Financial Reporting of Business Combinations - Week Three

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Financial Reporting of Business Combinations (Morgan Stanley & ETrade) By: Jiten Pomal University of Arizona Global Campus Module FIN689: Advanced Financial Management and Analysis (MUL2341A) Instructor: Susan Paris Due Date: 10/29/2023 1 | P a g e

Navigating the Financial Horizon: The Ripple Effect of Morgan Stanley’s E*TRADE Acquisition In the ever-evolving landscape of finance, mergers and acquisitions serve as seismic markers, indicating the direction in which the industry is headed. Among these notable shifts, Morgan Stanley’s recent acquisition of E*TRADE stands out as a significant milestone, underscoring the transformation underway in the world of wealth management and online brokerage. This strategic move, while raising eyebrows, reflects a broader trend in the financial sector – a trend characterized by consolidation, diversification, and the pursuit of innovation. Beyond the surface, this acquisition tells a tale of adapting to changing investor demographics, the rising significance of digital platforms, and the quest for stable, long-term revenue streams. In this exploration, we delve into the nuances of Morgan Stanley’s acquisition of E*TRADE, dissecting the motivations behind this colossal deal. Join us as we unravel the intricacies of this merger, shedding light on how it shapes the future of financial services and redefines the relationship between clients, advisors, and the institutions that bridge their financial aspirations 2 | P a g e

with reality. Welcome to a comprehensive analysis of a paradigm-shifting moment in the financial sphere, where tradition meets technology, and strategy meets the future. (Investopedia, 2022) Accounting method used to record the transaction. Acquisitions - Purchase Price Allocation (Details) - USD ($) $ in Millions Mar. 01, 2021 Oct. 02, 2020 Dec. 31, 2022 Assets Goodwill $ 16,652 Eaton Vance Corp. Assets Cash and cash equivalents $ 691 Loans and lending commitments 445 Investments 299 Corporate and other debt 52 Customer and other receivables 331 Goodwill 5,270 Intangible assets 3,956 Other assets 836 Total assets 11,880 Liabilities Other secured financings 399 Other liabilities and accrued expenses 2,147 Borrowings 678 Total liabilities $ 3,224 Eaton Vance Corp. | Customer relationships Liabilities Weighted-average intangible life 16 years E-TRADE Assets 3 | P a g e

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Cash and cash equivalents $ 3,807 Loans and lending commitments 1,124 Investments 44 Investment securities 48,855 Securities borrowed 975 Customer and other receivables 12,267 Loans: Held for investment 462 Goodwill 4,270 Intangible assets 3,282 Other assets 1,351 Total assets 76,437 Liabilities Deposits 44,890 Securities loaned 766 Customer and other payables 15,488 Other liabilities and accrued expenses 1,688 Borrowings 1,665 Total liabilities 64,497 E-TRADE | Customer relationships Assets Intangible assets $ 2,800 Liabilities Weighted-average intangible life 17 years (Sec, 2022) Based upon above table. The accounting method used to record the transactions for the acquisitions E*TRADE by Morgan Stanley is the Purchase Price Allocation method . Here's how the purchase method, as described, applies to the acquisition: Identifiable Assets and Liabilities: Under the purchase method, all identifiable assets acquired and liabilities assumed (including tangible assets, intangible assets, and liabilities) are recorded at their fair values as of the acquisition date. This means that Morgan Stanley would have recorded E*TRADE's assets and liabilities at their fair values at the time of the acquisition. 4 | P a g e

Goodwill: Goodwill represents the excess of the purchase price over the fair value of the net assets acquired. Goodwill is recognized as an asset on the acquiring company's balance sheet and reflects the value of the synergies and other intangible benefits expected from the acquisition. In this case, the excess of the purchase price over the fair value of E*TRADE's net assets would be recorded as goodwill on Morgan Stanley's balance sheet. Transaction Costs: Direct costs incurred in completing the acquisition, such as legal fees and advisory costs, are generally expensed as incurred and are not included in the cost of the acquired assets. This means that any transaction costs associated with the acquisition would be expensed and not added to the recorded value of E*TRADE's assets. Determining Compliance of Financial Statements with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) The financial statements are prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP). Additionally, the firm's management is responsible for establishing and maintaining adequate internal control over financial reporting. The internal control procedures are designed to ensure the reliability of financial reporting and the preparation of financial statements in accordance with U.S. GAAP. 5 | P a g e

