Financial Statements of

Commercial Banks – II
(Income Statement)
Dr. Shabir Hakim
Income Statement
• An income statement, or Report of Income, indicates the amount
of revenue received and expenses incurred over a specific period of
time.
• There is a close correlation between the size of the principal items
on a bank's balance sheet (Report of Condition) and the size of
important items on its income statement.
– Assets on the balance sheet usually account for the majority of operating
revenues, while liabilities generate many of a bank's operating expenses.

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Components of an Income Statement
• The income statement of a commercial bank can be divided into
four main sections:
1. Interest income
2. Interest expenses
3. Noninterest income
4. Noninterest expenses

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Interest Income
• The interest earned from loans and security investments
accounts for the majority of revenues for most depository
institutions.
• However, the relative importance of interest revenues versus
noninterest revenues (fee income) is changing rapidly.
• The fee income is growing faster than interest income on
loans and investments as financial-service managers work
hard to develop more fee-based services.

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Interest Expenses
• The number one expense item for a depository institution normally is interest on
deposits.
• The interest on deposits accounted for more than 60 percent of this bank's total
interest costs.
• Other interest expense items are the short-term borrowings in the money market,
such as:
– Federal funds (reserves) from other depository institutions
– Repurchase agreements

• Interest on the long-term borrowings, such as:

– Mortgages on the firm's property
– Subordinated notes and debentures outstanding

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Net Interest Income
• Net interest income (NII) is the difference between total interest
income and total interest expenses.
• NII 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.

• It is usually a key determinant of profitability.

• When the interest margin falls, the stockholders of financial firms
will usually see a decline in their bottom line-net after-tax earnings.

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Loan Loss Expense
• Loan loss expenses are deducted from current income and are
commonly known as the provision for loan and lease losses.
• The provision account is a noncash expense, created by a simple
bookkeeping entry.
• The annual loan loss provision is tax-exempt and is deducted from
current revenues before taxes are applied to earnings.

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Loan Loss Expense
• There are two approaches to calculating provisions for loan losses:
1. The experience method in which the amount of deductible loan loss expense
would be the product of the average ratio of net loan charge-offs to total loans in
the most recent six years times the current total of outstanding loans
2. The specific charge-off method allows banks to add to loan loss reserves from
pretax income each year no more than the amount of those loans actually written
off as uncollectible.
• Expensing worthless loans usually must occur in the year that troubled loans are
judged to be worthless.
• The largest banking companies are required to use the specific charge-off method.

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Noninterest Income
• Sources of income other than interest revenues from loans and investments
are called noninterest income (or fee income).
• The financial reports apportion this income source into four broad categories:
1. Fees earned from fiduciary activities (such as trust services)
2. Service charges on deposit accounts
3. Trading account gains and fees
4. Additional noninterest income (including revenues from investment banking, security
brokerage, and insurance services).

• Recently many financial-service providers have focused intently on

noninterest income as a key target for future expansion.

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Noninterest Expenses
• The key noninterest expense item for most financial institutions is wages,
salaries, and employee benefits, often referred to as personnel expenses
– Has become an important expense item in recent years as leading financial firms have
pursued top-quality college graduates and lured experienced senior management away
from competitors.

• The costs of maintaining a financial institution's properties and rental fees on

office space show up in the premises and equipment expense.
• The cost of furniture and equipment also appears under the noninterest expense
category
• Other expenses, which are small, include items such as legal fees, office
supplies, and repair costs.

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Net Operating Income and Net Income
• The sum of net interest income and net noninterest income is the
pretax net operating income.
• Taxes are paid on pretax net operating income plus securities gains
or losses
• The after-tax income comprises the income before extraordinary
items.

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Net Operating Income and Net Income
• Securities gains (losses) are usually small, but can be substantial
for some financial firms at various times.
• The activity of purchasing, selling, or redeeming securities during
a year may result in gains or losses above or below the original
cost (book value) of the securities.
• A bank can use these gains or losses to help smooth out its net
income from year to year.

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Net Operating Income and Net Income
• Smoothing of earnings
• If earnings from loans decline, securities gains may offset all or
part of the decline.
• In contrast, when loan revenues ( which usually are fully taxable)
are high, securities losses can be used to reduce taxable income.

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Net Operating Income and Net Income
• Smoothing of earnings
• Another method for stabilizing the earnings consists of nonrecurring sales
of assets.
• These one-time-only (extraordinary income or loss) transactions often
involve the sale of financial assets, such as common stock, or real property
pledged as collateral behind a loan upon which the lender has foreclosed.
– Such transactions, particularly loan foreclosures, have a substantial effect on current
earnings
– The collateral is carried on the lender's books at minimal market value, but its sale
price may turn out to be substantially higher.

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