Creative Accounting

Bernard Condon, Forbes Magazine, 11.01.99

FLEET FINANCIAL IS ON A TEAR, IF you can believe the second-quarter report. The bank, renamed Fleet Boston after buying BankBoston in September, reported an annualized "cash-based return on equity" of 30% . This would be fabulous news if the bank could keep up that kind of return on additions to its equity base. If, hypothetically, the bank paid no dividend and plowed back all profits, its earnings per share would compound at 30% a year. Don't count on it. To get that handsome 30% figure, the bank added back noncash goodwill charges to its earnings. Then it subtracted goodwill from its shareholders' equity. In short, in calculating the ROE ratio it artificially boosted the earnings figure in the numerator while depressing the shareholders' equity figure in the denominator. The resulting figure is actually cash return on tangible equity. If it's any comfort to Fleet's shareholders, there are a lot of other banks trumpeting cash return on tangible equity these days. Bank of New York's good but not dazzling 25% return on equity balloons to 38% using the cash-on-tangible formula. Wells Fargo goes from 18% to 33% . Mellon Bank goes from 21% to 41% . As for how banks started down this road of creative accounting, it all began with a longstanding debate about how goodwill should be handled in earnings statements. If one bank (or manufacturer) acquires another for $3 billion, and if the acquisition target has only $1 billion of net worth, then the $2 billion difference is recorded on the balance sheet as goodwill. Under Generally Accepted Accounting Principles, the $2 billion is supposed to be gradually written off against earnings--say, $50 million a year for 40 years. Since this $50 million charge does not represent a cash payment that the acquirer has to make to anyone, some analysts instinctively add it back to earnings in figuring the profitability of the acquirer. That's fair enough, but the banks are taking considerable liberties with the cash earnings concept. They proceed to subtract the $2 billion from their own shareholders' equity. Fleet has a lot of these goodwill accounts floating around because it has been on an acquisition spree. "We're trying to get to a true cash performance number," says Peter Culhane of Fleet's investor relations department. "It's a different way of looking at the financial power of this organization." Different--and very misleading. Consider what Fleet's return would have been if it had abandoned all financial discipline and paid a lot more in last year's deal for Advanta's credit card business, quadrupling the goodwill purchased. That profligacy would have jacked up its cash-on-tangible return to 38% . The more you overpay, the higher your profitability. "It's a sucker's ratio," says Joseph Stieven, a Stiefel, Nicolaus & Co. analyst who's been tracking accounting tricks at banks for nearly two decades. "It sounds great but it means nothing."