First Quarter Profits? Pick a number, any number!

[OldShooter]

"JPMorgan set aside a stunning $6.8 billion worth of reserves to insulate itself from loan defaults. That helped send JPMorgan's profit plummeting ..." (https://www.cnn.com/2020/04/14/investing/jpmorgan-earnings-coronavirus/index.html)

Why not $7.8B? $5.8B? Do I hear $3B?? The answer is simple: JPM management decided what P&L number they wanted and chose a reserve amount to suit.

The point, of course, is that most corporations will be socking away reserves without having the slightest idea what the future will bring. The game now is "What can we get away with?" Management hopes then the game will be followed in the future with the game: "Look what wonderful managers we are!" as reserves are unwound. Maybe that will happen. Maybe not. We don't know and they don't know either.

Many years ago at megacorp there was a huge loss in one of our divisions due to division management hiding defective product in an inventory account. Top management used that as an excuse to write off and reserve for every possible future negative event. Go big! was the mantra. And it worked.

The press will not understand this; be ready for words like "profit plummets" in the headlines.

 

[Montecfo]

Opportunism has gotten a lot harder than what you portray. You have to have a basis for record in a reserve and supporting analysis. But losses will be large and so will reserves. But I do not see a free lunch.

 

[OldShooter]

... You have to have a basis for [recording] a reserve and supporting analysis. ...

Of course. They have that. For whatever number they have chosen.

But I do not see a free lunch.

In the end, the losses are whatever the losses are. But in the mean time, games can be played.

 

[cbbennet]

As I remember from some accounting class they said that was called the big bath. Have one big, horrible quarter, with everything hiding on the books written off, and, start fresh the next quarter. In the future it is truthful to advertise only one down quarter in the past XX years.
Wonder if houses from 2008 are still on the books?

 

[pb4uski]

IME they are both right. There is a range that one can spin a reserve for that will pass muster with the auditors. You can't just pick any number out of the air based on what you want the bottom line to be as OldShooter suggests in the OP... but you can certainly shade towards the top end of the range or the bottom end of the range and be ok.

That said, if you are going to take a bath then you might as well look through all the closets and see what else should be thrown out since the truck is going to the junkyard. Big baths are also common for troubled companies with a new CEO... the new CEO wants to start with as clean a slate as can be justified since they won't be on the hook for the big bath... if it later turns out that certain reserves recorded in the big bath are not needed then s/he gets the credit.

 

[OldShooter]

IME they are both right. There is a range that one can spin a reserve for that will pass muster with the auditors. You can't just pick any number out of the air based on what you want the bottom line to be as OldShooter suggests in the OP... but you can certainly shade towards the top end of the range or the bottom end of the range and be ok. ...

Perfectly true in normal times and you are well-qualified to comment, but these times are not normal. No one knows how to estimate things like loan defaults due to government shutdowns. No one even knows when the shutdowns will end, much less the shape of the resulting revenue recoveries. So some arm waving and a few pseudo-scientific probability calculations and the auditors will have to take it as they have nothing better, nothing to check it against.

We'll see, but my original point was that these earning reports should be take with a truckload of salt even before the reporters start with their cause and effect hallucinations.

 

[Montecfo]

Perfectly true in normal times and you are well-qualified to comment, but these times are not normal. No one knows how to estimate things like loan defaults due to government shutdowns. No one even knows when the shutdowns will end, much less the shape of the resulting revenue recoveries. So some arm waving and a few pseudo-scientific probability calculations and the auditors will have to take it as they have nothing better, nothing to check it against.

We'll see, but my original point was that these earning reports should be take with a truckload of salt even before the reporters start with their cause and effect hallucinations.

No accounting practices have been repealed. You can perform an analysis that leads to a generous reserve, but unless facts changed a lot you are going to have a tough time using a different method in future quarters.

I agree with you that in bad quarters there will be a desire to be more aggressive, but I would also suggest Q1 was not the "bad" quarter that Q2 may be. If Q1 does turn out to be the "bad" quarter, that would be good news indeed.

I view these interim reports as less meaningful since we know they will be bad. The markets will look past them and evaluate in light of Covid news and prospects.

