Aiming to Please

Following the completion of the merger of Firstar Corp.with U.S. Bancorp, the combined bank announced that total transaction-related expenses would actually come to $970 million instead of the original estimate of $800 million. Part of the problem was a restructuring of the credit portfolio, including a $90 million charge related to the combined effects of its exit from a segment of the health care industry and the alignment of the banks’ risk management and chargeoff policies. It also reported a $76.6 million writedown of retail loans and $15 million for the reduced value it expected to receive on the sale of certain equity investments.

All in all, the report would not look good to investors. A 20% increase in merger-related charges might indicate that the bank did not perform enough due diligence prior to the merger.

But the bank held an ace up its sleeve. Falling interest rates during the quarter had created an opportunity to sell some $9.3 billion in investment securities, in the process booking a gain of $208.3 million for the quarter, more than enough to offset the expected increase in merger-related charges.

For most bank observers, such situations are not uncommon. Jim Moss, managing director of North American banks with Fitch, the bond rating agency, says banks frequently take unusual gains in the same quarter that they recognize a significant loss, and for good reasons.

“If you’re earnings are up 10% on a linked-year basis and half of that is driven by selling bonds out of your portfolio at a gain, the Street doesn’t see that as a regular, recurring stream of revenue,” Moss says. “The banks are more tempted to say, ‘We have this unusual expense item so we’ll try to put in an unusual revenue item, as well.’”

Though tempting, such maneuvers may be considered efforts on the part of a company to “manage earnings”u00e2u20ac”a loaded term that can mean anything from performing unique, yet reasonable and defensible one-time accounting entries, to those that may be felonious in nature. Thus, directors at institutions that are considering such things as deferring accruals, booking securities gains, or taking extraordinary charges to bolster current or future earnings should proceed with caution.

There is no question that the pressure to meet ever-more scrutinized earnings projections has caused an increase in risky accounting tactics taken by public companies. In a speech last December, then-chairman of the SEC Arthur Levitt reminded his audience at the Federal Reserve Bank of New York that trying too hard to meet or exceed analysts’ earnings projections was an exercise fraught with risk: “An abiding focus on long-term fundamentalsu00e2u20ac”in corporate oversight, in management decisions, and in sound financial reporting which does not bend to analysts’ quarterly earnings models, must win out the day.”

Michael Young, an attorney with Willkie, Farr & Gallagher in New York and the author of Accounting Irregularities and Financial Fraud, cautions bank directors to be wary of any board-related discussion that involves “manipulating accounting entries to compensate for operational shortfalls.”

“One of the toughest questions to answer is, ‘What is ‘earnings management?’” he says. At its core, earnings management is “manipulating accounting entries for the purpose of artificially inflating or deflating earnings,” Young says. And the board of directors will be directly in the line of fire if an audit committee should unearth such activity, he explains, forcing the company to issue a press release that publicly restates its earnings. The results could be disastrous: executive dismissals, shareholder suits, director liability, and in extreme cases, felony convictions. Of course, not all accounting adjustments are intentional attempts to defraud investors, and many have a reasonable, material basis for existence. Directors should be attuned to the red flags that can lead to such situations (see box.)

According to SNL Securities, the Charlottesville, Virginia-based financial research and publishing firm, 61 of the 89 banks or thrifts with a market capitalization above $1 billion reported some gains or losses from extraordinary items or investment securities during the second quarter of 2001. In fact, since 1999, only three of those institutions have not reported any such activityu00e2u20ac”Boston-based Investors Financial Services Corp., Paramus, New Jersey-based Hudson City Bancorp, and Topeka, Kansas-based Capitol Federal Financial.

In large part, such activity is a result of Wall Street’s view of noncore earnings. Mark Agah, a vice president and equity analyst in Dain Rauscher’s San Francisco office, says he makes it clear to many of the banks he follows that he does not consider securities gains as part of core earnings. On the other hand, he says he gets worried if institutions don’t use noncore gains to reduce future risk. “If a bank is underreserved and it has big gains, I view it almost negatively if they don’t put those gains into reserves and reduce the risk of the balance sheet,” he says.

