Introduction to Bank Accounting

1

Introduction to Bank Accounting Fundamentals

Bank Financial Statement Analysis

and Valuations

© FFAS 2012

2

Session structure

© FFAS 2012

• How the effective yield for a financial asset is calculated

• The accounting treatment for a vanilla fixed-rate term loan

• How impairment charges are used to create impairment allowances for identified credit losses

• The accounting treatment for variable-rate time deposits

• The accounting treatment of trading securities and trading liabilities

• The accounting treatment for financial assets/liabilities classified at fair value

• The accounting treatment for securities classified as available for sale

• The major changes due to be introduced in the move from IFRS 7 treatment of financial assets and liabilities to IFRS 9

On completion of this session students should be able to explain:

3

Accounting For Loans

• Most loans are held at Amortised Cost – looking at this treatment here.

• £100,000 loan, 2-year term fixed-rate loan (made on 31 December 2014).

• Interest calculated and paid on quarterly basis at 2% of principal outstanding at end of previous quarter.

1. Calculation of Quarterly payment.

2. Calculation of annual effective yield for loan.

3. Accounting treatment of interest income and principal repayments in 1Q14.

4. Introduction to accounting treatment of impaired loans.

• Will look at IAS 39 revenue recognition in more detail in Week 2

• The IFRS 7 IAS 39 standard will be revised in IFRS 9 for planned implementation in January 2015 – will cover the key proposed changes

4

• Interest charged = 2% of principal outstanding at end of previous quarter.

• 8 payments

• Value of loan at end of 8th period zero

Using Excel - PMT function

• Form of function PMT(rate,nper,pv,fv) e.g. =PMT(2%,8,100,000,0)

(1) Calculation of Quarterly payments

10201

0200201000100

8

8

).(

.).(,£ PMT

11

1

ni

in

i

)r(

r)r(VP PMT

0651131720

0230000100 .,£

.

.,£ PMT

Financial theory

Where r is the interest rate per period and n is the total number of periods

5

(2) Interest income and principal repayments – Borrowers Perspective

• Quarterly Interest expense = 2% x brought forward balance Cash

31-Dec-13 +100,000

31-Mar-14 13,651.0

30-Jun-14 13,651.0

30-Sep-14 13,651.0

31-Dec-14 13,651.0

31-Mar-15 13,651.0

30-Jun-15 13,651.0

30-Sep-15 13,651.0

31-Dec-15 13,651.0

Borrower‟s perspective:

Approximate effective yield = (1 + r)n -1

= (1 + 0.02)4 – 1 = 8.243%

9,207.8 100,000.0

• Principal repaid each quarter = Quarterly Payment − Interest expense

• Carried forward balance = Brought forward balance − Principal repaid

Principal repaid

Contractual balance

100,000

11,651.0 88,349.0

11,884.0 76,465.0

12,121.7 64,343.3

12,364.1 51,979.2

12,611.4 39,367.8

12,863.6 26,504.2

13,120.9 13,383.3

13,383.3 0

Interest Expense

2,000.0

1,767.0

1,529.3

1,286.9

1,039.6

787.4

530.1

267.7

6

(2) Calculation of Effective Yield (IAS 39) – Bank Perspective

Cashflows

31-Dec-13 -100,000

90 31-Mar-14 13,651.0

91 30-Jun-14 13,651.0

92 30-Sep-14 13,651.0

92 31-Dec-14 13,651.0

90 31-Mar-15 13,651.0

91 30-Jun-15 13,651.0

92 30-Sep-15 13,651.0

92 31-Dec-15 13,651.0

• Effective yield calculated based on expected (contractual) cashflows.

• Effective yield equivalent to Internal Rate of Return.

• IAS 39 – revenue recognition.

• Fewer days in first half of year than second half – receives money sooner than approximate method assumes

• This has an impact of value for loan on bank‟s balance sheet and the contractual balance

Using Excel to calculate effective yield – depends on version

• May have to make sure „Analysis Toolpak‟ Add-in installed.

• „Tools‟ then „Add-ins‟ then check (select) „Analysis Toolpak‟ and „Analysis Toolpak for VBA‟. Press OK.

• Use XIRR rather than IRR – far more flexible and powerful.