Management's assessment of the firm's internal control over financial reporting is based on criteria outlined by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework (2013). According to management's assessment using these criteria, they believe that the firm maintained effective internal control over financial reporting as of December 31, 2022. Analysis of Reported Contingent Assets, Liabilities, and Consideration in the Acquisition Upon reviewing the financial statements and disclosures of both Morgan Stanley and E*Trade, no reported contingent assets, liabilities, or contingent consideration related to the acquisition were found in the provided information. The Amount of Goodwill Recorded For The Transaction. The detail amount of goodwill recorded for the merger transaction is derived from the excess of the purchase price over the fair value of the identifiable net assets acquired. Goodwill represents the premium paid for acquiring the business and its assets, including intangible assets, beyond their individually assessed fair values. It often includes factors such as the value of the assembled workforce, customer relationships, and the synergies expected from the merger. In the provided data, the merger transaction resulted in the following changes to goodwill: 6 | P a g e

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December 31, 2020: Goodwill was $11,635 million. Acquisitions in 2021: Goodwill increased by $5,270 million due to the acquisition of Eaton Vance. December 31, 2021: Goodwill was $16,833 million. December 31, 2022: Goodwill was $16,652 million after adjustments for foreign currency effects and disposals. In this context, the $5,270 million increase in goodwill in 2021 represents the premium paid by the acquiring company over the fair value of Eaton Vance's identifiable net assets. This premium reflects the strategic value, synergies, and other intangible assets associated with the acquisition. Goodwill is subject to impairment testing, which involves evaluating its carrying value compared to its fair value. If the fair value is lower than the carrying value, an impairment charge would be recorded. The absence of impairments in the provided data suggests that the goodwill remains intact and is considered an accurate representation of the company's value. Goodwill is not amortized over time; instead, it is subject to annual impairment tests. Impairment testing compares the carrying value of goodwill to its fair value. If the fair value is lower than the carrying value, indicating that the value of the acquired business has decreased, an impairment charge is recorded, reducing the carrying amount of goodwill. 7 | P a g e

Analysis of Key Financial Statistics for Morgan Stanley and E*Trade: Unadjusted Earnings for the Two Most Recent Fiscal Years Morgan Stanley (Fiscal Years 2021 and 2022) 2022 2021 Operating Income Margin 26.28% 20.85% Net Profit Margin: 20.85% 25.31% Free Cash Flow: 31,235 million USD 31,663 million USD Return on Assets (ROA): 0.38% 0.54% Return on Equity (ROE): 6.77% 8.55% Debt-Equity Ratio: 34.62 30.25 E*Trade (Fiscal Years 2020 and 2019) 2022 2021 Operating Income Margin 32.30% 31.35% Net Profit Margin: 22.22% 22.50% Free Cash Flow: 2,698 Million USD 1,574 Million USD Return on Assets (ROA): 3.81% 3.69% Return on Equity (ROE): 26.59% 24.73% Debt-Equity Ratio: 0.36 0.28 Adjusted Financial Ratios for 2021:  Operating Income Margin: ($19,668M + $4,074M) / ($1,188,140M + $82,171M) = 2.76%  Net Profit Margin: ($15,120M + $3,120M) / ($1,188,140M + $82,171M) = 1.87%  Return on Assets (ROA): ($15,120M + $3,120M) / ($1,188,140M + $82,171M) = 1.39%  Return on Equity (ROE): ($15,120M + $3,120M) / ($106,598M + $12,458M) = 16.63% Adjusted Financial Ratios for 2022: 8 | P a g e

 Operating Income Margin: ($14,089M + $4,893M) / ($1,180,231M + $128,127M) = 2.63%  Net Profit Margin: ($11,179M + $3,530M) / ($1,180,231M + $128,127M) = 1.67%  Return on Assets (ROA): ($11,179M + $3,530M) / ($1,180,231M + $128,127M) = 1.30%  Return on Equity (ROE): ($11,179M + $3,530M) / ($101,231M + $13,411M) = 12.24% 2022 2021 Operating Income Margin 2.63% 2.76% Net Profit Margin: 1.67% 1.87% Free Cash Flow: $33,996 Million $34,361 Million Return on Assets (ROA): 1.3% 1.39% Return on Equity (ROE): 12.24% 16.63% Debt-Equity Ratio: 26.03% 32.72% Impact on Financial Statements and Ratios After Acquisition: Morgan Stanley: Revenue: Morgan Stanley's revenue experienced a substantial boost after the integration of E*Trade's financials. The consolidated revenue reflected the combined income of both entities, contributing to a significant increase in the top line. Net Income: The net income of Morgan Stanley surged following the acquisition, indicating the enhanced profitability achieved through the merger. E*Trade's profitable operations positively influenced the consolidated net income. 9 | P a g e

