Curious Accounting Tactics at Wells Fargo

Rod Serling wasn’t a banker, but he was a brilliant storyteller of all things bizarre. His creative genius brought us gems of TV fiction in such classics as Outer Limits, Twilight Zone and Night Gallery. As imaginations go, Serling was one of the best.

Bank executives (and their boards) also appear to have a flair for creativity, especially when presenting rosy Q1 earnings reports. However, in spite of seemingly “joyous” news, it cannot hide a darker secret most banker’s hold: “we screwed up and everybody else is gonna pay for it”.

At issue here is the oft-peculiar world of financial accounting. Over the years, we have seen plenty of imaginative bookkeeping in numerous industries, but never so debased as what’s being seen on bank financial statements lately. TARP, TALP and PPIP are confusing enough, what investors really need is HELP!

Banks, insurers, etc. are capitalized much differently than non-financial companies. Lenders, also rely heavily on assumptions to determine present and future values of assets and liabilities. As we know, “assumptions” have been liberally expressed in recent years which invariably have made asses out of you, me...and everybody else.

When analyzing a bank’s financial statements, we focus (mostly) on the balance sheet to divine future earnings quality. The income & cash flow statements are important too, but the information they provide is limited and finite to the period of time reported.

The Wells Fargo (WFC) anomaly: We were rather surprised when Wells Fargo offered a glowing outlook for Q1 in its “pre-announcement on April 9^th (last trading day going into a long holiday weekend) and several weeks before the scheduled earnings release date. In an interview with CNBC that same day (April 9^th), Wells CFO Atkins was asked if his bank had plans to issue stock. Atkins adroitly avoided any direct answer by replying he’d rather boost capital via earnings. Not surprisingly, Wells issued $7.5B in new shares on Friday May 8.

Timing is everything these days, but how pray-tell, does a bread-and-butter outfit like Wells with little exposure to the capital markets, suddenly declare they expect to report record net income? This we’d have to see with our own eyes in the 8k filing.

Once we had the financial statements in our grubby paws, we started by comparing the changes in loans over all categories. The spike in commercial and non-residential real estate lending caught our eye.

If it is true that commercial lending lags the residential markets by a few years, then aren’t we near show-time when these bigger shoes start to fall?

Wells’ consumer loans didn’t leave us warm and fuzzy either. The jump in first and second-lien residential loans, are tough to swallow, but the spike in “other” revolving credit obligations are significant.

Then we looked at changes in “trading assets”. We would expect to see declines in these “assets” because it would show the bank was comfortable with market risk by committing capital to supposedly less volatile markets and businesses. Instead, Wells’ trading assets grew seven-fold. It looks like Wells is hoarding capital, not lending it.

Goodwill and “Other assets” were also suspicious. Regardless of the slack banks are getting with loosened “mark-to-market" valuations, the increase in Goodwill indicates Wells paid more than fair value for whatever net assets are being shown.

Keep in mind, Goodwill is an intangible asset and amortized (to expense) in the income statement over a period of time. Typically, intangible assets are recorded at historical cost. Problem is, Wachovia was a very complex consolidation. In the event the related transactions (between parent and subsidiary) are not eliminated, the assets, liabilities, revenues, and expenses of the combined entity will all likely be overstated.

Other assets can vary widely, but usually these are assets which will likely not be turned into cash anytime soon. This category could include anything from debt issuance costs to land or property held for resale. Think of other assets as a storage closet for non-cash assets which (usually) do not produce income or cash-flow.

As for assets or investments “held for sale”, we would prefer to see reductions in these balances, especially during periods of difficult access to secondary market liquidity.

However, given the huge secondary offering Wells just pulled off (it was over subscribed), keep an eye on future changes to these figures and the related disclosures. If for example these assets get moved into “portfolio”, then it’s hard to move them back.

Wells Fargo shares have been on a tear since last month and investor sentiment towards financials is almost giddy. Sensational moves really! However, in the end, earnings quality does matter. While the balance sheet won’t tell you everything about Wells Fargo’s future profitability, it will provide good clues to the direction of earnings going forward.

Indeed, WFC shares could keep rising, but the balance sheet is not jibing with management’s perky outlook. Loan quality looks suspect and earnings quality appears to be declining not improving.

Disclosure: Author does not own WFC, but is long the SKF.

Comments

[valuemanager03:]

Did you forget that Wells took over Wachovia in Q1 2009... so the nominal amounts of ALL balance sheet items would skyrocket from that. So your entire argument about growing balance sheet is wrong unless you add in Wachovia's prior #'s pre-merger.

May 10 12:26 PM

[icandoitdon:]

"Keep in mind, Goodwill is an intangible asset and amortized (to expense) in the income statement over a period of time."

the accounting rules for goodwill were changed in 2001. goodwill is no longer amortized to income. if discounted future cash flows of the related assets are less than goodwill carrying cost, an impairment charge is required.

