Financial Statements Training for Volunteers

June 2011

Disclaimer - attendance at this seminar will not make you a CPA. - attendance at this seminar will not give you a Masters degree in accounting.

Michael J. Schmidt, CFE, CPA

Michael J. Schmidt has been a credit union auditor for 25 years. For the past18 years he has been the president of Schmidt & Associates, Inc. an accountingand auditing firm that exclusively serves the credit union industry. He graduated with his bachelors degree in accounting from Eastern Michigan University in 1985, and his masters degree in Fraud and Electronic Crime Management from Utica Collegein 2007.

He has been a certified public accountant since 1988 and a certified fraud examinersince 1999.

Contact Information:Schmidt & Associates, Inc. PO Box 2588Columbus, Ohio 43216(614) 529-1640Schmidt@Schmidt-and-Assoc.com

Introduction

Board members are required to read and understand the credit union'sbalance sheet and income statement.

Why?You are a board member of a financial institution, this being anumbers and financial company, board members should be ableto recognize trends and ask questions of management.

You should know what each line item represents, what is normal, andif the credit union’s number or ratio varies from the norm if thevariance is explainable.

Trends and ratios are used heavily in credit unions. If I say two credit unionseach have capital of $2,300,000 are they the same? Are they both good, or arethey both in trouble? The ratio tells us if the number is good or bad.

Note that peer is a range for credit unions, there is a difference between being at the top of the range compared to being at the bottom.

XYZ Credit Union

123 Credit Union

Capital $ 2,300,000 $ 2,300,000

Assets $ 23,250,000 $ 43,250,000

Net worth ratio 9.89% 5.32%

Well capitalized Under-capitalized

XYZ Credit UnionBalance Sheet

As of December 31, 2010

A balance sheet can be known as the statement of financial condition.A balance sheet is as of a specific time. It is a snapshot.

It is called a balance sheet because of the formula:

Assets = Liabilities + Members’ Equity

XYZ Credit UnionBalance Sheet

As of December 31, 2010

Loans $ 12,500,000 Principal balances owed by membersAllowance for Loan Losses (100,000) Expected losses in the next year

Net Loans 12,400,000

Accounts Receivable 50,000 Short term funds owed to CUCash 100,000 Tellers, vault, and ATM cash

Cash in Banks 1,000,000 Corporate, money markets, etc.

Investments 8,500,000 Short term for liquidityShare Insurance Fund 200,000 Deposit with NCUSIF or ASI

Prepaid Expenses 100,000 Expenses that benefit a period of time

Fixed Assets 800,000 Land, building, furniture & equipment

Accrued Income 50,000 Income earned but not yet receivedAssets Acquired in Liquidation 40,000 Collateral on loans that the CU ownsOther Assets 10,000 Deposits

Total Assets $ 23,250,000

XYZ Credit UnionBalance Sheet

As of December 31, 2010

Accounts Payable $ 50,000 Short term funds the CU owes

Accrued Expenses 100,000 Items that are owed but billed in future

Notes Payable - Borrowed funds

Other Liabilities 50,000 Clearing accounts 200,000

Shares to Members 20,750,000 Shares, drafts, IRAs, money market, certs

Net Worth 2,300,000 Statutory reserves, undivided earnings

Total Liabilities and Equity $ 23,250,000

XYZ Credit UnionIncome Statement

For the Year Ended December 31, 2010

Interest on Loans $ 900,000Income on Investments 170,000 Total Interest Income 1,070,000

Dividends on Shares (200,000)Interest on Borrowed Funds -0-___ Total Cost of Funds (200,000)

Interest Margin 870,000

Fee Income 200,000Other Income 75,000 Total Non–Interest Income 275,000

Expenses (see next slide) (1,065,000)

