14. Financial statements of a bank. (ebb Unit XVI)

Banks necessarily use sophisticated accounting systems to record as clearly as possible what the financial situation of the bank is. Most accounting information is designed to be useful in making economic decisions. Accountants use their experience to aid the management to select the best plan of action for the business.

As economic decisions are made by persons both within and outside the bank accounting information may be generated for internal and external users. Managerial accounting is concerned largely with providing information for internal use by the management and focuses more upon planning which includes financing, resource allocation and marketing decisions. Financial accounting is concerned largely with reporting upon the financial position of a firm and upon its profitability to outsiders. Thus this type of information deals with the firm’s financial condition (or position), and the results of operations (profitability). Many companies and banks publish these statements in an annual report. The report contains auditor’s opinion as to the fairness of the financial statement, as well as other information about a company’s activities, products or types of services, profits by major divisions and plans.

The actual record-making phase of accounting is usually called bookkeeping. Bookkeepers record all the transactions of a firm in a chronological order in journals showing the names of accounts that are to be debited or credited. Each item on the balance sheet and income statement has a separate account in the company’s ledger to where all the transactions are transferred or posted at regular intervals. Though each organization has its own bookkeeping requirements, all accounting systems operate on the same basic principles - double-entry method. This means that each transaction is entered twice (has a twofold effect), to show a value received and a value yielded or parted with. Thus the same transaction is entered as a credit (CR) in the account and as a debit (DR) in another account. The sum of $5,000 deposited with a bank will be entered as a debit for the receiver and as a credit for the giver.

The resources at a bank’s disposal are known as assets, whereas the indebtedness for these resources if they are provided by someone else other than the owner are known as liabilities. The total amount supplied by the owner is known as equity capital. The whole of financial accounting is based on the accounting equation:

Assets = Liabilities + Equity Capital

The particular services each bank chooses to offer and the overall

size of a banking organization will be reflected in its financial

statements, the two most important of them being the balance sheet and the income statement (the profit and loss account).

A balance sheet is described as a photograph of a company’s business at a moment in time, usually 31 December of a particular year. It shows the amount and composition of funds sources the bank has drawn upon to finance its lending and investing activities and how much has been allocated to loans and other funds used at any given time.

The assets are usually shown under two headings Fixed Assets (those of long life, such as buildings, machinery, vehicles, fixtures and fittings) and Current Assets (short-lived, such as cash or convertible into cash). There is a choice of two methods of listing the assets under their respective headings. The first, being used by companies, is that the assets are listed starting with the least liquid and in this case fixed assets will be followed by current assets. In the other method, used mainly by banks, it is the most liquid asset that appears first. Under the liabilities the order will be starting with capital to meet the claims against the respective assets, thus progressing from long-term liabilities.

In banking the assets on the balance sheet include four major items: cash in hand and due from banks (money in vaults, balances with other banks, cheques in process of collection), investments (bonds, shares and interest-bearing securities purchased on the open market), loans, fixed assets. Items listed in as liabilities are: deposits and non-deposit borrowings of funds in the money and capital markets, taxes payable, dividends payable. The largest asset of a bank is normally its total portfolio of loans. Deposits usually constitute the largest liability.

In contrast the income statement, or the profit and loss account, indicates how much it has cost the bank to acquire its deposits and other resources and to generate revenues from the uses of these funds. This costs include interest paid to depositors and other creditors of a bank, the expense of hiring management and staff, overhead costs in acquiring and using office facilities and taxes paid for government services. The income statement also shows the revenue (cash flow) generated by selling bank services to the public, including making loans and leases and servicing customers’ deposits. Finally the income statement shows the bank’s net earnings after all the costs (including taxes) are deducted from the sum of all revenues.

Figures published in financial statements provide essential data on the efficiency, liquidity, safety and solvency of a bank. In today’s highly competitive financial markets, the financial statements of banks are being scrutinized by investors, competing financial institutions, and by the general public. The fight for loan and deposit customers has increased dramatically. All this poses new challenges and demands for the effectiveness of a bank’s performance. The most important performance dimensions for any bank are profitability and exposure to risk.