Investors punished Bank of America Corp (NYSE:BAC) yesterday after finding out that the company had made a mistake in its Comprehensive Capital Analysis and Review (CCAR) filing by overstating its common equity tier 1 capital ratio. It turns out that Bank of America mishandled debt valuation adjustments (DVA) on structured notes that it assumed when it took over Merrill Lynch during the financial crisis, forcing it to put its buyback and dividend plans on hold while it resubmits, but stock’s 6% drop seems like an overreaction to a mistake that is more embarrassing than devastating.

Bank Of America BAC

Self-reporting should work to BAC’s benefit

“Market seems to be pricing in elimination of stock buybacks through 2016,” write Morgan Stanley analysts Betsy L. Graseck and Michael J. Cyprys in an April 28 report. “We feel this is too punitive given BAC’s high level of capital from which they’re starting from (9.9% revised down to 9.6%) and the fact that they self-reported this mistake.”

It’s important that the mistake was found by the Bank of America Corp (NYSE:BAC) CFO group and self-reported, not by the Fed and not by a third part auditor, because it shows that the bank is honestly engaged with the CCAR process and doesn’t give regulators a reason to increase the level of scrutiny on their resubmission. One sign of this is that banks are required to correct errors within 30 days, but the Fed has signaled that Bank of America will be given extra time.

Buybacks could be back as early as next year

But Bank of America Corp (NYSE:BAC) CEO Brian Moynihan has made it clear that he wants to return value to shareholders, and there’s no reason to think that this setback will change his priorities. While this year’s stock buybacks probably won’t happen we should still see an increase in dividend payments at least. Graseck and Cyprys also think that the total payout will go up another 50% next year when Moynihan adds ~$6.8 billion in buybacks into the capital plan for 2015.

Graseck and Cyprys lower their 2015 EPS estimate from $1.81 to $1.79 to account for the higher share count, but make no change to their 2014 EPS estimates and maintain a price target of $20 (currently $14.95). This 1.3% 2015E EPS reduction is about a fifth the size of yesterday’s contraction, implying that the market has swung too far against Bank of America Corp (NYSE:BAC). Bears argue that allowing an accounting mistake to get into the CCAR is a sign of deeper problems and that investors might want to be wary.

Robert Rostan on Bank of America’s accounting impact

Robert Rostan, a former Deloitte CPA and currently CFO and Principal of Training The Street, a leading corporate training provider for a majority of Wall Street Firms and top tier Business Schools spoke to ValueWalk about the numbers. Robert was also the director of financial reporting at an $8 billion public specialty retailer, Sonic Automotive. Below are some of his thoughts:

  • This was a $4 billion error that might otherwise have been quantitatively immaterial except for the fact that the error was approximately the same amount of capital which the Fed approved to be returned to shareholders in the latest stress tests
  • If we were not just not crawling out of the shadows of the financial crisis this error may have been merely back-page news
  • Accounting and spreadsheet errors happen frequently – this one was brought to light very quickly given the involvement of the Fed
  • However, it is unusual that this error went undetected for several periods – maybe it is time for some fresh eyes on the numbers at firms, their auditors and regulators
  • This may give fresh fuel to the auditor rotation debate
  • We cannot escape the ever-present financial complexity
  • Reconciling rules – the root of the error was that two different regulators  have two different sets of rules
  • Spreadsheets – firms use spreadsheets (that are prone to human error) to reconcile the financials for the two different regulators
  • A high profile error like this may provide additional momentum to the new COSO framework on internal controls that must be in place for public firms by the end