Making sense of earnings reports should be straight forward exercise. After all, a company’s bottom line is supposed to be a measure of its profitability.
How a company’s reported results compare to expectations has a direct bearing on its stock price performance. As simple as this process looks on the surface, it is anything but simple in the case of bank earnings reports — particularly in this current reporting cycle.
A ‘GAAP’ in Understanding
Accounting rules mandate what qualifies as ‘earnings,’ known as earnings under generally accepted accounting principles, or GAAP. At times, a company will have one-time gains and losses that have been accounted for in the GAAP earnings, but that tends to make it difficult to get a sense for the company’s ‘core’ or ‘recurring’ earnings. Analysts covering the company and folks like us that track all earnings data will make the ‘necessary’ adjustments to the GAAP number to arrive at the ‘recurring’ earnings number.
These one-time items are typically small and infrequent. But this has not been the case with U.S. banks since the latest financial crisis, making it difficult to get a measure of the bank’s underlying health. Along with this, one-time items for banks have dramatically increased in recent years. Most of the banks have so many items in their financials that the very decision on what to include or exclude has become very challenging.
Why Is It So Difficult?
Looking at the first quarter 2012 earnings releases of the major U.S. banks, you can see hefty accounting-related gains or losses are primarily responsible for the outsized differences between reported and ‘recurring’ numbers (as calculated by analysts and others). In addition, the difficulty in accounting adjustments and consequently the difference in calculations results in several ‘recurring’ numbers.
If we take a look at the big Wall Street firms that reported last week, we can see that their first quarter numbers were positively or negatively impacted by certain accounting adjustments and several one-off items. Though identifying these items was not difficult, analysts were not in agreement with respect to interpretation.
Bank of America Corporation‘s (BAC) first quarter profit declined 68% from the year-ago quarter because of a $4.8 billion accounting charge. Excluding the charge, its earnings per share would have been substantially better than the consensus expectation. We at Zacks recorded the company as having come out with a big positive surprise, though others have treated the company’s multiple supposedly non-recurring items differently.
In the case of Morgan Stanley (MS), on a reported basis, first-quarter loss from continuing operations came in at 5 cents per share, compared with an income of 51 cents in the year-ago quarter. The deterioration was due to a hefty accounting-related impact on its revenues during the reported quarter. But as with BAC, the company’s reported numbers turn into a strong positive surprise once adjusted for these accounting-related numbers. Excluding the accounting-related charge, the company posted 27% growth in earnings from continuing operations.
Citigroup Inc.‘s (C) 95-cents-a-share earnings came in lower than 99 cents earned in the year-ago quarter. Accounting charges of $1.3 billion was included in the result, causing the company to miss the consensus expectation of $1.01 per share. However, excluding accounting charges and many other one-off items, the company surpassed the consensus estimate.
It makes sense to adjust the banks’ reported GAAP earnings for non-recurring items that do not have a direct bearing on its underlying business. But the process is far from simple. Take the example of one such accounting adjustment that has been constant in recent bank earnings: the debit-valuation adjustment (DVA).
The DVA relates to the value of the bank’s debt during the period. According to this accounting measure, banks are allowed to mark some of their debt to market. To simplify, if the market value of their debt instruments decrease, it can be interpreted as a decline in liabilities and reported as earnings. The reasoning for this rule postulates that the bank can realize gains by buying back its own debt instruments at a lower value. So the bottom line here is that higher risk of a bank’s defaulting on its debt implies bigger DVA gain.
Most of the firms actually do not buy back their own debt instruments, but they certainly report DVA gains if they recognize market value declines. The firms do this by widening credit spreads in the swaps market. Now, widening credit spreads implies deterioration in the credit-worthiness of a bank.
So, should the investors be happy with the incremental earnings, at the cost of worsening credit-worthiness of banks?
Sleight of Hand at Play?
On the other hand, uncertainty arises with respect to reporting, as banks show these adjustments to convince investors of their financial strength. If the banks mostly experience accounting-related charges during the quarter, as is the case in the first quarter, they will significantly highlight those to give investors the notion that their performance weakened because of these changes. Otherwise, they would have reported a strong quarter.
But the same banks barely highlight these accounting adjustments when they gain from them. So the lack of consistency misguides investors about the real financial health of banks.
Again, is it meaningful to consider these accounting gains as one-off items anymore? We generally calculate core earnings by excluding items that are not related to the company’s underlying operations. Though these accounting adjustments are not related to a bank’s core business, they have been presented for several quarters now. So, whether to include or exclude these items as one-off is confusing.
In conclusion, before being impressed by a bank’s earnings, one should see how it has presented the accounted adjustments. First ensure that the beat or miss is not solely because of accounting adjustments.