So I agree with the grain of salt comment, but perhaps for different reasons.

 

[Running_Man]

Old Shooter,
There is no basis for your reckless accusation of fraud. You are implying that you know that the losses at these banks are less than the amounts they are reserving, if you know the history of banks and loan loss reserves, it is more likely these banks are under reserving future losses. JP Morgan has ONE TRILLION in loans on their books and just added an increase of 50% of their previous loan loss reserves to arrive at 2 percent of their loans outstanding that may go bad.

In the present situation what is your basis for the belief that more than 980 billion of the 1 trillion in loans will be paid in due course?
I expect, based on the sales collapse and ongoing GDP wipeout it is more likely that this will end up being short by more than 100 billion and that 10% of the loans will prove to be bad. In 2008 JP Morgan had 378 billion in loans outstanding and 20 billion in loan loss reserves 5.3% of the loan balance. To be at an equal loan reserve basis as 2008, and this crisis is far worse than 2008, JP Morgan should have taken another 30 billion on top of the loan losses they took in Q1. The question should be why is JP Morgan so optimistic?

Your authoritarian pronouncement of fraud betrays your knowledge of financial matters and not understanding the unprecedented destruction of an economy and the effect on financial statements. The amount of games that can be played are pennies on a per share basis, unless there is outright fraud.

 

[38Chevy454]

Agree with Montecfo, Q2 is when the really bad numbers will come out.

 

[BeachOrCity]

As a former employee of a large company I always have and still do feel that profits can be manipulated. All this gaap non gaap stuff has gotten completely silly in recent years.

Revenue cannot be (as easily) manipulated.

 

[pb4uski]

Perfectly true in normal times and you are well-qualified to comment, but these times are not normal. No one knows how to estimate things like loan defaults due to government shutdowns. No one even knows when the shutdowns will end, much less the shape of the resulting revenue recoveries. So some arm waving and a few pseudo-scientific probability calculations and the auditors will have to take it as they have nothing better, nothing to check it against.

We'll see, but my original point was that these earning reports should be take with a truckload of salt even before the reporters start with their cause and effect hallucinations.

I concede that to the extent that proper reserving was as much an art as science that it is even more artful and uncertain today. In theory, one should only consider events occurring through March 31.... additional impairments as a result of events occurring after March 31 technically belong to second quarter.... but in fluid situation like we have today it is very difficult... hence the art part. But at the same time one can't just throw out a number that makes the bottom line what you want it to be... there is much more to it than that.

 

[pb4uski]

As a former employee of a large company I always have and still do feel that profits can be manipulated. All this gaap non gaap stuff has gotten completely silly in recent years.

Revenue cannot be (as easily) manipulated.

Within ranges for sure given the judgement involved. I agree on the non-GAAP stuff... it has gotton to be silly... especially adjusted EBITDA measures... those can be pretty much whatever one wants to spin them to be.

I recall back in the 1990s when we first started doing "one-timers" where I worked (non-public company but for reporting to Board and other stakeholders)... the CFO and I both recognized that these one-time adjustments were a slippery slope... while there are some that are obvious and crystal-clear... from there it gets increasingly dicey.

 

[OldShooter]

... But at the same time one can't just throw out a number that makes the bottom line what you want it to be... there is much more to it than that.

Not quite apples and apples and an old story, but:

Years ago I worked for Rosemount Inc., which was owned by Emerson Electric. CEO was Chuck Knight, who was a poster child on Wall Street because he delivered a constantly increasing string of quarterly earnings.

As the end of each quarter approached, I found it amusing to swing by the shipping department. If they were lounging around, reading newspapers, with nothing to do -- Chuck's number was in the bag. If they were running like crazy people, shipping everything but their lunch boxes, Chuck needed help. One fall, Chuck needed help, and Rosemount shipped a multi-hundred $K order that was not needed on the construction site for months. It all came back, of course, and everyone involved with the order knew it would be returned, but Chuck got his number.

 

[OldShooter]

... I recall back in the 1990s when we first started doing "one-timers" where I worked (non-public company by for reporting to Board and other stakeholders)... the CFO and I both recognized that these one-time adjustments were a slippery slope... while there are some that are obvious and crystal-clear... from there it gets increasingly dicey.