• Form in Excel given by =XIRR(range of values, range of dates, guess)

• Gives Effective Yield of 8.262% for the loan. Effective yield 8.262%

7

(3) Interest income and principal repayments – Bank‟s Perspective

• Contractual balance is not necessarily same as value on balance sheet.

Days in quarter

Cash

31-Dec-13 -100,000

90 31-Mar-14 13,651.0

91 30-Jun-14 13,651.0

92 30-Sep-14 13,651.0

92 31-Dec-14 13,651.0

90 31-Mar-15 13,651.0

91 30-Jun-15 13,651.0

92 30-Sep-15 13,651.0

92 31-Dec-15 13,651.0

1,976.67 = 100.000 * ((1.08262)^(90/365)-1))

13,651.0 – 1,976.7 = 11,674.2

Interest income

1,976.7

1,765.6

1,544.9

1,300.3

1,027.6

786.8

535.5

270.4

Principal repaid

Value on balance

sheet

100,000

11,674.2 88,325.8

11,885.4 76,440.4

12,106.0 64,334.3

12,350.7 51,983.6

12,623.4 39,360.2

12,864.2 26,496.0

13,115.5 13,380.5

13,380.5 0.0

Contractual balance

100,000

88,349.0

76,465.0

64,343.3

51,979.2

39,367.8

26,504.2

13,383.3

0

Using Excel to calculate values for accounting entries

• Formula for Interest Income in each period =

Value at end of previous period × ((1 + Effective Yield)^(Number of days in period/365)-1)

• Principal repaid = Quarterly Payment less Interest Income

• Carried forward Value on Balance Sheet = Brought forward Value less Principal Repaid

• At end of term value of loan on balance sheet = contractual value = 0

9,207.8 100,000.0

8

(3) Accounting for loans (cont.) – Balance Sheet and Income Statement 1Q 2014

Accounting for loan and interest income (1Q14)

From previous slide for quarter

• Cash received = £13,651.0

• Principal repaid = £11,674.2

• Interest income = £1,976.7

Loans Cash I/S Retained profit

Loan drawdown 100,000.0 -100,000.0

Payment -11,674.2 13,651.0 1,976.7 1,976.7

End of 1Q 88,325.8 -86,349.0 1,976.7 1,976.7

9

(4) Impaired loans – accounting treatment introduction

Accounting for impaired loans (£ 000s)

• Impairment allowance (contra-asset) account used to reflect expected (identified) credit losses on loans.

• Created by „Impairment charge‟ taken through income statement.

• Impairment allowances may be created for individual loans or for groups of similar loans (collectively assessed).

• Loans may be impaired even if they are not past-due.

• Past-due loans may not be impaired if bank expects to make full recovery.

• Will look at treatment of credit losses in more detail in Week 4; controversial area

Loans Impairment

allowance

Loans net of impairment

allowance I/S Retained

profit

Loans + accrued interest 101,975.7

Impairment event 101,976.7 -26,616.0 75,360.7 -26,616.0 -26,616.0

End of 1Q 101,976.7 -26,616.0 75,360.7 -26,616.0 -26,616.0

10

Treatment of deposits

Interest expense (£ )

Deposit Balance (£)

31-Dec-13 100,000.0

31-Jan-14 250.0 100,250.0

28-Feb-14 250.6 100,500.6

31-Mar-14 301.5 100,802.1

802.1

• Effective yield calculated based on expected (contractual) cashflows – i.e. same as for loans, at amortised cost.

• Bank has £100,000 in 1-month floating-rate time deposits.

• Interest is calculated and paid on a full month basis at 0.25%.

• Interest is capitalised at end of each month.

• Interest rate for month of March increased to 0.3%.

£250.0 = £100,000.0 x 0.25%

£250.6 = £100,250.0 x 0.25%

£301.5 = £100,500.6 x 0.3%

• Accounting entries for deposits in 1Q14

Cash Deposits I/S Retained profit

Deposit made 100,000.0 100,000.0

Interest paid 802.1 -802.1 -802.1

End of 1Q 100,000.0 100,802.1 -802.1 -802.1

11

Accounting treatment of financial assets – IFRS 7

• Financial assets: loans, debt securities, equities, asset-backed securities, derivatives

• 3 alternative accounting treatments for financial assets under IFRS 7

– Held-to-maturity – equivalent to held at amortised cost and used for most loans

