In its 1999 annual report, Scotiabank’s auditors qualified their audit report. The problem was with the bank’s provision for credit losses. During 1999, Scotiabank decided to increase its general provision for credit losses on loans receivable by $ 700 million. This was in addition to a specific provision for loan losses on identified problem loans. The general provision applied to loans that had not as yet been specifically identified as in arrears.
Under GAAP, the $ 700 million increase in the general provision should be charged as an expense of the year. However, Scotiabank obtained permission from the Superintendent of Financial Institutions of Canada (OSFI) to charge $ 550 million of this amount ($ 314 million after tax) directly to retained earnings.
As a result, Scotiabank reported net income for 1999 of $ 1,551 million. Net incomes for 1998 and 1997 were $ 1,394 million and $ 1,514 million, respectively.
This direct charge to retained earnings was criticized in the financial media. For example, Eric Reguly, in The Globe and Mail, December 7, 1999, called it “an accounting sleight-of- hand that has never been used by the Big Five Canadian banks.” Reguly described the objections of the OSC, which, however, could do nothing because the federal Bank Act (administered by OSFI) overrides the Ontario Securities Act. OSFI permitted the direct charge, according to Reguly, because it wanted banks to have a “thicker safety cushion.”
a. Use the public interest theory of regulation to justify OSFI’s permission for the direct charge to retained earnings.
b. Use the interest group theory of regulation to explain OSFI’s permission for the direct charge.
c. Given that the treatment was fully disclosed in the notes to Scotiabank’s annual report, in the auditors’ report, and in the media, how do you think the securities market would respond to this treatment?