Yup, it's the job of the finance guys to be worried about stuff like that. Sometimes I think it might be genetic.

When mentoring small business owners with SCORE, I sometimes end up paired with a mentor who is a CPA. Occasionally, we get to a point where I say to the client: "Yeah, Frank is right, but what are your chances of getting an IRS audit? Zero. And if do get audited, you apologize and show that you relied on some kind of document. Worst case they want their tax money but probably they'll waive any penalty."

If you want to see an elderly CPA rise out of his chair, just say something like that. This kind of thing comes up frequently when discussing contract/1099 employees vs W-2 employee rules.

I have never had an IRS audit, personal or business. I used to have a CPA who said: 'If you don't get audited once in a while, you're not trying hard enough."

 

[pb4uski]

Not quite apples and apples and an old story, but:

Years ago I worked for Rosemount Inc., which was owned by Emerson Electric. CEO was Chuck Knight, who was a poster child on Wall Street because he delivered a constantly increasing string of quarterly earnings.

As the end of each quarter approached, I found it amusing to swing by the shipping department. If they were lounging around, reading newspapers, with nothing to do -- Chuck's number was in the bag. If they were running like crazy people, shipping everything but their lunch boxes, Chuck needed help. One fall, Chuck needed help, and Rosemount shipped a multi-hundred $K order that was not needed on the construction site for months. It all came back, of course, and everyone involved with the order knew it would be returned, but Chuck got his number.

Sounds plausible for a quarter since quarters are not audited.... back in the day when I was an auditor we would routinely look at returns after the financial statement date through when we were doing the audit and assess the implications on the allowance for returns and whether the client should have known... in a case like what you describe the sale might be reversed. It also might get tripped up and reversed if we confirmed the receivable with the customer if they said "I don't owe this... it was shipped to me before it was supposed to be and we returned it".

 

[Running_Man]

Yup, it's the job of the finance guys to be worried about stuff like that. Sometimes I think it might be genetic.

When mentoring small business owners with SCORE, I sometimes end up paired with a mentor who is a CPA. Occasionally, we get to a point where I say to the client: "Yeah, Frank is right, but what are your chances of getting an IRS audit? Zero. And if do get audited, you apologize and show that you relied on some kind of document. Worst case they want their tax money but probably they'll waive any penalty."

If you want to see an elderly CPA rise out of his chair, just say something like that. This kind of thing comes up frequently when discussing contract/1099 employees vs W-2 employee rules.

I have never had an IRS audit, personal or business. I used to have a CPA who said: 'If you don't get audited once in a while, you're not trying hard enough."

What you advocate for is fraud, plain and simple and you should be in jail for the advice you give. And yet you laugh at people finding proper reporting techniques. If anyone like you ever came into my firm, I would have immediately reported you to internal audit.

 

[pb4uski]

A bit harsh.... but I agree that the risk of getting caught should not be a factor.... assume that you will be audited even if it is a low probability.

My personal hurdle was more along the lines of if what we did, the facts and circumstances surrounding it and the reasoning of why we did it were spread out on the front page of our local newpaper the next day, could we still feel comfortable walking down Main Street with our heads held high or would we feel like we need to duck into the nearest alley when we saw someone we knew.

 

[OldShooter]

A bit harsh.... but I agree that the risk of getting caught should not be a factor.... assume that you will be audited even if it is a low probability.

My personal hurdle was more along the lines of if what we did, the facts and circumstances surrounding it and the reasoning of why we did it were spread out on the front page of our local newpaper the next day, could we still feel comfortable walking down Main Street with our heads held high or would we feel like we need to duck into the nearest alley when we saw someone we knew.

I don't know what RM said, as I got bored with him a few months ago and put him on my ignore list. He's the only one, actually. So all I see is that he has posted, not the posts themselves.

But to be clear, I am talking about judgment calls here not outright fraud. But there are lots of judgment calls, particularly in the question of 1099 vs. W-2. If you stick to strict reading of the IRS rules, most of the businesses using independent contractors (like delivery services, ride sharing, etc.) are in huge violation. But we know that is not the real world. My SCORE clients live and work in the real world.