Chapter 12
Special Industries:
Banks, Utilities, Oil and Gas,
Transportation, Insurance,
Real Estate Companies
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Banks
• Regulation and structure
– Federal charter
• Reports to Comptroller of the Currency
– State charter
• Controlled by state banking departments
• Sphere of operations controlled by state
– Federal reserve system members
• Report to Federal Reserve and FDIC
• Member banks maintain reserves at district reserve bank
Chapter 12, Slide #2
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Balance Sheet
– Assets
• Loans to customers are assets (receivables)
• Assets are not subdivided into current and noncurrent
• Typical assets
– Cash on hand or due from other banks, investment
securities, loans, bank premises, and equipment
• Fixed-rate assets expose bank to risk if rates rise
– The receivable itself decreases in value
• LDC (less-developed countries) loans more risky than
domestic
Chapter 12, Slide #3
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Balance Sheet
– Assets
• Review for related-party loans
• Allowance for loan loss account
• Other real estate – property taken during foreclosure;
holding for probable resale
– Liabilities
• Current: savings, time/demand deposits
– Reduction in this liability also indicates the loss of an
inexpensive source of lendable funds
• Long-term: loan obligations, long-term debt
Chapter 12, Slide #4
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Balance Sheet
– Stockholders’ equity
• Typically low in relation to total assets (averages 6–7%)
– Low stockholders’ equity indicates greater risk of failure
– High stockholders’ equity is less risky but more costly
because of capital requirements
• Review for accumulated other comprehensive income/loss
• Regulators view capital in relation to risk-adjusted assets
Chapter 12, Slide #5
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Balance Sheet
– Read notes and Management’s Discussion and
Analysis for indication of
• Nonperforming assets: assets no longer producing income
or producing reduced income
– Nonaccrual loans: payments are past due; interest no longer
being accrued
– Renegotiated loans: modified as part of a restructured
agreement
– Watch carefully; these may indicate potential future
difficulties
• Commitments and contingencies
Chapter 12, Slide #6
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Income Statement
– Interest
• Principal revenue is interest earned on loans and
investment securities
• Principal expense is interest on deposits and other debt
• Excess of interest revenue over interest expense is net
interest income (margin)
• Interest rates
– Falling: reduces expense (interest paid on deposits)
– Increasing: increases expense
Chapter 12, Slide #7
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Income Statement
– Other income
• Fees, service charges, trading securities gain/loss,
securities transactions
• Of increasing importance to banks
• Ratios
– Many ‘traditional’ ratios do not work for banks
– Workable ratios
• Return on assets
• Return on equity
• Most investment-related ratios
Chapter 12, Slide #8
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Ratios
– Earning Assets to Total Assets
• Earnings assets are loans, leases, investments securities,
money market assets
– Exclude cash, nonearning deposits, fixed assets
• High result reflects how well the bank puts bank assets to
work
– Interest Margin to Average Earning Assets
• A key measure of bank profitability
• Indicates management’s ability to control the spread
between interest income and interest expense
Chapter 12, Slide #9
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Ratios
– Loan Loss Coverage Ratio
• (Pretax income + provision for loan losses) ÷ net chargeoffs
• Measures
– Asset quality
– The level of protection of loans
– Equity Capital to Total Assets
• Measures the extent of equity ownership in the bank
Chapter 12, Slide #10
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Banks (cont’d)
• Ratios
– Deposits Times Capital
•
•
•
•
Average deposits ÷ average stockholders’ equity
A type of debt-to-equity ratio
Concerns both depositors and stockholders
Indicators
– More capital implies greater margin of safety
– More deposits indicate investment potential
– Loans to Deposits
• A type of asset to liability or debt coverage ratio
Chapter 12, Slide #11
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Regulated Utilities
• Regulation and structure
– Subject to government regulation and rate
regulation
– Accounting procedures prescribed by
• Federal Energy Regulatory Commission
• Federal Communications Commission
• State regulatory agencies
– Regulated utilities have added nonregulated
businesses
Chapter 12, Slide #12
