ALEXANDRIA, VA (Mar. 31, 1998) -- A bank or finance company's income statement is heavily reliant on accounting accruals. Accrual accounting is much different from cash-based accounting, which is more intuitive but fails to portray the economics of many businesses.
If you're a kid running a lemonade stand, your profits are going to be pretty close to the difference between your cash income and cash outflow for the day. If you're running a financial services company, though, the cash you take in today might not be recognized as revenues until later in the year. In addition, the income statement has to reflect expenses that are temporarily non-cash events. Loan loss provisions fall into that category.
When a company makes 10,000 loans during the quarter, it knows from experience and from other data (such as macroeconomic data) that, say, one percent of those loans will go bad. It doesn't know which ones will go bad, it just knows from statistical experience that 100 of those loans will not be repaid or will become slow-paying loans. If it knew who was going to welsh on their loans and who was going to be a slow-payer, then it wouldn't make those loans and wouldn't need to take provisions for credit losses. While the excellent financial services companies have the capability to go beyond standard credit bureau reports and construct proprietary risk profiles, thus lowering their credit loss experience, it's still a fact of life that sometimes people will run into financial trouble and not perform on the loan agreement.
So, rather than waiting for the credit loss to occur, a financial services company uses its best judgment to account for those losses when the loans are made. On the Statement of Cash Flows, the provision for credit losses is shown as a non-cash charge to earnings. It is temporarily a non-cash item because the provision is taken in advance of the loss experience or event. That provision for credit losses is transferred to the company's credit loss reserve or loan loss reserve, which is a balance sheet item called an asset contra account.
An asset contra account is a valuation adjustment to assets, stated against, or contra, the value of those assets. It is a valuation adjustment that reflects what the company believes to be the realizable net present value of asset that the asset contra account underlies. It has the same effect as a liability in that it reduces the net asset value carried on the balance sheet, but it's not a liability for which the company will incur a cash expense. The cash has already left the balance sheet of the company making the loan.
Another example of this accounting regime is accounting for accounts receivable and the asset contra account of allowance for doubtful accounts for companies that sell goods or services on credit.
When a company is said to charge off a loan, this is not an income statement event. It is a balance sheet event. When a loan is charged-off, it means the company has basically abandoned hope (in an accounting sense) of recovering the loan. Though the value of the loan was reflected in the loan loss reserve, a charge-off is a firmer admission that the value probably won't be recovered. The charge-off, then, is deducted from the loan loss provision.
If a loan starts to perform to the satisfaction of the bank, it is then deducted from the provision for loan losses and added back to loans. When a previously charged off loan is recovered or partially recovered, that amount is added back to the loan loss reserve. On the way out of a recession, a bank can frequently lessen its loan loss provision on the income statement because recoveries of charged off loans build up the loan loss reserve. Also, the income statement of a bank can be considerably less burdened by provisions for loan losses on the way out of a recession because the reserves during bad times was built up to such a high degree that actual loss experience down the road is not as bad as expected.
Here are the allowance for credit loss, charge-off, and loan loss reserve activity for a particular regional bank for one quarter. (AOL users, expand screen to view table.)
Third Quarter ------------- 1997 1996 ---- ---- Allowance for credit losses: (1) Balance at June 30 $123,458 $116,478 (2) Provision for loan losses 12,753 8,853 (3) Charge-offs (14,521) (10,742) (3) Loan recoveries 2,185 3,128 -------- -------- Balance at September 30 $123,875 $117,717
(1) Is a balance sheet item. (2) Is an income statement item. (3) Effects both (1) and (2).
The company's reserves for loan losses is equal to 25 months of charge-offs (take charge-offs for the quarter and divide by three to get monthly charge-offs, then divide into credit loss reserves). A well-reserved bank has 9-12 months of charge-offs in its loan loss reserves or credit loss reserves. Note, also, that recoveries were $2.18 million. Reserves for credit losses were equal to 30 months of net charge-offs.
So, what comes through the income statement depends on what is shown on the balance sheet in the loan loss reserve and on the company's estimates of what loan loss activity will be. It also depends partly upon the effectiveness of the company's credit collection activities. The better the credit collection, the better the income statement will look. Of course, this all depends on how well the company is able to select desirable borrowers. You want someone who needs money but not someone who can't pay it back.
Like any other company, the interplay between balance sheet and income statement, which flows through the statement of cash flows, is very important. These statements can't tell you everything you need to know about the conservativeness or riskiness of a management team, but they can give an investor a very good starting point for assessing the financial condition of the company and the faith that can be put in the company's preparation of the income statement.
More on the income statement tomorrow.