TOPIC 10 SEMINAR QUESTION

Seminar Question Discussion and Presentation Allocation:

Group 1: Seminar Question 1
Group 2: Seminar Question 2
Group 3: Seminar Question 3
Group 4: Seminar Question 4
Group 5: Seminar Question 5
Group 6: Seminar Question 6
Group 7: Seminar Question 7

PART A: POLICY CHOICES AFFECTING THE INCOME STATEMENT

Read the following article (dated 15 July 2014) regarding JPMs 2014 2nd quarter earnings
which you have read for your homework question and answer the questions below:
http://www.zerohedge.com/news/2014-07-15/jpm-earnings-slide-8-drop-trading-volumemortgage-production-offset-15-billion-stock

SEMINAR QUESTION 1
Notably, JPM's reserve release of $521 million was a key contributor to EPS, well above the
$417 million reported a quarter ago and shows that when JPM needs to report a profit at all
costs it will certainly resort to raiding the piggy bank.
Explain (i) what loan loss reserve and reserve release means, (ii) and its impact on
reported earnings. [To answer this question, you may find it useful to search zerohedge.com
using the JPM reserve release or Citigroup reserve release strings.]
Loan loss reserve : a provision (liability) against the loans (assets) that the bank made to
customers going bad and unable to repay the principal of the loan.
Reserve release: a net reduction in the loan loss reserve.
Impact on reported earnings: a reserve release, i.e. reducing the loan loss reserve, would
reduce expenses and increase reported profit.
Seminar leaders may find it useful to explain this in terms of an analogy: the loan loss reserve
is analogous to the allowance for doubtful debts against accounts receivable. The loan loss
reserve is a provision against the loans (assets) that the bank made to customers going bad
and unable to repay the principal of the loan.
Charging bad debt expense (adding to allowance for doubtful debts) would reduce profit, the
analogy is that increasing (or building) the loan loss reserve would increase credit related
expenses and reduce profit. In the reverse, a loan loss reserve release would reverse the credit
related expenses and increase profit, analogous to reversing (crediting back) the bad debt
expense which would increase profit.
Whether it is the bad debt expense/credit or loan reserve build/release, the value is a
management estimate based on estimates and thus amenable to a discretionary and arbitrary
change in policy choice.
Changing the value of loan loss reserves is a common way for banks to manage its earnings.
For example, if a bank makes record profits in a particular year, it may increase the loan loss
reserves to store up profits to release later in a bad year to make the profits in the bad year
look less bad. This earnings management policy choice has been commonly observed in
banks and has been described as storing profits in hidden reserves.
In our accounting terminology, reserve usually refers to some kind of shareholders equity
item, e.g. revaluation reserve, or general reserve. However, in this case the loan loss
reserve is closer to what we would call a provision, i.e. a liability item. The difference is
of terminology rather than economic substance.
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SEMINAR QUESTION 2
The following chart is extracted from the same article.

Explain the relationship between loan loss reserve and total loans and loan loss reserve
and NPLs. You may find it useful to look at the ratios of those two items in the chart.
Although the chart scale makes it hard to see, the brown and black dotted line of the 2 ratios,
that measure the adequacy of loan loss reserves held as provision against future losses from
the banks borrowers being unable to pay back loans, has declined over time. The banks
management has become less conservative.

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SEMINAR QUESTION 3
Consider the 2Q14 financial results on slide 2 of the presentation. Explain the results of JPM
in 2Q14 with respect to 1Q14 and 2Q13. In particular work out the effective tax rate for 2Q14
from the figures in the table. [If you are not sure what any of the notation or acronyms mean,
for assistance you may refer to the linked article and to the original analyst presentation from
JPM, which is also provided in the article.]
JPM has an interesting way to show the results of the current quarter relative to the last
quarter and the similar quarter one year ago. It uses O/U to show how much this quarters
results is over/under the comparative quarter. For example, the current quarters revenue is
$1,486m more than 1Q14, but $609m less than 2Q13.
Seminar leaders should get students to discuss the one line items as well, and to point out that
in the real world actual financial result presentations do not always show every step in the
income statement but may extract and aggregate information. In this instance, the pre-tax
income line is excluded and the information jumps to net income.
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For calculation:

Revenue
Credit costs
Expenses
Pre-tax income arrived at by deducting the expenses from
revenue
Net income
Working backwards tax rate must be
1 (net income/pre-tax income)

25349
692
15431
9226
5985
35.13%

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SEMINAR QUESTION 4
Suppose you are an investment analyst who after scrutinising the chart in Question 2, you
believe that the declining trend in loan loss reserves relative to NPLs was unwarranted and
have come to the same conclusion as zerohedge, i.e. that JPMs earnings was overstated as a
result of a loan loss reserve release. Conduct sensitivity analysis and recomputed the reported
net income based on the loan loss reserve/NPLs ratio for 2Q12. [Hint: You may want to
check with the group doing Question 3 to get the effective tax rate necessary for sensitivity
analysis. In sensitivity analysis we may want to consider a range of outcomes based on
various assumptions, however, for this question you are only required to only do sensitivity
analysis based on the assumption embedded in this question.]
The answers present 2 alternate outcomes based on 2 different assumptions. However, the
question only asked for the one for 2Q12. The other is just to illustrate sensitivity analysis
using alternate assumptions. We could have also used LLR/Total loans as a different basis.
However, the value of total loans is not available in the chart and is the ratio is difficult to
read from the chart. Students may consult the original presentation document or download the
Companys financial statements to do sensitivity analysis based on the LLR/Total loans ratio.

Using the LLR/NPL ratio

2Q12
2Q13
2Q14
21936
19384
15326
10609
9578
7634
2.067678 2.023805 2.007598

LLR
NPL

LLR in 2Q2014
assuming same ratio as in relevant quarter
Additional build (release)

15784.66 15449.72
3067.811

123.724

Recalculating net income

Original

Revenue
Credit costs
Expenses
Pre-tax income
Net income
Tax rate

25349
692
15431
9226
5985
35.13%

Sensitivity analysis
Based on
2Q12
ratio
25349
692
18498.81
6158.19
3994.88

Based on
2Q13
ratio
25349
692
15554.72
9102.276
5904.739

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PART B: POLICY CHOICES AFFECTING THE BALANCE SHEET

Refer to the following article (dated 13 July 2008) which you have read for your homework
question and answer the questions below:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a1liVM3tG3aI

SEMINAR QUESTION 5
The article refers to $1.1 trillion of mysterious assets. The title of the article seems to imply
that the information was hidden from the public. Based on the information in the article
discuss whether this is a fair implication.
As implied by the article, many people were surprised by the amount of off-balance sheet
assets/liabilities assumed by Citigroup.
Some people quoted in the article said that it was disclosed but the disclosure was cryptic and
difficult to figure out.
Seminar leaders should allow students to debate whether it is ok to have off-balance sheet
assets/liabilities with inadequate disclosure.
If companies say that adequate disclosure exists, should they not just account for the offbalance sheet asset/liabilities on the balance sheet as following their reasoning it would be
economically the same thing.
My personal opinion is that off-balance sheet treatments of assets and the liabilities that fund
them is to allow companies to recognize the revenues from such structures, while not
showing the liabilities of such structures to be on the balance sheet so that the companys
leverage looks better than it actually is.

