Three weak spots in the big four

The major banks have used aggressive accounting to optically enhance their earnings.

Summary: In their quest to boost earnings growth, the major banks have stepped up their use of aggressive accounting practices since 2010 to optically enhance their earnings. This has included heavy capitalisation of software expenditure as an asset, reducing collective provisions as a percentage of assets to lower bad debt charges, and by consistently excluding numerous “one-off” items.
Key take-out: Of the big four banks, Westpac has been the least aggressive amongst its peers generally, followed by Commonwealth Bank, ANZ and NAB.
Key beneficiaries: General investors. Category: Shares.

The Australian major banks have delivered consistently strong earnings growth since the GFC.

Post-GFC, investors had been focused on balance-sheet strength. However, since 2010 the focus has shifted to earnings growth. Given the earnings pressures now facing the industry, there is the risk that banks become more aggressive in their accounting practices, thus optically enhancing their earnings.

In this piece I explore three avenues through which banks have been able to boost their earnings. My analysis suggests that Westpac (WBC) has been the least aggressive amongst its peers generally, having been the most conservative in amortising software and in excluding “one-off” items from cash earnings. However, it has been marginally more aggressive in releasing collective provisions. WBC is followed by Commonwealth Bank (CBA), ANZ and then National Australia Bank (NAB) in terms of positioning.

1. Capitalisation of software expenditure

Software expenditure can be capitalised as an asset on the balance sheet if it provides economic benefits over multiple periods. This capitalised software is then amortised over the useful life of the particular software. The net effect is that the expenditure related to the software is deferred over multiple periods, thus boosting earnings in the short term.

Figure 2 depicts capitalised software balances for the major banks since 2007. The chart shows that the major banks have rapidly increased their capitalised software balances post the GFC and have therefore delayed the recognition of expenses. In aggregate, the banks have increased their balances from $2.2 billion in FY07 to $8 billion in FY13, implying a compound annual growth rate (CAGR) of 24% over this period.

In stark contrast to this growth in capitalised software, the major banks’ aggregated total assets have grown by only a CAGR of 9% over the same period. Figure 3  illustrates the capitalised software balances of each of the major banks as a proportion of their total assets. From this chart we can see that CBA has been the most aggressive at capitalising software expenditure since FY07, with capitalised software as a percentage of total assets growing from 0.07% to 0.26%. This represents a CAGR of 25%, while the major banks’ weighted average CAGR is 14%.

At the other end of the spectrum, NAB has been the least aggressive of the major banks, with capitalised software as a percentage of total assets growing at a CAGR of only 9%. It is clear that the major banks have benefitted from their increased capitalisation of software expenditure, with capitalised software growth significantly outstripping total asset growth.

The second part to look at when considering capitalised software are the useful life assumptions used by each of the banks. It is an important consideration, as a longer useful life assumption will lead to higher earnings. In the chart below, I depict my estimates of the useful lives being used by each of the banks. It is interesting to note that while all banks have increased the useful lives of their capitalised software, CBA has moved from being the most conservative to the most aggressive in terms of its useful life.

My estimates suggest that CBA is now capitalising software over a period of seven years, while it previously used a period of just under three years. WBC was the most conservative in FY08 and continues to remain the most conservative, while NAB has recently become more aggressive since FY12, increasing from just under four years to six years. ANZ was initially the most aggressive of the major banks in FY08 but is now considerably more conservative than both CBA and NAB and only marginally more aggressive than WBC.

2. Collective provision releases

While the major banks have not reduced their collective provisions in absolute terms, collective provisions as a percentage of risk-weighted assets (RWA) have been declining since 2010. It is appropriate to assess collective provisions in this manner rather than in absolute terms in order to account for growth in lending assets, as well as their appropriate level of risk. A decline in collective provisions leads to lower bad debt charges in the income statement, thus optically boosting earnings. However, this impacts the ability of the banks to be able to adequately withstand bad debts in the future. Collective provisions as a percentage of RWA peaked at 1.22% in 2010 and are currently at 0.92% on an aggregated basis for the major banks as illustrated below.

The table below depicts the collective provision coverage of each of the major banks. It is worth noting that all of the banks have reduced their coverage by a similar amount (29% on average). Having said that, WBC has reduced its coverage by the most, declining by 32% from 1.23% to 0.84%. Conversely, CBA has been marginally less aggressive on this front, with its coverage declining by only 27%.

3. Significant “one-off” items excluded from reported profit

The major banks have consistently excluded numerous “one-off” items when calculating cash earnings, although these items are included within statutory profit. The major banks differ considerably in their definitions of these significant items, with some clearly more aggressive than others when deciding what to include and exclude from cash earnings.

Figure 7  shows these significant items as a percentage of cash earnings for each of the major banks since FY09. A key observation is that significant items tend to be negative contributors when reconciling cash earnings with statutory profit. WBC and CBA appear to be the least aggressive on the basis that their net significant items have in fact been positive in two of the last five years, while ANZ and NAB have been negative in every year.

Figure 8 depicts the significant items as a percentage of cash earnings for each bank on an aggregated basis from FY09 to FY13. NAB is the clear negative standout on this basis, with significant items equivalent to 16% of cash earnings on average through this period. CBA and WBC are once again the most conservative amongst the major banks, with both averaging 2% of cash earnings while ANZ averages 6% of cash earnings.

As the banks move into an environment of lower earnings growth, they face more pressure to manufacture earnings growth in order to deliver the level of earnings growth that investors have come to expect.

While all the banks have engaged in these practices to various degrees, it is evident that WBC has been the least aggressive amongst its peers generally, followed by CBA, ANZ and then NAB.

Justin Braitling is a principal of Watermark Funds Management at

Related Articles