CHAPTER-1

INTRODUCTION

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1.1 Introduction:
A bank is a financial institution that accepts deposits from the public and
creates credit. Lending activities can be performed either directly or indirectly
through capital markets. Due to their importance in the financial stability of a
country, banks are highly regulated in most countries. Most nations have
institutionalized a system known as fractional reserve banking under which
banks hold liquid assets equal to only a portion of their current liabilities.
The particular services each financial firm chooses to offer and the overall
size of each financial services organization are reflected in its financial
statements. Financial statements are literally a “road map” telling us where
a financial firm has been in the past, where it is now, and perhaps, where it
is headed in the future. They are invaluable guideposts that can, if properly
constructed and interpreted, signal success or disaster. Unfortunately, much
the same problems with faulty and misleading financial statements that
placed Enron and Lehman Brothers in the headlines not long ago have also
visited some financial service provider, teaching us to be cautious in reading
and interpreting the financial statements financial service providers routinely
publish.

1.2 Objective of the Study

This research paper has put emphasized on financial statements of banks.

To know about the main parts of the financial statements

To know about the components of balance sheet
To know about the components of income statement
To know about the problems of financial statement

1.3 Sources of Data

Data has been collected from secondary sources. Necessary data has been
collected by the following sources:

Course text book

Different related websites

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1.4 Limitation of the Study
The main limitation for conducting this report is time limitation and
resources. The given time was not enough to understand all the
activities of a bank and how they handle their clients.
Lack of experience has also acted a constraint for the exploration of
the topic.

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 CHAPTER-2
THE FINANCIAL STATEMENTS OF
BANKS

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2.1 Financial Statement of Bank
Financial statements provide the information about the financial condition of
a bank. The two most important financial statements for a bank firm is
balance sheet and income statement. The balance sheet shows the amount
and composition of funds sources drawn upon to finance lending and
investing activities and how much has been allocated to loans, securities and
other funds uses at any 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. Income statement also
shows the revenues generate by selling services to the public, including
making loans and servicing customer deposits. Finally, income statement
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 stockholder as dividend.

2.2 The Balance Sheet

A balance sheet lists the assets, liabilities and equity capital held by or
invested in a bank or other financial firm on any given date. Because financial
institutions are simply business firm selling a particular kind of product, the
basic balance sheet identity
Asset = Liabilities + Equity Capital
must be valid for financial service providers, just as would be true for
nonfinancial companies. Now discuss about the principle components of the
balance sheet.

2.2.1 Assets of the Banking Firm

The components of the assets sides are discussed below

2.2.1.1 Cash and Due from Depository Institutions

The first asset item normally listed on a banking firm’s balance sheet is cash
and due from depository institutions. This item includes cash held in the
bank’s vault any deposits placed with other depository institutions, cash
items in the process of collection and the banking firm’s reserve account held
with the Federal Reserve bank in the region.

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2.2.1.2 Investment Securities: The Liquidity Portion
A second line of defense to meet demands for cash is liquid security
holdings, often called secondary reserves or referenced on regulatory
reports as “investment securities available for sale.”

2.2.1.3 Investment Securities: The Income-Generating Portion

Bonds, notes and other securities held primarily for their expected rate of
return or yield are known as the income-generating portion of investment
securities.

2.2.1.4 Trading Account Assets

Securities purchased to provide short-term profits from short-term price
movements are not included in “Securities” on the balance sheet.

2.2.1.5 Federal Funds Sold and Reserve Repurchase Agreements

A type of loan account listed as a separate item on the balance sheet is
federal funds sold and reverse repurchase agreements. This item includes
mainly temporary loans made to other depository institutions, securities
dealers or even major industrial corporations.

2.2.1.6 Loans and Leases

By far the largest asset item is loans and lease, which often account for half
to almost three-quarters of the total value of all bank assets. we may see
listed on a banking firm’s balance sheet the following loan types:
Commercial and industrial loans.
Consumer loans; on regulatory reports these are referenced as Loans
to Individuals.
Real estate loans.
Financial institutions loans.
Foreign loans.
Agricultural production loans.

2.2.1.7 Loan Losses

Loan losses, both current and projected are deducted from the amount of
gross loans and leases. Depository institutions are allowed to build up a
reserve for loan losses, called the allowance for loan losses (ALL) from their
flow of income based on their recent loan loss experience.

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Formula of calculating Allowance for Loan Losses

Beginning balance in the allowance for loan loss account (ALL) *********
+ This year’s provision for loan losses (PLL) *********
= Adjusted allowance for loan losses (ALL) *********
- Actual change offs of worthless loans *********
= Net allowance for loan losses (ALL) *********
+ Recoveries from previously charged off loans
*********
= Ending balance in the allowance for loan loss account (ALL) *********

2.2.1.8 Specific and General Reserves

ALL account divided into two parts: specific reserves and general reserves.
Specific reserves are set aside to cover a particular loan or loans expected
to be a problem. The remaining reserves in the loan loss account are called
general reserves.

2.2.1.9 Unearned Income

This item consists of interest income on loans received from customers but
not yet earned under the accrual method of accounting banks use today.

