Bank profits are illusory

Thanks to some accounting trickery, firms are able to magic losses into profits, says Tim Bennett. Here, he explains how, and what investors should watch out for.

How can you turn a loss into a profit without actually making more money? Just ask your banker. Around 25% of the latest third-quarter profits reported by the US's four biggest banks was down to accounting trickery. British banks pull similar tricks, using loan loss reserve accounting'. Here's how it works.

The problem with dodgy loans

Say a bank has allowed ten people in similar jobs to borrow £1m each. They each buy a £1m house. But six months later, one runs into trouble and stops paying interest on his loan. Three months later, he loses his job and is unable to pay the mortgage at all. Unfortunately, the house is now worth only £750,000. So even if the bank repossessed the house and sold it, it would only realise 75% of the loan value.

This means that one of the bank's ten loans is impaired'. About £250,000 of the original £1m asset (the amount the bank is owed on the original mortgage of £1m) must be written off. So the bank reduces the £10m of mortgage receivables on its balance sheet by £0.25m and takes a similar hit to its profits.

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But what about the other loans? It'd be optimistic to assume they're all safe after all, the borrowers work in the same sector. Accounting rules suggest the bank should write off a proportion of those loans now (make loan loss provisions') so shareholders don't get a nasty shock later. But how much? 25%? 10%?

That's not an easy question to answer, but it's important, as the figure chosen could have a big impact on reported profit. Whatever amount the bank chooses is booked as a hit to profits. It can always reverse it later if it turned out it was being too cautious.

The temptation to smooth profits

There's a clear temptation for the bank here. In bad years such as those following a financial crisis the bank's operating results will be ugly anyway. As the finance director, you might be tempted to make some provisions against dodgy loans, figuring that no one will notice a little bit of extra bad news. A few years later you can legitimately reverse part of those previous hits, and boost your profit number, claiming you were too cautious.

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The trick that turns banking losses into profits

The impact can be dramatic. Say a bank's core operating results show a £150m profit for 2012, which it expects to be followed by a £100m profit for 2013 and £80m for 2014. The view of falling profits won't please shareholders. So in 2012, the bank makes a loan loss provision of £50m.

In 2013, it says it has been overly cautious and reverses £10m back into profits. In 2014, it declares that mortgage recovery rates have picked up so much that it can reverse out the remaining £40m. Hey presto! Over three years the profit figure after these adjustments reads: 2012 £100m; 2013 £110m; 2014 £120m. A very different picture.

How to avoid being fooled

Never trust a firm's reported profits figure by itself. Test the quality' of its profits by checking each year's cash flow using the cash flow statement. You are looking for some consistency between the two numbers. Also be suspicious as soon as you see items in any profit and loss account (not just a bank's) described as reversal of provisions'.

Right now we are not fans of bank shares anyway we think there is plenty of bad news hidden in the sector. Loan loss provisions just give you one more reason to be wary.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.