How small banks manage financial risk

Risk management is the process of limiting risk while maintaining or growing bank profitability. Assessing risk in a small bank is an ongoing function as the banks clients' credibility can change over time. The same is true for business patrons since local markets and economics can also fluctuate based on various supply and demand trends, competition, lending rates etc. 

Risk management for small banks is achieved through implementing a number of risk management procedures that address the various areas of banking risk. This article will address the different types of risks small banks face and how these risks can be ameliorated for the benefit of the banks ownership and operational performance.

Types of small bank risks

Included in the types of bank risks facing small banks are 1) credit risk, 2) interest rate risk, 3) liquidity risk and 4) price risk. (Fraser, Gup and Kolari, p.9) These risks are linked to the banks solvency, investments, lending and borrowing rates, and clientele. If these risks are too high, the banks net income can decline through written off asset accounts, lowered revenue, and in some cases the bank can face undercapitalization. To illustrate the above credit risk, if small bank A makes credit loans to 100 customers, 25 of whom have less than excellent credit, the bank is taking on more credit risk than it would if all 100 customers had excellent credit.

The above credit risk scenario leads to another risk, specifically underperformance. For example, if bank A's management decides it does not want a high credit risk and instead only lends to customers with excellent credit the risk of underutilizing capital emerges if not enough customers with high credit borrow the same amount of money that would have been lent if people with less than perfect credit were allowed to borrow from the bank on credit. Thus, the adept risk manager will be experienced and knowledgeable enough to realize what adjustments to the bank's credit policy will lead to the highest lending return with the least amount of risk for that return. This is accomplished in part by effectively measuring risk.

Measurement of small-bank risk

Risk can be measured partly with the aid of 'risk ratios' which are usually simple division based mathematical scenarios that focus on specific aspects of the banking operation. For example, risk ratios address small bank concerns such as 1) capitalization, 2) liquidity 3) operating efficiency, and 4) interest rate sensitivity. (Fraser, Gup and Kolari, p.76-80) Moreover, capitalization ratios quantitatively determine how much money a small bank has set aside for loan charge offs in relation to the amount of loans made. 

This is calculated by dividing the loan loss reserve of a bank by the total dollar amount of loans. Risk management theory can be extensive and involved for the purpose of focusing on sufficiently accounting for and dealing with unnecessary risk. The result of this theory yields a number of risk management case studies and forumulaic, quantitative and qualitative measurements with statistical probabilities of success and viability in some cases. Essentially, if the risk a small bank faces can't be measured, that risk becomes a greater hazard to the bank, hence the need for risk management metrics.

Implementing risk management

Implementation of risk management policy involves developing a risk management bank policy that takes into account risk management metrics/measurements with the goal of profit optimization. This requires the bank's management to accurately record, monitor and forecast financial scenarios in which the bank can operate safely and profitably. The task of risk management is performed well when the small bank manager has a firm comprehension and sensitivity to the quantitative and qualitative factors within the banking industry. Over time, experience and knowledge of the banks capacity combined with adequate metrics and forecasting may yield a successful risk management policy that provides the bank with the financial security and success it often seeks.

Additional forms of risk management involve Federal regulatory policies that impact how a bank can borrow and lend funds, the services the banks can provide and how banks disclose information to their clients and the government for insurance and consumer protection purposes. Still further risk management positively affects the banks legal positioning through sound compliance with banking law in addition to strong public relations that can assist with lowering a banks reputational risk. Technological risk is another area of risk that can be soundly dealt with through a banking information technology management.

Summary

Small bank risk management deals with sources of risk to a bank whether it be financial, digital, legal or social and implements risk management policies to prevent and lower the various types of risk that can affect a bank and as described in this article. Implementation of risk management requires the bank's management to monitor, assess and supervise the banking operation to ensure enhanced profitability, adequate capitalization, needed liquidity, regulatory compliance, public relations and unnecessary debt for the bank. Experienced bank managers are or should be familiar with the banking environment, market forces, banking policies and regulations and sound financial management to properly deal with the risks that can face a bank in its daily operations.

