Financial Institutions Accounting
Dr. Salah Hammad
Chapter Five
The Financial Statements of Banks and
Their Principal Competitors
1
Introduction
• The particular services each financial firm chooses to offer and
the overall size of each financial-service organization are
reflected in its financial statements
• Financial statements can be viewed as a “road map”
▫ Tell us where a financial firm has been in the past, where it is
now, and possibly where it is headed in the future
• The two main financial statements that managers, customers,
and the regulatory authorities rely upon are
▫ The balance sheet (Report of Condition)
▫ The income statement (Report of Income)
2
An Overview of Balance Sheets and Income
Statements
• The Report of Condition shows the amount and composition of funds
sources (financial inputs) drawn upon to finance lending and investing
activities and how much has been allocated to loans, securities, and other
funds uses (financial outputs) at any given point in time
• In contrast, the financial inputs and outputs on the Report of Income show
how much it has cost to acquire funds and to generate revenues from the
uses the financial firm has made of those funds
• The Report of Income also shows the revenues (cash flow) generated by
selling services to the public, including making loans and servicing
customer deposits
• The Report of Income shows net earnings after all costs are deducted from
the sum of all revenues, some of which will be reinvested in the financial
firm for future growth and some of which will flow to stockholders as
dividends
3
TABLE 5–1 Key Items on Bank Financial Statements
4
The Balance Sheet (Report of Condition)
• A balance sheet lists the assets, liabilities, and equity capital
(owners’ funds) held by or invested in a bank or other
financial firm on any given date
5
The Balance Sheet (Report of Condition)
(continued)
• For banks and other depository institutions the assets on the
balance sheet are of four major types:
▫ Cash in the vault and deposits held at other depository institutions (C)
▫ Government and private interest-bearing securities purchased in the open market
(S)
▫ Loans and lease financings made available to customers (L)
▫ Miscellaneous assets (MA)
• Liabilities fall into two principal categories:
▫ Deposits made by and owed to various customers (D)
▫ Nondeposit borrowings of funds in the money and capital markets (NDB)
• Equity capital represents long-term funds the owners contribute
(EC)
6
The Balance Sheet (Report of Condition)
(continued)
• Cash assets (C) are designed to meet the financial firm’s need for liquidity
• Security holdings (S) are a backup source of liquidity and include
investments that provide a source of income
• Loans (L) are made principally to supply income
• Miscellaneous assets (MA) are usually dominated by fixed assets (plant
and equipment) and investments in subsidiaries (if any)
• Deposits (D) are typically the main source of funding for banks
▫ Nondeposit borrowings (NDB) are carried out mainly to supplement
deposits and provide the additional liquidity that cash assets and securities
cannot provide
• Equity capital (EC) supplies the long-term, relatively stable base of
financial support upon which the financial firm will rely to grow and to
cover any extraordinary losses it incurs
7
The Balance Sheet (Report of Condition)
(continued)
• One useful way to view the balance sheet identity is to note that liabilities
and equity capital represent accumulated sources of funds, which provide
the needed spending power to acquire assets
• A bank’s assets, on the other hand, are its accumulated uses of funds,
which are made to generate income for its stockholders, pay interest to its
depositors, and compensate its employees for their labor and skill
• Thus, the balance sheet identity can be pictured simply as:
8
TABLE 5–3 Report of Condition (Balance Sheet) for BB&T
(Year-End 2008 and 2009)
9
The Balance Sheet (Report of Condition)
(continued)
• Cash Assets
▫ Account is called Cash and Deposits Due from Bank
▫ Includes:
▫
▫
▫
▫
Vault Cash
Deposits with Other Banks (Correspondent Deposits)
Cash Items in Process of Collection
Reserve Account with the Federal Reserve
▫ Sometimes called primary reserves
10
The Balance Sheet (Report of Condition)
(continued)
• Investment Securities - The Liquid Portion
▫ Short Term Government Securities
▫ Privately Issued Money Market Securities
▫ Interest Bearing Time Deposits
▫ Commercial Paper
▫ Often called secondary reserves
11
The Balance Sheet (Report of Condition)
(continued)
• Investment Securities - The Income-Generating
Portion
▫ Taxable Securities
▫ U.S. Government Notes
▫ Government Agency Securities
▫ Corporate Bonds
▫ Tax-Exempt Securities
▫ Municipal Bonds
12
The Balance Sheet (Report of Condition)
(continued)
• Trading Account Assets
▫ Securities purchased to provide short-term profits from
short-term price movements
▫ Occurs when the bank acts as a securities dealer
▫ Valued at Market – FASB 115
13
The Balance Sheet (Report of Condition)
(continued)
• Federal Funds Sold and Reverse Repurchase Agreements
