Accounting Basics for Community Financial Institutions Chapters 3, 4 & 5 Presented by: Richard Rowe, Jr., CPA EVP and Treasurer Scituate Federal Savings Bank richard.rowe@scituatefederal.com FYI.. Many of the topics we will discussed today from Chapters 3, 4 and 5 are expanded upon in subsequent chapters. 2 1
Chapter 3 Accounting Uniqueness in Community Financial Institutions Unique characteristics While the accounting is similar from industry to industry, financial institutions have their own unique characteristics! 4 2
What is meant by unique characteristics? Financial institutions have no inventory. There is no merchandise to sell. This is significant when you consider that for the retail giant Target, inventories make up 20% of total assets. 5 So what are some of these unique characteristics? What financial institutions do is handle other people s money [OPM]. 6 3
OPM A financial institution receives OPM, usually in the form of a deposit and lends the OPM to borrowers. This line of business creates the unique characteristics. 7 Caveat Emptor Much of this chapter refers to checks and tickets. However, over the years, most financial institutions have sophisticated computer systems; some do not. In either case, the conceptual accounting issues discussed in this chapter do not change. 8 4
Some of the other unique characteristics: Daily balancing and posting to trial balance Single-entry tickets Continuous departmental accountability Proof functions Separate ledger and memo accounts 9 Daily balancing and posting to trial balance Customer s deposit and loan balances must be determined daily. Today a customer can obtain a balance within the day, i.e. on-line banking, VRUs. 10 5
Consider this The accounting cycle we discussed in Chapter 1 actually occurs daily, i.e., 24/7: beginning with analyzing each transaction through the preparation of the financial statements. 11 Recording deposits A deposit account is indeed a liability account because: The money belongs to the customer. The financial institution is merely safekeeping the customer s money. 12 6
Typical deposit accounting entries When a deposit is made the following entry is recorded: debit Cash 1,000 credit Deposits 1,000 The credit most likely will be to a specific type of deposit account, i.e. Checking or 6-month CD. 13 Deposit accounting entries, cont. When a withdrawal occurs, deposits are decreased by a debit and the following entry is recorded: debit Deposits 1,000 credit Cash 1,000 14 7
Balancing Deposits A separate subsidiary ledger exists for every customer within each deposit type. The subsidiary ledgers are maintained by each financial institution s core processor, service bureau or in-house system. 15 Balancing Deposits Sound internal control practices require a daily reconciliation of the subsidiary ledger deposit accounts to the general ledger control account. 16 8
Single-entry tickets Ouch! Sounds a bit dated because it is very likely that all of today s on-line systems have advanced beyond the single-ticket approach. 17 Single-entry tickets, cont. Those financial institutions using a single entry ticket approach do so to record cash transactions. Permits posting to one side of the entry. Determines the debits and credits to the individual and general ledger deposit accounts. 18 9
Single-entry tickets, cont. There are other tickets generated that do not involve cash, i.e., reversal of service charges, etc. 19 Continuous Departmental Accountability One department or branch can have accounts that are affected by activity in another department. This situation is common if a financial institution has done a good job cross selling services. 20 10
Continuous Departmental Accountability, cont. Some of the key features are: Security only authorized personnel can access accounts and make transactions. Control limited and authorized access to unused supplies of tickets, checks, etc. 21 Continuous Departmental Accountability, cont. Some of the key features, cont: Liquidity where negotiable instruments are held, individual accountability and constant balancing of transactions is mandated. 22 11
Time for terminology Drafts letter of instruction in which one party orders a financial institution to make payment to a third party. Checks a standardized demand draft, whereby the drawer of a check gives the financial institution written instructions to make a payment of funds against an account. 23 Time for terminology, cont. Certified checks offers greater assurance to the payee. the financial institution assumes liability and sets the funds aside in a separate liability account. The check is usually marked to prevent double processing. 24 12
Time for terminology, cont. Cashier s Checks Drawn on the financial institution, and exchanged for cash. When issued a liability account, such as Cashier s Checks is credited. Typically only sold to customers. Require strong controls over working supply. 25 Time for terminology, cont. Clearing and Exchange items checks deposited at one institution that are drawn on another institution. These checks must be presented for collection at the drawee financial institution by using a clearinghouse. 26 13
Proof Department A central unit in a financial institution that on a daily basis sorts, distributes, and arrives at control figures for all transactions. The check component to the proof function is typically outsourced. 27 Separate Ledger and Memo Accounts As previously discussed, a subsidiary ledger exists for all individual customer accounts which equal the general ledger control balance. Memorandum accounts for commitments and contingencies are maintained outside of the general ledger. 28 14
Chapter 4 Basic Business Functions and Risks of Community Financial Institutions Typical business functions Funding Lending Investing Fee-based services Support activities Internal accounting reporting and compliance activities 30 15
Funding Most funding comes from acquiring [retail] deposits through a branch network. 31 Funding Deposits are a very competitive source of funds due to: the abundance of financial institutions. alternative investments. 32 16
Funding, cont. As a rule, Deposits are a reliable source of funds. core deposits represent stable deposits not influenced by shifts in interest rates 33 Funding, cont. Deposits are either demand or time. both types are important to every financial institution. depending upon the interest rate environment the cost of each may differ significantly to the financial institution. 34 17
