Special Industries Chapter

Chapter 12
Special Industries:
Banks, Utilities, Oil and Gas,
Transportation, Insurance,
Real Estate Companies
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duplicated, or posted to a publicly accessible website, in whole or in part.
Types of Banks:
• The main types of banks are as under:

1. Central Bank:
 The central bank is the head, the leader, and the
supervisor of the banking and monetary system of
a country.
 Almost every country of the world has its own
central bank.
2. Commercial Banks:
 Commercial banks are the financial institutions,
which perform general banking functions.
 They receive deposits, advance loans and create
credit.
Types of Banks:
3. Industrial Banks:
 The industrial banks mainly provide, medium
and long-term credit to the industries.
 These banks are established for industrial
development.
4. Agriculture Banks:
 Agricultural banks are set up to provide financial
assistance to the agriculturists.
 They advances short-term and long-term credit
to the formers for purchasing seeds, tractors
and introducing modern techniques in forming.
Types of Banks:
5. Mortgage Banks:
 Such banks mortgage land, houses and other property
and advance loans. Some commercial banks perform
such activates.
6. Exchange Banks:
 Exchange banks mainly deal with international trade.
These banks take the responsibility of settlement of
foreign exchange and arrange the foreign business.
7. Investment Banks:
 These banks provide funds for long-term projects.
They can raise their funds by getting deposits or
selling share/stocks, issuing bonds or commercial
paper.
What is a commercial bank
A bank is a financial institution which deals with money
and credit. It is organized on a joint stock company
system primarily for the earning of profit. Commercial
bank accepts deposits from individuals , firms and
companies at a lower rate of interest and gives at a
higher rate to those who need it. The difference
between the terms at which it borrows and those at
which it lends forms the source of its profit.
According to Crowther “a bank is a firm which collects
money from those who have it spare .it lends money
to those who require it.”
According to Mr. . Parking .” a bank is a firm that takes
deposits from households and firms and makes
loans to other households and firms”.
Functions of commercial banks:
Functions of commercial
Banks
The basic The secondary

functions of Functions of
commercial Commercial banks
bank
Functions of commercial
banks:
1) Basic functions:
The basic functions of commercial banks are
(A) Accepting of deposits and (B) Advancing of
loans
A. Accept of deposits:
In order to attract the savings from different
persons and institutions, the banks maintain the
following three types of accounts:
(i) Current account (ii) Saving account (iii) Fixed

deposit account.
Functions of commercial banks
i. Current account.
 On demand deposits, the banks pay no interest.
The deposits can be withdrawn at any time in full
or in part.
Current account holders receive a check book
and regular statements containing details of money
paid in and paid out.
• Saving account:
 The banks pay interest on this types of deposits
and advance the facility to withdraw the amount,
subject to certain restrictions.
iii. Fixed deposit account:

 Fixed deposit (term deposit) are kept with the banks
for a specified period of time.
 The rate of interest on fixed deposits are fairly high.
 The longer the period of deposit, the higher is the rate
of interest.
B. Making loans:
the lending of money may be in any of the following
forms;
(i) Loans (ii) Cash Credit (iii) Overdraft

(iv) Discounting of Bills.
i. Loans:
 The commercial banks grant short term loans
and long term loans to individuals, firms, and
companies mostly against some securities.
ii. Cash credit:

 The banks advance long term loans to the
different sectors against the security of goods.
 The borrower is permitted to draw within the cash
credit limit sanctioned by the bank.
 The interest is charged only on the amount of
money withdrawn by the borrower.
iii. Overdraft ( O/D):
 It is a convenient form of short term financing by a bank.
 The customer is allowed to draw certain amount of money
over and above his own deposited money.
 Interest is charged on daily balance on the overdrawn
amount.
iv. Discounting of bills:

 A bill of exchange is a peace of paper representing a
promise by the buyers of goods on credit, to pay the seller
at a specified time.
 The discount charged is the earning of the bank.
2) Secondary functions:
The secondary function of a commercial bank are
as follows:
i. Special financial services:
 commercial banks are now offering international
services in the form of currency exchange, issue of
letters of credit, ATMs (Automatic Teller Machine),
banker’s acceptances and Electronic Fund
Transfer (EFT).
ii. Purchase or sell of securities:
 The bank, if authorized by the customer,
purchases or sells securities on behalf of the
customer.
iii. Execution of standing Instructions:
 The customer may order in writing to his bank to
make payments of regular installment to an
individual or firm by loaning them to his account.
 Against such payments the bank charge a small
commission.
iv. Acting as Trustee:
 If a client directs his bank to act as a trusty in the
administration of a business, the bank performs
this responsibility for the benefit of its customer.
 The bank charge a small fee for providing this
services.
Banks
• Regulation and structure

– Federal charter
• Reports to Comptroller of the Currency
– State charter
• Controlled by state banking departments
• Sphere of operations controlled by state
– Federal reserve system members
• Report to Federal Reserve and FDIC
• Member banks maintain reserves at district reserve bank
Chapter 12, Slide #14
Banks (cont’d)
• Balance Sheet (Report of Condition)

– Assets
• Loans to customers are assets (receivables)
• Assets are not subdivided into current and noncurrent
• Typical assets
– Cash on hand or due from other banks, investment
securities, loans, bank premises, and equipment
• Fixed-rate assets expose bank to risk if rates rise
– The receivable itself decreases in value
• LDC (less-developed countries) loans more risky than
domestic
Banks (cont’d)
• Balance Sheet (Report of Condition)

– Assets
• Review for related-party loans
• Allowance for loan loss account
• Other real estate – property taken during foreclosure;
holding for probable resale
– Liabilities
• Current: savings, checking, time/demand deposits
– Reduction in this liability also indicates the loss of an
inexpensive source of lendable funds
• Long-term: loan obligations, long-term debt
Banks (cont’d)
• Balance Sheet
– Stockholders’ equity
• Typically low in relation to total assets (averages 6–7%)
– Low stockholders’ equity indicates greater risk of failure
– High stockholders’ equity is less risky but more costly
because of capital requirements
• Review for accumulated other comprehensive income/loss
• Regulators view capital in relation to risk-adjusted assets
• Review sub prime residential real estate loans risks. These
loans became a major issue with financial institutions in
2007.
Banks (cont’d)
• Balance Sheet
– Read notes and Management’s Discussion and
Analysis for indication of
• Nonperforming assets: assets no longer producing income
or producing reduced income
– Nonaccrual loans: payments are past due; interest no longer
being accrued
– Renegotiated loans: modified as part of a restructured
agreement
– Watch carefully; these may indicate potential future
difficulties
– Check for reserves of sub prime loans.
• Commitments and contingencies
Banks (cont’d)
• Income Statement
– Interest
• Principal revenue is interest earned on loans and
investment securities
• Principal expense is interest on deposits and other debt
• Excess of interest revenue over interest expense is net
interest income (margin)
• Interest rates
– Falling: reduces expense (interest paid on deposits)
– Increasing: increases expense
Banks (cont’d)
• Income Statement
– Other income (noninterest income)
• Fees, service charges, trading securities gain/loss,
securities transactions
• Of increasing importance to banks
• Ratios
– Many ‘traditional’ ratios do not work for banks
– Workable ratios
• Return on assets
• Return on equity
• Most investment-related ratios
Ratios for analyzing a bank
Banks (cont’d)
• Ratios
– Earning Assets to Total Assets
• Earnings assets are loans, leases, investments securities,
money market assets
– Exclude cash, nonearning deposits, fixed assets
• High result reflects how well the bank puts bank assets to
work
– Interest Margin to Average Earning Assets
• A key measure of bank profitability
• Indicates management’s ability to control the spread
between interest income and interest expense
Banks (cont’d)
• Ratios
– Loan Loss Coverage Ratio
• (Pretax income + provision for loan losses) ÷ net charge-
offs
• Measures
– Asset quality
– The level of protection of loans
– Equity Capital to Total Assets

