What the analysts are saying: UBS says look behind the cash earnings facade

UBS banking analyst Jonathon Mott has challenged the major banks' over-use of below-the-line items in their financial reports, arguing that the practice overstates the banks’ true earnings picture.

The banks make adjustments to their statutory net profit, taking items below the line and referring to the residual cash earnings as their main earnings metric. Cash earnings are then used as the basis for calculating earnings per share, return on equity, dividends and, in some cases, management remuneration.

Mott said: "We have generally agreed with the exclusion of 'accounting noise' items, such as hedge ineffectiveness adjustments, but we are concerned with the recurrence of so-called 'one-off' items."

These one-offs include restructuring charges, integration provisions, tax settlements, legal settlements, asset write-downs and gains on sale.

Among the big four banks, restructuring provisions have been itemised as one-offs in 12 of the 15 years since 1997, adding up to A$4.5 billion.

Asset write-downs have been reported below the line in eight of the 15 years, adding up to $1.6 billion. Integration and due diligence expenses have been reported nine times, adding up to $2.1 billion.

In total, adding back net below-the-line losses amounts to about $7.1 billion after tax, or 3.7 per cent of net profit over a 15-year period.

NAB is the biggest user of below-the-line reporting, with items worth 8.2 per cent of net profits over the past 15 years. ANZ's below the line items have been worth 2.4 per cent of net profit over the same period, Commonwealth Bank's 2.2 per cent and Westpac's negligible.

Mott said: "Boards and auditors have a tendency to allow more expense and loss items to be taken below the line than revenue and profit items.

"This become significant over time, leading to an overstatement of delivered earnings and return on equity, and potentially an overpayment of dividends and management remuneration."

Mott's report poses the question of whether banks should be able to take integration charges, for example, below the line, while the subsequent benefits are taken above the line.

He said: "Overall, we believe that these integrations are generally one-off in nature, although banks do remain acquisitive over time.

"However, we believe that the cost of integration should be factored into the acquisition price in calculating the effective multiple paid for assets."

For example, in July 2009 NAB disclosed that it had paid approximately $99 million to acquire 80.1 per cent of JB Were. Although earnings multiples were not disclosed, this appeared to be a fair price. However, over the subsequent five halves NAB has spent $138 million integrating JBWere into NAB Wealth. This effectively doubles the price that NAB has paid for the business.