Sources:

1. Fraser, Gup and Kolari. 'Commercial Banking: The Management of Risk' 2nd edition' South-Western College Publishing, Cincinnati, Ohio. 2001.
2. http://www.chicagofed.org/banking_information/legal_reputational_risk.cfm
3. http://www.chicagofed.org/banking_information/risk_management.cfm
4. http://fic.wharton.upenn.edu/fic/papers/1096.html

The eifference between debt and equity financing

Companies use debt and equity financing to leverage capital expenditures, project development and operational expansion. Without leveraging company's financial growth is limited to retained earnings. For this reason debt and equity financing are often times considered vital to business expansion. Both debt and equity financing have advantages and disadvantages associated with them. This article will illustrate both forms of financing then come to a reasoned conclusion as to when and why each form of financing can be valuable.

Debt sources of financing

Debt financing includes collateralized bonds, debentures, business loans from banks, and lines of credit. Generally debt financing comes with an interest rate somewhere between 3-8% depending on the type. For this reason debt financing can be less expensive than equity finance depending on the expectations of the equity financiers. Debt financing may not always generate enough capital to perform intended business projects and goals as this type of financing tends to be more conservative in its lending requirements.

Equity sources of financing

When using equity as a source of financing a company is seeking capital from investors through the issuance of shares. These shares can be common or preferred i.e. having voting rights or priority in the case of company liquidation. Equity financing can also take the form of employee stock options which replace direct pay in the form of a corporate benefit. In the case of common and preferred shares, equity financing can be variable based on stockholder expectations and type meaning the higher the expectations, the higher the cost of financing.

Advantages and disadvantages of debt and equity financing

In business, both debt and equity financing have their advantages. Debt financing from financial institutions is subject to formal approval from lenders and monitored by organizations that rank the quality and credibility of corporate bonds. For this reason, debt financing can not only be a source of cheaper leveraging, but also an indicator of how viable a projects and goals actually are in terms of how convinced lenders and analysts are about the quality of the debt.

On the other hand, in a competitive market place, venture capital and equity financing can mean the difference between innovation, market share and a competitive edge. Often, such ventures can have more risk and therefore demand more return on investment making the financing more expensive. Nevertheless, if a business can garner a return on capital greater than the cost of goods and services including equity costs, then those projects become profitable.

Depending on the type of business, competitive ventures requiring excessive equity financing may simply be unnecessary, impractical or not in accordance with the goals of the business owners. In other words, not all businesses are designed to rapidly expand and yield growing profits on an annual basis. Businesses that simply intend on yielding a steady profit on an annual basis may benefit more from debt financing because of its structured and cost effective nature.

In the case of Equity financing, businesses that lack credibility, start ups and rapidly expanding businesses however may make positive use out of equity financing not only because it may be the only source of capital around but because it can provide the leverage necessary to accomplish the corporate vision.

Summary

Financing is a form of leverage not uncommon to most businesses in one form or another. Smaller businesses tend to use less, fixed or no equity financing due to corporate goals, cost of financing and business size. Contrarily, large high-powered industry leaders and high growth firms may find it essential to raise capital through equity financing to accomplish annual forecasts, corporate goals and owner objectives. Each form of financing has its advantages and disadvantages as this article has illustrated, but in the end financial leveraging is something that may be required for business survival and profitability regardless of cost.

Comparing Expense and Capitalization In Accounting

Accounting principles allow the purchase of large business items to be recorded on assets without cost other than depreciation expense on the income statement. In other words, the immediate cost of expensive business expenditures can be incurred over time via straight line or accelerated depreciation. This process is called capitalization of expenses and should not be confused with "capitalization" which is equity investment within a company.

Expensing is different from capitalizing of expenses because items i.e. assets or services are not depreciated in this method. Instead, with this accounting technique, when items are expensed immediately the costs are realized as a reduction to revenue rather than an increase to the liabilities of a company. If the expense is to be paid over a few months, all or part of it may become a short-term liability but will usually quickly become expensed as the debt is paid.

How to expense and capitalize costs 

To expense an item assets are debited if it is a product or prepaid service and liabilities are credited if the expense will payable in the future. If the expense is payable immediately, revenue is debited and cash is credited since revenue expenses are credit accounts and assets are debit accounts.

To capitalize and expense, assets are debited i.e. usually a long term or fixed asset and liabilities are credited. Then, as expenses are realized through depreciation, liabilities are debited and revenue is credited as an expense. Thus, instead of immediately lowering revenue and therefore profit calculations, capitalized expenses increase assets and liabilities for a balanced increase in both.