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Regulated Utilities (cont’d)
• Financial Statements
– Balance sheet
• Plant, property, and equipment is listed first
• Capitalization section includes sources of financing
– Long-term capital
– Long-term debt
• Current liabilities and deferred charges
– Income statement
• Operating income
• Other income
• Interest charges
Chapter 12, Slide #13
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Regulated Utilities (cont’d)
• Financial Statements
– Construction work in progress [balance sheet asset]
• Substantial construction work in progress should be
viewed as more risky
• Rate base determination will not normally consider
construction work in progress
• Disallowed costs provide no return
Chapter 12, Slide #14
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Regulated Utilities (cont’d)
• Financial Statements
– Allowance for funds used during construction
[income statement]
• Allowance for equity funds [other income]
– An assumed rate of return on equity funds
• Allowance for borrowed funds [interest charges]
Chapter 12, Slide #15
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Regulated Utilities (cont’d)
• Ratios
– Few of the traditional ratios are appropriate for
regulated utilities
– Operating Ratio
• Measures efficiency
• Operating expenses ÷ operating revenue
– Funded Debt to Operating Property
• Operating (net) property is plant and equipment less
accumulated depreciation
• Include construction in progress
• Measures debt coverage
Chapter 12, Slide #16
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Regulated Utilities (cont’d)
• Ratios
– Percent Earned on Operating Property
• Relates net earnings to the assets primarily intended to
generate earnings
– Operating Revenue to Operating Property
• A type of operating asset turnover ratio
• Fixed plant is often much larger than revenue
Chapter 12, Slide #17
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Oil and Gas
• General background
– Major impact on financial statements from method
of accounting for exploration and production
– Specific required supplemental disclosures
– Traditional ratios apply
Chapter 12, Slide #18
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Oil and Gas (cont’d)
• Successful-Efforts versus Full-Costing
Methods
– Successful-efforts
•
•
•
•
Theory: unsuccessful efforts are costs of the current period
Capitalize costs of successful efforts
Immediately expense costs of unsuccessful efforts
More conservative approach yielding lower net income
due to immediate expensing of unsuccessful efforts
Chapter 12, Slide #19
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Oil and Gas (cont’d)
• Successful-Efforts versus Full-Costing
Methods
– Full-costing
• Theory: all costs are part of eventually finding successful
wells
• Capitalize all costs of exploration
• Items capitalized are subject to depletion
– In total, the same amount is expensed under either
method, but the timing of expense recognition
varies dramatically
Chapter 12, Slide #20
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Oil and Gas (cont’d)
• Successful-Efforts versus Full-Costing
Methods
– Practical application
• Smaller companies choose full-costing method
• Larger balance sheet due to full capitalization
• Short-run higher profit (expense is periodic depletion, not
full cost)
• Presents more favorable picture to creditors and investors
• Larger companies use variation of successful-efforts
method
• Smaller balance sheet with only successful efforts
capitalized
• Short-run lower profit due to immediate expensing of
unsuccessful efforts
Chapter 12, Slide #21
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Oil and Gas (cont’d)
• Required supplementary disclosure: SFAS 69
– Proved oil and gas reserve quantities
– Results of operations for oil- and gas-producing
activities
– Costs incurred in oil and gas property acquisition,
exploration, and development activities
– Capitalized costs relating to oil- and gas-producing
activities
– A standardized measure of discounted future net
cash flows relating to proved oil and gas reserve
quantities
Chapter 12, Slide #22
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Transportation
• Regulation and oversight
– Civil Aeronautics Board
• Commercial aviation
• Uniform system of accounts and reporting
– Interstate Commerce Commission
• Interstate railroads
• Interstate motor carriers
• Uniform system of accounts and reporting
Chapter 12, Slide #23
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Transportation (cont’d)
• Financial Statements
– Balance sheet
• Similar to manufacturing and retailing reporting
• Plant, property, and equipment makes up large portion of
assets
– Income statement
• Similar to utility reporting