– Trading securities and financial assets classified as held at fair value (includes derivatives): gains and losses resulting from changes in market prices recognised during period and taken through the profit and loss account (income statement)

– Held as available for sale (AFS) – changes in market value of securities (debt and quoted equities) reflected in balance sheet

• Unrealised gains (losses) [net of tax] reflected in fair value reserves within equity account

• Creation of associated deferred tax liability (asset)

• Gains (losses) only taken through income statement at time of disposal

• Held as available for sale but no market price (e.g. unquoted equity holdings, illiquid bonds) – held at historic cost with dividends or interest recognised when received

12

Equity Holding held as Trading Security

Cash Equities I/S

Available for sale

reserves Retained

profit

End of 1Q -1,000 900 0 -100

Sale of holding +900 -900 0

1 April -100 0 0 -100

• Buys £1,000 worth of equities on Jan 1 2014 – market price falls to £900 on 31 March 2014

– Value of holding marked-to-market (MTM)

– Unrealised loss taken through income statement when price changes

• Accounting of disposal on 1 April 2014

– No impact on income statement

Cash Equities I/S

Available for sale

reserves Retained

profit

Buy stocks -1,000 1,000

Price falls to 900 -100 -100 -100

End of 1Q -1,000 900 -100 -100

13

Equity Holding held as Available For Sale (AFS)

Cash Equities I/S AFS reserves Retained

profit

End of 1Q -1,000 900 0 -100 0

Sale of holding +900 -900 -100 +100 -100

1 April -100 900 -100 0 -100

• Using stock as example – banks do not generally have significant equity positions

– Buys £1,000 worth of equities on Jan 1 2014 – market price falls to £900 on 31 March 2014

– Value of holding marked-to-market (MTM)

– Unrealised loss reflected in available for sale reserves within equity accounts

– Simplification – AFS reserves actually reflect unrealised loss net of tax and have creation of associated deferred tax asset (liability)

• Accounting of disposal on 1 April 2014

– Unrealised loss (or gain) in AFS reserve reversed

– Realised loss taken through the income statement

– Difference in accounting treatment between AFS and trading affects the timing of the recognition of losses or gains through the income statement

Cash Equities I/S AFS reserves Retained

profit

Buy stocks -1,000 1,000

Price falls to 900 -100 -100 0

End of 1Q -1,000 900 -100 0

14

Treatment of bond when booked as trading security

Asset Cash I/S AFS reserve Retained profit

Buy 90,702.95 -90,702.95

Increase in rate -1,703.30 -1,703.30 -1,703.30

Interim balance 88,999.64 -90,702.95 -1,703.30 -1,703.30

Interest income at 6% 5,339.98 5,339.98

Retain profit for the year 3,636.67 3,636.67

End of Y1 94,339.62 -90,702.95 3,636.67

Interest income at 6% 5,660.38 5,660.38

Payment -100,000.00 100,000.00

Retain profit for the year 5,660.38 9,297.05

End of Y2 0.00 9,297.05 5,660.38 9,297.05

Difference in cash flows = total recognised in I/S 9,297.05 9,297.05

• Gains or losses recognised through income statement at time of change in yield

• Purchases 2-year £100,000 zero coupon bond: price £90,702.95 yield at issue 5%

• Immediately after purchase yield rises to 6% price falls to £88,999.64

15

• IFRS does not define uniform presentation standards

• Banks report income from trading security holdings in one of two distinct ways

– Some banks report interest income from trading securities as separate item from gains and losses resulting from changes in market rates (prices)

– Others report single number for trading income i.e. combine interest income and trading gains (losses) together

– Makes comparison of interest income (and hence interest spreads) between banks impossible and hides true level of volatility of trading gains and losses

• US GAAP (FASB/SEC) does define presentation standards which require banks to report separate numbers for interest income from trading securities and gains and losses arising from changes in market rates

