Adjusted diluted provision

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• "earnings per share"
• "allowance for credit losses"
• "financial assets"
• "amortized cost"
• "loan loss provision"
• "income statement"
• "balance sheet"
• "debt securities"
• "financial statements"
• "revenue"
• "profitability"
• "regulatory capital"
• "net income"
• "dilution"
• "common stock"

What Is Adjusted Diluted Provision?

Adjusted Diluted Provision (ADP) is a financial metric used primarily by financial institutions to refine the reported earnings per share (EPS) by taking into account the impact of certain non-recurring or non-cash adjustments, particularly those related to the allowance for credit losses, on diluted EPS. This metric falls under the broader category of financial accounting and aims to provide a more representative view of a company's underlying operational performance and potential dilution from contingent securities. The adjusted diluted provision often helps analysts and investors assess the true recurring earning power by normalizing for items that might distort the reported figures.

History and Origin

The concept of adjusting financial metrics like earnings per share evolved over time as accounting standards became more complex and companies sought to present their financial performance in various ways. The emphasis on diluted EPS itself gained prominence with the issuance of accounting standards like FASB Statement No. 128, "Earnings per Share," which aimed to standardize the calculation of basic and diluted EPS. The Securities and Exchange Commission (SEC) also played a role in shaping how EPS and related adjustments are reported. For example, Staff Accounting Bulletin (SAB) No. 98, issued in February 1998, provided guidance to align SEC staff views with recently adopted accounting standards, including those related to earnings per share¹³, ¹⁴, ¹⁵.

More recently, the introduction of the Current Expected Credit Loss (CECL) accounting standard by the Financial Accounting Standards Board (FASB) significantly impacted how financial institutions recognize credit losses. CECL requires entities to forecast expected credit losses over the lifetime of financial assets measured at amortized cost¹¹, ¹². This forward-looking approach can lead to more volatile and larger loan loss provision figures compared to the previous incurred loss model. As a result, many financial institutions and analysts began looking at adjusted figures, such as Adjusted Diluted Provision, to assess core profitability apart from these new, often significant, non-cash provisions. The CECL standard became effective for SEC filers in fiscal years beginning after December 15, 2019, with some exceptions and later adoption dates for other entities⁹, ¹⁰.

Key Takeaways

• Adjusted Diluted Provision refines diluted earnings per share by isolating the impact of specific non-recurring or non-cash items, especially those tied to credit loss provisions.
• It offers a clearer picture of a financial institution's ongoing operational profitability by mitigating the volatility of certain accounting adjustments.
• The metric is particularly relevant for financial institutions impacted by accounting standards like CECL, which mandate more forward-looking credit loss recognition.
• Analysts use Adjusted Diluted Provision to compare performance across periods or against peers by normalizing for unique accounting treatments.

Formula and Calculation

The Adjusted Diluted Provision is not a universally standardized formula but rather a concept applied to modify diluted EPS. Generally, it involves taking the reported diluted EPS and adjusting it for the per-share impact of a specific provision, most commonly the loan loss provision under CECL.

The conceptual formula can be expressed as:

Where:

• Reported Diluted EPS: The diluted earnings per share as reported on the company's income statement.
• Impact of Specific Provision: The dollar amount of the provision being adjusted for (e.g., the change in the allowance for credit losses due to CECL adoption or significant adjustments).
• Tax Rate: The company's effective tax rate, used to adjust the provision to a post-tax basis.
• Diluted Weighted-Average Shares Outstanding: The number of shares used in the calculation of diluted earnings per share, accounting for potential dilution from options, warrants, and convertible securities.

Interpreting the Adjusted Diluted Provision

Interpreting the Adjusted Diluted Provision involves understanding what aspects of a company's financial health it highlights or obscures. When a financial institution reports a significant loan loss provision, especially under the CECL model, its reported net income and thus its diluted EPS can be substantially affected. The Adjusted Diluted Provision attempts to show what the diluted EPS would have been if this specific provision, particularly a non-cash or non-recurring adjustment, were either less impactful or entirely removed.

A higher Adjusted Diluted Provision compared to the reported diluted EPS suggests that the reported earnings were significantly reduced by the provision being adjusted. This could indicate a large one-time charge, a substantial increase in expected credit losses, or a management decision to be conservative in its provisioning. Conversely, if the adjustment is minor, it implies that the provision did not materially distort the underlying diluted EPS. Investors often use this adjusted figure to gain insights into a company's core operating performance, separating it from accounting estimates that might fluctuate widely.

Hypothetical Example

Consider "Bank A," a publicly traded financial institution. In a given quarter, Bank A reports the following:

• Reported Diluted EPS: $1.50
• Pre-tax impact of increased CECL provision (due to a revised economic forecast): $50 million
• Effective Tax Rate: 25%
• Diluted Weighted-Average Shares Outstanding: 100 million shares of common stock

To calculate the Adjusted Diluted Provision:

1. Calculate the after-tax impact of the CECL provision:
   $50,000,000 \times (1 - 0.25) = $37,500,000

2. Calculate the per-share impact of the CECL provision:
   (\frac{$37,500,000}{100,000,000 \text{ shares}} = $0.375 \text{ per share})

3. Calculate the Adjusted Diluted EPS:
   ($1.50 + $0.375 = $1.875 \text{ per share})

In this hypothetical example, Bank A's Adjusted Diluted EPS of $1.875 is higher than its reported diluted EPS of $1.50. This indicates that the significant increase in the CECL provision, a non-cash accounting adjustment, had a material negative impact on the bank's reported earnings per share for the quarter. From an analytical perspective, the $1.875 figure might be considered a better reflection of the bank's operational earning power, excluding the specific impact of the revised CECL estimate.