In recent years, consolidation in the financial services industry has created a unique opportunity for acquirers to recognize impairments in the value of assets or lines of business. It is called merger-related restructuring charges. “You flush everything down the toilet now so that next year you don’t have anything to flush,” says Jim Gardner, senior managing director with Dallas-based SAMCO Capital Markets and past vice chairman of Bank One Texas. “It makes the acquisition look great, because you’ve written off all your problems so that earnings look great for a year or two until you have time to create more problems.”

Such actions run the risk of crossing the fine line between what is prudent accounting practices and what is not. Agah says it is particularly troubling when large portions of those restructuring charges are not fully described or such charges are overstated. The concern is that the institution may be running loan losses through those chargesu00e2u20ac”a situation that implies the buyer didn’t do enough due diligence on the loan portfolio prior to announcing the deal.

In recent years, an increasing number of banks and thrifts have taken restructuring charges that were not related to acquisitions. Indeed, much of the activity has come when institutions have decided to exit businesses or to recognize deterioration of specific investment portfolios.

That is what happened during the second quarter of 2001 to Well Fargo & Co. Generally recognized for its quality of earnings, some saw the $1.2 billion charge it took in the second quarter to reflect an impairment of its venture capital and equity securities portfolio as a crack in that facade. But Moss says that the bank had done everything correctly up to that point by reducing stockholders’ equity periodically for any reductions in value it saw as temporary. When the losses started to look more permanent, however, the bank had to reverse those earlier charges out of stockholders’ equity and run them through the income statement. The effect on overall capital was negligible, but the accounting entries produced an $87 million net loss for the second quarter.

While Wells’ one-time charge was an event tied to the decline in the overall equity market, in general, banking institutions run a risk by taking regular extraordinary charges because investors will eventually factor the expectation for such charges into their earnings models. Stephen Percoco, an analyst at Lark Research in Rahway, New Jersey, says when they become a regular item on a company’s financial statements, analysts and investors question whether the items are really nonrecurring.

“If restructuring is a cost of doing business, then companies have to respond to the business and make changes,” he says. But, he adds, “You want to get some sense of what the company is likely to show going forward.”

In some cases, that is already happening. Moss says that increasingly, Fitch is including such charges as operating expenses in its ratings calculations, even though it recognizes many as nonrecurring. That is particularly true in the commercial banking industry, he says, because of the proliferation of new businesses. In recent years, a large number of banks have launched business-to-business marketplaces, online banking products, mobile banking services, and account aggregation, among other products and services. Eventually, however, those businesses will likely face a shakeout, forcing most institutions to restructure their investments as part of a closure or sale to competitors.

There are also situations where the charges come as a result of an attempt to postpone until the last minute acknowledging that adjustments are necessary. Mortgage companies, for example, may delay recognizing the effects falling interest rates have on their servicing portfolios because they anticipate that rates will recover in the near future.

Yet such delays may be risky.

“If the market continues going against you, then you have to come clean,” says Moss. “That’s when the questions from the Street come forward. ‘Why didn’t you make a more timely adjustment? What are you doing to prevent the same thing from happening in the future?’”

Likewise, deferring the accrual of expenses such as employee stock options or loan-loss provisioning can lead to trouble down the road. “You can optically make a firm look more efficient by taking still-appropriate but not-so-conservative approaches to accruals,” Moss says. “Our experience, though, is that eventually you have to pay.”

When such accounting maneuvers become transparent, however, the investment community can become concerned.

Take the specialty finance sector during the latter half of the 1990s, for example. Consumer finance companies specializing in auto finance, home equity, manufactured housing, and other markets were able to bolster their earnings through gains from the sale of their loans as asset-backed securities. Many used aggressive assumptions about loan losses, prepayments, and yield to book large gains, thereby increasing earnings and igniting share prices. The transactions also helped lenders raise cash that was used to make more loans and securitizations.

Because the transactions did little to limit the risk for the sellers, however, consumer lenders took the first-loss position on anywhere from 5% to 10% of the loans. So when losses started to appear, they not only directly affected earnings, they also ruined the industry’s credibility with investors. The result was not only a rapid decline in the value of securities already in the market, but also the closure of the capital markets to those companies. In the end, many consumer finance lenders filed for bankruptcy.

As the specialty finance industry showed, the way in which earnings are reported can make a significant impression on investors. Still, it is not unusual for companies to spin their results, and the banking industry is no exception. Over the past decade, financial institutions have adopted the use of such alternative earnings metrics as operating income, which indicate how an institution is performing exclusive of its nonrecurring expenses, and cash earnings, which take operating income one step further by eliminating the noncash charges for amortization of goodwill and core deposit intangibles, to show investors management’s view of the bank’s real performance. .

