[FAQs] Audit of Banks – Auditing Framework and Audit of Advances & Revenue

In the case of a nationalised bank, the auditor is required to make a report to the Central Government in which the auditor should state the following:

1. Whether, in the auditor’s opinion, the balance sheet is a full and fair balance sheet containing all the necessary particulars and is properly drawn up so as to exhibit a true and fair view of the affairs of the bank.
2. In case the auditor had called for any explanation or information, whether it has been given and whether it is satisfactory.
3. Whether or not the transactions of the bank, which have come to the auditor’s notice, have been within the powers of that bank.
4. Whether or not the returns received from the offices and branches of the bank have been found adequate for the purpose of audit.
5. Whether the profit and loss account show a true balance of profit or loss for the period covered by such account.
6. Any other matter which the auditor considers should be brought to the notice of the Central Government.

Long Form Audit Report:

• • The long form Audit Report has to be furnished by the auditor of a bank in addition to the audit report as per the statutory requirement.
  • The matters which the banks require their auditor to deal with in the form of Long Form Audit Report have been specified by the RBI.
  • The LFAR is to be submitted before 30th June every year. To ensure timely submission of LFAR, proper planning for completion of the LFAR is required. While the format of LFAR does not require an executive summary to be given, members may consider providing the same to bring out the key observations from the whole document.

Reporting of Fraud to RBI:

• • Circular issued by RBI regarding liability of accounting and auditing profession, provides that

“If an accounting professional, whether in the course of internal or external audit or in the process of institutional audit finds anything susceptible to be fraud or fraudulent activity or act of excess power or smell any foul play in any transaction, he should refer the matter to the regulator. Any deliberate failure on the part of the auditor should render himself liable for action”

• • This requirement is applicable to all scheduled commercial banks excluding Regional Rural Banks. Auditor is not expected to look into each and every transaction but to evaluate the system as a whole.
  • While reporting such kind of matters as stated in the circular, auditor need to consider the provisions of SA 250, “Consideration of Laws and Regulations in an Audit of Financial Statements”.
  • SA 240, “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements” further expounds the concept and states that an auditor conducting an audit in accordance with SAs is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error.

Understanding the Risk Management Process:
An effective risk management system in a bank generally requires the following:

(a) Involvement of TCWG: Risk Management policies should be approved by TCWG. While approving the policies, TCWG should ensure that the policies should be consistent with the bank’s business objectives and strategies, capital strength, management expertise, regulatory requirements and the types and amounts of risk it considers as acceptable.
(b) Identification, measurement & monitoring of risks: Risks that may significantly affect the achievement of bank’s goals and objectives should be identified, measured and monitored against pre-approved limits and criteria.
(c) Control activities: Banks must have appropriate controls to manage its risks, including the following:

• • • effective segregation of duties,
    • verification and approval of transactions,
    • setting of limits, and
    • reporting and approval of exception.

(d) Monitoring activities: Independent risk management unit should be set up which regularly assess the risk management models, methodologies and assumptions used to measure and manage risk.
(e) Reliable information systems: Banks must have a reliable information system that provide adequate financial, operational and compliance information on a timely and consistent basis to management and TCWG.

Engagement Team Discussions:
Engagement team should hold discussions to gain better understanding of banks and its environment, including internal control, and also to assess the potential for material misstatements of the financial statements. All these discussions should be appropriately documented for future reference. The discussion should be done on the susceptibility of the bank’s financial statements to material misstatements. These discussions are ordinarily done at the planning stage of an audit.

Benefits of discussion:

• • Opportunity for team members to share their insights based on their knowledge of the bank and its environment.
  • Opportunity for team members to exchange information about the bank’s business risks.
  • To make an understanding amongst the team members about effect of the results of the risk assessment procedures on other aspects of the audit, including decisions about the NTE of further audit procedures.

Matters to be discussed:

(a) Errors that may be more likely to occur;
(b) Errors which have been identified in prior years;
(c) Method by which fraud might be perpetrated by bank personnel or others within particular account balances and/or disclosures;
(d) Audit responses to Engagement Risk, Pervasive Risks, and Specific Risks;
(e) Need to maintain professional skepticism throughout the audit engagement;
(f) Need to alert for information or other conditions that indicates that a material misstatement may have occurred.

Assessing Risk of Fraud:

• • As an Auditor of XYZ Bank Limited, risk of fraud including money laundering would be assessed as explained hereunder which is in line with SA 240.
  • As per SA 240 “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial 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 (“Know Your Customer Guidelines – Anti Money Laundering Standards”), requiring banks to establish policies, procedures and controls to deter and to recognise and report money laundering activities.

