Citi's $1.6 billion profit based on $2.5 billion accounting trick

Today we have another example of why it is such a huge mistake to let companies write their own report cards. That's right folks, Citigroup, Inc. (C) reported a $1.6 billion profit for the first quarter of 2009. Doesn't this sound great? It sure does until you take two seconds to realize that the profit would have been a $900 million loss were it not for a $2.5 billion accounting trick.

What accounting trick? I could not believe my eyes when I read it but it turns out that Citi was able to take to a $2.5 billion gain on a rule that lets it record any declines in the market value of its debt as an unrealized gain. The rule, which Citi adopted in 2007, reflects the possibility that a company could buy back its own debt at a discount, which under traditional accounting methods would result in a profit. But Citi didn't do that -- this has to be some kind of an error.

How could an accounting rule allow a company to record a decline in the market value of its debt as a gain? Does this mean that Citi got $2.5 billion in cash because it owes less to its lenders based on a temporary decline in the value of its debt? Are accounting rules letting Citi record a profit for getting less and less attractive to lenders? This rule makes no sense to me.

And there should be a rule that forces Citi to take a loss for a decline in the market value of its assets too. But thanks to FAS 157-e, it can record any gain it wants on the value of its toxic waste -- and I would not be surprised if Citi did just that in the first quarter.

On a real-world level, there was a mix of bad and good news in the report. Bad loans boomed. Net credit losses in Citi's North American credit card division rose 81 percent from 2008. Citi's total credit costs were $10.3 billion during the quarter, up 76 percent from a year ago.

But expenses fell -- Citi's operating expenses dropped 23 percent from the first quarter of 2008 with 13,000 fewer employees, to 309,000 since the fourth quarter 2008. And like its peers, Citi benefited from strong fixed-income trading results -- its investment banking and trading businesses reported net income of $2.8 billion.

Overall, Citi's "profit" did not translate to shareholders -- it reported a loss of 18 cents a share, reflecting the conversion price of a $12.5 billion preferred share offering from January 2008.

But the market expected worse and Citi stock is up 12 percent in pre-market. I should be happy but I don't trust the numbers when I realize that Citi's executive pay is tied to its use of accounting gimmicks.

Peter Cohan is president of Peter S. Cohan & Associates. He also and is the author of You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He owns Citi shares.

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