Citigroup Reaches into Accounting Cookie Jar

Citigroup Inc. wants to bounce back from the ignominy of having been state-owned. To get back on top, the bank has been using “cookie jar” accounting to manage profitability.

It posted net income of $3.8 billion for the third quarter, 74% higher than the same period a year earlier. About $1.9 billion of that reported net income came from a “credit valuation adjustment”, a perverse accounting entry that adds book income when a bank’s credit spreads widen. If you also subtract “management’s best estimate” of a $1.4 billion loan loss reserve release, you end up with a more modest after-tax profit.

To be fair, other banks got big boosts from valuation adjustments during the period, and they’re all required to report these under generally accepted accounting principles. The adjustment is based mainly on models and estimates and judgments, and thus can be easily manipulated to manage earnings.

But give Citi the benefit of the doubt and assume it did not game this figure. The other main element of its third-quarter profit, the reserve release, is something the company has been using to enhance its income statement for years.

A “cookie jar” is the place manipulative managers build up generous reserves in good quarters so they can use them to offset losses that might be incurred in bad quarters. Managing the allowance for loan losses, or ALL, for profitability is one of the oldest cookie jar accounting manipulation techniques for banks. There’s always room to maneuver when a balance sheet number represents “management‘s best estimate.”

That’s why the ALL account gets so much scrutiny by the Securities and Exchange Commission and the audit regulator, the Public Company Accounting Oversight Board. Citigroup’s auditor, KPMG, reviews the ups and downs of the “calculation” of the allowance for loan losses every quarter, audits them every year, and has been giving its seal of approval to the number for 41 years. But KPMG, in particular, has been cited for deficient audits of the ALL balance in at least two clients in three out of its last four PCAOB inspection reports. The PCAOB says that on more than one occasion, KPMG “failed to obtain sufficient competent evidential matter to support its audit opinion” when auditing ALL.

 The most recent PCAOB inspection report for KPMG audits performed in 2009, published this week, criticizes the firm for its audits of the ALL account at three different financial services clients. It seems the audit firm is getting worse, not better at the task. KPMG declined to comment for this article.

There’s no lack of information about loan loss reserves in Citigroup’s quarterly and annual financial statements. Schedules include a breakdown of reserve balances between the consumer and corporate businesses. Since the January 2009 establishment of Citi Holdings, the group of noncore businesses positioned for restructuring, runoff, or sale, there’s also been a breakdown between those unwanted lines and the core businesses, housed under the unit known as Citicorp. Despite the wealth of detail now available to investors and regulators, there are only two things you really need to know:

• The total Citigroup ALL grew from $8.9 billion at the end of 2006 to $48.7 billion, or 6.8% of total loans, at the end of the first quarter of 2010, but it’s been declining every quarter since. At the end of this year’s third quarter the amount set aside to cover losses was $34.4 billion, or 5.4% of total loans. 

• Citigroup determines its total ALL number from the top, not by building it from the bottom up. All the detail in the quarterly and annual reports about how the balances are estimated and allocated may give you the opposite impression. In reality, according to a source familiar with the bank’s regulatory reviews, Citigroup senior executives choose a number for the balance sheet, then use their judgment to estimate how much more or less to allocate to each business unit based on recommendations from the operating executives.