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Cash Flow: Cash flow demonstrated a remarkable increase post-acquisition. The integration of E*Trade's financial activities substantially bolstered Morgan Stanley's overall liquidity position, ensuring better financial flexibility. Equity: Total equity showed a substantial rise after the merger, incorporating E Trade's equity into Morgan Stanley's balance sheet. This increase in equity signified the additional value brought in by E Trade. Impact on Ratios: Operating Income Margin: Morgan Stanley's operating income margin improved notably due to E*Trade's robust profitability. The merged entity's operations were more efficient and lucrative, leading to a higher operating income margin. Net Profit Margin: While the net profit margin slightly decreased, it remained healthy. This decrease could be attributed to E*Trade's net income being lower than Morgan Stanley's original margin. However, the consolidated net profit margin still indicated a profitable operation. Free Cash Flow: Morgan Stanley's free cash flow witnessed a substantial increase, primarily driven by the additional cash flows from E*Trade. The merger provided a significant boost to the company's ability to generate free cash flow. 10 | P a g e

Return on Assets (ROA): The ROA experienced a slight decrease due to the significant rise in total assets post-acquisition. While the net income increased, the increase in assets was proportionally higher, causing a marginal decrease in ROA. Return on Equity (ROE): The ROE decreased as a result of the rise in total equity post- acquisition. While net income increased, the substantial increase in equity led to a decrease in the return on equity ratio. Debt-Equity Ratio: The debt-equity ratio increased post-acquisition due to the additional debt incurred for the merger. The higher debt level, combined with the rise in equity, led to an increase in the debt-equity ratio. E*Trade: Revenue: E*Trade's revenue was fully integrated into Morgan Stanley's financial statements, contributing to the overall revenue of the merged entity. Net Income: E*Trade's net income was incorporated into the consolidated net income of Morgan Stanley, enhancing the overall profitability of the merged entity. Cash Flow: E*Trade's cash flow became an integral part of the consolidated cash flow statement, strengthening the overall cash position of the combined company. 11 | P a g e

Equity: E*Trade's equity was seamlessly merged into Morgan Stanley's equity structure, augmenting the total equity of the merged entity. ETrade's specific impact on individual ratios (like operating income margin, net profit margin, ROA, ROE, and debt-equity ratio) cannot be provided separately as ETrade's financials are now consolidated with Morgan Stanley's. These ratios are reflected in the consolidated financial statements of the merged entities. This merger has strategically positioned the newly formed entity for sustained growth and enhanced financial stability by capitalizing on the strengths of both companies. Summary ETRADE's revenue seamlessly integrated into Morgan Stanley's financials, contributing to the overall revenue of the merged entity. E TRADE's net income was incorporated into the consolidated net income of Morgan Stanley, enhancing the overall profitability of the merged entity. E TRADE's cash flow became an integral part of the consolidated cash flow statement, strengthening the overall cash position of the combined company. Furthermore, E TRADE's equity was seamlessly merged into Morgan Stanley's equity structure, augmenting the total equity of the merged entity. This merger strategically positions the newly formed entity for sustained growth and enhanced financial stability by capitalizing on the strengths of both companies. The amalgamation of 12 | P a g e

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expertise, resources, and market presence has created a financial powerhouse poised for a prosperous future. Reference www.sec.gov. (n.d.). Inline XBRL Viewer. [online] Available at: https://www.sec.gov/ix?doc=/Archives/edgar/data/0000895421/000089542123000284/ms- 20221231.htm#i2f6975a563604b0cb1bffa00a50db3ed_133 [Accessed 31 Oct. 2023]. Bisnoff, J. (n.d.). Here’s Why The $13 Billion E-Trade Deal Makes Sense For Morgan Stanley . [online] Forbes. Available at: https://www.forbes.com/sites/jasonbisnoff/2020/02/21/heres-why- the-13-billion-e-trade-deal-makes-sense-for-morgan-stanley/?sh=4eabf22778d8 [Accessed 31 Oct. 2023]. CONSOLIDATED STATEMENT OF FINANCIAL CONDITION AS OF JUNE 30, 2023 (UNAUDITED) ********. (n.d.). Available at: https://www.morganstanley.com/about-us-ir/shareholder/morganstanley_co_llc.pdf. Morgan Stanley. (n.d.). Morgan Stanley Closes Acquisition of E*TRADE . [online] Available at: https://www.morganstanley.com/press-releases/morgan-stanley-closes-acquisition-of-e-trade. Redshelf.com. (2023). Available at: https://ashford.redshelf.com/app/ecom/shelf/course- section/6122376 [Accessed 31 Oct. 2023]. 13 | P a g e