Financial Statements Training
for Volunteers
June 2011
Disclaimer - attendance at this seminar will not make you a CPA.
- attendance at this seminar will not give you a Masters degree in accounting.
Michael J. Schmidt, CFE, CPA
Michael J. Schmidt has been a credit union auditor for 25 years. For the past
18 years he has been the president of Schmidt & Associates, Inc. an accounting
and auditing firm that exclusively serves the credit union industry. He graduated
with his bachelors degree in accounting from Eastern Michigan University in 1985,
and his masters degree in Fraud and Electronic Crime Management from Utica College
in 2007.
He has been a certified public accountant since 1988 and a certified fraud examiner
since 1999.
Contact Information:
Schmidt & Associates, Inc.
PO Box 2588
Columbus, Ohio 43216
(614) 529-1640
Schmidt@Schmidt-and-Assoc.com
Introduction
Board members are required to read and understand the credit union's
balance sheet and income statement.
Why?
You are a board member of a financial institution, this being a
numbers and financial company, board members should be able
to recognize trends and ask questions of management.
You should know what each line item represents, what is normal, and
if the credit union’s number or ratio varies from the norm if the
variance is explainable.
Trends and ratios are used heavily in credit unions. If I say two credit unions
each have capital of $2,300,000 are they the same? Are they both good, or are
they both in trouble? The ratio tells us if the number is good or bad.
Note that peer is a range for credit unions, there is a difference between being at the top
of the range compared to being at the bottom.
XYZ Credit Union
123 Credit Union
Capital
$ 2,300,000
$
Assets
$ 23,250,000
$ 43,250,000
Net worth ratio
2,300,000
9.89%
5.32%
Well capitalized
Under-capitalized
XYZ Credit Union
Balance Sheet
As of December 31, 2010
A balance sheet can be known as the statement of financial condition.
A balance sheet is as of a specific time. It is a snapshot.
It is called a balance sheet because of the formula:
Assets = Liabilities + Members’ Equity
XYZ Credit Union
Balance Sheet
As of December 31, 2010
Loans
Allowance for Loan Losses
$
12,500,000
(100,000)
Net Loans
12,400,000
Accounts Receivable
Cash
Cash in Banks
Investments
Share Insurance Fund
Prepaid Expenses
Fixed Assets
Accrued Income
Assets Acquired in Liquidation
Other Assets
50,000
100,000
1,000,000
8,500,000
200,000
100,000
800,000
50,000
40,000
10,000
Total Assets
$
23,250,000
Principal balances owed by members
Expected losses in the next year
Short term funds owed to CU
Tellers, vault, and ATM cash
Corporate, money markets, etc.
Short term for liquidity
Deposit with NCUSIF or ASI
Expenses that benefit a period of time
Land, building, furniture & equipment
Income earned but not yet received
Collateral on loans that the CU owns
Deposits
XYZ Credit Union
Balance Sheet
As of December 31, 2010
Accounts Payable
$
Accrued Expenses
Notes Payable
50,000
Short term funds the CU owes
100,000
Items that are owed but billed in future
-
Other Liabilities
50,000
Borrowed funds
Clearing accounts
200,000
Shares to Members
20,750,000
Net Worth
Total Liabilities and Equity
2,300,000
$
23,250,000
Shares, drafts, IRAs, money market, certs
Statutory reserves, undivided earnings
XYZ Credit Union
Income Statement
For the Year Ended December 31, 2010
Interest on Loans
Income on Investments
Total Interest Income
$ 900,000
170,000
1,070,000
Dividends on Shares
Interest on Borrowed Funds
Total Cost of Funds
(200,000)
-0-___
(200,000)
Interest Margin
870,000
Fee Income
Other Income
Total Non–Interest Income
200,000
75,000
275,000
Expenses (see next slide)
Net Income
(1,065,000)
$
80,000
XYZ Credit Union
Income Statement
For the Year Ended December 31, 2010
Comp & Benefits
$
Travel & Conf
Occupancy
Operations
Education & Promo
Loan Servicing
Prof Services
Prov for Loan Losses
Member Insurance
Operating / Supervision
Other Expenses
(360,000)
( 10,000)
( 60,000)
(285,000)
( 25,000)
(150,000)
( 15,000)
( 90,000)
( 55,000)
( 5,000)
( 10,000)
Total Operating Exp $ (1,065,000)
salaries, insurance, payroll taxes
volunteer & staff education
rent, utilities, prop taxes, bldg depr.
