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Materiality Matters: Huntington Bancshares

 

Good piece on “materiality” – the decision issue of when something is important enough to make financial statements misleading – in this morning’s Wall Street Journal “Tracking The Numbers” column. [As always, subscription required.]

I’ve mentioned materiality on a few occasions recently, and I suspect we will be hearing more in the coming months as a result of remedies of already-discovered control weaknesses – and if the SEC issues new discussion/guidance on materiality and error corrections, we could see a lot more wrangling over materiality.

Materiality figures into the private investment trust International case, as the Wall Street Journal reminds us. But there’s a far less notorious case that stretched materiality beyond the limits of reasonableness. It involved Huntington Bancshares, earnings managed by selective ignorance or manipulation of accounting principles, Wall Street expectations, poorly-designed management incentives – and Staff Accounting Bulletin 99, “Materiality.” Not as much of a splashy story as AIG; it lacks the colourful character of a Hank Greenberg – also, Huntington’s market cap is about 1/26th of AIG’s. Besides, this one’s unravelled over the last couple years and there’s been plenty of other competing stories. Nevertheless, this one’s got all the ingredients of a Harvard Business School case study, I think. Or maybe a chapter in an auditing textbook. Nevertheless, the SEC settlement was announced yesterday, and the proceeding makes good reading.

What happened? Bonuses were dangled before Huntington’s senior management based on one criteria: earnings per share. Before the change in 2001, the bonus system was based on return on shareholder’s equity. Whose idea was it to change it to EPS? Why, the CEO recommended it to the Compensation Committee of the board, of course. Minimum 2001 bonuses were earned for EPS of $1.15; the next bonus tranche was triggered at $1.18 and the maximum bonus was attained at $1.25 or above. There’s your incentive for accounting mischief as well as performance. It’s like pouring gasoline on straw: just add matches, please.

(Note: some portion of the bonuses were figured on the ROE method in 2001, and one of the players had 60% of his bonus figured on EPS in 2002. In the 2001- 2002 period in question, the preponderance of the bonuses were calculated on just EPS.)

Let me make a long story short. Here’s the excerpt from the summary:

“In both years, Huntington reported inflated earnings in its financial statements, enabling the Bank to meet or exceed Wall Street analyst earnings per share (“EPS”) expectations and to meet internal EPS targets (“Target EPS”) that determined the bonuses of senior management. Using improper accounting that was qualitatively material, Huntington overstated 2001 operating earnings by $8.5 million ($.04 per share) and 2002 operating earnings by $17.1 million ($.08 per share). Without the misstatements, Huntington’s earnings would have fallen short of analyst operating earnings expectations in both years and in 2002 bonuses for Hoaglin and McMennamin, the Bank’s CEO and CFO, respectively, would have been eliminated and the bonus for Van Fleet, the Bank’s controller, would have been reduced. In 2001 and 2002, Huntington offered and sold securities pursuant to … registration statements filed with the Commission under the Securities Act. The registration statements incorporated by reference materially misleading reports … containing the above-described overstatements of earnings.”

That term “qualitatively material:”what is it? Think of it this way: if a known error would likely affect the decision of an informed investor, even if it’s not a big number relative to earnings or equity, then it’s qualitatively material. Given that the Huntington earnings wouldn’t have matched the analyst expectations had the maladjustments not been carried out – they were qualitatively material.

Accounting mechanics used to get earnings “up where they belong:”

– In 2001 and 2002, Huntington recognized fees received for origination of automobile lease financing and loans as revenue immediately; proper accounting, in SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, “ requires that they be recognized over the related loan’s life as a yield adjustment -unless the difference is immaterial. Not so here.

– In 2001 and 2002, Huntington deferred the recognition of sales commissions paid to employees for obtaining new deposit accounts. Proper treatment for selling and administrative salaries is to expense them immediately.

– In 2002, Huntington incurred pension settlement losses and moved to a policy of expensing them immediately to deferring them over eight years – without disclosing the change in policy.

– In 2001, Huntington realized a gain on a bank-owned life insurance policy on its officers – but didn’t include it in 2001 earnings. It “saved” it for when it needed it in 2002.

– The firm maintained a valuation reserve for residual values on its auto leasing portfolio. No problem with that, but such reserves are not to be discounted. Huntington discounted it. The counter-GAAP move occurred at the end of 2002, worth about a penny of EPS.

– While the reversal of a restructuring reserve was numerically proper, its geography in the income statement was not. It was included in operating earnings and was just enough to nudge earnings to the target operating EPS. Because it had been previously reported as a non-operating special charge when initially taken, the reversal should have been symmetrically reported. There’s that “qualitative” bugaboo again.

Like I said, it’s an amazing confluence of bad incentives and bad accounting. Epilogue: the CEO is still the CEO; the CFO and controller are not around. Penalties were not overly harsh: disgorgement of profits all around for the trio, and a round of “cease-and-desist orders” for them, too. The only one that is barred from being an officer or director of a public company (for five years) is the CFO. There’s been plenty of concern about the consequences of certifying financial statements since this CEO/CFO requirement came into being in 2002. In this case, it looks like the CFO suffered most of those consequences.