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.

 The dollar amount of the allowance for loan loss reserves represents one pot for all of Citigroup, on a consolidated basis, to draw from, if needed. The bank does not physically set aside dollars by asset class and business unit but only makes digital blips “for analytical purposes.”
Citigroup spokesman Jon Diat insists otherwise. He told me it reviews and records loan loss reserves at the legal entity level and by business segment. But Citi’s own quarterly and annual reports bear out what the source familiar with the regulatory reviews says.

The company explains it to investors in its quarterly SEC filings, on the schedule entitled “Details of Credit Loss Experience.

 “Attribution of the allowance is made for analytical purposes only and the entire allowance is available to absorb probable credit losses inherent in the overall portfolio,” the company says.

The total balance sheet provision for loan losses, and the percentage of loan assets it represents, may be mentioned at earnings announcement time. However, bank executives emphasize the incremental changes or reserve releases when explaining the impact of delinquencies on earnings to investors and analysts. 

The rationalizations for releasing reserves or adding provisions are fickle. They change with the wind each quarter and, at times, contradict each other from one period to another. But most investors and analysts pay attention only to the lists of incremental changes in the reserves that executives rattle off on earnings calls or regurgitate in press releases and presentations, rather than the new overall level of the total reserve for losses.

What’s wrong with the top-down approach? If the ALL number is decided at a top level and then allocated down using “management’s estimates,” how do you know that the estimated losses align with the ownership of the loans at the subsidiary level? Is the ALL at one separate legal entity truly available to absorb the losses at another separate legal entity, especially one outside the United States?

How will these balances be treated if a Citi Holdings business unit is sold or requires a significant infusion beyond previous allocations? It looks like Citicorp (the so-called “good bank”) would pick up the difference.

What does this say about the arbitrary nature of performance targets and bonus awards if such a significant offset to business unit profitability is recorded “for analytical purposes only” and can fluctuate so often?

Jon Diat, the Citi spokesman, responded to my inquiries by emphasizing that the bank follows all applicable accounting rules and practices on loan loss reserves. He reminded me that loan loss reserves cover losses inherent in the portfolio at a particular point in time. According to Diat, the overall balance sheet reserve for loan losses has gone down every quarter since the first quarter of 2010 because “net credit losses, delinquencies and other indicators of losses inherent in the portfolio have all improved over the past seven quarters resulting in lower losses in Citi's loan portfolios.”

KPMG, Citigroup’s audit firm, also works for Wells Fargo. A review of the most recent Wells Fargo annual report reveals similar language about general availability of the reserve balance as found in Citigroup’s filings: “While our methodology attributes portions of the allowance to specific portfolio segments, the entire allowance for credit losses is available to absorb credit losses inherent in the total loan portfolio.” But Wells Fargo’s use of the top-down ALL methodology, per the approval of auditor KPMG, does not present the same risk to investors as we see with Citigroup.

Citigroup has significant legal entities outside of the United States and created a separate legal entity, Citi Holdings, to position assets for sale or runoff. Wells Fargo is primarily a domestic bank and it has not established a “bad bank” legal entity. An under- or over-allocation of the loan loss provision has a greater likelihood of misleading Citigroup investors about the true book value of its loan portfolios.

The other two megabanks, JP Morgan Chase & Co. and Bank of America Corp., are both audited by PricewaterhouseCoopers, and neither makes the same statements in regulatory filings about the general availability of ALL to all business units. The descriptions of the calculations of loan loss reserves and allocation of provisions are significantly more detailed, and specific to each product and business unit, at JPM and B of A than at KPMG’s clients Citi and Wells.

According to the Financial Times, Citigroup chief financial officer John Gerspach acknowledged deteriorating conditions, again, in the bank’s mortgage portfolio during the third quarter. Those assets are housed at Citi Holdings.

Gerspach “said the bank was seeing ‘re-defaults’ on mortgages that had been modified to make them more affordable,” the FT reported, quoting him as saying, “We could begin to see increased delinquencies and net credit losses.”

Conveniently, during the third quarter, Citigroup released net loan loss reserves of $1.4 billion, more than half of which was attributable, supposedly, to an improvement in delinquency experience in private-label credit cards. The private-label credit card business is housed in Citi Holdings but this business is getting a reprieve from the chopping block because of Citigroup’s view that there’s been a turnaround. It’s heading back as “core” to Citicorp by early 2012.

Don’t be surprised when Citigroup adds back significant reserves for mortgage redefaults. That will happen as soon as other parts of the business give the company some breathing room. Until then, the loan loss reserve account gives the bank some space to maneuver.

Francine McKenna worked in consulting, professional services, accounting and financial management for more than 25 years. She writes "Accountable," a BankThink column on corporate governance, risk management and the Big Four audit firms and their impact on financial institutions. McKenna also blogs at re: The Auditors.