Net Income $ 80,000

XYZ Credit UnionIncome Statement

For the Year Ended December 31, 2010

Comp & Benefits $ (360,000) salaries, insurance, payroll taxesTravel & Conf ( 10,000) volunteer & staff educationOccupancy ( 60,000) rent, utilities, prop taxes, bldg depr.Operations (285,000) postage, telephone, ATM, debitEducation & Promo ( 25,000) member education (marketing)Loan Servicing (150,000) credit reports, recording feesProf Services ( 15,000) legal, auditProv for Loan Losses ( 90,000) fund the allowance for loan lossesMember Insurance ( 55,000) corp stabil, NCUSIF premiumOperating / Supervision ( 5,000) regulatorsOther Expenses ( 10,000) annual mtg, association dues Total Operating Exp $ (1,065,000)

XYZ Credit UnionRatio AnalysisPower Ratios

Net Worth Ratio

Statutory Reserves + Undivided EarningsTotal Assets

2,300,000 = 9.89% 23,250,000

Congress defined well capitalized as 7%. (can be higher for complex credit unions)

6% = adequately capitalized, 4% = undercapitalized. If you are undercapitalized you will need a capital restoration plan approved by the regulators.

Net worth above 7% allows the credit union the ability to weather a storm. For example a bad recession. This is why I refer to it as a power ratio, it buys you time if you’re losing money, or allows you to grow.

XYZ Credit UnionRatio AnalysisPower Ratios

Return on Assets

Net IncomeAverage Assets

80,000 = 0.34% 23,250,000

Net income must be annualized. If you are using income for the month multiply by 12 to annualize.

Return on assets is a power ratio because earnings are the only way to increase net worth which allows a credit union to grow.

How these Power Ratios Work Together

If the board wants to maintain capital and they want the credit union to grow, the return on assets ratio can tell us what our rate of growth should be.

By moving the decimal to the right one place, the 0.34% return on assets becomes a growth rate of 3.4%. If the credit union grows faster than 3.4%, net worth will be depleted.

The rule works in reverse. If the board sets an annual growth rate of 9%, the return on assets required can be calculated by moving the decimal to the left one place. The 9% growth rate equates to a required return on assets of 0.90% to maintain net worth.

• Select Ratio Analysis

Delinquency Ratio

Delinquent LoansTotal Loans

150,000 = 1.20% 12,500,000

Delinquent loans are calculated for the purpose of this ratio to include loans over 2 months delinquent.

Caution should be used when making decisions based on this ratio. A credit union heavy in real estate loans may have low delinquency, but also may have a lower yield on loans.

A small credit union can see this ratio move a lot from month to month because one or two members can cause the ratio to change dramatically.

Select Ratio Analysis

Net Charge Off Ratio

Charge offs – RecoveriesAverage Loans

100,000 = 0.80% 12,500,000

This ratio needs to be annualized.

If XYZ Credit Union has a net charge off ratio of 0.80% and ABC Credit Union has a net charge off ratio of 0.20%, which credit union is doing a better job?

That was a trick question.The proper answer is that I did not give you enough

information.

Yield Net Net

on Loans Charge offs Yield

ABC CU 5.50% 0.20% 5.30%

XYZ CU 7.20% 0.80% 6.40%

From this example XYZ has four times the amount of charge offs, yet they still make more money on their loans. Why?

ABC may have more A credit borrowers with lower rates and lower delinquency.

ABC may have a different loan mix, heavy in real estate loans, whereas XYZ may be more of a consumer lender.

Select Ratio Analysis

Loan to Share Ratio

Total LoansTotal Shares

12,500,000 = 60.24% 20,750,000

This ratio is especially important in a low interest rate environment. The peer is yielding 6.57% on its loan portfolio while yielding 1.85% on investments. This means that a loan generates 4.72% more interest. A 10% increase in XYZ Credit Union’s loan to share ratio equates to $2,075,000 in additional loans. This increases income by $97,940. Considering that XYZ’s net income for the year was $80,000, this increase is significant.

Select Ratio Analysis

Operating Expense Ratio

Operating Expenses 975,000 = 4.19%

Average Assets 23,250,000

Net Operating Expense Ratio

Operating Expenses – Fee Income 775,000 = 3.33% Average Assets 23,250,000

Operating expenses do not include dividends or provision for loan losses.

This ratio must be annualized.