postage, telephone, ATM, debit
member education (marketing)
credit reports, recording fees
legal, audit
fund the allowance for loan losses
corp stabil, NCUSIF premium
regulators
annual mtg, association dues
XYZ Credit Union
Ratio Analysis
Power Ratios
Net Worth Ratio
Statutory Reserves + Undivided Earnings
Total Assets
2,300,000 = 9.89%
23,250,000
Congress defined well capitalized as 7%.
(can be higher for complex credit unions)
6% = adequately capitalized, 4% = undercapitalized.
If you are undercapitalized you will need a capital
restoration plan approved by the regulators.
Net worth above 7% allows the credit union the ability
to weather a storm. For example a bad recession. This
is why I refer to it as a power ratio, it buys you time if
you’re losing money, or allows you to grow.
XYZ Credit Union
Ratio Analysis
Power Ratios
Return on Assets
Net Income
Average Assets
80,000 = 0.34%
23,250,000
Net income must be annualized. If you are using
income for the month multiply by 12 to
annualize.
Return on assets is a power ratio because earnings
are the only way to increase net worth which
allows a credit union to grow.
How these Power Ratios Work Together
If the board wants to maintain capital and they want the credit union to grow, the return
on assets ratio can tell us what our rate of growth should be.
By moving the decimal to the right one place, the 0.34% return on assets becomes a growth
rate of 3.4%. If the credit union grows faster than 3.4%, net worth will be depleted.
The rule works in reverse. If the board sets an annual growth rate of 9%, the return on
assets required can be calculated by moving the decimal to the left one place. The 9%
growth rate equates to a required return on assets of 0.90% to maintain net worth.
• Select Ratio Analysis
Delinquency Ratio
Delinquent Loans
Total Loans
150,000 = 1.20%
12,500,000
Delinquent loans are calculated for the purpose of this ratio
to include loans over 2 months delinquent.
Caution should be used when making decisions based on this
ratio. A credit union heavy in real estate loans may have
low delinquency, but also may have a lower yield on loans.
A small credit union can see this ratio move a lot from month
to month because one or two members can cause the
ratio to change dramatically.
Select Ratio Analysis
Net Charge Off Ratio
Charge offs – Recoveries
Average Loans
100,000 = 0.80%
12,500,000
This ratio needs to be annualized.
If XYZ Credit Union has a net charge off ratio of
0.80% and ABC Credit Union has a net charge
off ratio of 0.20%, which credit union is doing
a better job?
That was a trick question.
The proper answer is that I did not give you enough information.
ABC CU
XYZ CU
Yield
Net
on Loans Charge offs
5.50%
0.20%
7.20%
0.80%
Net
Yield
5.30%
6.40%
From this example XYZ has four times the amount
of charge offs, yet they still make more money
on their loans. Why?
ABC may have more A credit borrowers with lower
rates and lower delinquency.
ABC may have a different loan mix, heavy in real
estate loans, whereas XYZ may be more of a
consumer lender.
Select Ratio Analysis
Loan to Share Ratio
Total Loans
Total Shares
12,500,000 = 60.24%
20,750,000
This ratio is especially important in a low interest rate
environment. The peer is yielding 6.57% on its loan
portfolio while yielding 1.85% on investments. This means
that a loan generates 4.72% more interest. A 10% increase
in XYZ Credit Union’s loan to share ratio equates to
$2,075,000 in additional loans. This increases income by
$97,940. Considering that XYZ’s net income for the year
was $80,000, this increase is significant.
Select Ratio Analysis
Operating Expense Ratio
Operating Expenses
Average Assets
975,000 = 4.19%
23,250,000
Net Operating Expense Ratio
Operating Expenses – Fee Income
Average Assets
775,000 = 3.33%
23,250,000
Operating expenses do not include dividends or provision for loan
losses.
This ratio must be annualized.
I use the net operating expense ratio. I believe this to be a more
fair comparison if comparing to other credit unions or the peer.
