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Earnings Management in Financial Institutions

JP Morgan Reserves to Cover $124 million losses

Are we returning to the days of widespread earnings management by financial institutions and corporate America similar to the late 1990s and early 2000s? Is it possible that accounting standards are fueling the current problem? Can reliable estimates of potential losses on energy-loan portfolios be made that meet the relevance and representational frameworks of solid accounting standards? How will we know and when whether financial institutions are playing fast and loose with the accounting rules once again? These are all important questions in light of the rapidly declining share value in energy stocks, turmoil in the markets, and uncertainty about whether energy companies can survive $30 per barrel prices for oil.

Last week JP Morgan announced it had set aside $124 million to cover potential defaults in its energy-loan portfolio during the fourth quarter. Finance chief Marianne Lake said that is oil were to stay around $30 a barrel for 18 months, the bank would set aside an additional $750 million in reserves. The question is how can investors feel confident that these amounts are accurate reflections of the economic value of the portfolio and not chosen to buffer reserves in good profit years only to be released back into earnings in bad years – or earnings management?

A little historical perspective is warranted. During the financial recession the banks were not required to estimate potential loan losses at the time the loans were made. Instead, estimates were made with the passage of time and experience. The problem was the portfolios tended to show retrospective values rather than prospective ones so that their usefulness to investors was limited.

The Financial Accounting Standards Board has been working on a new standard for a few years and while closer to the goal, FASB still needs to put the finishing touches on the new rules. The credit impairment standard will significantly change the way entities recognize credit impairment on financial assets. The recognition and measurement provisions of a “current expected credit loss (CECL)” model will apply to the majority of financial assets.

CECL is a complicated model so I’ll explain it in as plain terms as I can. Upon initial recognition and at each reporting date, entities will recognize an allowance for lifetime expected credit losses for instruments within the scope of the model. The amount recognized will be based on the current estimate of contractual cash flows (both principal and interest) not expected to be collected. Subsequent changes in expected credit losses (favorable and unfavorable) will be recognized immediately through earnings.

The projected final standard will not require a specific method to estimate lifetime expected credit losses (e.g., discounted cash flows, loss-rate, roll-rate, or probability of default). Entities will have the latitude to develop the methods to estimate and measure expected credit losses as long as they are applied consistently and reflect the key elements of the CECL method, which include.

  • Evaluate financial assets with similar risk characteristics on a collective (pool) basis.

  • Consider available information to assess collectability of contractual cash flows, including external and internal information about past events, current conditions, and reasonable, supportable forecast of future conditions.

  • When reasonable and supportable forecasts of future conditions are not possible, revert to unadjusted historical loss experience or a period or pattern that reflects the assumptions about expected credit losses.

  • Consider the entire contractual term of financial assets, including expected prepayments.

  • Reflect the risk of loss, even when that risk is remote.

You don’t have to be an accounting wonk to realize the standard is subject to a variety of estimates and assumptions that may or may not turn out to be valid, thereby providing the opportunity to manage earnings. Evaluations of risk; estimates of collectability; forecasts of future conditions; expected prepayments; and so on. How are investors to know whether these amounts are based on good faith assessments rather than a desire to report a level of earnings for a period of time that reflects what the entity wants it to reflect rather than economic reality?

Is there an answer to the dilemma of how best to warn investors of reasonably possible and/or probable losses on energy-loan loss portfolios? After all, we do want to avoid another period of bloated asset values and overstated earnings as we witnessed during the financial recession.

I propose that FASB move the charge against earnings when reserves for loan losses are initially set up out of profit and loss and into the equity section of the balance sheet by charging an account that is part of accumulated other comprehensive income. In that way we would control for earnings management. We do use the AOCI approach to recording estimated losses on available-for-sale marketable securities rather than the earnings account. Why not do the same for estimated losses on energy-loan portfolios and credit impairments on other financial assets? The full disclosure standard would be met without compromising the quality of earnings.

Blog posted by Dr. Steven Mintz, aka Ethics Sage, on January 19, 2016. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at:

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