Practical Applications

Adjusted Diluted Provision finds several practical applications, particularly in the analysis of financial institutions and other companies with significant credit exposures.

• Financial Performance Analysis: Analysts use Adjusted Diluted Provision to normalize financial statements and compare a company's performance over different periods or against competitors. For example, if a bank experiences a sudden, large increase in its allowance for credit losses due to a change in economic outlook under CECL, the reported diluted EPS might show a sharp decline. By adjusting for this non-cash provision, analysts can determine if the core operational revenue and expense trends are still strong, helping to distinguish between accounting impacts and underlying business health.
• Valuation Models: When valuing financial institutions, investors often use earnings-based valuation multiples. Fluctuations caused by significant, potentially non-recurring, provisions can distort these multiples. Using an adjusted diluted provision can provide a more stable and comparable earnings base for valuation purposes.
• Credit Risk Assessment: While the CECL standard aims to provide a more transparent view of credit risk, the large upfront recognition of expected losses can sometimes obscure the ongoing trend in credit quality. Adjusted Diluted Provision allows stakeholders to focus on the recurring aspects of earnings, while still acknowledging the overall provisioning levels. The Federal Reserve, along with other banking regulators, provides guidance on leveraged lending and capital adequacy that factors into how banks manage and report on their credit exposures, influencing the context of such adjustments⁶, ⁷, ⁸.
• Regulatory Capital Implications: Although Adjusted Diluted Provision is an analytical metric, the underlying provisions, especially those under CECL, directly impact a bank's reported earnings, which in turn affect its regulatory capital. Regulators like the Federal Reserve oversee compliance with capital requirements, such as those introduced under Basel III, which are designed to ensure financial stability⁴, ⁵. The impact of CECL on regulatory capital has been a significant consideration for banks since its implementation³.

Limitations and Criticisms

While Adjusted Diluted Provision can offer valuable insights, it comes with several limitations and criticisms:

• Subjectivity: The primary criticism lies in its subjective nature. There is no universally agreed-upon definition or standard for what constitutes an "adjustment" or "provision" to be excluded. Management can choose which items to adjust for, potentially leading to a figure that presents a more favorable, but not necessarily more accurate, picture of performance.
• Lack of Comparability: Due to the lack of standardization, comparing Adjusted Diluted Provision across different companies or even for the same company over different periods can be challenging. Each company might have its own methodology for what it considers "adjusted," making direct comparisons unreliable.
• Masking Real Issues: While the intention is to reveal underlying performance, over-reliance on Adjusted Diluted Provision can inadvertently mask genuine financial challenges. For instance, consistently large loan loss provisions, even if adjusted for, might signal persistent issues with credit risk management or a deteriorating loan portfolio, which should not be ignored. Critics argue that such adjustments can obscure the full economic reality of expected losses¹, ².
• Non-GAAP Measure: Adjusted Diluted Provision is typically a non-GAAP (Generally Accepted Accounting Principles) financial measure. Non-GAAP measures are not subject to the same stringent rules and audits as GAAP figures, which can reduce their reliability and verifiability. Investors are often cautioned to scrutinize non-GAAP metrics carefully and reconcile them to their GAAP equivalents to understand the full picture.
• Complexity: The calculation can become complex, especially when dealing with various types of debt securities, convertible instruments, and stock options that contribute to dilution. This complexity can make it difficult for an average investor to fully understand the adjustments being made.

Adjusted Diluted Provision vs. Diluted Earnings Per Share

The distinction between Adjusted Diluted Provision and Reported Diluted Earnings Per Share (EPS) is crucial for understanding a company's financial narrative.

The confusion often arises because both metrics relate to per-share earnings, but they serve different analytical purposes. Reported Diluted EPS provides the legally mandated, comprehensive view of earnings, while Adjusted Diluted Provision attempts to offer a supplementary perspective by isolating specific impacts.

FAQs

Why is it called "Adjusted Diluted Provision" instead of "Adjusted Diluted EPS"?

While the ultimate goal is to present an adjusted earnings per share, the term "Adjusted Diluted Provision" emphasizes that the adjustment is specifically for a provision (most commonly the allowance for credit losses) and its impact on the diluted earnings per share. It highlights the source of the adjustment rather than just the adjusted outcome.

Is Adjusted Diluted Provision a GAAP measure?

No, Adjusted Diluted Provision is generally a non-GAAP (Generally Accepted Accounting Principles) measure. Companies that report such metrics are usually required to reconcile them back to the most directly comparable GAAP measure, which would be reported diluted earnings per share, in their financial statements.

What types of companies use Adjusted Diluted Provision?

Adjusted Diluted Provision is most commonly used by financial institutions, such as banks and credit unions, because they are significantly impacted by credit loss provisioning standards like CECL. However, any company with material, often volatile, provisions that affect their net income might use similar adjusted earnings metrics.

How does the Current Expected Credit Loss (CECL) standard relate to Adjusted Diluted Provision?

The CECL standard, by requiring earlier recognition of expected credit losses, has made loan loss provisions more volatile and forward-looking. This has increased the need for financial institutions and analysts to use adjusted metrics, like Adjusted Diluted Provision, to assess core profitability separate from these often significant and non-cash accounting impacts on the balance sheet and income statement.