The reason is that one credit union may have a service such as
drafts, it is only fair to be able to reduce the expense by the
income generated (NSFs).
Select Ratio Analysis
Fixed Asset Ratio
Fixed Assets
Total Assets
800,000 = 3.44%
23,250,000
Credit Unions are generally limited to 5% of assets in fixed
assets. 5% of XYZ Credit Union’s assets is equal to
$1,162,500. This means XYZ is under the limit by
$362,500. This can be helpful if the board is
considering expansion.
Select Ratio Analysis
Liquidity Ratio
Cash + Investment under 1 year
Total Assets
4,100,000 = 17.63%
23,250,000
State chartered credit unions must exceed 10%.
Select Ratio Analysis
Productivity Ratios
Assets
Full Time Equivalent Employees
Members
Full Time Equivalent Employees
Salary & Benefits
Full Time Equivalent Employees
23,250,000
9.5
4,200
9.5
= $ 2,447,368
=
360,000 = $
9.5
442
37,894
Once again be careful with these ratios. There are several
factors that could make these ratios not comparable.
If a credit union has not purged membership or has a high
number of $5 accounts, the number of members may be
inflated.
If a credit union has an employee that works 10 hours per week
they are still counted as half an employee.
A credit union with multiple locations may have a higher
number of employees than a single location credit union.
Select Account Details
Loans
Common Types
• New Vehicle
• Used Vehicle
• 1st Mortgage
• 2nd Mortgage
• Home Equity
• Share Secured
• Other Secured
• Credit Card
• Commercial
Open End – this means that the member has a limit
that can be advanced. Credit cards and home equity
loans are examples. The difference between the loan
limit and the loan balance is a loan commitment.
Closed End – this loan type has a specific end date.
Select Account Details
Loans
Common Risks
Default risk – the risk that the member does not pay.
Interest risk – the risk that a change in interest rates
causes the loan to lose money in the future. The
longer the term of the loan, the greater the risk.
Example of interest rate risk.
The credit union offers 30 year mortgages. The credit
union decides that these loans are safe because they
have had no mortgage loan losses. In 2010 XYZ Credit
Union increased its 1st mortgage portfolio to
$10,000,000. The credit union charges 5.50% on 1st
mortgage loans. When subtracting 0.86% cost of
dividends and 3.72% operating expenses the credit
union nets 0.92% on these mortgage loans (good job).
Select Account Details
Loans
Now five years pass; and some things have changed, interest rates
return to the 1970s rates.
The mortgage loans are still yielding 5.50% since they were at a
fixed rate. The credit union has done a great job of holding
expenses at 3.72%. The cost of funds have gone up substantially
because rates have gone up and the cost of dividends is now at
6%. A 1st mortgage in this market would be at 12%. Now when
the 3.72% operating expenses and the 6.00% cost of funds are
subtracted the net return is a negative 3.22%, not so good.
Example of default risk changes.
In 2005, 50% of the credit union’s loan portfolio consisted of
vehicle loans, of these 80% were A paper. In 2010, 50% of the
credit union’s loan portfolio was in vehicle loans, of these 30%
were A paper. The C, D, and E paper went from 5% of the vehicle
loans in 2005 to 50% of the vehicle loans in 2010. It is likely that
the default risk went up even though the portfolio composition
stayed the same.
Select Account Details
Allowance for Loan Losses
This account is used to fund the amount of time between when the adverse
event occurs in a member’s life that puts collection of a loan in jeopardy
and when a loss actually occurs.
Since it is impractical for a credit union to evaluate each loan individually, the
accounting standards allow for loans with similar characteristics to be
pooled together to determine a loss rate for that pool. Generally the larger
the credit union the more pools they will have. A small credit union may
only have 2 pools secured loans and unsecured loans. In a large credit
union indirect new vehicle loans granted with C paper may get their own
pool.
In addition to pooling individual classification is used for loans that are too
unique to be pooled. Common examples of these are commercial loans or
large real estate loans.
The third component would be economic conditions. If the pooling method
uses historical data for the past three years while the sponsor company’s
employees are working overtime and now there are layoffs, historical data
may not be enough.
