It’s going to be exciting week next week for RBS and Lloyds Bank shareholders with both AGMs on Thursday in Scotland – we expect to issue a report on events. Indeed it’s going to be an exciting period ahead because the law suits by those investors in the RBS rights issue who have not yet settled, and an action over the takeover of HBOS by LloydsTSB, are both getting into court in the next few months. Having Fred Goodwin on the witness stand, as expected, will be particularly interesting.
But the really astonishing recent news to this writer was the revelation on Monday (1/5/2017) by the FT that bankers are recognising future profits on zero-interest credit card customers. Bankers who offer zero interest balance transfers recognise some of the revenue and profits from new such customers based on the expectation that the customer will remain a customer, and not fully pay of the debt, when the interest free period ends.
Now a lot of them might not, but surely it is imprudent to recognise the cost of such promotions as other than a marketing expense which is surely what they are? And recognising future profits in the current accounting period is definitely neither sound accounting nor prudent in my view.
Was this not what Rolls-Royce had been doing which they have had to back-track on? With a major impact on their bottom-line as profits were routinely being overstated (see previous blog post on that).
The level of credit card debt is currently of concern to the Bank of England, and they might bring in tighter regulation on such offers and the level of debt. Or the customers might suddenly realise that not paying off such very expensive debt was nonsensical, particularly as the ability to roll it over to another credit card company might disappear. So all those future bank profits on credit card lending they are recognising now, and paying bonuses to management on them, might vanish.
Virgin Money is one bank where it is suggested they could lose as much as 18% of their earnings if there was a move to “cash accounting” on such arrangements, i.e. profits can only be recognised when the cash arrives.
So there are two questions that investors in banks might wish to ask at this year’s AGMs: 1) Are you doing this and if so why are the directors following this imprudent accounting practice? and to their auditors: Why are you approving this imprudent practice and under what accounting principles?
I fear this may be yet another example where banks will face regulatory action, and have to write off some of their claimed profits. And will investors ever learn to trust the reported accounts of banks when this kind of sharp practice continues?
Roger Lawson
Bankers have a long and ignoble track record for dodgy revenue recognition, allowing them to pay themselves bonuses based on illusory profits at shareholders’ funds. It’s self-evident that offering someone typically four years’ interest-free credit on balances transferred from a previous card is unlikely to result in that customer remaining with the bank once interest becomes payable, assuming similarly insane introductory deals remain available in the marketplace.
Recognising profits without solid evidence that they will be realised is false accounting. In any other industry that would lead to dismissal, being banned from being a company director and getting prosecuted and jailed. But bankers? Not so much…
You don’t need to ask the question at an AGM, just read the article in full and it explains that the accounting standard is Effective Interest Rates:
http://www.ft.com/content/a7df4432-2daa-11e7-9555-23ef563ecf9a
They will have to produce evidence to demonstrate historical performance of portfolios showing statistically what the returns are justifying the EIR that they use on the portfolio. The same EIR standard is what is used to ensure that charges on corporate debt are accrued over the lifetime of the debt rather than expensed on a cash paid basis. And on the flipside that banks accrue the income on the debt over the lifetime rather than on a cash received basis.
As to the banking bashing tone of the article: Yawn that’s so boringly 2009, the Daily Mail are attacking Bremoaners now but congratulations on alienating a good chunk of the City of London!
The EIR (Effective Interest Rate) accounting standard is used to calculate the effective overall interest on a debt instrument over the life of the loan when there are varying interest rates applied. But with a credit card debt, it is not a term loan and the lender has no idea how long the debt may be live because there is no agreed term. I suggest it is a distortion of accounting policy to apply that standard in this way. As I pointed out in the article, the credit card issuers may find the terms suddenly shortened so it is not prudent to apply this method now, if it ever was.
This is the kind of issue that arises when people are following complex rules to their own advantage, instead of looking at underlying principles. The auditors should certainly query this practice in the case of interest free credit periods, which as I indicated in the article are a marketing “come-on” in essence and the cost of such to the issuer should be treated as a marketing expense – and marketing expenses are usually written off in the current year, not capitalised. It is wrong to assume any certain future pay back and recognise it as revenue or profit in the current period. Such a practice would be equivalent to ShareSoc recognising a new subscribing member as instantly worth ten times their membership fee on the basis that the average renewal subsequently might be for ten years. And we certainly would not do that! Nor do we capitalise and amortise marketing expenditure.
The kinds of businesses that recognise future profits are ones like Quindell and we now know the reputation they built for themselves. Or as I mentioned in the article Rolls-Royce, who have recently back-tracked on this following the issue of a new accounting standard to clarify that it is not acceptable.
But my apologies to any bankers who might have sunk into a deep depression following my critical article. I didn’t realise they were that sensitive.
Roger Lawson