Here&#39;s What Mike Mayo Thinks Citi Is Doing To Cook Its Books (C)

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In analyst Mike Mayo's view, Citigroup needs to re-do its accounting.

He thinks the profitable firm should be in the red.

Mayo argues that Citi is "cooking the books," by wrongly writing off Deferred Tax Assets that legally, should appear no where on their books.

From HuffPo:

In Mayo's view, Citigroup needs to take an immediate loss of some $10 billion on its DTAs (deferred tax assets), something that would place the marginally profitable bank, back in the red.

Banks can use DTAs to reduce the amount of tax that they’ll need to pay in a later tax period*, as FTAlphaville puts it. But there are some restrictions as to when firms can use them. Mayo thinks Citi is in violation of those restrictions.

According to Gasparino:

Banks are allowed to write-off DTAs as long as they've been profitable for at least one of the past three years. They aren't allowed to write off DTAs if they've been unprofitable three years in a row.

Citi recorded a net loss in 2009, 2008 and 2007. According to Mayo, and several accounting experts I've come across, that means the firm is required to give a chunk of the money back, and take a large multibillion writedown.

Citi, understandably, hates Mike Mayo for making his argument. Vikram Pandit has apparently shut him out completely. So have other top executives at the firm. And when asked about Mayo, the firm's press rep told Gasparino: I have no comment on Mike Mayo.

So the question is, why are these two in hot dispute over Citi's accounting of DTAs?

It seems like Mayo thinks the size of the DTA Citi is writing off is too big; that they're expecting too large of a future profit to justify writing off so much loss in as-yet-unpaid future taxes. If he's right, and the bank has overestimated its future profit, Citi will experience a big write-down in the future.

But Citi is betting that their profits will be large enough in the future to justify the size of their DTA.

From the Wall Street Journal:

A Citigroup official said the company is confident in its ability to earn enough over the next 20 years to warrant the current size of the DTA. This official said Citigroup’s outside auditor, KPMG, has signed off on the company’s third-quarter DTA.

But here's another thing to worry about. Because more people are starting to worry that banks are at risk of future DTA write-downs, there is a bigger the chance that banks will no longer be allowed to include DTAs in their regulatory capital. Which means they could be forced to make those write-downs sooner.

The rating agency, Fitch, apparently sees an imminent impairment risk, according to FTAlphaville.

The uncertainty surrounding individual companies’ operating performance coupled with the higher level of DTAs, increases the risk that certain banks will need to write down their DTAs and/or have their DTAs disallowed from regulatory capital.

‘The risk to DTA impairments will become greater before it subsides, and more banks will become vulnerable to write-downs,’ said Julie Solar, Director in Fitch’s Financial Institutions Group, ‘but the risk to profitability and capital diminution is modest in aggregate at this point in time.’

* Here's a longer explanation of what banks do with DTAs from Reuters:

Deferred tax assets arise because companies keep two sets of books: one for taxes and one for reporting to investors. Income in these two books may be different at different times.

If a company has a loss on the income it reports to investors, but cannot record the loss for tax purposes until the future, it records a deferred tax asset, which reflects the future cash flow from paying lower taxes.

But if a company is unlikely to generate enough taxable income in the future, it must essentially write down the deferred tax asset, which it does by creating a “valuation allowance” on its balance sheet. That valuation allowance cuts into income reported to investors and can hit a portion of a bank’s regulatory capital, as well.

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