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Lecture 2: Understanding Bank Financial


Statements
Dr Lixiong Guo
Semester 2 ,2014

Part I

MARKET VALUE VS. BOOK VALUE


ACCOUNTING

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


market value balance sheet?

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


a book value balance sheet?

Market Value vs. Book Value Accounting


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.

Part II

WESTPAC 2013 ANNUAL REPORT

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.

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.

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.

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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 noninterest 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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Part III

LOAN LOSS ACCOUNTING

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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:
Debit
Provision for loan losses (an expense account)
Allowance for loan losses (a contra asset account)

Credit

$50,000
$50,000

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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