusive third-party
contract.
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The continued employment of the former owners of ICA was
crucial only to the BCBS exclusive third-party contract, as
that contract was specifically between the former owner of
ICA and BCBS. The value of the customer lists acquired in
the ICA purchase is instead tied to the remaining ICA senior
staff, who have developed and maintained the relationships
underlying these customer lists. This staff is seasoned and
well-qualified to continue the operations of ICA and to
maintain these valuable customer relationships. There has
been no turnover in this staff since we acquired ICA in
2003. Our quarterly evaluation of the carrying value of
these contracts under SFAS 144 indicates that there has been
no impairment to the customer list intangible since the
acquisition of ICA.
As noted above, in future filings, we will include
disclosure related to the customer list intangible.
o A discussion of how we considered the expected reductions in
future cash flows resulting from termination of the
exclusive contract with BCBS and the loss of the former
owner of ICA in our SFAS 142 impairment testing regarding
the $1.4 million of goodwill recorded as part of the ICA
acquisition.
Response: Our annual evaluation of potential impairment of
overall goodwill under SFAS 142 takes into account total
premium dollars of the agency, which have risen since our
acquisition of ICA, indicating that the termination of the
exclusive contract was not a triggering event that would
cause impairment of overall goodwill. Our overall analysis
for 2006 (and all years prior since acquisition) indicate
that there has been no impairment to any of the intangible
assets or the overall goodwill.
In evaluating whether there is impairment to overall
goodwill, we engage an accounting firm to help us determine
a market value for ICA by gathering market multiples from
different sources that they subscribe to. They use a service
known as Pratt's Stats to arrive at an Equity Price to Net
Sales Multiple. This is a relevant ratio in that it
eliminates the need for income statement adjustments. Their
annual research of the Pratt database provides them with
approximately 10 companies to work with. Typically,
approximately 6 of these companies are viable for purposes
of comparables. The comparables that are excluded are not
included because those agencies' small size (sales volume)
rendered them not useful for this purpose. The remaining
viable comparables are split up into assets sales (3) and
stock based sales (3).
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Each year, the analysis of these comparables has indicated a
mean ratio of 1.3 to 1.9 multiples of net sales. Blending
the multiples provides us with a composite factor of
approximately 1.6 multiples of net sales. We apply this
multiple to net sales number for ICA and then add this
figure to the current value of the tangible assets and
deduct current payables (commissions, bonuses and business
payables) to arrive at a total enterprise value. We compare
that total enterprise value to the book values of goodwill,
related intangible assets and investment in ICA. Each year
that we have done this analysis, the book value has been
lower than the value based on the comparables. Based on this
analysis, management has determined that there has been no
impairment of the asset on a global or overall basis.
In future filings, our goodwill disclosure will read as
follows:
Goodwill was created in both the 2003 ICA transaction and
the 2005 customer list purchase. Goodwill will not be
amortized but tested annually for impairment. Annual tests
of impairment have included obtaining third party sales
multiple information for comparable companies. The mean of
the multiples is applied to annual net sales of ICA and
added to the value of tangible assets less current
liabilities. This value is then compared to the current book
value of goodwill, Intangibles, and Investment in ICA. Each
year this analysis has indicated no impairment of goodwill
exists. The $900,000 of payments made under the earn-out
agreement in the ICA transaction were added to goodwill as
was $48,000 in earn-out payments accrued in 2006 related to
the 2005 customer list purchase.
Conclusion
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On staff comment #2, we concluded that there has been no impairment of
the intangible assets or goodwill resulting from the purchase of ICA.
We will continue to monitor this issue and as discussed above, will
expand our disclosures in future filings as indicated above.
Form 10-Q for the period ended September 30, 2007
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Note 1, Summary of Critical Accounting Policies, page 7
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3. In comment #3, the staff refers to the "Financial Accounting Standard
Number 159" section of the above referenced filing. The staff has
indicated that the Company's early adoption of SFAS 159 does not
appear to be substantive and consistent with the disclosure objectives
of SFAS 159. The staff has asked the Company to revise the interim
financial statements for 2007 to reverse the adoption of SFAS 159.
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Response: We respectfully disagree with the staff's conclusion that
the Company's adoption of SFAS 159 was not substantive. However,
subject to the concurrence of the Company's audit committee, the
Company will file amendments to Form 10-QSB for the periods ended
March 31, 2007, June 30, 2007 and September 30, 2007 to reflect the
reversal of SFAS 159. We expect that the amendments will be filed
before the filing of the Form 10-KSB for the year ended December 31,
2007.
The Company acknowledges that:
o the Company is responsible for the adequacy and accuracy of the
disclosures in the filings;
o staff comments or changes to disclosure in response to staff
comments in the filings reviewed by the staff do not foreclose
the Commission from taking any action with respect to the filing;
and
o the Company may not assert staff comments as a defense in any
proceeding initiated by the Commission of any person under the
federal securities laws of the United States.
Please feel free to contact me if you have any questions or concerns relating to
these responses. Our goal is the same as yours: we wish to properly comply with
the applicable disclosure requirements and to enhance the overall disclosure in
our filings. We appreciate the assistance you and your staff have provided as we
worked through our responses to your comment letter.
Sincerely,
/s/ Amy E. Essex
Amy E. Essex
Chief Financial Officer
First Federal of Northern Michigan