Lecture 2: Understanding Bank Financial

Statements

Dr Lixiong Guo

Semester 2 ,2014

1

MARKET VALUE VS. BOOK VALUE

ACCOUNTING

Part I

2

How is a $12 million market value loan loss reflected in a

market value balance sheet?

3

How may a $12 million market value loan loss reflected in

a book value balance sheet?

4

Under book value accounting, FIs have greater discretion in

recognizing loan loss on their balance sheet both in terms of the

amount of the loss and the timing of when it is recognized.

If an FI were closed by regulators before its book value of capital became zero, liability holders and deposit insurance fund may still

suffer a loss.

Market value accounting is advocated by many academics and

analysts because the capital value under market value

accounting presents a more accurate picture of the net worth of

the FI, and thus, its ability to absorb losses before liability holders

do.

If an FI were closed by regulators before its economic net worth became zero, neither liability holders nor deposit insurance fund

would stand to loose.

Market Value vs. Book Value Accounting

5

WESTPAC 2013 ANNUAL REPORT

Part II

6

Historical Cost Convention

The financial report has been prepared under the historical cost

convention, as modified by applying fair value accounting to

available-for-sale financial assets and financial assets and

liabilities (including derivative instruments) at fair value through

profit or loss.

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Consolidated vs. Parent Entity Results

The consolidated financial statements incorporate the assets and

liabilities of all subsidiaries (including special purpose entities)

controlled by the Parent Entity and the results of all subsidiaries.

The effects of all transactions between entities in the Group are

eliminated.

Control exists when the Parent Entity has the power, directly or

indirectly, to govern the financial and operating policies of an

entity so as to obtain benefits from its activities. The definition of

control is based on the substance rather than the legal form of an

arrangement. In assessing control, potential voting rights that are

presently exercisable or convertible are taken into account.

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Four Categories of Financial Assets

Financial assets at fair value through profit or loss.

This category has two sub-categories: firstly financial assets held for trading and secondly those designated at fair value through

profit or loss at inception. A financial asset is classified in this

category if acquired principally for the purpose of selling it in the

near term, if it is part of a portfolio of financial instruments that are

managed together and for which there is evidence of a recent

pattern of short-term profit taking, if it is a derivative that is not a

designated hedging instrument, or if so designated on acquisition

by management, in accordance with conditions set out in Note

1(f)(i)(e).

Loans and receivables

Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active

market.

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Four Categories of Financial Assets (cont.)

Held-to-maturity investments

Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity that the

Groups management has the positive intention and ability to hold to maturity.

Available-for-sale securities

Available-for-sale securities are those debt or equity securities that are designated as available-for-sale or that are not classified

as financial assets at fair value through profit or loss, loans and

receivables or held-to-maturity investments.

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Recognition of Financial Assets

The fair value of a financial instrument is the amount at which the

instrument could be exchanged in a current transaction between

willing parties, other than in a forced or liquidation sale.

Financial assets at fair value through profit or loss are recognised

initially at fair value. All other financial assets are recognised

initially at fair value plus directly attributable transaction costs.

Available-for-sale financial assets and financial assets

recognised at fair value through profit or loss are subsequently

carried at fair value.

Loans and receivables and held-to-maturity investments are

subsequently carried at amortised cost using the effective

interest method.

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Gains and Losses on Assets Carried at Fair Value

Realised and unrealised gains or losses arising from changes in

the fair value of financial assets at fair value through profit or loss

are included in the income statement in the period in which they

arise.

Gains and losses arising from changes in the fair value of

available-for-sale financial assets are recognised in other

comprehensive income until the financial asset is derecognised

or impaired, at which time the cumulative gain or loss previously

recognised in other comprehensive income is recognised in the

income statement.

12

Impairment of Assets Carried at Amortised Cost

The Group assesses at each balance date whether there is

objective evidence that a financial asset or group of financial

assets is impaired.

A financial asset or a group of financial assets is impaired and

impairment charges are recognised if there is objective evidence

of impairment as a result of one or more events that occurred

after the initial recognition of the asset (a loss event) and that loss event (or events) has an impact on the estimated future

cash flows of the financial asset or group of financial assets that

can be reliably estimated.

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Impairment of Assets Carried at Amortised Cost (cont.)

If there is objective evidence that an impairment on loans and

receivables or held-to-maturity investments has been incurred,

the amount of the charge is measured as the difference between

the assets carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not

been incurred) discounted at the financial assets original effective interest rate.

If a loan or held-to-maturity investment has a variable interest

rate, the discount rate for measuring any impairment is the

current effective interest rate determined under the contract.

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Evidence of Impairment

Significant financial difficulty of the issuer or obligor.

A breach of contract, such as a default or delinquency in interest

or principal payments;

The Group granting to the borrower, for economic or legal

reasons relating to the borrowers financial difficulty, a concession that the Group would not otherwise consider;

It becoming probable that the borrower will enter bankruptcy or

other financial reorganisation;

The disappearance of an active market for that financial asset

because of financial difficulties; or

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Evidence of impairment (cont.)

Observable data indicating that there is a measurable decrease

in the estimated future cash flows from a group of financial

assets since the initial recognition of those assets, although the

decrease cannot yet be identified with the individual financial

assets in the Group, including:

Adverse changes in the payment status of borrowers in the Group; or

National or local economic conditions that correlate with defaults on the assets in the Group.

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Impairment of Assets Carried at Amortised Cost (cont.)

The carrying amount of the asset is reduced through the use of a

contra asset account in the balance sheet.