Advantages of expensing 

The advantages of expensing are not the same as those of capitalizing, however since capitalizing of expenses is only realized for larger expenditures the benefits of capitalizing expenses cannot be realized when expensing and vice versa. Below are a few of the advantages that may be realized with the expensing method:

• Increases to liabilities are short lived if accrual and do not occur if paid immediately
• Taxable income may decline more than a capitalized expense depending on the exact amounts
• Interest payments, if any, will likely be short lived
• May not involve as much bookkeeping requirements as large capitalized expense

Advantages of capitalization 

Capitalizing expenses is a little more complicated than expensing but can have advantages that aren't realized with expensing. These advantages may have a greater impact on a company because the monetary amounts of capitalized expenses are larger. A few of the potential benefits of capitalized expenses are listed as follows:

• Does not have as a dramatic effect on the income and income statement as when fully expensed.
• May encourage equity investments
• Interest and/or value changes of debt over time may end up costing less
• Has potential tax benefits that can add additional value and/or savings to the expenditure

Since many businesses don't operate with zero debt, looking into different ways of expensing purchases may be wise to an overall business strategy. Two such methods of expensing are short term expensing and capitalization expensing. The former is usually used with more current and/or revolving expenses such as pre-paid services whereas the latter usually applies to larger, more long-term expenditures such as buildings, and expensive equipment or machinery. Each method has unique advantages, bookkeeping requirements, and effects on financial statements and income numbers.

Sources:

1. http://www.answers.com/topic/capitalize?cat=biz-fin
2. http://www.admin.mtu.edu/admin/procman/ch2/ch2p9.htm
3. http://www.dwmbeancounter.com/tutorial/MouseQuizzes/Test4-1.html

What is cost accounting?

Cost accounting identifies, documents, implements and resolves business costs for both managerial decision making and financial reporting. Without cost accounting, businesses may have out of control expenses, inefficient business practices, excessive liabilities and no effective cost management systems and solutions. Just as financial accounting is regulated by General Accepted Accounting Principles (GAAP), cost accounting is also regulated by Cost Accounting Standards Cost Accounting Standards (CAS)

Cost accounting that encompasses a process of utilizing cost accounting information for improved business functioning is a helpful if not essential aspect of running a business competitively and efficiently. This article will discuss cost accounting in terms of 1. types of business costs, 2. cost accounting records, 3. cost management systems and 4. solutions for cost management.

1. Types of business costs

Business costs in cost accounting vary from industry to industry and the ideal business has no expenses, which is rare. The different types of costs incurred by a business reflect the management's decision making, the business products and services, and aspects of how a business is operated. Properly identifying business costs is helpful and necessary in preparing and analyzing corporate fundamentals. Some of the business costs handled by cost accounting are listed below:

• Manufacturing costs ex: Nuts and bolts
• Overhead costs ex: Lighting
• Variable and fixed costs ex: Nuts and bolts and salaries
• Direct and indirect costs ex: Paper used for invoices
• Sunk and opportunity costs ex: Investment in equipment

2: Cost statements and documents

What cost accounting also helps with is the recording and documenting of business costs. This process helps track costs every step of the way from origination, through completion of a product manufacturing, sale and service. Cost accounting statements and documents also provide regulators, investors and auditors with necessary financial information with which to analyze the profitability, accounting methods, accuracy and effectiveness of cost accounting systems. A few of the documents, reports and statements used in cost accounting are:

• Schedule of cost of goods manufactured ex: cost of completed product
• Schedule of cost of goods sold ex: costs of sold inventory
• Income statement ex: COG raw materials
• Job cost record ex: costs of work in progress
• Balance sheet ex: product and period costs

3. Different cost management systems:

Cost accounting also uses what is referred to as 'cost management systems'. Cost management systems 1. define how costs are identified, 2. organize the method by which costs are recorded and 3. assist in reviewing and improving business costs. These cost management systems are used in various aspects of business operations to properly account for, record and identify business costs. Some of these cost management systems are cataloged hereafter:

• Actual and normal costing: ex. Average and exact water used cleaning lettuce
• Activity based costing: ex: cost of electricity used shredding
• Product costing systems ex: average cost of boys and girls bicycles
• Job order costing: ex: manufacturing cost for custom furniture
• Cost allocation and cost classification: Cost per apple vs apple picker cost

4. Solutions for management:

Without solutions for cost management, cost accounting hasn't completely fulfilled its task. In other words, identifying, methodologically assessing costs and recording costs do not necessarily help a business improve.  Rather, solutions to cost management problems may be needed frequently or occasionally depending on how much a market and business environment change. With changes in prices, equipment capacity, training, know how and product manufacturing, also come possible changes to the cost accounting that studies these things.

