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'
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
Bank of America Corporation
) 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
In the case of
), 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
) 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
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 (
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
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
BANK OF AMER CP (
): Free Stock Analysis Report
CITIGROUP INC (
): Free Stock Analysis Report
MORGAN STANLEY (
): Free Stock Analysis Report
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