Reporting requirements of the Statutory Central Auditors (SCAs) in addition to their main audit report:
Presently, the Statutory Central Auditors (SCAs) have to furnish the following reports in addition to their main audit report:

(a) Report on adequacy and operating effectiveness of Internal Controls over Financial Reporting in case of banks which are registered as companies under the Companies Act in terms of Section 143(3)(i) of the Companies Act, 2013 which is normally to be given as an Annexure to the main audit report as per the Guidance Note on Audit of Internal Financial Controls over Financial Reporting issued by the ICAI.
(b) Long Form Audit Report. (LFAR)
(c) Report on compliance with SLR requirements.
(d) Report on whether the treasury operations of the bank have been conducted in accordance with the instructions issued by the RBI from time to time.
(e) Report on whether the income recognition, asset classification and provisioning have been made as per the guidelines issued by the RBI from time to time.
(f) Report on whether any serious irregularity was noticed in the working of the bank which requires immediate attention.
(g) Report on status of the compliance by the bank with regard to the implementation of recommendations of the Ghosh Committee relating to frauds and malpractices and of the recommendations of Jilani Committee on internal control and inspection/credit system.
(h) Report on instances of adverse credit-deposit ratio in the rural areas.

An Advance will be classified as NPA if:

(a) It ceases to generate income for a bank.
(b) Interest and/or instalment of principal in respect of such an advance have remain overdue or out of order for a specified period of time

• • • Overdue: An amount is said to be ‘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 the 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 balance sheet date or the credits are not enough to cover the interest debited during the same period.

NPA classification w.r.t. specified advances

• • Term Loans: Term loan will become NPA if interest and/or Instalment of principal has remained overdue for a period exceeding 90 days.
  • CC/OD: CC/OD account will become NPA if the account has remained out-of-order for a period exceeding 90 days.
  • Bills Purchased & Discounted: Bills purchased & Discounted will become NPA when bill remains overdue & unpaid for a period exceeding 90 days.

An agricultural advance is classified as NPA is interest and/or instalment of principal is overdue for

• • two crop seasons, in case loans granted for Short Duration crops,
  • one crop season, in case loans granted for Long Duration crops (i.e. more than 1 year)

For this purpose, the following points are to be considered:

1. Long duration crops mean the crops with crop season longer than one year.
2. Short Duration Crops means the crops, other than long duration crops.
3. Crop season means the period up to harvesting of the crops, as determined by the State Level Bankers’ Committee in each State.
4. The above norms should be made applicable to all direct agricultural advances as listed in the Master Circular on Lending to Priority Sectors. In respect of all other agricultural loans, identification of NPAs would be done on the same basis as non-agricultural advances, which, at present, is the 90 days delinquency norm.
5. If natural calamities impair the repaying capacity of agricultural borrowers, banks may decide on their own as a relief measure conversion of the short-term production loan into a term loan or re-schedulement of the repayment period; and the sanctioning of fresh short-term loan, subject to guidelines issued by RBI.

(i) NPA Norms for agricultural advances:
An agricultural advance is classified as NPA is interest and/or instalment of principal is overdue for

• • two crop seasons, in case loans granted for Short Duration crops,
  • one crop season, in case loans granted for Long Duration crops (i.e. more than 1 year)

For this purpose, the following points are to be considered:

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

In case there arise erosion in the value of security or any fraud is committed by Borrowers, banks can directly classify these accounts as Doubtful Assets or Loss Assets, irrespective of the period for which the account has remained NPA.

(i) Erosion in the value of securities by more than 50% of the value assessed by the bank or accepted by RBI inspection team at the time of last inspection, as the case may be, would be considered as “significant”, requiring the asset to be classified as doubtful straightaway and provided for adequately.
(ii) The realisable value of security as assessed by bank/approved valuers/RBI is less than 10% of the outstanding in the borrowal accounts, the existence of the security should be ignored and the asset should be classified as loss asset. In such cases the asset should either be written off or fully provided for.

To determine the nature, timing and extent of substantive procedures over advances, auditor should examine the efficacy of various internal controls over advances.

