BANK AUDIT This chapter is classified into following parts: 1. Introduction 2. Audit of Balance Sheet and Profit and Loss items 3. Long form Audit Report 4. Concurrent Audit 5. Residuary Topics

INTRODUCTION It consists of following topics: 1. Format of Balance Sheet and P & L A/c 2. Appointment of auditors 3. Special features of Bank Audit Report 4. Signature on Balance Sheet and P & L A/c 5. Principal Enactments governing Bank Audit

[1]

BANK AUDIT

Auditor’s Appointment Type of Commercial Bank SBI SBI’s Subsidiaries Nationalized Banks

Banking Companies

Appointment by whom By RBI in consultation with CG SBI By Board of Directors of the Bank with prior approval of RBI By shareholders of the Bank with prior approval of RBI

Remuneration fixed by By RBI in consultation with CG SBI By RBI in consultation with CG By shareholders

Audit Report addressed to President of India SBI President of India

Shareholders

Special features of Bank Audit Report 1. Reference to Third Schedule Form A and B. 2. Number of branches that are audited by Central Auditors, Other CAs, foreign auditors and unaudited branches. 3. Reference to reliance on Branch Auditor’s Report 4. A statement by the auditor that the transactions entered into by the Bank are within its powers. Also LFAR is prepared by the auditor. [2]

BANK AUDIT Central Bank Auditor addresses his LFAR to the Chairman of the Bank and RBI. Bank Branch Auditor addresses his LFAR to the Management of the Bank.

Signature on Balance Sheet and P & L A/c By the Principal Officer of the Bank and at least 3 Directors.

Principal Enactments governing Bank Audit Refer Question Bank for this answer Q.9

AUDIT OF BALANCE SHEET AND PROFIT AND LOSS ITEMS AUDIT OF ADVANCES 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Different types of facilities – Funded and Non-funded What is a Non Performing Asset Exceptions / Clarifications Income Recognition Reversal of Income Classification of Assets Provisioning of Assets Verification of Advances Interest Suspense A/c Corporate Debt Restructuring

Funded Advances: 1. Demand/Term loan – Such advance, though called “demand loan” is generally repayable in pre-determined instalments. If the repayment period exceeds 36 months, it is called Term loan. 2. Cash Credit (CC) – This advance is generally granted against security of stocks/book debts without any stipulation for repayment, but is required to be renewed every year. When a borrower is allowed to draw beyond his sanctioned limit or drawing power limit, the said amount is called “Temporary Over limit – TOL”. This TOL is secured by the existing securities against which the CC limit has been sanctioned. 3. Overdraft (OD) – This advance is similar to CC, except that either no security is taken (termed as “Unsecured Overdraft”) or the security is other than stock and book debts – e.g. FD receipts, NSC receipts, shares, LIC policies, etc.When such secured or unsecured overdraft is granted to the borrower to tide over temporary financial crisis, it is called “Temporary Overdraft – TOD”. Unlike TOL, which is generally secured, TOD is generally unsecured. 4. Bills Purchased/Discounted – When an advance against a sale bill is granted to the seller with the condition that the same should be repaid before the physical possession of the goods passes on to the buyer, it is called “Bills Purchased” facility; when an advance is granted against a sale bill, wherein the buyer has received the goods and has agreed to pay the amount therein within a stipulated period, such a facility is called “Bills Discounted”.

Non-funded advances They are called “Off Balance Sheet” items, as their value is not reflected in the Balance Sheet. They form the “Contingent Liability” items of the bank. However, for the purpose of keeping a control over these items, banks have a system of passing contra entries in its books of accounts at the branch level and hence these items get reflected on the liability as well as asset side of the Trial Balance. However, while preparing the Balance Sheet of the bank as a whole, the value of these items are reflected in the “Notes to Accounts”. 1. Guarantees Guarantees are of two types – financial guarantee, wherein the guarantor (the bank) promises to pay the stated amount to the beneficiary, if the person for whom the guarantee is given, fails to pay the same (also referred to as [3]

BANK AUDIT invoking the guarantee); performance guarantee, wherein the guarantor promises to pay the beneficiary a stated sum of amount, if the person for whom the guarantee is given, fails to perform, as expected, in a given period of time. Banks are generally discouraged from issuing performance guarantees. A Guarantee transaction usually comprises of two independent, but related components – one is the guarantee issued by the banker (of the buyer) to the beneficiary (i.e. seller) and the other is a counter guarantee given by the buyer to his banker, who has issued the guarantee. 2. Co-acceptance of bills In this type of facility, the seller despatches the goods and raises the bill on the buyer. The buyer accepts the bill and then it is co-accepted by buyer’s banker. The seller’s banker then discounts this bill. 3. Letter of Credit (LC) Letter of Credit (LC) is a promise by a banker to honour the payments to be made by its customer (the buyer or importer) to the seller or exporter. This type of payment facility is generally used in international trade. In this type of facility, at the request of the buyer, his banker opens an LC, which is sent to the seller. Based on such LC, the seller despatches the goods and then sends the bills and other documents through his banker to the buyer’s banker, which has opened the LC, to make payment of the bill. The buyer then makes the payment and routes it through his banker to the seller’s banker. In case the buyer fails to make the payment (also known as devolvement of LC), the buyer’s banker, who has opened the LC, is liable to make the payment to the seller.