• Measures the extent of equity ownership in the bank
Banks (cont’d)
• Ratios
– Deposits Times Capital
• Average deposits ÷ average stockholders’ equity
• A type of debt-to-equity ratio
• Concerns both depositors and stockholders
• Indicators
– More capital implies greater margin of safety
– More deposits indicate investment potential
– Loans to Deposits
• A type of asset to liability or debt coverage ratio
Regulated Utilities
• Regulation and structure

– Subject to government regulation and rate
regulation
– Accounting procedures prescribed by
• Federal Energy Regulatory Commission
• Federal Communications Commission
• State regulatory agencies
– Regulated utilities have added nonregulated
businesses
Regulated Utilities (cont’d)
• Financial Statements
– Balance sheet
• Plant, property, and equipment is listed first
• Capitalization section includes sources of financing
– Long-term capital
– Long-term debt
• Current liabilities and deferred charges
– Income statement
• Operating income
• Other income
• Interest charges
– Construction work in progress [balance sheet asset]
• Substantial construction work in progress should be
viewed as more risky
• Rate base determination will not normally consider
construction work in progress
• Disallowed costs provide no return
– Allowance for funds used during construction
[income statement]
• Allowance for equity funds [other income]
– An assumed rate of return on equity funds
• Allowance for borrowed funds [interest charges]
Ratios for Utility Performance
• Ratios
– Few of the traditional ratios are appropriate for
regulated utilities
– Operating Ratio
• Measures efficiency
• Operating expenses ÷ operating revenue
– Funded Debt to Operating Property
• Operating (net) property is plant and equipment less
accumulated depreciation
• Include construction in progress
• Measures debt coverage
• Ratios
– Percent Earned on Operating Property
• Relates net earnings to the assets primarily intended to
generate earnings
– Operating Revenue to Operating Property
• A type of operating asset turnover ratio
• Fixed plant is often much larger than revenue
Oil and Gas
• General background
– Major impact on financial statements from method
of accounting for exploration and production
– Specific required supplemental disclosures
– Traditional ratios apply
Oil and Gas (cont’d)
• Successful-Efforts versus Full-Costing

Methods
– Successful-efforts
• Theory: unsuccessful efforts are costs of the current period
• Capitalize costs of successful efforts
• Immediately expense costs of unsuccessful efforts
• More conservative approach yielding lower net income
due to immediate expensing of unsuccessful efforts

Methods
– Full-costing
• Theory: all costs are part of eventually finding successful
wells
• Capitalize all costs of exploration
• Items capitalized are subject to depletion
– In total, the same amount is expensed under either
method, but the timing of expense recognition
varies dramatically

Methods
– Practical application
• Smaller companies choose full-costing method
• Larger balance sheet due to full capitalization
• Short-run higher profit (expense is periodic depletion, not
full cost)
• Presents more favorable picture to creditors and investors
• Larger companies use variation of successful-efforts
method
• Smaller balance sheet with only successful efforts
capitalized
• Short-run lower profit due to immediate expensing of
unsuccessful efforts
• Required supplementary disclosure: SFAS 69

– Proved oil and gas reserve quantities
– Results of operations for oil- and gas-producing
activities
– Costs incurred in oil and gas property acquisition,
exploration, and development activities
– Capitalized costs relating to oil- and gas-producing
activities
– A standardized measure of discounted future net
cash flows relating to proved oil and gas reserve
quantities
Transportation
• Regulation and oversight

