Friday, August 08, 2008

Accounting gimmmickry...

For those of you who like to invest in individual stocks in the market: read the financial statements. I am a traditional Graham-Dodd value type (most of the time) who likes to dig through the financial statements and find equities that trade below "intrinsic value" so that I have a margin of safety in a down market.
In light of the downturn in financial stocks as of late, and the corresponding collapse in the housing bubble, there are buying opportunities out there to purchase solid companies at discount prices. But, not all companies are created equal.
One of my biggest negatives on a company are accounting issues. During the tech bubble, a lot of companies (i.e. Nortel) were playing fast and loose with revenue recognition rules to front load as much of it as possible. Others were playing with the valuation of officer stock options. Others just took accounting policies that were too aggressive or down right misleading.
Case in point: Wells Fargo (WFC/NYSE) came out with stronger than expected second quarter earnings (i.e. a profit) on July 16th and the stock price jumped from $20.51 at the close of the prior day to $27.23. However, upon further examination of their earnings, things were not a rosy. A little change of their accounting policy for home equity loans explains it. In prior quarters, Wells Fargo would write off any home equity loan that was in arrears for greater than 120 days. However, at the start of the second quarter, they changed this to 180 days. My changing the criteria of when a loan was to be written off, they essentially added roughly $265 million to their earnings - turning a loss to a gain in the case of Wells Fargo's second quarter.
The worse part of this is that considering how many home equity loans they had in the housing bubble epicenters of California and Nevada, where the drop of home values they loans are essentially now unsecured, that the better accounting policy would be to more aggressively write off these positions? Wouldn't you, as a shareholder or depositor, show you a "worst case" balance sheet where there is less likelihood of downward surprises rather than overly optimistic guesses that have read downside?
As I said earlier, I don't like companies that play games with their accounting, as it reflects poorly on management in terms of performing their fiduciary duty to shareholders.


Anonymous said...

This comes straight from their earnings release. Either you didn't listen to the call or didn't take the time to read the release but they essentially took the hit on the $265 in second quarter in their provision for loan losses. They are not overstating their income.

As previously announced, the Home Equity charge-off policy changed in the second quarter from 120 days to no more than 180 days to provide more time to work with customers to solve their credit problems and keep them in their homes. The Company has helped nearly 900 customers, and approximately $90 million of Home Equity loans have been modified due to this change. The policy change had the effect of deferring an estimated $265 million of charge-offs from the second quarter, but did not reduce provision expense in the second quarter since this loss content was included in the $1.5 billion credit reserve build.

Mitch said...

Your points are quite valid. However, I am usually very wary about changes in accounting policy for public companies, especially when there is a strong pressure to show good earnings.

I think the change of policy has negligible effects on work outs. If they write them off before and successfully work them out with the borrower, they can claim a recovery. I think this is a more conservative treatment and better for investors.