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SEMINAR QUESTION 6
Calculate the leverage ratio (in percent) according to the balance sheet as at 31 December
2007 and if these mysterious assets were brought back onto the balance sheet. [Hint: you may
think if that the off-balance sheet items as a t-account with $1.1 trillion in assets on the LHS
and $1.1 trillion in liability and zero equity on the RHS. Off-balance sheet asset are funded
almost entirely if not entirely by debt.]
(a) Leverage ratio (in percent) according to balance sheet as at 31 December 2007:
$113.6 / 2,187.63 = 5.19%

(b) Leverage ratio (in percent) if the mysterious assets were bought onto the balance sheet:

$113.6 / (2187.63+1100) = 3.46%

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(c) Discuss your concerns, if any, regarding the different inferences from the before/after
mysterious assets analysis.
From the balance sheet, we would infer that a fall in value of assets of 5.2% is required
before shareholders equity is wiped out.
But including the mysterious assets a much lesser value of a 3.46% fall in the value of assets
would be enough to wipe out shareholders equity.
Background: I prefer to use this version of the leverage ratio (E/A) expressed as a percentage
of equity portion of assets on the balance rather than the traditional multiple (A/E). It is in my
opinion more informative because it gives immediate and obvious information about how
much of the value of assets the company can afford to lose before equity is wiped out. It is
the preferred method of expressing a leverage ratio by regulators, especially for purposes of
checking the capital adequacy of financial institutions.

SEMINAR QUESTION 7
The above Question 6 assumes that there are no potential losses embedded in the $1.1 trillion
in off-balance sheet assets. The following quote extracted from the article gives us some idea
of the challenge to shareholders, investors and analyst.
It's impossible to predict what the losses might be from off-the-books assets or liabilities
because disclosures are thin relative to what is required for balance-sheet assets, said Neri
Bukspan, chief accountant for Standard & Poor's in New York.
However, despite the difficulty we often need to make some assumptions to conduct
sensitivity analysis. Of course, we need to have some basis for our assumptions. The quote
below gives us such a basis.
Now, as Citigroup prepares to announce second-quarter results July 18, those off-balancesheet assets, used by U.S. banks to expand lending without tying up capital, are casting a
shadow over earnings. Since last September, at least $100 billion of assets have flooded back
onto Citigroup's balance sheet, accompanied by more than $7 billion of losses.
(a) Assume a similar loss percentage and recalculate the leverage ratio.
Leverage ratio (in percent) if the mysterious assets were bought onto the balance sheet:

Loss based on assumption 7/100 = 0.07

= 1,100*0.07
= 77b loss
Leverage ratio = (113.6 - 77) / (2187.63 + 1023) = 36.6/3210.63 = 1.14%

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(b) Write journal entries for impact of item in (a)

Dr
Dr

Assets 1,023b
Equity 77b
Cr
Liability 1,100

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The following financial information which is relevant for the homework

Question 1 is extracted from:
FINAL EXAM, SEMESTER 1, 2008 QUESTION 3:
Summary data:
US$
Fiscal Year Ends
Price as at 17 April 2008
Market Cap
Trailing P/E*
Forward P/E (fye 31-Dec-09)*
PEG Ratio (5 yr expected)
Price/Sales
Price/Book
Profit Margin
Return on Assets
Return on Equity
Income Statement
Revenue:
Net Income Available to shareholders:
Diluted EPS:
Balance Sheet
Total Asset
Total Liability
Shareholders Equity
Cash Flow Statement
Operating Cash Flow
Investing Cash Flow
Financing Cash Flow

Citigroup (C)
31 Dec 2007
24.03
125.11B
33.51
7.35
2.07
1.9
1.03
5.63%
0.18%
3.10%

JP Morgan (JPM)
31 Dec 2007
45.12
153.25B
10.3
10.62
1.77
2.37
1.23
23.82%
1.06%
12.86%

159.23B
3.58B
0.72

116.35B
15.37B
4.38

2,187.63B
2,074.03B
113.6B

1,562.15B
1,438.93B
123.22B

-71.43B
-62.38B
144.49B

-110.56B
-73.12B
182.99B

* Trailing PE means PE based on published/historical earnings (in this case for FYE 31 Dec
2007), forward PE is based on earnings forecasted by analysts.

The full question is the PASS question for Topic 9.

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