The Board should be careful. This account uses a great deal of estimation and
management assertions. If examiners and auditors are repeatedly telling
you that the account is underfunded that should be a red flag.
Select Account Details
Investments
Common types.
Certificates of Deposits
Negotiable Certificates
US Government and Federal Agency Securities
Mortgage Backed Securities
Classifications
Hold to Maturity (ability and intent is not to sell)
Available for Sale (may choose to sell for liquidity reasons)
Trading
(buy and sell regularly – rarely used)
Accounting & Reporting
Hold to Maturity – recorded at cost (market value on investment report)
Available for Sale – recorded at market value on balance sheet
Trading
- recorded at market value on income statement also
If your investments are recorded as hold to maturity, management should
not be selling them.
Select Account Details
Investments
Premiums are an adjustment of interest rate. If an
investment has a coupon rate of 6%, but the current
market rate for that term and level of risk is 4%, the
seller will sell the investment at a premium. When the
market is working properly the net of the coupon rate
and the amortization of the premium (the yield) will
equal the market rate (4%).
Common risks.
Default risk -- Most credit unions do not buy
investments with high default risk.
Interest rate risk -- Once again the longer the
term the greater the interest rate risk.
Although available for sale may appear to
reduce some of this risk, be careful, the credit
union may still be reluctant to recognize a loss
on investments.
Discounts are an adjustment of interest rate. If an
investment has a coupon rate of 2%, but the current
market rate for that term and level of risk is 4%, the
seller will sell the investment at a discount. When the
market is working properly the net of the coupon rate
and the amortization of the discount (the yield) will
equal the market rate (4%).
Call dates are dates in the future, but before the maturity
date, that a party to the investment can force an early
maturity.
Select Account Details
Fixed Assets
Common types.
Land
Land improvements
Building
Building improvements
Furniture
Equipment
not depreciated
landscaping, parking lots
additions, remodeling
desks
data processing
Fixed assets are depreciated because the property will last for several
accounting periods, therefore the cost of the asset will be spread
over the period of time that the credit union benefits from the asset.
As noted earlier the amount of fixed assets should be below 5% of
total assets.
Periodic inventories should be done for two major reasons: The
first reason is to determine that assets on the books are still being
utilized by the credit union. The second is to determine that
nobody has taken a credit union asset.
Select Account Details
Assets Acquired in Liquidation
Assets acquired in liquidation is the transfer of ownership of
collateral from the member to the credit union.
This is required for vehicles, but many credit unions ignored the
requirement because it was immaterial to the financial
statements and because of the short time between repossession
and subsequent sale of the vehicle.
The increase in foreclosures has caused credit unions to begin
recording assets acquired in liquidation.
Assets acquired in liquidation are carried on the balance sheet at the
LOWER of cost or the fair market value less selling expenses.
Example – XYZ Credit Union has a 1st mortgage on a home with a
loan balance of $150,000. After meeting with a local realtor the
fair value (selling price) was determined to be $100,000.
Expected selling expenses are $5,000. The Credit Union will
charge off $55,000 of the loan and transfer the remaining
$95,000 to assets acquired in liquidation. The house is later sold
for $85,000, the $10,000 loss is recorded as loss on sale of assets.
Complex Credit Unions
Generally adequately capitalized credit unions have 6% of assets in net
worth. An additional 1% of net worth increases the status to well
capitalized (remember our power ratio). This is true for non-complex
credit unions.
A complex credit union has certain characteristics that requires additional
net worth. Page 12 of the quarterly call report details the risk based net
worth requirement to be considered adequately capitalized. The following
are assets that require additional net worth:
Long Term Real Estate Loans.
The first 25% of assets in long term real estate loans require net worth of 6%.
Any real estate loans above 25% of assets require net worth of 14%.
Member Business Loans.
The first 15% of assets in member business loans require net worth of 6%.
The next 10% of assets in member business loans require net worth of 8%.
Any business loans above 25% of assets require net worth of 14%.
Long Term Investments.
Investments maturing in under 1 year require net worth of 3%.
Investments maturing in 1-3 years require net worth of 6%.
Investments maturing in 4-10 years require net worth of 12%.
Investments maturing in over 10 years require net worth of 20%.