Taxes may be one of life’s certainties, but just how much a banking company owes the Internal Revenue Service is the latest factor in whipsawing earnings.
Wells Fargo & Co. offers an illustration of the impact of Financial Accounting Standards Board’s Financial Interpretation No. 48, which requires public companies to disclose uncertain tax positions.
The San Francisco company’s tax rate hovered between 33% and 35% last year, investors were caught off guard when it reported its rate dropped to 30% in the first quarter. Resolving a dispute with the IRS over pre-2002 payments added $119 million to its bottom line.
Scott Siefers, an analyst at Sandler O’Neill & Partners LP, said in an interview that the change added an unexpected 3 cents a share to Wells’ first-quarter earnings.
“This is probably a pretty good example” of how FIN 48’s impact “might flow through on a quarterly basis for any company,” Mr. Siefers said. The accounting change “adds a new element of uncertainty into your earnings.”
Wells declined to comment for this story, but Howard Atkins, its chief financial officer, addressed the issue in his first-quarter earnings commentary April 17. “We expect that this accounting change will cause more volatility in our effective tax rate from quarter to quarter,” he said.
FIN 48, which applied for the first time to first-quarter reports, requires public companies to disclose how much they have reserved in the event the IRS or another authority rejects a tax position. It also standardizes how the reserves are calculated.
The goal of the Securities and Exchange Commission is to make it more difficult for companies to use hidden tax reserves to manage earnings.
“The bane of the SEC is earnings smoothing — artificial jiggling of earnings — and they don’t care if the dollar amounts are big,” Cristi A. Gleason, an accounting professor at the University of Iowa’s Henry B. Tippie College of Business, who co-authored a study last month on FIN 48, said in an interview. “Tax reserves have been for a lot of large firms a cookie jar, and they’ve released those reserves in years when they needed them.”
FIN 48 “will inject some volatility in earnings,” Prof. Gleason said, because companies have to disclose the resolution of what are typically multiyear audits involving large sums.
The dollars being set aside for uncertain tax moves can be huge, especially for the largest companies, which have international operations and complex tax strategies. The five largest U.S. banking companies had a combined $16.1 billion of reserves for risky tax positions in the first quarter, according to their disclosures.
JPMorgan Chase & Co. had the largest, with $4.7 billion. Wachovia Corp. had the smallest, with $2.5 billion.
Bank of America Corp. had $2.7 billion of tax reserves, while Citigroup Inc. and Wells had $3.1 billion each. Those three companies, along with JPMorgan Chase, had four of the 10 largest tax reserves among S&P 500 companies as of Jan. 1, according to an analysis by Credit Suisse Group.
Under FIN 48, if a benefit claimed on tax returns is more likely than not to be denied in an audit, a reserve must be set aside as an “unrecognized tax benefit.” The guidance also requires companies to disclose interest and penalties related to tax disputes and to provide a 12-month outlook on possible changes in their reserve. Investors will be able to see the reserve fluctuate from quarter to quarter and how changes affect a company’s tax rate and earnings.
“It’s definitely better information than we had in the past — which for most companies was no information,” David Zion, an accounting and tax analyst at Credit Suisse, said in an interview.
Regions Financial Corp. of Birmingham, Ala., said the adoption of FIN 48 raised its first-quarter tax rate by 170 basis points from a year earlier, to 33.2%, and will shave 7 cents a share off this year’s earnings.
“These adjustments resulted from a change in the recognition of the tax benefit related to a transaction in 2000 with a mortgage-related subsidiary,” Regions said in its 10-Q filing May 7.
Jeff Davis, an analyst at First Horizon National Corp.’s FTN Midwest Securities Corp., said in an interview last week that FIN 48 tells investors “caveat emptor on assigning an earnings power level to a company whose tax rate is unusually low.”
Regions would not discuss the matter, nor would the other banking companies contacted for this story.
Sheryl Vander Baan, an executive in the financial institutions national tax practice of Crowe Chizek & Co. LLC, said FIN 48 disclosures will be even better in the 2007 annual reports released next year. Those reports will include a table showing a company’s tax reserve at the beginning and end of the year. It will reflect changes in the reserve from settlements with tax authorities, from lapses in statutes of limitation, and from new tax positions.
Companies provided some glimpses into pending tax disputes in their first-quarter reports.
BB&T Corp., for example, said it had a $181 million tax reserve as of Jan. 1, as well as $209 million of penalties and interest for tax-related liabilities.
State Street Corp. revealed that its $115 million reserve includes $93 million of interest related to a dispute with the IRS over the timing of tax deductions on leveraged leases.
Investors are aware that companies may take aggressive tax positions to lift earnings in the short run, but Mr. Zion said such disclosures show how interest and penalties that accumulate while a tax issue is in dispute may become an expensive form of financing.
Citi said in its first-quarter filing that its tax reserve could change in the next 12 months, because the company is “currently under audit by the IRS and other major taxing jurisdictions around the world.”
B of A said in its 10-Q that this year it expects the IRS to complete an audit of its 2000-2002 returns and an audit of 2001-2004 returns for MBNA Corp., which B of A bought last year. The filing also said that 1997-2004 returns for FleetBoston Financial Corp., which the Charlotte company bought in 2004, are being audited.
These audits “will not significantly affect the corporation’s effective tax rate,” B of A said.
Wachovia said it reduced its tax reserve by $126 million in the first quarter after the IRS proposed adjustments to the Charlotte company’s 2000-2002 returns.
Though the biggest banking companies have some of the largest tax reserves among S&P 500 companies, Mr. Zion of Credit Suisse said they do not necessarily have the biggest tax risks.
“It’s not enough to just say, 'Wow, they’ve got a big, unrecognized tax benefit.’ The next step is to look at it relative to the company,” he said.
To gauge a company’s tax risk, Mr. Zion compares the unrecognized tax benefit to several numbers, including the company’s total liabilities and market capitalization.
JPMorgan Chase’s unrecognized tax benefit was about 2.7% of its market capitalization as of Jan. 1. Wells’ was 2.6%, Wachovia’s was 2.5%, and Citi’s and B of A’s were both 1.2%.
The average among 19 commercial banking companies in the S&P 500 was 1.6%, according to Credit Suisse’s analysis. By comparison, the auto industry’s average was the highest, at 8.9%.
Huntington Bancshares Inc. was one of the 14 companies in the study that had no material tax risk in the first quarter. The Columbus, Ohio, company said in its 10-Q that it had no tax reserve as of Jan. 1.
