On February 2, 2018 one story splashes on the newspaper of China that changed the fate of banking industry. It was related to the loan fraud done by the largest banking institutions, for which they were heavily penalized by the banking regulators. As per the news, the criminals had taken loans from the large state lenders such as Industrial and Commercial Bank of China Ltd and Postal Savings Bank of China Co by illegally pledging the low purity gold. This was identified by the regulators and the same lead to the third major penalty in the start of the year worth 52.5 million ($8.36-million) Yuan on 19 banks across the country. It was also mentioned in the news that according to China Banking Regulatory Commission (CBRC), there was lack of internal control and poor management of loan and collaterals on the end of banks involved in the scam. Further, the commission stated that the financial institutions were so much focused on developing their business that they neglected and avoided the background of their customers (Reuters 2018).
The news highlights that due to the poor risk assessment and weak legal framework the banking system suffer from ‘ghost collateral’. It means a security appears to be on books but does not exist in real. The regulators uncovered illegal trading of bank bills worth 7.9 billion Yuan and penalized 12 banks for the same. It has been seen that three branches of PSBC were fined 10 million Yuan for being involved in the loan fraud. In addition, four branches of ICBC were also got fined worth 6.5 million Yuan for its involvement in the same scam. Furthermore, 104 bank employees got punished as said by the regulators. Overall, the crux of the story is granting illegal loan to criminals cost a lot to the large banking institutions of China (Caixin. 2018).
Industrial and Commercial Bank of China Limited is a multinational banking company engaged in providing financial services to the country. It is considered as the largest bank of the world in terms of total assets and is included in the Big-Four state owned commercial banks of China. The company was founded on 1984 and ranks first on the list of Forbes Global 2000. It provides various types of services related to banking, commercial and investment (Financial Times. 2012). It is focused on promoting and innovating reforms as well as engaged in developing retail finance, asset management and other businesses to stimulate profit growth for the institution. The financial highlights of ICBC reflected the total assets worth RMB 24,137,265 million for the year 2016. During the same period, the company made net profit of RMB 279.1 billion showing an increase of 0.5% as compared to last year. However, the net interest income of the bank reduced by 7.1% and reached to RMB 471,846 million during 2016. The bank is successfully listed on Shanghai Stock Exchange and Stock Exchange of Hong Kong Limited (ICBC. 2018).
However, being a large financial institution the bank was involved in the scam of illegally pledging the loans to the criminals due to its weak legal infrastructure and poor management and assessment of risk and customers. The issue or problem with the company was that it did not try to get proper knowledge about its customers to whom the loans were granted. Moreover, it failed to establish appropriate internal control systems within the business so as to avoid the scam. In addition, it violated some of the accounting policies and provisions related to disclosure. The bank showed securities on its books which were not present in real time (Caixin. 2018).
The relevant accounting standard applied to the case study is IFRS 9 which deals with the measurement and recognition of financial instruments. According to this, companies are required to follow all the requirements for recognizing and measuring it financial instruments (Deloitte. 2018). In addition to this, another reporting standard which applies to the case is IFRS 13 Fair Value Measurement. As per this, the banks were required to critically and fairly evaluate the value of gold which was used as collateral security for taking loans. The companies and financial institutions are required to measure and recognize the assets and liabilities on their fair value (Deloitte. 2018). The accounting theory which is relevant to the case is normative theory as it focuses on telling what should be done instead of emphasizing on what has been already done. The theory basically deals with providing guidance to the companies and financial institutions in respect of pursuing better accounting practices within the business. Concerning the case, the banks must have investigated about its customers with due diligence before issuing the loans to them. In the urge of expanding their businesses, they violated business rules and also fail to employ appropriate audit mechanisms and internal controls (Motley Fool. 2018).
Apart from the relevant theory and standard, there are other concepts also which are been violated by ICBC while providing loans to the criminals in illegal manner. One of them is materiality concept, which explains that companies should disclose such financial information which is relevant and can influence the decision making of the users. The data presented in the financial statements must be complete in all material terms and should represent true and fair view of entity’s position and performance (Charles, 2008). However, the same was not followed by the banks of China they fail in the proper assessment of collateral value and disclosure of the same in their financial reports.
Referring to the loan fraud done by Industrial and Commercial Bank of China Limited in the recent time, there were many accounting problems and issues that got highlighted which led to such scam and caused for heavy penalty. The major problem with ICBC banking system was the weak risk management of the institution. The bank could not establish proper internal controls in order to manage the risk related to the loans issued. The main reason for this was the inefficiency in managing and collecting the data required for granting loan to the customers. Another problem was that the accounting practices adopted by ICBC resulted in the mismanagement of loans and their issuance (Reuters 2018).
Moreover, the banks did not correctly measure and recognize the value of collateral pledged by the criminals. It accepted low purity gold as security for granting loans which resulted in heavy penalties on it. This reflected unfair presentation of collateral security in the financial statements of the bank. Furthermore, the audit framework and mechanisms adopted by ICBC failed to set up the proper internal control measures and indentify the faulty accounting practices of the bank. In urge of expanding and developing its business, ICBC violated many of the business rules like issuing loans to the customers without gathering the proper and complete information about their customers and clients. As a result of which, the bank faced many problems such as Nonperforming loans (NPLs). These are those loans which are not being repaid and have very low possibility of being repaid. Also as per the recent audit report of ICBC’s auditors Ernst & Young, it is observed that there are many problems in banking system of China. Being operating in a complex environment, it was very difficult for ICBC to measure and manage its risk properly and timely. All such accounting issues and problems resulted in huge penalty on the institution by the banking regulators of the country (China Daily. 2018).