• Revenues and expenses grouped by natural objectives
and functional activities
• Reports operating income (operating revenues minus
operating expenses)
• Presented in single-step fashion
Chapter 12, Slide #24
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Transportation (cont’d)
• Ratios
– Sources of comparable data
• Interstate Commerce Commission’s Annual Report on
transport statistics
• American Trucking Association’s Financial Analysis of the
Motor Carrier Industry
– Operating Ratio
• Operating expenses ÷ operating revenue
• External forces will impact the ratio
– Long-Term Debt to Operating Property
• Operating property: long-term property and equipment
• Measures the sources of funds with which property has
been obtained
Chapter 12, Slide #25
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Transportation (cont’d)
• Ratios
– Operating Revenue to Operating Property
• Measures turnover of operating assets
• Operating objective is to generate as many dollars in
revenue per dollar of property
– Per-Mile, Per-Person, and Per-Ton Passenger Load
Factors
• Not required but often presented in the financial statement
notes or highlights
Chapter 12, Slide #26
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Insurance
• Types of service
– Identified contract service (mortality or loss)
– Investment management service
• Types of insurance organizations
– Stock companies: organized to return a profit to
stockholders
– Mutual companies: incorporated without private
ownership interest
– Fraternal benefit societies: similar to a mutual
insurance company
– Assessment companies: organized group with a
similar interest
Chapter 12, Slide #27
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Insurance (cont’d)
• Primary regulation is at the state level
• Accounting
– Uniform SAP (statutory accounting practices)
reporting under auspices of the National
Association of Insurance Commissioners
• Balance sheet is emphasized; focus is on solvency
• Ratio analysis conducted by the NAIC
– GAAP exists for public (SEC) filings
Chapter 12, Slide #28
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Insurance (cont’d)
• Sources of comparative data
– Best’s Insurance Reports
• Separate ratings for life-health and property-casualty
companies
• Ratings range from A+ (Superior) to C– (Fair); also a “Not
Assigned” category
Chapter 12, Slide #29
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Insurance (cont’d)
• Balance Sheet Under GAAP
– Investments
• High liquidity, typically bonds
• Review spread between cost or amortized cost and fair
value
• Review stockholders’ equity for unrealized gains and
losses on investments
– Assets Other than Investments
• Operating (plant) assets
• Policy acquisition costs are deferred and matched to
premium-earning period for GAAP; expensed for SAP
• Goodwill and other intangibles
Chapter 12, Slide #30
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Insurance (cont’d)
• Balance Sheet Under GAAP
– Liabilities
• Loss reserves: commitments reported at present value
• Policy and contract claims: claims accrued net of
recoverable portion
– Stockholders’ equity
• Resembles other industry stockholders’ equity
• Review for unrealized gains and losses on investments
Chapter 12, Slide #31
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Insurance (cont’d)
• Income Statement Under GAAP
– Duration of contract governs revenue
• Short-duration: revenue recognized over period of the
contract in proportion to protection provided
• Long-duration: revenue recognized when premium is due
– Low-risk contracts are “investment contracts” and accounted
for as liabilities
– Realized gains/losses from investments
Chapter 12, Slide #32
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Insurance (cont’d)
• Ratios
– Industry-specific based on SAP reporting to states
– Ratios based on GAAP data
• Profitability
• Investor-related
– Confusion surrounding insurance industry reporting
• Two accounting standards: SAP and GAAP
• Insurance stock typically carries discount to the average
market price
Chapter 12, Slide #33
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Insurance (cont’d)
• Federal oversight and enforcement
– Limited by McCarran-Ferguson Act of 1945
– SEC has jurisdiction only over publicly-traded
companies
– Nationwide review of insurance practices by FBI
Chapter 12, Slide #34
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Real Estate Companies
• Construct and operate income-producing real
properties
• Contend that conventional accounting
misleads investors
• Real estate companies supplement historical
cost information with current value
– Current value is based on future income potential
Chapter 12, Slide #35
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.