I use the net operating expense ratio. I believe this to be a more fair comparison if comparing to other credit unions or the peer. The reason is that one credit union may have a service such as drafts, it is only fair to be able to reduce the expense by the income generated (NSFs).

Select Ratio Analysis

Fixed Asset Ratio

Fixed AssetsTotal Assets

800,000 = 3.44% 23,250,000

Credit Unions are generally limited to 5% of assets in fixed assets. 5% of XYZ Credit Union’s assets is equal to $1,162,500. This means XYZ is under the limit by $362,500. This can be helpful if the board is considering expansion.

Select Ratio Analysis

Liquidity Ratio

Cash + Investment under 1 yearTotal Assets

4,100,000 = 17.63% 23,250,000

State chartered credit unions must exceed 10%.

Select Ratio AnalysisProductivity Ratios

Assets 23,250,000 = $ 2,447,368

Full Time Equivalent Employees 9.5

Members 4,200 = 442

Full Time Equivalent Employees 9.5

Salary & Benefits 360,000 = $ 37,894

Full Time Equivalent Employees 9.5

Once again be careful with these ratios. There are several factors that could make these ratios not comparable.

If a credit union has not purged membership or has a high number of $5 accounts, the number of members may be inflated.

If a credit union has an employee that works 10 hours per week they are still counted as half an employee.

A credit union with multiple locations may have a higher number of employees than a single location credit union.

Select Account DetailsLoans

Common Types• New Vehicle• Used Vehicle• 1st Mortgage• 2nd Mortgage• Home Equity• Share Secured• Other Secured• Credit Card• Commercial

Open End – this means that the member has a limit that can be advanced. Credit cards and home equity loans are examples. The difference between the loan limit and the loan balance is a loan commitment.

Closed End – this loan type has a specific end date.

Select Account DetailsLoans

Common RisksDefault risk – the risk that the member does not

pay.Interest risk – the risk that a change in interest

rates causes the loan to lose money in the future. The longer the term of the loan, the greater the risk.

Example of interest rate risk.The credit union offers 30 year mortgages. The credit

union decides that these loans are safe because they have had no mortgage loan losses. In 2010 XYZ Credit Union increased its 1st mortgage portfolio to $10,000,000. The credit union charges 5.50% on 1st

mortgage loans. When subtracting 0.86% cost of dividends and 3.72% operating expenses the credit union nets 0.92% on these mortgage loans (good job).

Select Account DetailsLoans

Now five years pass; and some things have changed, interest rates return to the 1970s rates.

The mortgage loans are still yielding 5.50% since they were at a fixed rate. The credit union has done a great job of holding expenses at 3.72%. The cost of funds have gone up substantially because rates have gone up and the cost of dividends is now at 6%. A 1st mortgage in this market would be at 12%. Now when the 3.72% operating expenses and the 6.00% cost of funds are subtracted the net return is a negative 3.22%, not so good.

Example of default risk changes.

In 2005, 50% of the credit union’s loan portfolio consisted of vehicle loans, of these 80% were A paper. In 2010, 50% of the credit union’s loan portfolio was in vehicle loans, of these 30% were A paper. The C, D, and E paper went from 5% of the vehicle loans in 2005 to 50% of the vehicle loans in 2010. It is likely that the default risk went up even though the portfolio composition stayed the same.

Select Account DetailsAllowance for Loan Losses

This account is used to fund the amount of time between when the adverse event occurs in a member’s life that puts collection of a loan in jeopardy and when a loss actually occurs.

Since it is impractical for a credit union to evaluate each loan individually, the accounting standards allow for loans with similar characteristics to be pooled together to determine a loss rate for that pool. Generally the larger the credit union the more pools they will have. A small credit union may only have 2 pools secured loans and unsecured loans. In a large credit union indirect new vehicle loans granted with C paper may get their own pool.

In addition to pooling individual classification is used for loans that are too unique to be pooled. Common examples of these are commercial loans or large real estate loans.

The third component would be economic conditions. If the pooling method uses historical data for the past three years while the sponsor company’s employees are working overtime and now there are layoffs, historical data may not be enough.