Concerning the above issues, it is evident that ICBC has violated some accounting standards and did not follow the conceptual framework of financial reporting. IFRS 9 and IFRS 13 are the two relevant standards whose requirements are not been met by the bank. IFRS 9 financial instruments require the companies to classify and measure their financial assets and liabilities. The standard has replaced the framework of IAS 39 and covered up the criticism of the same. The concept explained by new standard is that the financial assets should be classified and measured at their fair value while taking into account the changes in FV. The approach adopted by this new standard is very logical as it is driven by cash flow characteristics and the business model in which the asset is held. ICBC being a financial institution holds loans as its financial assets (IFRS. 2018). However, the bank does not follow the requirements of the standard and fails to classify its assets accordingly. Such poor classification led to the mismanagement of loans issued and created financial risk in the business. IFRS 13 Fair Value Measurement is another accounting standard which applies to this case as it had also been breached by the company. The concept requires entities to measure their assets on fair value and make the consistent disclosure of the same. The standard provides guidance on how to measure the fair value and how to disclose such measurements in the financial statements. The FV defined by IFRS 13 is the price at which the asset has been sold or the liability is transferred in the market (EY. 2012). It was highlighted in the news that the ICBC does not value the collateral security correctly and did not disclose the same in their reports on its fair value. This resulted in banks suffering from ghost collateral means the securities that does not exist in real and appears to be in books on low values. Overall, ICBC does not follow the requirements of both the relevant standards and manipulates its financial statements. The bank misstated many factors and represented its faulty image to others (Reuters 2018).
Normative accounting theory is the concept which explains what should be done instead of focusing on what has already been done. It assists the policy makers to work according to a theoretical principle and guides them to create appropriate accounting policies and practices for the business. The objective of the theory is to provide full disclosure of the information to the interested parties and users (Riahi-Belkaoui, 2004). The main advantage of following such theory is that it helps the companies to evaluate new accounting techniques and practices as per the changes in the environment. ICBC does not apply the normative theory to its practices and thus resulted in getting involved in loan fraudulent activities (Chatfield and Vangermeersch, 2014). According to the theory, the bank should properly collect the information about its customers and clients before granting or issuing loan to them. Instead of this, ICBC failed to recognize the background of its customers and therefore the risk of nonperforming loans rose in the banking system. Apart from this, the bank does not employ adequate internal control measures to manage the risks related to lending credits to the customers. Furthermore, it did not correctly assess the value of collateral security which resulted in the imposition of heavy penalties by the regulators (Caixin. 2018). As per the theory, the bank should follow the requirements of conceptual framework and should meet the provisions of accounting standards, specifically IFRS 9 and IFRS 13. The main theme of the theory is to provide guidance on how accounting process should be done and it applies various methods through which suitable accounting practices can be employed in the business. In order to cover up its amount of penalty, the bank needs to change its accounting policies and practices and has to develop new disclosure requirements so that its financial statements provide fair and true view of its assets and liabilities (Griff, 2014).
It is suggested to Industrial and Commercial Bank of China that it should follow all the requirements of General Purpose Financial Reporting in order to prepare its books of accounts according to the specified accounting standards. Firstly, the bank must establish suitable internal control functions so as to deal with the various types of risks. These include separation of duties, conducting physical audits, standardizing the documents, making periodic reconciliations and many others. Segregation of duties involved assigning the responsibilities for deposits, bookkeeping, auditing and reporting. Such separation will reduce the chances of fraudulent activities on part of employees. Physical audit relates to the actual verification of the existence of collateral and mortgaged securities that are pledged against loans. This will help in reducing the discrepancies in the banking system and books of accounts. Use of standardized documents such as invoices, receipts, collateral papers can help in maintaining consistency in the financial reporting of the institution (Norton and Walker, 2014).
Apart from setting internal control measures, the bank also need to follow its business rules and should not only focus on expanding its business. It should be aware about the background and financial stability of its customers before issuing any sort of loan to them. This will help ICBC to reduce the risk of NPLs and enhance its position in the market. Availability of proper information about the clients would result in efficient loan management and increased effectiveness of the institution. Furthermore, ICBC should follow the requirements of IFRS 9 and IFRS 13 while measuring and reporting the value of collateral security in their books. It should formulate its procedures and policies, keeping in mind the normative theory of accounting. Overall, all such suggestions would result in less mal-practicing in the system.
The above discussion and analysis conclude that the largest bank of China, ICBC has completely violated its business rules and does not follow the conceptual framework of reporting. In urge of developing its business, the bank offers loans to criminals on illegal basis and also considered the collateral without assessing its real market value. All such represents the faulty image of bank’s accounts and resulted in heavy penalty of 6.5 million Yuan by the banking regulators. It was also observed that it had weak internal control system and inefficient management of loans and securities. Overall, it can be concluded that by following proper accounting standards and theory, ICBC can cover up its penalty and improve its position and practices.
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