Accounting for Financial Institutions

Chapter 2: The Financial Statements of a Bank

2.1. Introduction

The bank accounting system is a specialized accounting system that differs in many aspects from
other business accounting systems. These differences due to the following characteristics of the
banking industry:
1. The product or commodity sold by banks is money. Thus, a bank’s accounting system must
collect data and provide reports to help management in structuring and balancing its assets and
liabilities to control for different potential risks such as liquidity risk, operating risk, and market
risks.
2. The accounting system of a bank must record data in a verifiable form to make it easy for
regulatory firms to assure that the bank is following all the specified regulations regarding
disclosure requirements, risk management, interest rates, ……. etc.
3. The accounting system of a bank must provide sufficient and accurate data related to costs and
prices to the management to maintain its competitive advantage in the market.
Banks are only one part of a vast financial system markets and institutions that circles the
globe. The primary purpose of this ever-changing financial system is to encourage individuals and
institutions to save and to transfer those savings to those individuals and institutions planning to
invest in new projects. This process of encouraging savings and transforming savings into
investments would maintain economic growth, create new job opportunities, and increase living
standards.
Banks are required to prepare the following financial statements at the end of the fiscal
period:
1. Balance Sheet.
2. Income Statement
3. Statement of Changes in Stockholders' Equity
4. Statement of Cash Flows

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The two financial statements that managers, customers, and the regulatory authorities rely upon
are:
- Report of Condition – Balance Sheet
- Report of Income – Income Statement
2.2. Report of Condition: The Balance Sheet
The Balance sheet of a bank showing its assets, liabilities, and equity capital (owners’ funds) at a
given point of time. May be viewed as a list of financial inputs (sources of funds) and outputs
(uses of funds).
The Balance Sheet
Assets Liabilities & Equity
(Accumulated uses of funds) (Accumulated sources of funds)
Cash in vault & deposits made at Deposits made & owned by different
other banks or institutions: (primary
kinds of customers (demand, NOWs,
reserves) money market, savings, time)
Investment securities: the liquid Non-deposit borrowings of funds in
portion (secondary reserves) money & capital markets
Security holdings: (the income- Other Liabilities (e.g., acceptance
generating portion) outstanding, miscellaneous liabilities)
Reserve fund sold Equity Capital:
Loans - Capital
- Additional paid-in-capital
Fixed assets (building, equipment,
- Surplus (reserves)
etc.….)
- Retained earnings
Miscellaneous assets and debit
balances
Customers’ liability on acceptances

Items included in the bank balance sheet:

2.2.1. Assets
- Cash & due from banks represent the most liquid items. They stand for meeting the bank’s
need for liquidityto cover deposit withdrawals, customer demands for loans & any unexpected
needs for cash. This item includes four sub-items:
• Currency & coins held by tellers
• Cash held in the bank’s vault
• Deposits placed with other banks

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• Cash items in the process of collection such as uncollected checks, bank’s reserve
account held with the central bank
This item is often known as primary reserve. Normally, banks try to keep the size of
this account as low as possible, because cash balances earn little income for the bank.
Also, those balances considered in risk magament issues.
- Reserve fund sold; banks are obliged to deposit a specific percentage of customers' deposits
in the central bank. This amount is named as “legal reserve”. Some banks have excess reserve
(surplus) while others have shortage. Banks with excess reserves sold or lend those excesses
to banks in need of fund. Those transactions called overnight or during the weekend
transactions. As the name implies, they are a short-term period transactions.
- Investments in government treasury securities; banks purchase government marketable
debit obligations, which are called treasury bills, notes, or bonds. Treasury bills are issued
with 91, 182 days and one-year maturities, they are sold in L.E 10,000 denominations at
weekly government actions. These bills are bought on a discount basis. Treasury notes and
bonds are issued for a longer period of time (e.g., 10 years or more).
- Security holdings are a backup source of liquidity and provide another source of income.
- Loans are made basically to supply income. The bank can lend money for real estate purchase,
for business development, and personal as installment loans. Allowance for possible loan
losses (uncollectible loans) and unearned discount on loans are deducted form gross loans in
the balance sheet. Unearned discount stands for the interest (discount) and other charges
added to the amount advanced to the customer (the difference between gross amount of the
installment loan and the net amount paid). This amount of interest and other charges are not
earned yet. Unearned discount and allowance for loan losses are contra-asset accounts to
loans”
There is another type of loans called “non-performing loans” which are nolonger accrual
interest, there are many regulations to classify loans under this type. However, in common
if any schedual loan is past due for more than 90 days, then it is placed under this type.

