Improving financial statements of SoCBs

According to the latest available information as of September 30, 2014 the amount of classified loans with all banks and financial institutions in the country reached more than Tk 570 billion (57,000 crore) or 11.60 per cent of the total outstanding loan balance. As of December 31, 2013 the total volume of classified loans reached Tk 405.83 billion (40,583 crore) or 8.52 per cent of the total outstanding loans. So, within the nine months' period the amount of default loans increased by more than Tk 16,000 crore or Tk 160 billion. Not only in terms of amount but also in terms of percentage, the default loans increased abnormally within the last nine months. Out of the total default loans, a major part (almost 45 per cent) lies with the four state-owned commercial banks (Sonali Bank Ltd, Janata Bank Ltd, Agrani Bank Ltd and Rupali Bank Ltd). As per the latest published financial statements, the total amount of classified loans with the four state-owned commercial banks (SOCBs) reached Tk. 18,933 crore or 189.33 billion, which is more than 20 per cent of the total outstanding loans as of December 31, 2013. This percentage of classified loans excludes the amount of loans written off earlier. Recently a meeting held at the Bangladesh Bank advised authorities to reduce the amount of default loans through rescheduling, recovery and write-off. In this connection it is pertinent to mention that during the year 2012 the amount of non-performing loans (NPLs) with all the SOCBs increased abnormally and during the year 2013 the NPLs saw a significant fall. Despite the fall in NPLs in 2013 the volume of such loans again increased in the year 2014. All the NPLs are the corresponding assets of investors' investments in and creditors' receivables from the SOCBs. Investors of the SOCBs are the government of Bangladesh and creditors are the depositors. The loan balance represents almost 60 per cent of the corresponding assets of investors' equity and creditors' liability. To safeguard the interest of investors and depositors, there is no other alternative but to protect the loss of credit as well as publish material and true information for the investors and creditors so that they can take right decisions. But on review of financial statements of SOCBs it appears that there remains a serious lack of information in the published annual reports. For example, firstly, how did the NPLs decline in 2013 compared to that of 2012 as mentioned above? Nothing has been disclosed in the published financial statements. On analysis it appears that in 2013 the total balance of NPLs fell by Tk 6,628 crore or Tk 66.28 billion.  Although quantitative details about Tk. 6,088 crore or Tk 60.88 billion could be found from the financial statements, no narrative or descriptive explanations were available there on the change of quality of such a big amount of financial assets except Tk 2.45 billion (745 crore), which was removed from the classified loan head to be declared unclassified loans on a stay order of the High Court. But as per contents of the International Financial Reporting Standards, such disclosure was very essential. As per the International Financial Reporting Standards, a bank should disclose the terms of financial assets that would be been renegotiated and the accounting policy for financial assets that are the subject of renegotiated terms.
Secondly, on analysis of financial statements it is observed that during the last three years (2010 to 2012) a total of Tk 40,000 crore (400 billion) was disbursed over the aggregate amount recovered. As is the general practice, bank loans are sanctioned and disbursed mainly in consideration of two aspects. The first element is the project profile and the second element is security. The objectives of these two elements are completely different. The objective of the project profile is to assess the strength of recovery of loans with interest by analysing the potential viability and profitability of a project. On the other hand, the objective of security is to ensure recovery of a loan in the event of failure of a project. The assessment of creditworthiness of a project profile is a matter of judgment. It is completely a projection. It is very difficult to determine the future prospect of any proposed project or industry. Obtaining sufficient security before disbursement of a loan is a practical issue, it is not a projection. In view of the two elements of loan sanction, there arises the question: if any loan is disbursed without examining its pros and cons due to inability and if it turns into a non-performing loan, what is the problem with recovering the loan by selling the security? To answer this question it may be said that according to the information presented in the published financial statements the practical scenario is different. If we pay our attention to the last four years' performance as published in the annual financial statements of four state-owned commercial banks it is found that there is a serious information gap and sometimes it appears that information is not presented in the financial statement correctly. For example, the year-wise position of the total outstanding loan balance and the amount of secured loan is as follows:

From the above chart it appears that 77 per cent to 81 per cent loans are secured by sufficient amounts of security money i.e. loans are well secured. But genuineness of the amount of security creates confusion, when the information of security is compared with the loan recovery against loan write-off. The recovery position of non-performing and write-off loans of four SOCBs in last four years stood at Tk 13,569 million against the loan write-off of Tk 125,491 million. From the calculation it is clear that the average rate of recovery of four SOCBs in last four years from non-performing write-off loans is only 10.8 per cent. If we consider both the pieces of information given above simultaneously, it may be found that only 10.8 per cent loans were recovered by selling the security assets taken during disbursement of loans. This reveals that the loan recovery from security is only 13 per cent of its book value which is completely unbelievable. In view of the above information, it stands clear that the value of security which has been disclosed in the financial statements is not correct. One of the objectives of the International Accounting Standards for banks and financial institutions is to develop the accounting system aligning it more closely with risk management. In consistence with this view the International Accounting Standard has emphasised that information about credit quality should give a greater insight into the credit risk of assets to help users assess whether such assets are more or less likely to become impaired in future. With a view to complying  with this objectives, banks and financial institutions should disclose in their financial statements the policies and processes for valuing and managing collateral and credit enhancements obtained, a description of the main types of collateral and other credit enhancements, the main types of counterparties to collateral and other credit enhancements and other creditworthiness, information about risk concentrations within the collateral or other credit enhancements and an analysis of impaired financial assets by class. The analysis may include the nature and fair value of collateral available and other credit enhancement obtained to describe collateral available as security it holds and other credit enhancements obtained.
Thirdly, on analysis of the last four years' financial statements of all SOCBs it is observed that there remain questions as to how far the performance of loans is presented in the financial statements correctly. Earning interest is the main performance indicator of a loan. As per accounting norms in the income statement of a bank, interest is accounted on the accrual basis and in the cash flow statement interest is shown by the amount which is realised in cash. According to the accounting formula, the main difference between interest received in cash and interest earned on an accrual basis is the interest due for collection and interest received in advance. Considering the reasons of difference between interest accrued and interest received in cash it can be said that the amount of such difference will not be very substantial. Information as mentioned above relating to four SOCBs is presented below:

The above statistics reveals that almost for all the cases there remains a big difference between accrued interest income and interest received in cash. Especially if we pay our attention to the figure related to the year 2013, it can be seen that interest received in cash one and a half times the accrued interest, which denotes the upcoming year's interest i.e. interest for the year 2014, has been realised in advance during the year 2013. It is quite impossible for the bank, where the rate of non-performing loan is more than twenty per cent, to collect half the year's interest in advance. So, without any doubt it may be said that neither of the figures as mentioned above is correct.
 Fourthly, another important element of financial statements is irrevocable letter of credit, which is shown under contingent liability. During the last four years the balance of letters of credit (LCs) of four SOCBs was as under:

From the above chart, it appears that changes took place as regards to the balance of LCs during the last four years. No break-up or any other quantitative or qualitative disclosures are available in the financial statements as to LCs, which reveals that due care or attention was not given to recognition, measurement, presentation and disclosure of the volume of LCs. But we will have to keep in mind that an LC is not a contingent liability like others. It is the initial stage of a funded loan facility. If any new project is accepted for funding by a bank as the first step of such funding, an LC is opened for importing machinery. Before shipment of such machinery, the bank normally makes payment by creating a loan facility named Payment against Document (PAD). In this way the loan is created in the name of a borrower. So, the balance against an LC is not simply a contingent liability as off-balance sheet items. If we look at the year-wise balance of LCs, it may be seen that during the year 2012 the LC balance decreased by the amount of more than Tk 50 billion (5,000 crore). On the contrary, if we look at the balance of loan of the same year, it may be observed that the loan balance increased by the amount of more than Tk 100 billion (10,000 crore). So, there might have been a correlation between the decreasing LC balance and the increasing balance of loan i.e. the LC balance might have been converted into a loan. As per contents of the relevant Bangladesh Financial Reporting Standard (BFRS) relating to the contingent liability i.e. letter of credit, the bank should give a brief description of them mentioning nature, the estimate of its financial effect, an indication of the uncertainties relating to the amount of any reimbursement that needs to be disclosed. To avoid credit risk of the bank and to comply with the contents of BFRS, it is essential to disclose detailed movement, explanation, a major list of newly added LCs with necessary terms and conditions and adjustment or reduction of LC balance with necessary explanations.
Finally, we will have to keep in mind that disbursement and recovery of a loan are the responsibilities of the credit department; managing the credit risk is the responsibility of other relevant departments of banks and financial institutions, but the responsibility of the accounts and finance departments of banks and financial institutions is to prepare a general-purpose financial statement, which covers the objective of providing financial information about the reporting entity that is useful for the existing and potential investors, lenders and other creditors in making any decision about providing resources to the entity.
To protect the loss of credit the accounts and finance departments of state-owned commercial banks should play a vital role by recognising the loan, measuring the amount of loan, presenting the loan balance in financial statements and disclosing all the relevant and material quantitative and qualitative information in the financial statements in accordance with the International Financial Reporting Standards. Branches are authorised to disburse loans by following all formalities and all the branches of banks are independent. The branch managers are responsible for preparing financial statements. The accounts department at the head office only performs the functions of consolidating all the branches and preparing financial statements of the banks. So, the original financial statements of banks are prepared by the branch management. But how far the personnel responsible for preparation of financial statements for their branches by ensuring proper recognition, measurement, presentation and disclosure as required by the International Financial Reporting Standards adopted by the Institute of Chartered Accountants of Bangladesh as BFRS are knowledgeable and capable is open to question. Since individual branches' financial statements come into question as to their preparation on the basis of the BFRS, the consolidated financial statements of the bank are also come into question. A lot of information which is important for the users of financial statements is not disclosed properly. As per Note-A of Schedule xi under Section 185 of the companies act, all material information that is necessary for making the balance sheet clear and understandable should be disclosed. So, the non-disclosure of important information amounts to not only non-compliance with the BFRS but also violation of the law. Risk management is one of the objectives of the accounting standard adopted for banks and financial institutions.
As part of ways and means of such risk management, emphasis has been laid on valuation and disclosure about collateral securities and all the documents and records. So, to get the real picture of the disbursement of loans, recovery, classification, security and letters of credit, extensive audit needs to be conducted at the branch level. Without knowing the fact or real picture of each and every loan, mere rescheduling and writing off any loan balance to reduce the amount of default loan will not bring any fruitful result. As the regulator of the banks and financial institutions, the Bangladesh Bank should take effective steps to bring all the branches under audit by the Chartered Accounting (CA) firms immediately.
The writer is chartered accoun-tant, council member and
ex-vice president of the Institute of Chartered Accountants of Bangladesh
 sha.hossain@gmail.com