Some banks provide both measures. As a result of its 25 acquisitions since its founding in 1987, particularly its recent $1.4 billion purchase of 178 New England branches from FleetBoston Financial Group, Sovereign Bancorp is one such institution. During the first half of 2001, for example, it reported GAAP net income of $41.2 million, amounting to an annualized return on average assets of just 3.3%.

In its second quarter report, the bank explained that the Fleet transaction had created a temporary drag on earnings. In particular, the purchase provided for Sovereign to pay $1.1 billion up front for the branches and pay the remaining $340 million in equal installments between December 2000 and October 2001. The bank has recorded the payments, amounting to $72.2 million per quarter, as an operating cost on the bank’s income statement, which helped create a $3.3 million net loss for the bank in the fourth quarter of 2000.

Adding back the after-tax effect of the Fleet payments, however, allowed the bank to report operating earnings of $140.7 million for the first half of 2001. By excluding the goodwill expense, Sovereign produced cash earnings of $187.6 million for the period, making the cash return on average equity a respectable 19.1% (see Figure 1).

Tye Barnhart, a senior vice president in the bank’s investor relations department, says reporting cash earnings gives investors the ability to compare the operations of institutions that have made numerous acquisitions with those that haven’t.

“Most financial institutions that have grown through acquisitions will have on their balance sheets a large number for goodwill and core deposit intangibles,” he says. “There is an underlying trend, particularly among financial companies, to report cash earnings to strip away the impact of amortizing goodwill.”

The use of cash earnings has come into vogue over the past 12 to 18 months as it became clear that the Financial Accounting Standards Board would change the accounting rules for mergers and acquisitions. That change, Financial Accounting Standard 142, eliminates or thoroughly restricts the use of pooling-of-interests accounting and requires purchase accounting for all but a few transactions. In the process, FASB also moved to eliminate the regular, periodic amortization of acquisition goodwillu00e2u20ac”the primary drawback to the purchase accounting method. Instead, acquirers are required to periodically review the value of the purchased assets and, if necessary, report any impairment as a charge against earnings in that period.

For the most part, critics of other alternative earnings measures have little problem with institutions showing cash earnings by excluding noncash goodwill. For one thing, the item does not require a cash outlay. For another, such assets have indeterminable lives, making it difficult for regulators, accountants, or banks to define an amortization period.

“In many respects, adding back goodwill from an acquisition makes sense,” says Pamela Stumpp, senior vice president in the corporate finance group at Moody’s Investors Service and author of a report on the subject, “Putting EBITDA in Perspective.” “It is not so problematic provided the acquisition is earning reasonable returns.”

Stumpp says other performance measures such as return on assets would indicate whether an acquirer has paid too much for a target. Under those circumstances, she says, the denominator of the ratiou00e2u20ac”total assetsu00e2u20ac”will grow faster than the numeratoru00e2u20ac”earningsu00e2u20ac”regardless of whether goodwill expense is excluded.

Overpaying for an acquisition is still a big problem for some investors, however. David Harvey, a principal with Everest Managers LLC in Gardnerville, New Jersey, said that by paying too much attention to cash earnings, buyers can erode tangible equity.

“If you destroy too much tangible book in order to get something that is accretive to cash earnings, at some point it is going to matter,” he says. “That’s not good because tangible book is what you’re going to rely on in a recession to keep the bank solvent.”

Harvey says deals that create small reductions in tangible equity of around 10% can recover quickly as a result of the increase in cash earnings. But deals that cut equity significantly create the greatest risk for shareholders because it will take a number of years for the institutions to recoup through increased cash earnings what they’ve lost in tangible equity.

That is not to say that cash earnings will go away after FAS 142 is implemented next year. Banks will still have to amortize the goodwill created by the purchase of deposits.

But while the components of cash earnings are seemingly the same, not all noncash expenses are created equal. Indeed, there are no hard-and-fast rules to show management what to include and what to exclude for cash earnings or operating earnings.