The amount of the loss is recognized through the use of an

expense account in the income statement.

Income Statement:

Impairment on loans and receivables carried at amortised cost

The charge recognised in the income statement for impairment on loans and receivables carried at amortised cost reflects the net

movement in the provisions for individually assessed and collectively

assessed loans, write-offs and recoveries of impairments previously

written-off.

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Impairment of Available-for-Sale Assets

If any evidence of impairment exists for available-for-sale

financial assets, the cumulative loss measured as the difference between the acquisition cost and the current fair value,

less any impairment charge on that financial asset previously

recognised in profit or loss is removed from other comprehensive income and recognised in the income statement.

If, in a subsequent period, the fair value of a debt instrument

classified as available-for-sale increases and the increase can be

objectively related to an event occurring after the impairment

charge was recognised in the income statement, the impairment

charge is reversed through the income statement.

Subsequent reversal of impairment charges on equity

instruments are not recognised in the income statement until the

instrument is disposed of.

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Shareholders Equity

Ordinary shares

Ordinary shares are recognised at the amount paid up per ordinary share net of directly attributable issue costs.

Retained Profits (as of 30 September, 2013)

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Shareholders Equity (cont.)

Available-for-sale securities reserve

This comprises the changes in the fair value of available-for-sale financial securities and hedges where applicable, net of tax.

These changes are transferred to the income statement in non-interest income when the asset is either derecognised or impaired.

Non-controlling interests

Non-controlling interests represents the share in the net assets of subsidiaries attributable to equity interests that are not owned

directly or indirectly by the Parent Entity.

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Note 28: Fair Values of Financial Assets and Liabilities

Quoted price in an active market

The best evidence of fair value is a quoted price in an active market. Wherever possible the Group determines the fair value of

a financial instrument based on the quoted price.

Valuation techniques

Where no direct quoted price in an active market is available, the Group applies present value estimates or other market accepted

valuation techniques. The use of a market accepted valuation

technique will typically involve the use of a valuation model and

appropriate inputs to the model.

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Note 28: Fair Value Hierarchy

Level 1

Financial instruments valued using recent unadjusted quoted prices in active markets for identical assets or liabilities. An active

market is one in which prices are readily and regularly available

and those prices represent actual and regularly occurring market

transactions on an arms length basis.

Valuation of Level 1 instruments require little or no management judgment.

Financial instruments included in this class are spot and exchange traded derivatives for equities, foreign exchange, commodities and

interest rate products

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Note 28: Fair Value Hierarchy (cont.)

Level 2

Valuation techniques utilizing observable market prices applied to these assets or liabilities include the use of market standard

discounting methodologies, option pricing models and other

valuation techniques widely used and accepted by market

participants.

The financial instruments included in this category are mainly over the counter (OTC) derivatives with observable market inputs and

financial instruments with fair value derived from consensus

pricing with sufficient contributors.

Financial instruments included in the Level 2 category are:

trading securities including government bonds, state government bonds, corporate fixed rate bonds and floating rate bonds; and

derivatives including interest rate swaps, credit default swaps, foreign exchange swaps, foreign exchange options and equity options.

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Note 28: Fair Value Hierarchy (cont.)

Level 3

Financial instruments valued using at least one input that could have a significant effect on the instruments valuation which is not based on observable market data (unobservable input).

Unobservable inputs are those not readily available in an active market due to illiquidity or complexity of the product. These inputs

are generally derived and extrapolated from other relevant market

data and calibrated against current market trends and historic

transactions.

A financial instruments categorization within the valuation hierarchy is based on the lowest level input that is significant to

the fair value measurement.

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Amount of Assets Using Different Valuation Techniques

on Westpacs Balance Sheet

The fair value of substantially all securities positions carried at

fair value is determined directly from quoted prices or from

market observable inputs applied in valuation models.

The majority of the Groups derivatives are valued using valuation techniques that utilize observable market inputs.

The Group has financial assets measured at fair value of

$126,957 million (Total Assets: $696,603 million). $1,332 million

of this is measured at fair value based on significant

unobservable market inputs.

The Group has financial liabilities measured at fair value of

$106,873 million, $37 million of this is measured at fair value

based on significant unobservable market inputs.

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LOAN LOSS ACCOUNTING

Part III

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Allowance for Loan Losses Account

Allowance for loan losses (ALL)

Also called Loan Loss Reserves (LLR).

A contra-asset (negative asset) account on the balance sheet

An estimate by the banks management of the amount of gross loans that will not be repaid to the bank.

Balance in the ALL account is increased through a provision

account on the Income Statement.

The provision account is usually called Provisions for Loan Losses (PLL). It is an expense account on the Income Statement.

An example accounting entry for a $50,000 provision is:

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Debit Credit

Provision for loan losses (an expense account) $50,000

Allowance for loan losses (a contra asset account) $50,000

Charge-Offs and Recoveries

Gross charge-offs or write-offs

The dollar value of loans actually written off as uncollectible during a period.

Charge-offs reduce the balance in the Allowance for Loan Losses account.

Recoveries:

The dollar amount of loans that were previously charged-off but now collected.

Recoveries add to the balance in the Allowance for Loan Losses account.

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Balance in the Allowance for Loan Losses Account

Allowance for loan losses:

Beginning balance

+ Provisions for loan losses

Gross charge off

+ Recoveries

--------------------------------------------------------

Ending balance

Net charge off = Gross charge-off - Recoveries

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Accounting for a $5,000 loan loss and its charge-off

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