DISCLOSURES OF THE FINANCIAL STATEMENTS OF BANKS AND SIMILAR FINANCIAL INSTITUTIONS THE CASE OF: (TRANSPARENCY AND BANK FAILURES)

Transcription

1 DISCLOSURES OF THE FINANCIAL STATEMENTS OF BANKS AND SIMILAR FINANCIAL INSTITUTIONS THE CASE OF: (TRANSPARENCY AND BANK FAILURES) FATEMEH PANAHI INTERNATIONAL FINANCIAL REPORTING AND ANALYSIS Berndt Andersson 1

2 ABSTRACT In this study we are going to debate about benefits of making financial statements more transparent and we review some suggestions for enhancing the transparency of financial statements. We also can find out about the role of transparent disclosures in preventing bank failures in the time of recession. We will consider some parts of IAS30 and IFRS7 and also we will mention examples about American bank failures, Iranian Islamic banks and banks of prosperous countries such as Sweden to make a conclusion. 2

3 INTRODUCTION & OBJECTIVES Financial crisis is increasingly effecting real economy through higher credit risks and falling asset prices, which are holding investment and consumer spending in check. The global economy is going toward recession and banks are near failures 1. In these situations how banks can be saved from failures? How can people make accurate decisions? How can people s requirements be determined? In order to find out about the answers of questions above at first we should consider a classification about different types of users of financial reports and their requirements. Note that financial statements are the part of financial reports. Users of financial reports (for the case of banks) are divided into 8 parts: 1- Equity investors 2- Creditors 3- Suppliers 4- Employees 5- The analyst adviser group 6- Competitors 7- Government 8- The public Equity investors: need sort of information that shows the ability of an entity to report cash inflows, they need to know about whether or not to invest in a business, to buy or to sell shares or not. They need to know about future profits and as s accounting information is based on present or past events they can t rely just on such information they need a sort of information to make them able to estimate future and this estimation can be done by disclosures of financial statements, these disclosures should be very transparent to make users able to make their own estimation accurately. 1 Swedbank annual report

4 Creditors: in addition to the information required for equity investors, creditors need to know about the ability of banks in paying their money back, they are interested to know about the amount of cash, and the amount of assets and also about the other creditors other than their own. However long term creditors need to make some estimation about the future position of the firm and this is possible if they consider disclosures of financial statements, therefore a necessity for transparent disclosures can be found out again. Suppliers: as the same as creditors need information about firm s payments and also they need to know about the stability of the firm which could be understand from disclosures about risk information and management policies, however, there aren t so many users in this category for banks. Employees: need to know about the stability of the firm for their future position, profitability of the firm for estimating their future benefits, firm s payments, information about the particular part of the firm, they also need non-financial information such as conditions of services. It should be mentioned that all of these information should be very simple and clear. The analyst-adviser group: need more detail and advance information of financial reports because they are all experts and need technical information. Competitors: need all of the information to compare their position to enhance their efficiency. Government: need information for the purpose of taxation, they also need very detail information for the economic decision making and they need disclosures for estimating future situations. Public: need information about employment opportunities, activities, services, interest rate for deposits or saving accounts and investment opportunities. This category seems to be very important for banks because as we will discuss it later, banks need to represent their financial reports transparent in order to attract people, because their money will be a very important source for banks to save them from failures. (Britton and Jorissen 2007) According to the required information of all types of users, transparent disclosures is one of the main requirements, so we should discuss about how to make financial information more transparent and useful. 4

5 Literature review In this study we will discuss about how transparency can be enhanced and how can future risks be controlled, accordingly in this part we are going to review the past related literatures and journals. As we know, readers of financial statements need the sort of information that can make them able to understand and evaluate financial statements and especially readers of financial statements of banks need extra information which won t announce to the folks. These users are interested in reading about liquidity, solvency and risks of assets and liabilities in the balance sheet and off- balance sheet items. Philip M. Linley and Philip J. Shrives (2005) have discussed about disclosures for users, who like to be informed about the risk information. They have pointed to 5 basic and require characteristics of the disclosures transparency, which are: Timeliness, comprehensiveness, reliability, relevance, comparability and materiality When we say that comprehensive risk information should be disclosed, it means that they should be disclosed in the way that makes readers understand completely about the bank s risk situation. It doesn t mean that all the risk information should be disclosed, those, are not important and will not effect on the user s decisions shouldn t be disclosed. (Materiality) Information should be timely, which means they should be announced in their relevant period. In order the information to be relevant, banks should consider who will use the information because users need kind of information which is related to their decision making. Moreover, information should be reliable; it means they shouldn t misinform users, in other words information should be trustable. The last one is comparability, which makes users able to compare their information with all the banks in the same or different countries. They conclude that it is important to give useful risk information to the stockholders, in order to make them able to make a correct and accurate decision. They noticed that at present banks don t announce complete disclosures about risk information and they are not clear in this part and complete transparency is not possible because market is volatile, it means the prices are changing and if we disclose all information it wouldn t be reliable and it might lead to misinforming users. 5