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Net loans = Gross – Allowance for loan – Unearned

loans losses (ALL)* discount on
loans

*Allowance for loan losses (ALL)

= Beginning balance in the allowance for loan losses (ALL)
+ provision for loan losses (income statement)
Adjusted allowance for loan losses.
- Actual charge-offs of worthless loans
+ Recoveries form previous charge-offs.
= Ending allowance for loan losses
- Fixed assets (property, equipment & plant), net including buildings, office equipment,
leasehold improvements, furniture, and land.
- Miscellaneous assets and debit balances include assets possessed by the bank as a settlement
of a loan, prepaid expenses, accrued revenues, …. etc.
- Customers’ liability on acceptances: banks often provide a form of credit for their customers.
The amount of fund involved appears as an asset account labeled customers’ liability on
acceptances outstanding. Note that, this term coincides exactly with an item listed under bank
liabilities, acceptances outstanding.
This dual pair of accounts increases each time a bank agrees to stand behind a customers’
credit. Usually, a bank grants this credit to help that customer pay for imported goods from
overseas. In this case, the bank issues a signed letter of credit. This letter gives authorization
to a third party (e.g., a foreign exporter of goods) to draw a draft against the issuing bank for
a specified amount of money on a designated future date.
On or before the designated date, the customer that requested the acceptance must pay the
bank in full. The bank that issued the acceptance, in turn, will honor the acceptance on its
due date, paying the full amount of the draft to the current holder of the instrument. Thus,
bank’s acceptance gives rise simultaneously to both asset item (the customer’s liability to

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the bank) and a liability item (the bank promise to honor the acceptance draft on the date
specified).
2.2.2. Liabilities
- Deposits: are the main source of funding for banks. There are six kinds of deposits:
1. Demand deposit accounts (DDA) represent customer deposits in regular checking
accounts that don’t pay interest.
2. Negotiable Order accounts (NOW) represent checking accounts that pay interest.
3. Savings deposit (SA) represent traditional passbook saving accounts.
4. Time deposit accounts (TDA) represent high yielding saving certificates offered by
banks. They include retail certificate of deposits (CDs) which are fixed-maturity
instruments, wholesale CDs were created by banks as a contractual mechanism to allow
depositors liquidate their position in these CDs by selling them in the secondary market
rather than having to hold them to maturity or requesting that the bank cash in the deposit
early to avoid the penalty cost. Thus, they are “negotiable instruments” that could be
resold by little assignment in a secondary market to other investors. TDA also include
gold accounts, platinum certificates, and other time deposits.
5. Money, market deposit accounts (MMDAs) can pay competitive interest and have
limited check-writing privileges. Banks must reserve the wright to require seven days’
notice before any withdrawals are made.
6. Deposits due to other banks: domestic & foreign.
- Non-deposit borrowings represent the bank’s temporary borrowing in the money market,
mainly from reserves loaned to the bank by the Central Bank in Egypt or the Federal Reserve
Bank in the USA, or from securities sold under repurchase agreements. These transactions
are carried out mainly to supplement deposits and provide the additional liquidity that cash
assets and securities cannot provide.
One reason for bank from non-deposit funds sources is that there are no reserve
requirements on most of these funds, which lowers the cost of non-deposit funding. In
addition, borrowing in the money market usually can be arranged in a few minutes and the
funds wired immediately to the bank that needs them.