What is a Non Performing Asset? Non-Performing Asset (NPA): An asset becomes NPA when it ceases to generate income for the bank. Type of facility To be Classified as NPA if Term Loan Interest and/or installment remain overdue for more than 90 days. Working Capital If accounts remain out of order for more than 90 days. Finances (Over draft Out of order: and Cash Credit) An account should be treated as ‘out of order’ if the outstanding balance remains continuously in excess of the sanctioned limit/ drawing power. In cases where the outstanding balance in the principal operating account is less than the sanctioned limit/drawing power, but there are no credits continuously for 90 days as on the date of Balance Sheet or credits are not enough to cover the interest debited during the same period, these accounts should be treated as ‘out of order’ Bills The bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted Agricultural Advances Short duration crops: The instalment of principal or interest thereon remains overdue for two crop seasons Long duration crops: The installment of principal or interest thereon remains overdue for one crop season. Liquidity Facilities The amount of liquidity facility remains outstanding for more than 90 days, in respect of a securitisation transaction undertaken in terms of guidelines on securitisation dated 1st February, 2006 Derivative Transactions The overdue receivables representing positive mark-to-market value of a derivative contract, if these remain unpaid for a period of 90 days from the specified due date for payment. Banks should, classify an account as NPA only if the interest due and charged during any quarter is not serviced fully within 90 days from the end of the quarter.

Exceptions / Clarifications Temporary Deficiencies [4]

BANK AUDIT The classification of an asset as NPA should be based on the record of recovery. Bank should not classify an advance account as NPA merely due to the existence of some deficiencies which are temporary in nature such as nonavailability of adequate drawing power based on the latest available stock statement, balance outstanding exceeding the limit temporarily, nonsubmission of stock statements and non-renewal of the limits on the due date, etc. In the matter of classification of accounts with temporary deficiencies, banks have to follow the following guidelines: (a) Banks should ensure that drawings in the working capital account are covered by the adequacy of the current assets. Drawing power is required to be arrived at based on current stock statement. Proper computation of drawing power is imperative as the advances are to be checked with reference thereto, e.g. in case of current assets comprising stock, drawing power is to be computed by the reduction of sundry creditors comprising of unpaid stocks before application of margin, in case of advance against book debts which are current and within the stipulated period would be reckoned. However, considering the difficulties of large borrowers, stock statements relied upon by the banks for determining drawing power should not be older than three months. (b) The outstanding in the account based on drawing power calculated from stock statements older than three months is deemed as irregular. (c) A working capital borrowing account will become NPA if such irregular drawings are permitted in the account for a continuous period of 90 days even though the unit may be working or the borrower's financial position is satisfactory. Asset Classification to be Borrower-wise not Facility-wise All facilities granted to a borrower and investment made in securities issued by the borrower will have to be treated as NPA/NPI and not the particular investment/facility once any or a part of the facility/investment has become irregular. In case of advances granted under the on-lending system, however, only the particular credit facility granted to Primary Agricultural Credit Societies (PACSs) or Farmers Service Societies (FSSs), which is in default, will have to be classified as NPA and not all the credit facilities Sanctioned. Government Guaranteed Advances The credit facilities backed by guarantees of central government though overdue may be treated as NPA only when the government repudiates its guarantee when invoked. This exemption from classification of Central Government guaranteed advances as NPA is not for the purpose of recognition of income. Advances Under Consortium Consortium advances should be based on the record of recovery of the respective individual member banks and other aspects having a bearing on the recoverability of the advances. Where the remittances by the borrower under consortium lending arrangements are pooled with one bank and/or where the bank receiving remittances is not parting with the share of other member banks, the account should be treated as not serviced in the books of the other member banks and therefore, an NPA. The banks participating in the consortium, therefore, need to arrange to get their share of recovery transferred from the lead bank or to get an express consent from the lead bank for the transfer of their share of recovery, to ensure proper asset classification in their respective books. Advances Against Term Deposits, NSCs, KVPs/ IVPs, etc. Advances against Term Deposits, NSCs eligible for surrender, KVP/IVP and life policies need not be treated as NPAs, provided adequate margin is available in the accounts. Agricultural Advances Affected by Natural Calamities Where, in the wake of natural calamities, short-term agricultural loans are converted into term loans or there is rescheduling of repayment period or fresh short-term loans are sanctioned, the term loan as well as fresh short term loan may be treated as current dues and need not be classified as NPA.