• Restructuring of capital management
• Identification of redundant costs
• Redesign of cost systems
• Improved day to day operations techniques
• Enhanced sourcing and implementation of cost items

Sources: 

1. Hilton, Ronald 'Managerial Accounting: Creating value in a dynamic business environment' 5th ed,  McGraw-Hill, 2002 Chapters 1-6.
2. http://www.fasab.gov/ (Federal Accounting Standards Advisory Board)
3. http://fast.faa.gov/archive/v1198/pguide/98-30C14.htm (Federal Aviation Administration)

Accounting And Its Many Aspects

Accounting involves the taking of financial information and organizing it in ways that are representative of fiscal scenarios at given points in time. In other words, accounting re-configures financial data into things like spreadsheets, account records, financial statements, financial reports, forecasts analysis etc. This enables business owners, managers, financial analysts, government agencies, shareholders, clients etc. to be more aware of events as represented through accounting.

Accounting is regulated by federal acts of legislation and generally accepted accounting principles GAAP. Specific titles within legislative Acts govern how particular aspects of the practice of accounting is carried out. For example, public corporations may be required to produce financial statements every three months and those financial statements should generally conform to standardized accounting principles, be audited and accurate.

The field of accounting is quite broad and spans a number of areas such as managerial accounting, tax accounting, financial accounting, cost accounting etc. The profession can involve significant training, has varying levels of expertise, and requires considerable accuracy, diligence and passion for numbers and organizing of numerical information. Important aspects of accounting education, compliance and regulation can be summarized categorically in the following sections.

Accounting classes

Business schools and professional training programs offer accounting classes at various levels. These classes can help prepare the individual for a career in accounting by equipping them with the necessary know how, and skills. Accounting classes can also be taken through online programs.

Accounting courses

Accounting courses are a series of individual classes that focus on a specific topic or course of curriculum. Courses in accounting are taught by instructors and/or professors and are sometimes part of an accounting program. Completion of an accounting course may allow an accounting student to receive educational credit.

Business accounting

In the field of business, certain types of accounting methods and techniques are utilized. Business accounting involves invoicing of clients, maintaining of client and creditor account records, preparation of account statements and paying of bills. Other aspects of business accounting involve tax reporting, cost analysis, account research and financial organization.

Accounting education

To become familiar with the practice of accounting, and education is often necessary. Accounting education may include a series of workshops, a single class, a course or a program and is aimed at the task of learning and achieving knowledge of aspects of accounting.

Online accounting

Accounting classes can be taken online through online schools. Accounting can also be practiced online through educational accounting simulations or real life online applications. Online accounting makes use of the internet to learn, practice and engage in accounting via world wide web resources.

Accounting training

New jobs and careers in accounting may require one to retrain despite an existing knowledge of accounting. For example, a company may use a different accounting software and/or accounting record-keeping system making the need to train necessary. Accounting training may be provided by colleagues or professional trainers.

CPA review

Certified Public Accountants (CPA's) must pass an accounting examination to achieve licensure. CPA review helps examinees prepare for the CPA exam with greater confidence and knowledge. CPA review may also involve study of previous CPA exams and specific content requirements recommended by the American Institute of Certified Public Accountants (AICPA).

Nonprofit accounting

When a business is non-profit it is not allowed to retain earnings as profit. This can have a considerable impact on the financial accounting and record-keeping practices of a non-profit organization. Additionally, non-profit businesses are subject to different accounting practices than for profit companies.

Sarbanes-Oxley compliance

The Sarbanes-Oxley Act of 2002 is a U.S. legislated system of accounting that institutes stronger accountability toward accurate financial reporting by public companies. It also aims to reduce accounting fraud through stronger audit mechanisms, penalties, and greater executive affiliation with the accounting process.

Financial reporting

Companies that pay taxes, have shareholders, boards of directors and managers utilize financial reporting as a means of analyzing, organizing and complying with accounting regulations. Financial reporting helps a company and its owners measure financial performance and allow tax authorities to assess corporate observance of tax law.