6 However risk information disclosures could be enhanced by thinking to tell the best story of risk information in order to make all the users understand better and give them relevant information (relevant information means considering who will use this information) In addition they can be enhanced by knowing when users should be informed because of the volatility of the market. In relation with the literature above an unknown author in Emerald journal (2002) states that a fair value can enhance the transparency of the information in financial statements, this literature tries to show how fair value works and why we choose fair value to enhance the transparency of financial statements. Fair value is what we receive in the market It states that a fair value helps users to predict better by evaluating the reliable amounts, timing and uncertainty of enterprise s future cash-flows. In addition, applying fair values in the balance sheet can help users to make more accurate decisions rely on exposed risk information. Furthermore, reporting information by fair value can show the volatility of changes in value of financial instruments in market conditions and operation of enterprises. It concludes that according to its survey results, fair value measurements is needed for reliable and relevant financial statement and states that if enterprises (include banks and also other firms) measure financial instruments differently, financial information would be less transparent and incomparable. However, small and medium size enterprises may encounter problem because they don t access to the public capital market to indicate fair values. (Which would be a separate important problem and we are not going to debate about it in this study) Furthermore, it states that disclosures in balance sheet should be detail information about the nature of financial instruments and management s policies and disclosures in income statement should state changes in fair values separately but not completely and also risk information is very important to be disclosed for better judging of users and enhancing the comparability of financial statements. (Emerald journal, 2002) 6

7 Dominique Rachez 2 in related to this study states the different kind of risks that might be occurred in every firm and especially in banks which I would like to explain here: Typical risks arising from financial instruments: 1- Credit risk occurs when loans or other credits haven t paid by debtors. 2- Liquidity risk occurs when assets or securities cannot be traded or sold quickly in the market. 3- Market risk occurs when price of assets are fluctuated in the market Interest rate risk occurs when we have changes in the rate of interests Currency risk occurs when we have changes in foreign exchange rates Other price risk: share price occurs due to fluctuation of prices commodities price occurs due to fluctuation of prices Recovery risk occurs when investments won t be able to cover losses Prepayment risk occurs when homeowners pay off their mortgages early, for example when interest rates fall down 2 Dominique Rachez, lecture, 16 th of September 200 7

8 Methodology & Case study In this part we are going to discuss and interpret some parts of IAS 30 and IFRS7, but we are not going to state all the standard we just consider it with a different angle. This standard was approved by the IASB (International Accounting Standard Board) first time on the January of 1990 and then became operative on January of Then, on 1994 it was just reformatted but its text didn t change. Later, after so many deliberation and discussions with all the bankers and managers around the world, on 1998 this standard was revised by the changes in IAS39 and IAS 32.Finally, on August 2005, this standard was replaced by IFRS 7, which became operative after 1 st of January 2007; however there are still so many banks in different countries that haven t applied it yet. IAS 30 consider all banks and those enterprises : which are financial institutions, whose main activities are accepting deposits and borrow money with the purpose of lending and investing, which are in the area of banking and similar legislations.(barry j.epstein & Abbas Ali Mirza 2001); whereas IFRS 7 considers all enterprises and it doesn t separate banks. As we considered, information about liquidity, solvency and risks are very important to disclose in the way that could enhance the understandability of users of financial statements and make them able to judge accurately, but disclosures of banks are more than other enterprises disclosures, because they have to give their users some imaginations about the special characteristics of banks, their operation and their relations with related parties and also extra disclosures about different kinds of probable risks include risks related to the bank s balance sheet items and off balance sheet items, liquidity means the ability of banks in financing for depositors and commitments and solvency means excess of assets over liabilities and therefore adequacy of bank s capital. (Note that liquidity is different from liquidity risk) Banks may encounter liquidity risk or risk of currency fluctuations or interest fluctuations or risk of changes in market prices and partner s failure, these risks should be stated in balance sheet and if bank manager can state that how we will control these risks and give some solutions, it could enhance the transparency of financial statements and users can obtain good knowledge about the financial statements. (Paragraph 7, IAS 30) Banks uses different methods in measuring and recognizing of items in financial statements and related disclosures should be applied in financial statements and also according to IAS1 an entity should disclose the summery of significant accounting policies that are relevant to understanding of financial statements. (Paragraph 8, IAS 30) 8