Income Recognition Banks recognise income (such as interest, fees and commission) on accrual basis, i.e., as it is earned. It is an essential condition for accrual of income that it should not be unreasonable to expect its ultimate collection. In view of the significant uncertainty regarding ultimate collection of income arising in respect of non-performing assets, the guidelines require that banks should not recognise income on non-performing assets until it is actually realised. When [5]

BANK AUDIT a credit facility is classified as non-performing for the first time, interest accrued and credited to the income account in the corresponding previous year which has not been realised should be reversed or provided for. Further, i. Interest income on advances against term deposits, NSCs, IVPs, KVPs and life policies may be taken to income account on the due date, provided adequate margin is available in the accounts. ii. Fees and commissions earned by the banks as a result of re-negotiations or rescheduling of outstanding debts should be recognised on an accrual basis over the period of time covered by the re-negotiated or rescheduled extension of credit. iii. If Government guaranteed advances become NPA, the interest on such advances should not be taken to income account unless the interest has been realised.

Reversal of Income 1. If any advance, including bills purchased and discounted, becomes NPA as at the close of any year, the entire interest accrued and credited to income account in the past periods, should be reversed or provided for if the same is not realised. This will apply to Government guaranteed accounts also. 2. In respect of NPAs, fees, commission and similar income that have accrued should cease to accrue in the current period and should be reversed or provided for with respect to past periods, if uncollected. 3. Further, in case of banks which have wrongly recognised income in the past should reverse the interest if it was recognised as income during the current year or make a provision for an equivalent amount if it was recognised as income in the previous year(s). On Leased Assets The finance charge component of finance income [as defined in ‘AS 19 – Leases] on the leased asset which has accrued and was credited to income account before the asset became non-performing, and remaining unrealised, should be reversed or provided for in the current accounting period.

Classification of Assets NPA Category Sub- Standard Asset

Criteria for classification Which has remained NPA for a period less than or equal to 12 months. In such cases, the current net worth of the borrower/ guarantor or the current market value of the security charged is not enough to ensure recovery of the dues to the banks in full. In other words, such an asset will have well defined credit weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected.

Doubtful Asset

An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as sub standard, with the added characteristic that the weaknesses make collection or liquidation in full, – on the basis of currently known facts, conditions and values – highly questionable and improbable. For provisioning, Doubtful Assets are further classified as per age in doubtful category, in sub- categories generally called as D-1, D-2 and D-3.

Loss Asset

A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value.

Accounts where there is erosion in the value of security/ frauds committed by borrowers

In respect of accounts where there are potential threats for recovery on account of erosion in the value of security or non-availability of security and existence of other factors such as frauds committed by borrowers it will not be prudent that such accounts should go through various stages of asset classification. In cases of such serious credit impairment the asset should be straightaway classified as doubtful or loss asset as appropriate: Value Classification to be done [6]

BANK AUDIT Realizable Value of the Security Less than 50 per cent Less than 10 per cent

Classification of Asset Doubtful Asset Loss Asset

Provisioning of Assets Standard Assets Substandard Assets Doubtful Assets

Loss Assets

(a) direct advances to agricultural and SME sectors at 0.25 per cent; (b) advances to Commercial Real Estate (CRE) Sector at 1.00 per cent; (c) all other loans and advances not included in (a) and (b) above at 0.40 per cent Secured exposure: 15 per cent on outstanding balance Other unsecured exposures: 25 per cent on outstanding balance Unsecured Portion : 100 per cent Secured Portion : Period for which the advance has remained in ‘doubtful’ Provision category requirement (%) Up to one year –D1 25 One to three years-D2 40 More than three years –D3 100 100 per cent

Verification of Advances List of PBCs: Some of the statements that could be generated by the system are: 1. facility-wise/party-wise list of accounts outstanding, along with the outstanding balance. The aggregate total of these lists should first be tallied with the figure of total advances in the Trial Balance to ensure that none of such statements have been missed out; 2. sanctioning powers of the branch officials and the higher authorities; 3. list of accounts where the regular facility is due for renewal, but has not been renewed, where stock/book debt statements are in arrears, where no insurance or inadequate insurance has been taken, where accounts are overdrawn beyond the sanction/DP (drawing power) limit, where stock audit is due, but has not been done, where inspection has not been carried out in the last three to six months; 4. for CC (Cash Credit)/OD (Overdraft) accounts, month-wise details of debit and credit transactions (turnover); 5. NPA (Non-Performing Assets) statements, as prepared by the branch.

Interest Suspense A/c In order to comply with guidelines regarding non-recognition of income on NPAs while ensuring at the same time that legal remedies against defaulting borrowers are not adversely affected and that proper control is exercised over nonperforming advances, many banks adopted the practice of recording interest on non-performing advances to a separate account which is usually styled as ‘Interest Suspense Account’. The balance in this account represents interest on nonperforming advances debited to the respective borrowers’ accounts in accordance with the terms of the agreement but not recognised as income. For purposes of balance sheet presentation, the gross advances portfolio is arrived at after deducting the credit balance in Interest Suspense Account from the total advances as per the ledgers.

[7]