2.2.1.10 Non performing Loans

Banks have another loan category on their financial statement called
nonperforming loans, which are credits that no longer accrue interest
income.

2.2.1.11 Bank Premises and Fixed Assets

Bank assets also include the net value of buildings and equipment. A banking
firm devotes only a small percentage of its assets to the institution’s physical
plant.

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2.2.2 Liabilities of the Banking Firm
The components of the liabilities side are discussed below

2.2.2.1 Deposits
The principal liability of any bank is its deposits, representing financial claims
held by business, households and governments against the banking firm.
There are five major types of deposits:
Noninterest-bearing demand deposits
Saving deposits
Now accounts
Money market deposit accounts
Time deposits

2.2.2.2 Borrowing from Nondeposit Sources

Although deposits typically represent the largest portion of funds sources for
many banks, sizable amounts of funds also stem from miscellaneous liability
accounts. All other factor held equal the larger the depository institution, the
greater use it tends to make of nondeposit sources of funds. There are No
reserve or insurance fees on most of these funds, which lower the cost of
nondeposit funding.

2.2.3 Equity Capital of the Banking Firm

The equity capital accounts on a depository institution’s balance sheet
represent the owners’ share of the business. Every new financial firm begins
with a minimum amount of owners’ capital and then borrows funds from the
public to lever up its operations. Financial institutions are the most heavily
leveraged of all business.

2.3 Income Statement of the Banking Firm

An income statement indicates the amount of revenue received and
expenses incurred over a specific period of time. The principle source of
bank revenue generally is the interest income generate by earning assets-
mainly loans and investments. Additional revenue is provided by the fees
charged for specific services. The major expenses incurred in generating this
revenue include interest paid out to depositors; interest owed on nondeposit
borrowings; the cost of equity capital; salaries, wages, and benefits paid to

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employees; overhead expenses associated with the physical plant. Now
discuss about the components of income statement.
2.3.1 Interest Income
Interest earned from loans and security investments accounts for the
majority of revenues for most depository institutions and for many other
lenders as well.

2.3.2 Interest Expenses

The number one expenses item for a depository institution normally is
interest deposits. Another important interest expense item is the interest
owed on short term borrowings in the money market-mainly borrowings of
federal funds from other depository institutions and borrowings backstopped
by security repurchase agreements.

2.3.3 Net Interest Income

Total interest expenses are subtracted from total interest income to yield net
interest income. This important item is often referred to as the interest
margin, the gap between the interest income the financial firm receives on
loans and securities and the interest cost of its borrowed funds.

2.3.4 Loan Loss Expense

Another item that banks and selected other financial institutions can deduct
from current income is known as the provision for loan and lease losses. This
provision account is really a noncash expense.

2.3.5 Noninterest Income

Sources of income other than interest revenues from loan and investments
are called noninterest income.

2.3.6 Noninterest Expenses

The key noninterest expense item for most financial institutions is wages,
salaries and employee benefits often referred to as personal expenses which
has been an important expenses item.

2.3.7 Net Operating Income and Net Income

The sum of net interest income (interest income – interest expense) and net
noninterest income (noninterest income – noninterest expenses – provision
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for loan losses) is called pretax net operating income. Income tax rates are
applied to pretax net operating income plus securities gains or losses to
derive income before extraordinary items

2.4 Off Balance Sheet Items in Banking

The balance sheets a good place to start does not tell the whole story about
a financial firm. Financial firms offer their customers a number of fee-based
services that normally do not show up on the balance sheet that shows in off
balance sheet which are given below.

2.4.1 Unused Loan Commitments

Unused loan commitments, in which a lender receives a fee to lend up to a
certain amount of money over a defined period of time.

2.4.2 Standby Credit Agreements

Standby credit agreements in which a financial firm receives a fee to
guarantee repayment of a loan that a customer has received from another
lender.

2.4.3 Derivatives Contracts

Derivatives contracts in which a financial institution has the potential to make
a profit or incur a loss on an asset that it presently does not own.

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 CHAPTER-3
CONCLUSION

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3.1 Conclusion
In this term paper presents an overview of the content of bank financial
statements, which provides us with vital information that managers, investors
regulators and other interested parties can use to assess each financial
firm’s performance. Several key points emerge in the course of the term
paper:
 The two most important financial statements issued by depository
institution are the balance sheet and income statement.
 Bank balance sheet report the value of assets held (usually broken
down into such categories as cash assets, investment securities,
loans and miscellaneous assets), liabilities outstanding (including
deposits and nondeposit borrowings) and capital equity. The values
recoded on the balance sheet are measured at a single moment in
time.
 The income statement includes key sources of revenue and operating
expenses. Revenue sources for most financial firms typically include
loan and investment income and revenue from the sale of fee
generating services. Major sources of operating expense include
interest payments on borrowed funds, employee wages, salaries and
benefits and taxes.
 By carefully reading the financial statements of banks and their
competitors we learn more about the services these institutions
provide and how their financial condition changes time. These
statements when accurately prepared provide indispensable
information to managers, owners, creditors and regulators of financial
service providers. Unfortunately, some financial institutions engage in
window dressing and other forms of data manipulation, which can
send out misleading information.

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