Last year the banks had an easy way to juice their profits. All they had to do was allocate a little less money to loan-loss reserves -- the money they set aside to cover bad debt. As the economy has improved and defaults have slowed, many decided they didn't need as much in reserve as they did in 2003, and presto, their earnings per share would rise a few cents.Academics have done dozens of studies on earnings management by non-financial firms over the years. There's been relatively little done, however on earnings management by banks (a few have been done on insurance companies, which also have to set aside loss reserves). This is surprising, since researchers often use the different regulatory environments faced by financial institutions as an interesting spin for examining issues faced on non-financial firms. However, since I don't do research in the area of financial institutions, there could be good reasons why the issue hasn't been done that I'm simply not aware of.
But investors who assume the profits are humming and decide to buy bank stocks could be in for a shock. In 2005 many banks won't have this profit source. Some have already pared loan-loss reserves as much as they reasonably can, analysts say. "A lot of banks may do this from time to time to meet estimates," says Brian Shullaw, senior research analyst at SNL Financial in Charlottesville, Va.
Earnings Management By Banks
Business Week Online has this on earnings management by banks (compliments of The FInancial Accounting Blog):