That was then; this is now

By DAVID MOON, Moon Capital Management
October 17, 2004

It's tough when they change the rules in the middle of the game and don't send out a memo. Ask the two SunTrust executives who were just placed on administrative leave for errors in its last two quarterly reports. A year or so ago, these same 'errors' would have earned plaudits from Wall Street, and possibly SunTrust's senior management.

On October 11, SunTrust announced that its Chief Credit Officer and Controller would be taking involuntary 'vacations' because the company incorrectly reported its earnings in the last two quarters. Interestingly, however, SunTrust did not exaggerate its earnings; it understated them. Folks at Enron and WorldCom got into trouble for telling people they made more money than they actually did. SunTrust appears guilty of the opposite. So what's the big sin?

Everything in life is about timing.

For years, investors rewarded companies that reported smooth, predictable earnings increases. It was almost an art form. If a mature company could report a steady five percent earnings growth each year, it gave investors a sense of safety. Investors hate surprises. If a company can eliminate (or reduce) surprises, investors sleep a bit better, consistent companies are awarded higher P/E multiples and everyone makes a bit more money.

The well-known secret on Wall Street, however, is that companies often had to manipulate their numbers (usually non-cash expenses) a bit to create an artificially smooth earnings trend. For a bank, this is particularly easy. Banks have to make estimates of how many borrowers are going to default on their loans. By playing games with these estimates, a bank can shift some earnings or losses from one period into another. This really isn't earnings fabrication as much as it is just changing the timing of the recognition of the earnings. Eventually, these timing games work themselves out. Yes, it is misleading, but it was the type of mirage preferred by Wall Street ' until recently.

Neither the company nor any analysts have suggested that the SunTrust earnings misstatements were intentional or intended to 'save' some earnings that it could use in a future quarter when operating results might be a bit soft. But it sure has the look of internal manipulation. (A SunTrust press release places the blame on 'errors in input data.') If it is artificial manipulation, the bank has good company. For years, Coca-Cola would massage its earnings by selling a bottling company or two when it needed a little extra quarterly boost. GE is guilty. Retailers can play games with inventory adjustments to accelerate or postpone earnings changes. Even Fannie Mae, the huge government sponsored enterprise, has recently been under attack for misstatements similar to SunTrust's. 'Errors in input data' are more common than you might imagine.

SunTrust's only sin is probably one of timing. A practice that was silently lauded two years ago now draws the wrath of audit committees and the SEC. The top executives at SunTrust appear to be reacting out of an overabundance of caution; there certainly isn't anything wrong with that.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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