The Board should be careful. This account uses a great deal of estimation and management assertions. If examiners and auditors are repeatedly telling you that the account is underfunded that should be a red flag.

Select Account DetailsInvestments

Common types.Certificates of DepositsNegotiable CertificatesUS Government and Federal Agency SecuritiesMortgage Backed Securities

ClassificationsHold to Maturity (ability and intent is not to sell)Available for Sale (may choose to sell for liquidity reasons)Trading (buy and sell regularly – rarely used)

Accounting & ReportingHold to Maturity – recorded at cost (market value on investment report)Available for Sale – recorded at market value on balance sheetTrading - recorded at market value on income statement also

If your investments are recorded as hold to maturity, management should not be selling them.

Select Account DetailsInvestments

Common risks.

Default risk -- Most credit unions do not buy investments with high default risk.

Interest rate risk -- Once again the longer the term the greater the interest rate risk. Although available for sale may appear to reduce some of this risk, be careful, the credit union may still be reluctant to recognize a loss on investments.

Premiums are an adjustment of interest rate. If an investment has a coupon rate of 6%, but the current market rate for that term and level of risk is 4%, the seller will sell the investment at a premium. When the market is working properly the net of the coupon rate and the amortization of the premium (the yield) will equal the market rate (4%).

Discounts are an adjustment of interest rate. If an investment has a coupon rate of 2%, but the current market rate for that term and level of risk is 4%, the seller will sell the investment at a discount. When the market is working properly the net of the coupon rate and the amortization of the discount (the yield) will equal the market rate (4%).

Call dates are dates in the future, but before the maturity date, that a party to the investment can force an early maturity.

Select Account DetailsFixed Assets

Common types.Land not depreciatedLand improvements landscaping, parking lotsBuildingBuilding improvements additions, remodelingFurniture desksEquipment data processing

Fixed assets are depreciated because the property will last for several accounting periods, therefore the cost of the asset will be spread over the period of time that the credit union benefits from the asset.

As noted earlier the amount of fixed assets should be below 5% of total assets.

Periodic inventories should be done for two major reasons: The first reason is to determine that assets on the books are still being utilized by the credit union. The second is to determine that nobody has taken a credit union asset.

Select Account DetailsAssets Acquired in Liquidation

Assets acquired in liquidation is the transfer of ownership of collateral from the member to the credit union.

This is required for vehicles, but many credit unions ignored the requirement because it was immaterial to the financial statements and because of the short time between repossession and subsequent sale of the vehicle.

The increase in foreclosures has caused credit unions to begin recording assets acquired in liquidation.

Assets acquired in liquidation are carried on the balance sheet at the LOWER of cost or the fair market value less selling expenses. Example – XYZ Credit Union has a 1st mortgage on a home with a loan balance of $150,000. After meeting with a local realtor the fair value (selling price) was determined to be $100,000. Expected selling expenses are $5,000. The Credit Union will charge off $55,000 of the loan and transfer the remaining $95,000 to assets acquired in liquidation. The house is later sold for $85,000, the $10,000 loss is recorded as loss on sale of assets.

Complex Credit Unions

Generally adequately capitalized credit unions have 6% of assets in net worth. An additional 1% of net worth increases the status to well capitalized (remember our power ratio). This is true for non-complex credit unions.

A complex credit union has certain characteristics that requires additional net worth. Page 12 of the quarterly call report details the risk based net worth requirement to be considered adequately capitalized. The following are assets that require additional net worth:

Long Term Real Estate Loans.The first 25% of assets in long term real estate loans require net worth of 6%. Any real estate loans above 25% of assets require net worth of 14%.

Member Business Loans.The first 15% of assets in member business loans require net worth of 6%.The next 10% of assets in member business loans require net worth of 8%.Any business loans above 25% of assets require net worth of 14%.

Long Term Investments.Investments maturing in under 1 year require net worth of 3%.Investments maturing in 1-3 years require net worth of 6%.Investments maturing in 4-10 years require net worth of 12%.Investments maturing in over 10 years require net worth of 20%.