Presentation of income statement when booked as trading security

16

Bonds – available for sale treatment

• Purchases 2-year £100,000 zero coupon bond for £90,702.95; yield at issue 5%

• Immediately after purchase yield rises to 6%; price falls to £88,999.64

At issue End of year 1

FV at 5% 90,702.95 95,238.10

FV at 6% 88,999.64 94,339.62

FV loss -1,703.30 -898.47

Asset Cash I/S AFS reserve Retained profit

Buy 90,702.95 -90,702.95

Increase in rate -1,703.30 -1,703.30

Interim balance 88,999.64 -90,702.95 -1,703.30 0.00

Interest income at 6% 5,339.98 5,339.98

Amortisation of loss* -804.83 804.83

Retain profit for the year 4,535.15 4,535.15

End of Y1 94,339.62 -90,702.95 4,535.15 -898.47 4,535.15

Interest income at 6% 5,660.38 5,660.38

Amortisation of loss -898.47 898.47

Payment -100,000.00 100,000.00

Retain profit for the year 4,761.90 4,761.90

End of Y2 0.00 9,297.05 4,761.90 0.00 9,297.05

Difference in cash flows = total recognised in I/S 9,297.05 0 9,297.05

*Amortisation of fair value loss during Y1 £804.83 = £1,703.30 − £898.47

17

Coupon Bonds

• Semi-annual and annual

• Accounting treatment same as for zero coupon bonds

• Complicated by regular coupon payments

• As bond approaches coupon payment date price increases

• After coupon paid price falls

• Need to maintain record of price schedule at yield when bond was bought

• Unrealised gains and losses calculated by comparing current market price with that of original schedule

• Computational overhead but not difficult to do with automated bank accounting systems

18

Accounting treatment of liabilities

• Liabilities: deposits, issued bonds, subordinated debt, derivatives

• 2 alternative accounting treatments for financial liabilities

• Amortised cost

• Trading liabilities and financial liabilities classified as held at fair value (includes derivatives): gains and losses resulting from changes in market prices recognised during period and taken through the profit and loss account (income statement)

– Short positions in bonds issued by other institutions (trading liability)

– Bonds issued by the bank may be classified at amortised cost or may be accounted for at fair value (own-credit)

– Demand deposits are explicitly prohibited from being held at fair value

19

IFRS 9 – Financial Assets Classification and Measurement

• Replacement of IFRS IAS 39

– Draft July 2009 dealt with financial assets only, Effective implementation date 1 Jan 2015 but early adoption allowed

• Most important changes on asset side are

– Elimination of the (AFS) and HTM classifications

– Under IFRS 9 financial assets will be classified as:

• Held at amortised cost

– Business model requires intention to collect contractual cashflows (e.g. retail bank may make loan with intention to hold it, investment bank may hold loans with intent to trade); cashflows are solely principal and interest payments on outstanding balance of financial asset

• FV with changes in value reflected in Other Comprehensive Income (an equity reserve)

– Restricted to investments in equities not held for trading (e.g. Associates) but very few financial assets will fall in this category also means that can’t hold unquoted equities at cost less any impairment

• FV though the P&L account (income statement)

– All other financial assets

– May include financial assets which could be held at amortised cost where an economic hedge is in place (e.g. An interest rate swap)

20

IFRS 9 – Financial Liabilities Classification and Measurement

• Financial liabilities (Draft November 2010, implementation date 1 Jan 2015)

• Treatment of financial liabilities largely unchanged compared with IAS39

• Accounting treatment of bonds issued and accounted for at fair value under IAS39 was controversial

– Deterioration of bank’s financial position will result in credit spread on its bonds widening

– Result will be fall in market value of these liabilities and an unrealised gain

– This unrealised gain was taken through the income statement and P&L account introducing un-wanted volatility to net income

– Any gains were reversed in calculating regulatory capital (Basel Accord)

• Under IFRS 9 any unrealised gain (or loss) on own-credit will be reflected in Other Comprehensive Income (an equity reserve account)

– Will still be reversed in calculating regulatory capital

• No changes in treatment of other financial liabilities

21

Session Objectives

© FFAS 2012

• How the effective yield for a financial asset is calculated

• The accounting treatment for a vanilla fixed-rate term loan

• How impairment charges are used to create impairment allowances for identified credit losses

• The accounting treatment for variable-rate time deposits

• The accounting treatment of trading securities and trading liabilities

• The accounting treatment for financial assets/liabilities classified at fair value

• The accounting treatment for securities classified as available for sale

• The major changes due to be introduced in the move from IFRS 7 treatment of financial assets and liabilities to IFRS 9

On completion of this session students should be able to explain:

22

Introduction to Bank Accounting Fundamentals

“The love of money is the root of all evil.”

The Bible, Timothy, Chapter 12