Demand Deposits: Yes, a liability account. Funds easily accessible to customer. Checking is the most common type, although there are many creative variations. Generally non-interest bearing. 35 Time Deposits: And once again, yes, a liability account. Two broad categories: Savings Certificates 36 18
Time Deposits, cont.: Savings: Funds in a savings account are easily accessible to customer. Pays a higher interest rate than demand deposits. 37 Time Deposits, cont.: Certificates: Maturity ranges from very short [3-months] to 3-5 years. Very difficult to acquire funds at the intermediate and long end of the yield curve. Pays a higher interest rate than savings deposits. A penalty is charged for early withdrawal. 38 19
Lending The primary business of a community financial institution!!! 39 Lending, cont. Similar to deposits, part of the attraction to loans is developing and maintaining a profitable relationship. 40 20
Lending, cont. Loans represent the disbursement of funds to borrowers who agree to pay back the principle and interest over time as scheduled. 41 Some of the more common loan types Fixed rate, fixed term conventional mortgages Adjustable rate mortgages Equity loans Commercial loans Personal loans secured, unsecured, auto, home improvement and education 42 21
Lending, cont. Regulation and compliance overload. Must adhere to fair lending practices. Limits established by type of loan and lending officer. Credit policies determined by each institution 43 Lending, cont. Loans or Loans Receivable are assets. When a new loan is closed: debit Loans Receivable 100,000 credit Cash 100,000 44 22
Lending, cont. At the end of each month interest earned is recorded: debit Accrued Interest Receivable 200 credit Interest Income 200 A perfect example of ACCRUAL accounting! 45 Lending, cont. When a payment* is received: debit Cash 1,000 credit Accrued Interest Receivable 800 credit Loans Receivable 200 * Assumes payment consists of principle and interest. 46 23
Lending, cont. Loans are carried on the books at the net realizable value. Every financial institution must provide for loan losses. Why? Not all borrowers will repay all or some portion of the amount borrowed. 47 Lending, cont. Estimated losses are recorded using a contra asset account called: Allowance for loan losses If the allowance is inadequate, an EOM adjusting entry is booked: debit Provision for Loan Losses 500 credit Allowance for Loan Losses 500 48 24
Investments Funds that are not converted into loans are invested in financial instruments. 49 Some of the more common investments US Treasury securities Federal agencies securities Mortgage-backed bonds Collateralized mortgage obligations Municipal securities Corporate securities 50 25
Investments, cont. Goals in order of priority: 1. Liquidity 2. Risk aversion [safety] 3. Income 51 Investments, cont. Before an investment is purchased both credit risk and market risk must be considered. Investment portfolios are managed with and without the assistance of fee-based external investment advisors. 52 26
Investments, cont. Concerns: credit risk issuer not able to repay principal and interest market risk security declines in value 53 Investments, cont. Other matters: Closely watched by management, accountants, auditors and regulators. Pledged as collateral: to borrow from a Federal Reserve Bank, or for repurchase agreements. 54 27
Fee-Based Services All activities that generate income based on service performed rather than based on funds loaned or invested. Fee-based services are revenue accounts. 55 Why Fee-Based Services? The difficulty sustaining net interest margin --- the difference between interest income and interest expense --- validates the importance of fee-based services. A financial institution can not survive on margin. Today s flat yield curve has taken a big bite out of the margin. 56 28
Fee-Based Services, cont. Customers may pay cash or an account may be charged for fee-based services. Some of the more common fee based services are: Sale of traveler s checks ATM usage fees Debit card fees Loan origination service fees 57 Support Services These are activities that are not directly related to the primary businesses of banking. Some of the more common support services are: Asset/liability management Audit Payroll Regulatory compliance 58 29
Internal Accounting, Reporting and Compliance Activities These are similar to support activities, but less directly related to line activities. Some of the more common activities are: Accounting for loans Pension accounting Off-balance sheet accounting and control Regulatory accounting and control 59 Chapter 5 Internal Controls in Community Financial Institutions 30
What are internal controls? If you work for a financial institution there is a distinct possibility that you have heard some reference to internal controls. 61 What are internal controls, cont.? Internal controls are the procedures management puts in place to: safeguard the assets, and ensure the accuracy and reliability of the financial statements. 62 31
The COSO Report COSO was formed to support the implementation of the Treadway recommendations. Internal control was defined as a process, affected by an entity s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: effectiveness and efficiency of operations reliability of financial reporting compliance with applicable laws and regulations 63 The COSO Report, cont. Some keys to internal control: Not a separate activity, but rather a series of activities. Effectiveness depends on people Provides only a reasonable assurance that the company s objectives have been achieved. A repetitive process 64 32
FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991. Applies to depository institutions with $500 million or more in assets. 65 FDICIA, cont. Some of the key components: Addresses the problems that occurred in the 1980 s and 1990 s. Regulators look favorably upon FDICIA requirements with respect to internal control and encourage all community financial institutions to comply. 66 33
SOX Sarbanes-Oxley Act of 2002. Applies to all public companies. 67 SOX, cont. Some of the key components: Prohibits outside [external] auditors from providing many outsourced services for the same company. In each annual or quarterly report filed, the financial institutions principal executive officer and principal financial officer must provide an internal control certification. 68 34