May 10 12:50 PM

[RonB:]

The two comments above are on point. People have become so paranoid and suspicious about bank earnings that even highly ethical companies like Wells come under attack. Fortunately, the comments in this article have virtually no basis, the writer does not understand Wells operations or the imact of the Wachovia acquisition. Wells earnings power is substantial, its deposit base has doubled, its cost of funds is the lowest of all major banks, its credit quality among the highest.

Wells Fargo is presently the largest holding in my personal and client accounts.

Ron Beasley
rwbi.net

May 10 01:01 PM

[Mr H220:]

Any port in a storm to hold down Government regulations. I can not separate fact from the political.

May 10 01:43 PM

[Mark Streator:]

The author has absolutely no credibility. As noted by the other comments, how could the acquisition of Wachovia and its impact on Wells' balance sheet not be taken into account? And the goodwill comments are laughable -- in addition to the out-of-date comment about amoritization, the comment suggesting that a company with the sophistication of Wells would not eliminate intercompany transactions is beyond comprehension.

May 10 03:15 PM

[WAMPUS1:]

Did you notice that the author of this article does not own any shares of Wells Fargo? However, he is LONG the SKF. In other words he is being squeezed for shorting WFC and is trying to instigate a serious drop in price. The fact that Wells Fargo issued for sale 7.9 billion dollars worth of stock and sold every share in one day should speak volumes about the future of the combined worth of Wachovia and Wells Fargo.

May 10 04:19 PM

[Jason Merriam:]

Author replies: I am well aware to FASB SFAS 142 and 141 changes regarding goodwill amortization and regret the error. My reference to expensing or amortizing intangibles should have been limited to “Other Assets”.

My point essentially is that as Wells goes through its massive merger and restructuring, earnings will be suspect at best, and possibly lousy, depending on merger costs, further credit reserves and its need (or desire) to amortize intangibles, depreciate assets, and de-lever its balance sheet.

During Jack Welch’s watch at GE, the company would often restate intangible adjustments to segment profit information (GE Capital for example) as a corporate cost rather than a unit operating cost. However, it does not alter the fact that even with the elimination of the previous amortization rules this has a substantial effect on financial statements.

In the case of Wells Fargo, management is basically telling investors that most of Wachovia’s goop is behind them. I would also note that although both amortization and/or impairment is a non-cash expense/charge with no likely tax benefit, companies have gotten pretty crafty in mitigating the effects via pro forma figures in recent years.

As for the surge in the assets (nominal or other wise) discussed in the article, I believed it was or should be obvious to any reader that Wachovia is included in the consolidated statements. While I fully support constructive criticism, it does not require an abacus to realize an acquisition like Wachovia is going to balloon somebody’s balance sheet big-time.

The real issue here is the stock has had a great run and judging by the sentiment in many of your comments, most folks are long and expect more upside. This could very well be the case and the best of luck.

I never implied WFC should be shorted, but do believe the share price is extended at these levels. My only suggestion is to be careful.

The bottom line for me is what I’m seeing on the balance sheet doesn’t have the feel of quality or sustainability in its future earnings potential (at least in the short-term). The bigger question you should be asking is how is Wells funding all this blossoming loan growth?

According to management’s clipped tone it isn’t TARP funds and the recent secondary only gives them a bit of wiggle room in meeting their capital requirements. Maybe ‘ol Dick Bove is right this time. Perhaps Wells is funding loans with long-term debt. JM

May 11 01:28 AM

[Albert Meyer:]

"... would also note that although both amortization and/or impairment is a non-cash expense/charge"

Assumed you paid cash for an acquisition at above book value, the resultant goodwill is carried on the balance sheet. A year or two later you take a goodwill impairment charge. Is that really a non-cash charge? These days a lot of cash is falling through the cracks under the guise of a non-cash charge.

Consider the argument that stock option compensation is a non-cash charge. Yes, but only until the company takes real cash and repurchases the stock it issued to employees. FASB says, hide that in the Financing Section and don't let it influence your free cash flow calculations. CEOs say, ignore the FASB123R charge, it is just a non-cash irritant.

We'll invest ourselves into insolvency following FASB rules. According to FASB's rules, Countrywide was such a profitable concern that the CEO took home over $300 million in performance-based compensation (cash and stock) over a two-year period. We'd be better off without FASB and the SEC, don't yah think?.

May 11 09:45 AM

[Jason Merriam:]

Albert- "These days a lot of cash is falling through the cracks under the guise of a non-cash charge".

I couldn't agree with you more. That said, accounting changes such as FASB 142 & 141 disrupt data time series making it difficult to estimate trends and forecast future performance. More importantly, the tax-related cash flows associated with these changes make it necessary to pay more attention to operating cash-flow when assessing a company's financials.

Another thing; SFAS 142 does not require companies to disclose the methodology used when applying the impairment test. In Wells' case it is difficult at best to determine quality of their goodwill assets to the associated earnings and cash-flow they are intended to support.

May 11 12:38 PM