9 These disclosures are divided to 5 categories: 1- Items in income statement 2- Balance sheet items 3- Off-balance sheet items 4- Different kind of risks 5- Transactions with related parties In the income statement users need to know about current income or losses and retain earnings and also they need to know about their components. For example one of the items of retain earnings is provision on loans and advancements which has to disclose in details. In balance sheet users need to know about kinds of deposits, loans, contingent receivables, current receivables and in general all assets and liabilities should be cleared and have transparent disclosures. Off-balance sheet items are the items that are disclosed in the notes, such as: changes in provisions, contingent liabilities or assets, types of loans and objectives of consuming money and types of collaterals. In this study we are going to focus on presenting of collaterals in the financial statements of banks and then we debate about some bank failures but at first it is important to explain about some items. A liability is a present obligation of the entity, arising from the past events. (IAS 37) A provision is a liability of uncertain timing or amount A contingent liability is a possible obligation of the firm that arises from the past events, which will be confirmed by occurrence or non-occurrence of one or more uncertain future events which may not be in the control of the entity, or a present obligation that arises from past events but it is not recognized because they couldn t be measured or it is not probable to determine an obligation for an out flow of economic benefits. (Britton and Jorissen 2007) 9

10 Contingent liabilities can be divided in to three categories: 1- Probable contingent liability which is likely to be or to happen but not necessarily; in such cases that we have present obligations that are expected to be paid, a provision should be recognized and information should be disclosed. Disclosures should represent the amounts, nature, uncertainties, assumptions, reimbursements of the contingent liability. 2- Possible contingent liability which the possibility of its occurrence is less than probable ones; in such cases, no provisions should be recognized but information should be disclosed and disclosures should represent the nature, estimation of financial effect, uncertainties and reimbursement of contingent liabilities. 3- Remote contingence liability which is unlikely to be occurred; in such cases neither provisions nor disclosures should be presented. A contingent assets is not recognized in the accounts but it is disclosed when the inflow of economic benefit is probable in other words when we expect to receive economic benefits, a contingent asset should be disclosed. In such cases disclosures should represent the nature and financial effects of a contingent asset. (Britton and Jorissen 2007) It is very important for users and especially for the stockholders to know about the secured liabilities and collaterals which are pointed out in IFRS7. According to ifrs7 an entity shall disclose: a) The carrying amount of financial assets it has pledged as collateral for liabilities or contingent liabilities, b) The terms and conditions relating to its pledge. IFRS 7 states that banks should disclose the terms and conditions related to its pledge First of all it should be cleared that what we mean by collateral; collateral usually is a kind of assets that banks receive from the borrower for the guarantee of their loan payments. If banks disclose what kinds of collaterals they have in their financial statements, investors and depositors can make more accurate decisions and it could enhance the transparency of financial statements. It is important for both the users of financial statements and banks to be careful about the types of collaterals, for example if most of their collaterals are checks or promissory notes, the credit risk will be surely enhanced because if the borrower for any reason can t pay for its loan, banks encounter with the lack of money and finally bank failures. 10

11 In addition collaterals shouldn t be the same because for example imagine when all of the collaterals are lands and buildings, in such cases when the price of buildings and lands fall down bank failure is inevitable. As an example we can mention one of the famous bank failures in America which its reason was giving large amounts of house loans and accepting buildings as collaterals. (It was a kind of contract that bank gave house loans provided that borrower will own the house after the complete payment of its loan). After giving the loans and accepting houses as collaterals, prices fell down and America encountered recession, then, it was not economical for the borrowers to pay the rest of their loans, so they preferred to give their houses back to the banks which had been accepted as collaterals. Therefore, banks encountered credit risk and a very serious problem which was about their liquidity; they couldn t sell these houses and they couldn t provide money for their depositors and finally the bank failure happened. The second example is about the operation of banks in Iran. In Iran similar problem has happened but the government has been able to control the losses to a large extent. The problem appeared when banks gave large amount of house loans and accepted collaterals such as: lands, buildings, cashier s checks and promissory notes and after that prices of houses and lands were fell down and Iran encountered recession, therefore, borrowers couldn t pay their loans and so many lands and buildings remained as collaterals which nobody was able to buy them and many cashier s checks and promissory notes was remained which their owners had been arrested, therefore providing money had been impossible for banks, thus, banks faced with the lack of money; however government began to solve the problem because in Iran we have national banks and government can intervene in the time of problems. The solution was reducing the rate of legal reserves. (Legal reserve is the amount of deposit which banks are obligated to give to the central bank.) Therefore, by the help of government after 3 years the rate of legal reserve was reduced from 32% to 18%! In addition government helped banks by buying their lands and buildings which no one was able to buy them. These government assistances cause banks to be saved from failure; however financial crises are seems to be continued. Most of the people are interested in investing in the banks of prosperous countries such as Sweden and Switzerland, and it is because these banks have a kind of popularity between people, people can trust them for providing money and they feel a kind of safety for their money. 11