– Civil Aeronautics Board
• Commercial aviation
• Uniform system of accounts and reporting
– Interstate Commerce Commission
• Interstate railroads
• Interstate motor carriers
• Uniform system of accounts and reporting
Transportation (cont’d)
– Balance sheet
• Similar to manufacturing and retailing reporting
• Plant, property, and equipment makes up large portion of
assets
– Income statement
• Similar to utility reporting
• Revenues and expenses grouped by natural objectives
and functional activities
• Reports operating income (operating revenues minus
operating expenses)
• Presented in single-step fashion
Ratios for Transportation
• Ratios
– Sources of comparable data
• Interstate Commerce Commission’s Annual Report on
transport statistics
• American Trucking Association’s Financial Analysis of the
Motor Carrier Industry
– Operating Ratio
• Operating expenses ÷ operating revenue
• External forces will impact the ratio
– Long-Term Debt to Operating Property
• Operating property: long-term property and equipment
• Measures the sources of funds with which property has
been obtained
• Ratios
– Operating Revenue to Operating Property
• Measures turnover of operating assets
• Operating objective is to generate as many dollars in
revenue per dollar of property
– Per-Mile, Per-Person, and Per-Ton Passenger
Load Factors
• Not required but often presented in the financial statement
notes or highlights
Insurance
• Types of service
– Identified contract service (mortality or loss)
– Investment management service
• Types of insurance organizations
– Stock companies: organized to return a profit to
stockholders
– Mutual companies: incorporated without private
ownership interest
– Fraternal benefit societies: similar to a mutual
insurance company
– Assessment companies: organized group with a
similar interest
Insurance (cont’d)
• Primary regulation is at the state level

• Accounting
– Uniform SAP (statutory accounting practices)
reporting under auspices of the National
Association of Insurance Commissioners
• Balance sheet is emphasized; focus is on solvency
• Ratio analysis conducted by the NAIC
– GAAP exists for public (SEC) filings
• Sources of comparative data

– Best’s Insurance Reports
• Separate ratings for life-health and property-casualty
companies
• Ratings range from A+ (Superior) to C– (Fair); also a “Not
Assigned” category
• Balance Sheet Under GAAP

– Investments
• High liquidity, typically bonds
• Review spread between cost or amortized cost and fair
value
• Review stockholders’ equity for unrealized gains and
losses on investments.
– Assets Other than Investments
• Operating (plant) assets
• Policy acquisition costs are deferred and matched to
premium-earning period for GAAP; expensed for SAP
• Goodwill and other intangibles
• Balance Sheet Under GAAP

– Liabilities
• Loss reserves: commitments reported at present value
• Policy and contract claims: claims accrued net of
recoverable portion
– Stockholders’ equity
• Resembles other industry stockholders’ equity
• Review for unrealized gains and losses on investments
(Accumulated Other Comprehensive Income). These can
be large for insurance companies).
• Income Statement Under GAAP

– Duration of contract governs revenue
• Short-duration: revenue recognized over period of the
contract in proportion to protection provided
• Long-duration: revenue recognized when premium is due
– Low-risk contracts are “investment contracts” and accounted
for as liabilities
– Realized gains/losses from investments
• Ratios
– Industry-specific based on SAP reporting to states
– Ratios based on GAAP data
• Profitability
• Investor-related
– Confusion surrounding insurance industry reporting
• Two accounting standards: SAP and GAAP
• Insurance stock typically carries discount to the average
market price
• Federal oversight and enforcement

– Limited by McCarran-Ferguson Act of 1945
– SEC has jurisdiction only over publicly-traded
companies
– Nationwide review of insurance practices by FBI
Real Estate Companies
• Construct and operate income-producing real

properties
• Contend that conventional accounting
misleads investors
• Real estate companies supplement historical
cost information with current value
– Current value is based on future income potential

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Chapter 12

• The main types of banks are as under:

The basic The secondary

(i) Current account (ii) Saving account (iii) Fixed

iii. Fixed deposit account:

(i) Loans (ii) Cash Credit (iii) Overdraft

ii. Cash credit:

iv. Discounting of bills:

• Regulation and structure

• Balance Sheet (Report of Condition)

• Balance Sheet (Report of Condition)

– Equity Capital to Total Assets

• Regulation and structure

• Successful-Efforts versus Full-Costing

• Successful-Efforts versus Full-Costing

• Successful-Efforts versus Full-Costing

• Required supplementary disclosure: SFAS 69

• Regulation and oversight

• Primary regulation is at the state level

• Sources of comparative data

• Balance Sheet Under GAAP

• Balance Sheet Under GAAP

• Income Statement Under GAAP

• Federal oversight and enforcement

• Construct and operate income-producing real

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