Audit of Banks Chapter 10

Assessing Risk • As per SA 240 “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial
of Fraud Statements”, the auditor’s objective is to identify and assess the risks of material
misstatement in the financial statements due to fraud, to obtain sufficient appropriate audit
evidence on those identified misstatements and to respond appropriately.
• The attitude of professional skepticism should be maintained by the auditor so as to
recognise the possibility of misstatements due to fraud.
• The RBI has framed specific guidelines that deal with prevention of money laundering and
“Know Your Customer (KYC)” norms. The RBI has from time to time issued guidelines (“KYC
Guidelines – Anti Money Laundering Standards”), requiring banks to establish policies,
procedures and controls to deter and to recognise and report money laundering activities.

10.3 – Types and Classification of Advances

Types of Funded loans • Loans where there is an actual transfer of funds from the bank to the
Advances borrower.
• Examples: Term loans, Cash credits, Overdrafts, Demand Loans, Bills
Discounted and Purchased, Interest-bearing Staff Loans, etc.

Non-funded • Facilities which do not involve transfer of funds.

facilities • Examples: Letters of credit, Bank guarantees, etc.

Disclosure Nature wise (i) Bills purchased and discounted

Requirements (ii) Cash credits, Overdrafts and loans repayable on demand
(iii) Term Loans

Security wise (i) Secured by tangible assets

(ii) Covered by Bank/Government guarantees
(iii) Unsecured

Location wise I. Advances in India:

(i) Priority sectors
(ii) Public sector
(iii) Banks
(iv) Others
II. Advances outside India:
(i) Due from Banks
(ii) Due from Others:
(a) Bills Purchased and discounted
(b) Syndicated loans
(c) Others

Creation of Primary Security offered by the borrower for bank finance or the one against which
Security security credit has been extended by the bank.

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Chapter 10 Audit of Banks
Collateral It is an additional security and can be in any form i.e. tangible or intangible
security asset, movable or immovable asset.

Examples of (a) Personal Security of Guarantor

Securities (b) Goods/Stocks/Debtors/Trade Receivables
(c) Gold Ornaments and Bullion
(d) Immovable Property
(e) Plantations (For Agricultural Advances)
(f) Third Party Guarantees
(g) Banker’s General
(h) Lien Life Insurance Policies
(i) Stock Exchange Securities and Other Instruments

Mode of Creation of Security

Security may be created by different modes like Mortgage, Pledge, Hypothecation, Lien,
Assignment.

Mortgage • Registered Mortgage can be affected by a ‘Mortgage Deed’ signed by the

mortgagor.
• Equitable mortgage, is affected by a mere delivery of title deeds or other
documents of title with intent to create security thereof.

Pledge • It involves physical delivery of goods by the borrower to the lending

bank with the intention of creating a charge thereon as security for the
advance.
• Legal ownership of the goods remains with the pledger while the lending
banker gets certain defined interests in the goods.

Hypothecation • Hypothecation is the creation of an equitable charge, which is created in

favour of the lending bank by execution of hypothecation agreement in
respect of the movable securities belonging to the borrower.
• Borrower holds the physical possession of the goods. Neither ownership
nor possession are transferred to the bank.
• Borrower periodically submits statements regarding quantity and value
of hypothecated assets (like stocks, debtors, etc.) to the bank on the basis
of which the drawing power of the borrower is fixed.

Lien Lien is creation of a legal charge with consent of the owner, which gives
lender a legal right to seize and dispose/liquidate the asset under lien.

Assignment • It is a transfer of an existing or future debt, right or property belonging to

a person in favour of another person.
• Only actionable claims (i.e., claim to any debt other than a debt secured
by a mortgage of immovable property or by hypothecation or pledge of
movable property) such as book debts and life insurance policies are
accepted by banks as security by way of assignment.

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Audit of Banks Chapter 10
Set-Off • Set-off is a statutory right of a creditor to adjust, wholly or partly, the
debit balance in the debtor’s account against any credit balance lying in
another account of the debtor.
• Right of set-off enables a bank to combine two accounts (a deposit
account and a loan account) of the same person provided both the
accounts are in the same name and same right.
• For this purpose, all branches of a bank are treated as one single entity.
Right of set-off can be exercised in respect of time-barred debts also.

Prudential Non – An Advance will be classified as NPA if:

Norms Performing (a) It ceases to generate income for a bank.
Advances
(b) interest and/or installment of principal remain overdue for a period of
more than 90 days in respect of a term loan;
(c) account remains ‘out of order’ in respect of an Overdraft/Cash Credit
(OD/ CC);
(d) the bill remains overdue for a period of more than 90 days in the case of
bills purchased and discounted.

Overdue Any amount due to the bank under any credit facility is
‘overdue’ if it is not paid on the due date fixed by the bank.

Out of Order An account should be treated as ‘out of order’ if:

• outstanding balance remains continuously in excess of
the sanctioned limit/drawing power or
• if 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.

Special Mention Special Mention accounts (SMA) are those accounts which are resulting signs
accounts of incipient stress leading to the possibility that borrowers may default on
debt obligations.
SMA 0 – Accounts showing stress signals
SMA 1 – Overdue between 31 to 60 days
SMA 2 – Overdue between 61 to 90 days
Such a classification is significant as early recognition of such accounts
enables banks to initiate timely remedial actions to prevent potential
slippages of such accounts into NPAs.

Classification as Standard assets Assets which do not disclose any problem and does not
per prudential carry more than normal risk.
norms
Sub-standard Asset which has remained NPA for a period less than or
assets equal to 12 months.

Doubtful assets Asset which has remained in the substandard category

for a period of 12 months.