▫ Includes mainly temporary loans (usually extended overnight,
with the funds returned the next day) made to other depository
institutions, securities dealers, or major industrial corporations
▫ The funds for these temporary loans often come from the reserves
a bank has on deposit with the Federal Reserve Bank in its district
▫ “Fed funds”
▫ Some of these temporary credits are extended in the form of
reverse repurchase (resale) agreements (RPs) in which the
banking firm acquires temporary title to securities owned by the
borrower and holds those securities as collateral until the loan is
paid off
14
The Balance Sheet (Report of Condition)
(continued)
• Loan Accounts
▫ The Major Asset
▫ Gross Loans – Sum of All Loans
▫ Allowance for Possible Loan Losses
▫ Contra Asset Account
▫ For Potential Future Loan Losses
▫ Net Loans
▫ Unearned Discount Income
▫ Nonperforming Loans
15
The Balance Sheet (Report of Condition)
(continued)
• Types of Loans
▫
▫
▫
▫
▫
▫
▫
▫
Commercial and industrial (or business) loans
Consumer (or household) loans
Real estate (or property-based) loans
Financial institutions loans
Foreign (or international) loans
Agricultural production loans
Security loans
Leases
16
The Balance Sheet (Report of Condition)
(continued)
• Loan Losses
Beginning Allowance for Loan Losses
+ This Year’s Provision for Loan Loss
= Adjusted Allowance for Loan Losses
- Actual Charge-Offs of Worthless Loans
+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses
17
The Balance Sheet (Report of Condition)
(continued)
• Specific and General Reserves
▫ Specific Reserves
▫ Set aside to cover a particular Loan
▫ Designate a portion of ALL or
▫ Add more reserves to ALL
▫ General Reserves
▫ Remaining ALL
▫ Determined by management but influenced by taxes and
government regulation
▫ Loans to lesser developed countries require allocated transfer
reserves
18
The Balance Sheet (Report of Condition)
(continued)
• Miscellaneous Assets
▫ Bank Premises and Fixed Assets
▫ Other Real Estate Owned (OREO)
▫ Goodwill and Other Intangibles
19
The Balance Sheet (Report of Condition)
(continued)
• Liabilities of the Banking Firm
▫ Deposits
▫
▫
▫
▫
▫
Non interest-Bearing Demand Deposits
Savings Deposits
Now Accounts
Money Market Deposit Accounts (MMDA)
Time Deposits
20
The Balance Sheet (Report of Condition)
(continued)
• Liabilities of the Banking Firm
▫ Nondeposit Borrowings
▫ Fed Funds Purchased
▫ Securities Sold Under Agreement to Repurchase (Repurchase
Agreements)
▫ Acceptances Outstanding
▫ Eurocurrency Borrowings
▫ Subordinated Debt
▫ Limited Life Preferred Stock
▫ Other Liabilities
21
The Balance Sheet (Report of Condition)
(continued)
• Equity Capital of the Banking Firm
▫
▫
▫
▫
▫
▫
▫
Preferred Stock
Common Stock
Common Stock Outstanding
Capital Surplus
Retained Earnings (Undivided Profits)
Treasury Stock
Contingency Reserve
22
The Balance Sheet (Report of Condition)
(continued)
• Recent Expansion of Off-Balance-Sheet (OBS) Items
in Banking
▫ Unused Commitments
▫ Standby Credit Agreements
▫ Derivative Contracts
▫ Futures Contracts
▫ Options
▫ Swaps
▫ OBS transactions expose a firm to counterparty risks
▫ OBS items have grown so rapidly that, for the banking
industry as a whole, they exceed total bank assets many times
over
23
TABLE 5–5 Examples of Off-Balance-Sheet Items Reported
by FDIC-Insured Banks
24
Components of the Income Statement (Report
of Income)
• Indicates the amount of revenue received and expenses
incurred over a specific period of time
• Shows how much it has cost to acquire funds and to
generate revenues from the uses of funds in the Report of
Conditions
• Shows the revenues (cash flow) generated by selling
services to the public
• Shows net earnings after all costs are deducted from the
sum of all revenues
25
Components of the Income Statement (Report
of Income) (continued)
26
Components of the Income Statement (Report
of Income) (continued)
• Income statements are a record of financial flows over
time
• Therefore, we can represent the income statement as a
report of financial outflows (expenses) and financial
inflows (revenues)
• Four main sections
1.
2.
3.
4.
Interest income
Interest expenses
Noninterest income
Noninterest expenses
27
TABLE 5–6 Report of Income (Income Statement) for BB&T
(2008 and 2009)
28
Components of the Income Statement (Report
of Income) (continued)
• Net Interest Income = Interest Income – Interest Expenses
• Interest Income Sources
▫
▫
▫
▫
Interest and Fees on Loans
Taxable Securities Revenue
Tax-Exempt Securities Revenue
Other Interest Income
• Interest Expense Sources
▫ Deposit Interest Costs
▫ Interest on Short-Term Debt
▫ Interest on Long-Term Debt
29
Components of the Income Statement (Report
of Income) (continued)
• Net Noninterest Income = Noninterest Income –
Noninterest Expenses
• Noninterest Income Sources
▫
▫
▫
▫
Fees Earned from Fiduciary Activities
Service Charges on Deposit Accounts
Trading Account Gains and Fees
Additional Noninterest Income
• Noninterest Expense Sources
▫ Wages, Salaries, and Employee Benefits
▫ Premises and Equipment Expense
▫ Other Operating Expenses
30