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The most important non-deposit source for most banks is represented by reserve fund
purchased and securities sold under agreements to repurchase. In this repurchase agreements
the bank borrows funds collateralized by some of its own securities from another bank or a
large corporate customer. Other short-term borrowings the bank may draw upon include
borrowing reserves from the discount windows of the Central Bank.
2.2.3. Owner’s Equity
- Equity capital or shareholders’ equity represents the long-term and relatively stable base of
financial support upon which the bank will reply to grow and to cover any extraordinary
losses it occurs.
Liabilities & equity capital represent accumulated sources of funds, which provide the
needed spending power for the bank to acquire its assets. On the other hand, a bank’s assets
represent the accumulated uses of funds, which are made to generate income for
shareholders, pay interest to depositors, and compensate the bank’s employees. Thus,
Accumulated uses of funds = Accumulated sources of funds
(assets) (Liabilities & equity capital)
Example (1)
Bank XXX
Balance Sheet, Dec.31, 2023
Assets
Cash & deposits at the central bank 90,000
Cash & deposits due from banks 137,000
Treasury bills 47,000
Interest-bearing deposits in banks 45,800
Central Bank certificate of deposits 36,200
Investment securities (available for sale) 187,600
Investment securities - Trading 67,400
Reserves fund sold & securities purchased under 43,200
resale agreement
Loans, gross (including different types of loans & 490,800
leases)
(-) Allowance for loan losses 11,600
(-) Unearned discount on loans 6,400
Net loans 472,800

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Investment securities (held to maturity) 62,000

Investment securities in associates 56,800
Lease financing receivables (investment in leveraged 20,000
leases)
Bank premises (plant & Equip.), net 30,600
Customer’s’ liability on acceptances 17,200
Other miscellaneous assets 22,600
Goodwill 70,000
Total Assets 1,406,200
Liabilities & Shareholders’ Equity
Deposits
Demand deposits 65,600
NOW deposits 77,100
Savings deposits 144,800
Money market deposits 56,000
Time deposits 220,200
Deposits due to domestic & foreign banks 49,200

Total deposits 612,900

Non-deposit borrowings
Reserve funds purchased & securities sold under 63,600
repurchase agreements
Other short-term debt 67,200
Mortgage indebtedness 71,800
Subordinated notes & debentures 132,900
Other Liabilities
Acceptance outstanding 17,200
Miscellaneous liabilities 70,600
Total Liabilities 1,036,200
Shareholders’ equity
Common stock (par value L.E. 200, 1,600,000 shares 160,000
authorized & outstanding)
Capital surplus 130,000
Retained earnings 90,000
Treasury stock (10,000)
Total shareholders’ equity 370,000
Total Liabilities & Shareholders’ equity 1,406,200

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2.2.4. Off-Balance-Sheet Financing:

Banks have converted many of their customer services in recent years into fee-generating
transactions that are not recorded on their balance sheets. Prominent examples of these off-
balance-sheet items include:
1- Standby credit agreements in which a bank pledges to guarantee repayment of
customer’s loan received from a third party.
2- Interest rate swaps in which a bank promises to exchange interest payments on debt
securities with another party. Each swap partner borrows in the market in which it has
the greatest comparative cost advantage, and then the two parties exchange interest
payments owed on the funds they have each borrowed. In total the cost of borrowing is
lower after a swap is arranged.
3- Financial futures & option interest-rate contracts: in which a bank agrees to deliver
or take delivery of securities from another party at a guaranteed price.
4- Loan Commitments: in which a bank pledges to lend up to a certain amount of funds
until the commitment matures in return for commitment fee.
5- Foreign exchange rate contracts: in which a bank agrees to deliver or accept delivery
of foreign currencies.
These off-balance-sheet transactions often expose a bank to added risks even though they
may not appear on the balance sheet.

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