12 According to my interview with Martin 3, one of the financial advisors of Swedbank in Karlstad, this bank has never encountered with the liquidity problem and he states that if we encounter with such problems, other banks will help us and we will borrow money from them and even if other banks cannot help us, it is the duty of the central bank of Sweden to help us and also if central bank encounter problem and cannot help us government will solve the problem. He also told me about the percentages of the negative interest rate which Swedish banks are obligated to pay to the central bank. This rate last year was 1.25% which is diminished this year to 0.25% and this reduction is because of financial crises, in these situations central bank of Sweden is helping banks to solve their problems. In addition if we want to analyze the reason that why Swedish banks haven t had such problems science now we should consider differences. 1- Interest rate on the saving accounts in Sweden is 0.75% whereas in Iran this rate is about 9% to 19/5%, (It should be mentioned that after the Islamic revolution, banks in Iran has obligated to follow Islamic rules and according to Islamic rules, giving interest is something forbidden, therefore banks don t announce a fixed percentage for their interests, they state that if we can obtain enough economic benefits then we pay all the percentage of the interest) 2- Swedish banks take higher fees for their services in comparison to the Iranian banks. These differences represent that Swedish banks spend less and save more sources of money, but a question arises here that why people are interested more to invest in such banks, despite all the higher fees and lower interests? To answer this question we should consider what motivates people to invest in such banks; According to my interview, Martin states that we offer personal contacts, meetings through the internet and when our clients come to us we spend our time to consult with them and we try to enhance their knowledge to make them able to analyze financial information by themselves, in addition we can say generally, people need safety, they need to be sure about a safe place for their money an also expecting that they will give their money back with extra amounts. In addition in today s fast digital world everything seems to be based on speed and efficiency, therefore people prefer to use popular credit cards despite all the fees that is expected to have. Furthermore, sometimes banks determine some gifts for saving accounts and it can be a motivation for people to put their money in such accounts. Accordingly we can conclude that bank s money recourses could be increase by motivating people in different ways and specially by enhancing their knowledge with more transparent disclosures and efficient bank services. 3 Martin, Financial advisor of Swedbank, interview on the 20 th of October

13 Conclusion We consider different types of users and the information that each type of users need to know and also explain 6 characteristics for disclosed information which are: Timeliness, comprehensiveness, reliability, relevance, comparability and materiality We understood that complete transparency is not possible because of the volatility of the market and because it is against of reliability of information; however it can be enhanced. Accordingly, we reviewed some ways for enhancing the transparency of disclosures of financial statements, which are: 1- Making a risk story in the way that users can understand risk information better. 2- Considering the time of presenting this information with the notice of volatile market. 3- Reporting financial instruments by their fair value is not only enhancing the transparency of information but it can show the volatility in the values of financial instruments given changes in the market. 4- Disclosing risk information and in contrary management policy about how to encounter the risk, clearly. 5- Disclosing collaterals with the broad explaining about the types and its value which is according to IFRS 7 fair value should be chose and also disclosing types of loans with clear explanations about their amounts and their period In addition, according to this study we can conclude that enhancing the transparency of financial statements has important benefits for both users and banks, which are: 1- Enhancing the understandability of users. 2- It causes users to make more accurate decisions. 3- It causes users to recognize where to investment and where not to investment, to feel more safety and more convenience. 4- It causes banks to receive more recourse of money and therefore reducing bank failures. We also consider three examples about banks in America, Sweden and Iran and as a conclusion we can say that at the moment that we are under the pressure of financial crises in all around the world, banks of prosperous countries like Sweden seems to be more successful. The reason could be: they have a strong providence, they spend less and save more but instead they provide efficient services to their clients and they convince people by keeping bank in a stable situation, they keep their clients satisfied and high motivated by spending time on them and enhancing their knowledge about financial information. Finally, we can say banks should motivate people with more transparent disclosures to make them able to make adequate decisions and also for banks to obtain more sources and enhance their liquidity for the times of risks. That way, they can prevent failures in the time of facing with financial crisis. 13

14 Bibliography 1-David Alexander & Anne Britton & Ann Jorissen, (2007).Provisions, contingent liabilities and contingent assets. In Thomson Learning.(ed).International financial reporting and analysis. London. Pp David Alexander & Anne Britton & Ann Jorissen, (2007).Basic of financial reporting. In Thomson Learning. (ed).international financial reporting and analysis. London. Pp International Accounting Standard Board, (2002). IAS30. London. 4-(2002).Financial instruments: fair values and disclosure. Emerald journal. 10(1), Philip M. Linsley & Philip J. Shrives, (2005).Transparency and the disclosure of risk information in the banking sector.journal of Financial Regulation and Compliance.13 (3), Barry J. & Abbas, (2001).Specialized industry accounting.wiley IAS 2001 interpretation and application.london.pp