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Loss assets Asset in respect of which loss has been identified by the
bank or internal auditors or the RBI inspection, but the
amount has not been written off, wholly.

Provisioning Standard assets 0.40%

Requirements
Sub-standard 15%
assets

Doubtful assets Unsecured 100%

portion

Secured 25% to 100% depending upon the period

portion for which advance has remained doubtful.
• Upto one year - 25%
• More than one year but upto 3 years -
40%
• Above three years - 100%

Loss assets 100%

Special cases Classification as NPA should be based on record of recovery. Availability of security or net worth
w.r.t. NPA of borrower/guarantor is not to be considered for purpose of treating an advance as NPA.
Classification
Asset Asset classification would be borrower-wise and not facility-wise. All
Classification facilities including investments in securities would be termed as NPA.
borrower-wise

Accounts • Where it appears that an account has inherent weakness and few credits
regularised near the balance sheet tries to make it regular, the account should be
near B/S date classified as NPA.
• Auditor should check for sample transactions immediately before and
after closing of financial year to get a knowledge of objective behind the
transactions if they have any relation to each other which might show an
arrangement to prevent Borrower account(s) from slipping into NPA
category.

Govt. • Credit facilities backed by C.G. guarantee, though overdue will be

guaranteed classified as NPA only when govt. repudiates its guarantee when invoked.
advances This exemption is only for asset classification and provisioning and not
for the purpose of recognition of income. Interest on such advances
should not be taken to income account unless it has been realized.
• Credit facilities backed by S.G. guarantee should be classified as NPA in
normal way.

Advances under • Consortium advances mean advancing loans to a borrower by two or

Consortium more Banks jointly by forming a Consortium. Joint appraisal, control and
monitoring will facilitate for exchange of valuable information among the
Banks. Usually, a Bank with a higher share will lead the consortium.

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Audit of Banks Chapter 10
• Classification of Consortium advances should be based on the record of
recovery of respective individual member banks and other aspects
having a bearing on the recoverability of the advances.
• Where the remittances by 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, account
should be treated as not serviced in the books of the other member banks
and therefore, an NPA.
• Banks participating in consortium, 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.

Erosion in In case there arise erosion in value of security or any fraud is committed by
Value of Borrowers, banks can directly classify these accounts as Doubtful or Loss
Securities Assets, irrespective of the period for which the account has remained NPA.
(i) Erosion in value of securities by more than 50% of value assessed by the
bank or accepted by RBI inspection team at time of last inspection,
would be considered as “significant”, requiring the asset to be classified
as doubtful straightaway and provided for adequately.
(ii) If realisable value of security as assessed by bank/approved valuers/
RBI is less than 10% of outstanding in borrowal accounts, existence of
security should be ignored and the asset should be classified as loss
asset. In such cases asset should either be written off or fully provided
for.

Advances Advances against Term Deposits, NSCs eligible for surrender, KVP/IVP and
Against Term life policies need not be treated as NPAs, provided adequate margin is
Deposits, NSCs, available in the accounts.
KVPs/ IVPs, etc.

Agricultural Where, in the wake of natural calamities, short-term agricultural loans are
Advances converted into term loans or there is rescheduling of repayment period or
affected by fresh short-term loans are sanctioned, the term loan as well as fresh short-
Natural term loan may be treated as current dues and need not be classified as NPA.
Calamities

Advances to • Interest-bearing staff advances should be included as part of advances

Staff portfolio of bank. In case of housing loan or similar advances granted to
staff members where interest is payable after recovery of principal,
interest need not be considered as overdue from the first quarter
onwards.
• Such loans/advances should be classified as NPA only when there is a
default in repayment of installment of principal or payment of interest on
respective due dates.

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Chapter 10 Audit of Banks
Agricultural Interest and/or Instalment of principal is overdue for –
Advances/ • two crop seasons, in case loans granted for Short Duration crops,
Loans
• one crop season, in case loans granted for Long Duration crops (i.e. more
than 1 year)

Points to Remember
• Long duration crops mean the crops with crop season longer than one
year.
• Short Duration Crops means the crops, other than long duration crops.
• Crop season means the period up to harvesting of the crops, as
determined by the State Level Bankers’ Committee in each State.

10.4 - Computation of Drawing Power (DP)

Meaning of DP • DP is an important concept for Cash Credit (CC) facility availed from banks and financial
institutions.
• It may be defined as the limit up to which a firm or company can withdraw from the
working capital limit sanctioned.

Sanctioned • Sanctioned limit is the total exposure that a bank can take on a particular client for facilities
Limit vs. DP like cash credit, overdraft, export packing credit, non-funded exposures etc.
• On the other hand, DP refers to the amount calculated based on primary security less
margin as on a particular date.

Considerations • All accounts should be kept within both DP and sanctioned limit at all times.
• Accounts which exceed the sanctioned limit or DP or are against unapproved securities or
are otherwise irregular should be brought to the notice of the Management/Head Office
regularly.

Bank’s Duties • Banks should ensure that drawings in the working capital account are covered by the
adequacy of the current assets.
• DP is required to be arrived at based on current stock statement. 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.
• Outstanding in the account based on DP calculated from stock statements older than 3
months is deemed as irregular.

Auditor’s • Stock statements, quarterly returns and other statements submitted by the borrower to the
Concern bank should be scrutinized in detail. Audited Annual Report submitted should be
scrutinized properly.
• Monthly stock statement of the month for which the audited accounts are prepared and
submitted should be compared and the reasons for deviations, if any, should be ascertained.

Computation of • Ensure that DP is calculated as per extant guidelines formulated by the BoD of respective
DP bank and agreed upon by concerned statutory auditors.

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