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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

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PART A: POLICY CHOICES AFFECTING THE INCOME STATEMENT Read the following article (dated 15 July 2014) regarding JPM’s 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-volume-mortgage-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 shareholder’s 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 bank’s 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 quarter’s results is over/under the comparative quarter. For example, the current quarter’s 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.

DO NOT WRITE OUTSIDE THE BOX PROVIDE For calculation: Revenue 25349 Credit costs 692 Expenses 15431 Pre-tax income arrived at by deducting the expenses from revenue 9226

Net income 5985

Working backwards tax rate must be 35.13% 1 – (net income/pre-tax income)

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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 JPM’s 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 Company’s financial statements to do sensitivity analysis based on the LLR/Total loans ratio. Using the LLR/NPL ratio

2Q12 2Q13 2Q14 LLR 21936 19384 15326 NPL 10609 9578 7634

2.067678 2.023805 2.007598

LLR in 2Q2014 15784.66 15449.72 assuming same ratio as in relevant quarter Additional build (release) 3067.811 123.724

Recalculating net income Original Sensitivity analysis

Based on 2Q12 ratio

Based on 2Q13 ratio

Revenue 25349 25349 25349 Credit costs 692 692 692 Expenses 15431 18498.81 15554.72

Pre-tax income 9226 6158.19 9102.276

Net income 5985 3994.88 5904.739

Tax rate 35.13%

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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 off-balance 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 company’s 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%

DO NOT WRITE OUTSIDE THE BOX PROVIDED (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.

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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-balance-sheet 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%

DO NOT WRITE OUTSIDE THE BOX PROVIDED (b) Write journal entries for impact of item in (a) Dr Assets 1,023b Dr 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$ Citigroup (C) JP Morgan (JPM) Fiscal Year Ends 31 Dec 2007 31 Dec 2007 Price as at 17 April 2008 24.03 45.12 Market Cap 125.11B 153.25B Trailing P/E* 33.51 10.3 Forward P/E (fye 31-Dec-09)* 7.35 10.62 PEG Ratio (5 yr expected) 2.07 1.77 Price/Sales 1.9 2.37 Price/Book 1.03 1.23 Profit Margin 5.63% 23.82% Return on Assets 0.18% 1.06% Return on Equity 3.10% 12.86% Income Statement Revenue: 159.23B 116.35B Net Income Available to shareholders: 3.58B 15.37B Diluted EPS: 0.72 4.38 Balance Sheet Total Asset 2,187.63B 1,562.15B Total Liability 2,074.03B 1,438.93B Shareholders Equity 113.6B 123.22B Cash Flow Statement Operating Cash Flow -71.43B -110.56B Investing Cash Flow -62.38B -73.12B Financing Cash Flow 144.49B 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.