For example, as much as $181 million of the $570.8 million in merger-related restructuring charges reported by U.S. Bancorp in the first quarter were for credit-related items. In most cases, those losses would appear as part of the bank’s provision for loan losses, part of the institution’s primary operations. In this case, however, it was part of a group of one-time charges that were reported below the line for operating income. As such, it was added back to the company’s net income to help the bank report operating earnings of $797.3 million, instead of GAAP net income of $410.1.

It is that lack of comparability that has investors, analysts, accountants, and regulators concerned about using alternative measures. “There aren’t any clear guidelines about what to include and what to exclude,” says Barry Kroeger, national director of banking for Ernst & Young in Minneapolis. “If you do treat them all as comparable, you may be in for some disappointments.”

Tyler Burke, principal with Trenton Capital, a new Dallas-based investment fund, says in most cases it doesn’t matter to him what is reported because it is his job to see through the earnings reports. Still, he says comparing the cash earnings of a company like BB&T Corp., which included $71 million in acquisition goodwill and $95 million in gains from securities and asset sales against $3 billion in total gross revenue during the first six months of 2001, to Greenpoint Financial Corp., which sold more than $4 billion in mortgage and manufactured housing loans through whole-loan sales and securitizations during the same period, is tricky.

“Greenpoint has always had a different definition of cash earnings,” Burke says. “I’m not that concerned with comparability because if I’m doing any kind of surface research, I will find the difference.”

Nonetheless, the lack of comparability has regulators on high alert. In one March 30 speech before the Philadelphia Bar Association, Laura Unger, the Securities and Exchange Commission’s acting chairman, described pro forma earnings measures as an invention of management designed to create an idealized version of performance.

“It may exclude any cost or expense the company wants, yet it is presented in a form that suggests reliability and soundness,” she says. “And that’s the problem with pro forma financials. You don’t really know what you’re getting, except that it’s what the company wants you to know.”

And that is what bugs Everest Managers’ Harvey. “We do know that any time you give these guys more and more judgments to make, that the temptation is to make things look good upon themselves. The more judgments they get to make, the less reliable the books become.”

Alternative earnings measures also create concerns in two other areas. First, companies that use alternative metrics often downplay or even neglect to mention GAAP earnings in their earnings releases, leading less-sophisticated investors to see the alternative number as the sole indicator of the company’s performance. Beyond that, companies that give investors different ways to look at their operations may neglect to provide sufficient detail to help them understand what goes into the calculations.

Investors’ concerns are lower in the commercial banking industry largely because of the regulatory oversight of the industry, but they aren’t removed altogether. Sovereign, for example, devoted the first paragraph of its second quarter 2001 report to cash earnings and described how it was calculated. Its GAAP net income was reported at the end of the second paragraph.

Many in the investment community recognize that companies will continue to make their earnings look as positive as possible. What bothers them is when the companies do not provide the additional information needed to understand how calculations were made. Indeed, Sovereign dedicated a full page in its earnings release to reconciling its operating earnings and GAAP net income.

What it did not provide, however, was the additional detail to help investors calculate cash earnings. But, Sovereign’s Barnhart says, the bank will begin giving investors that information immediately.

“I think it makes all the sense in the world,” he says. “I can’t think of any reason why we wouldn’t break out those numbers. It provides more complete disclosure and transparency.”

To help finance professionals understand what they should and should not do regarding alternative earnings metrics, the Financial Executives International (FEI) and the National Investor Relations Institute (NIRI) have jointly issued guidelines. Among other things, the guidelines say that, “Pro forma results should always be accompanied by clearly described reconciliation to GAAP results; this reconciliation is often provided in tabular form. Although management does not hold an independent or arm’s-length view of the enterprise, it is management’s responsibility to prepare earnings press releases with a reasonably balanced perspective of operating performance.”

Likewise, the accounting firm of Grant Thornton advised companies in a report released earlier this year that they should clearly label alternative measures as pro forma or cash earnings and to present GAAP results with similar prominence. The firm also advises companies to disclose all assumptions used to calculate the pro forma numbers and list all material adjustments clearly and adequately. Further, it suggests that companies review the presentations with their accounting firms and legal counsel prior to issuing a news release.

In the end, whatever banks do to present their earnings reports, they should strive to avoid creating surprises for investors. That requires a combination of disclosure and consistency, says Ernst & Young’s Kroeger. “You want to look and see what others are doing in the industry,” he says. “But mostly you want to make sure that your numbers and definitions are consistently applied.” |BD|