1. Advances should be made only after evaluating creditworthiness of the borrowers and obtaining sanction from the proper authorities of the bank.
2. All the loan documents like promissory notes, letters of hypothecation, guarantee letter, etc. should be executed by the parties before advances are made.
3. While determining the loan amount to be sanctioned, sufficient margin should be kept against securities taken so as to cover any decline in the value thereof and also to comply with RBI directives.
4. Securities should be received and returned by responsible officer and should be kept in the joint custody of atleast two responsible officers.
5. Securities requiring registration should be registered in the name of the bank.
6. In the case of physical possession of goods as security, the goods should be test checked at the time of receipts. In respect of hypothecated goods not in possession of the bank, surprise checks should be made.
7. Personal inquiries should be made so as to determine market value of goods.
8. For any increase/decrease in the value of securities, drawing power should be adjusted. All the accounts should be kept within both the drawing power and the sanctioned limit at all times.
9. All irregular accounts should be brought to the notice of the H.O. regularly.
10. The operation in each advance should be reviewed at least once every year.
11. There should exist a proper system for post disbursement supervision and follow-up.
12. Classification of advances should be made as per RBI Guidelines.
13. Ensure that the funds disbursed should be utilized only for the purpose for which advances has been granted.

Collection of Evidences in respect of Advances:
Evidences in respect of advances may be collected by performing compliance and substantive procedures.
Compliance Procedures:

(a) Examine the following:

• • • loan documentation;
    • validity of the recorded amounts;
    • existence, enforceability and valuation of the security;

(b) Ensure compliance with the

• • terms of sanction
  • end use of funds
  • loan Policy of Bank as well as RBI norms including appropriate classification and provisioning
  • review the operation of the accounts.

Substantive Procedures:

(a) Verify that amounts included in balance sheet in respect of advances are outstanding at the date of the balance sheet.
(b) Verify that advances represent amount due to the bank.
(c) Ensure that outstanding amount is appropriately supported by Loan documents.
(d) Ensure that there are no unrecorded advances.
(e) Verify the appropriateness of basis of valuation of advances.
(f) Ensure that the recoverability of advances is recognised in their valuation.
(g) Check that the advances are disclosed, classified and described in accordance with recognised accounting policies and relevant statutory and regulatory requirements.
(h) Ensure that appropriate provisions towards advances have been made as per the RBI norms.

Nature of Securities to be offered:

(a) Primary security: Security offered by the borrower for bank finance or the one against which credit has been extended by the bank.
(b) Collateral security: It is an additional security and can be in any form i.e. tangible or intangible asset, movable or immovable asset.

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

(a) 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.
(b) 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.
(c) 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.
(d) Assignment: Assignment represents a transfer of an existing or future debt, right or property belonging to a person in favour of another person. Only actionable claims such as book debts and life insurance policies are accepted by banks as security by way of assignment. An assignment gives the assignee absolute right over the moneys/debts assigned to him.
(e) 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.
(f) 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.

Auditor’s considerations while obtaining evidence in carrying out audit of advances:
In carrying out audit of advances, the auditor is primarily concerned with obtaining evidence about the following:

(a) Amounts included in balance sheet in respect of advances which are outstanding at the date of the balance sheet.
(b) Advances represent amount due to the bank.
(c) Amounts due to the bank are appropriately supported by loan documents and other documents as applicable to the nature of advances.
(d) There are no unrecorded advances.
(e) The stated basis of valuation of advances is appropriate and properly applied and the recoverability of advances is recognised in their valuation.
(f) The advances are disclosed, classified and described in accordance with recognised accounting policies and practices and relevant statutory and regulatory requirements.
(g) Appropriate provisions towards advances have been made as per the RBI norms, Accounting Standards and generally accepted accounting practices.

Provisioning Requirements of NPA:
Statement that “There is no difference in provisioning of NPA as regards to categories of NPA, whether the debt is secured or unsecured” is not correct as the provisioning requirements for substandard and doubtful categories of NPA are different for secured and unsecured advances.

(a) For Substandard advances: Additional provision is required @ 10% (5% for infrastructure advances).
(b) For Doubtful Advances: Provisioning requirements are given below:

Primary Security and Collateral Security:

1. 1. Primary security refers to the security offered by the borrower for bank finance or the one against which credit has been extended by the bank. This security is the principal security for an advance.
   2. Collateral security is an additional security. Security can be in any form i.e. tangible or intangible asset, movable or immovable asset.
      Examples of most common types of securities accepted by banks are the following:

• • • Personal Security of Guarantor
    • Goods/Stocks/Debtors/Trade Receivables
    • Gold Ornaments and Bullion
    • Immovable Property
    • Plantations (For Agricultural Advances)
    • Third Party Guarantees
    • Banker’s General Lien
    • Life Insurance Policies
    • Stock Exchange Securities and Other Instruments

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

(a) 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.
(b) 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.
(c) 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.
(d) Assignment: Assignment represents a transfer of an existing or future debt, right or property belonging to a person in favour of another person. Only actionable claims such as book debts and life insurance policies are accepted by banks as security by way of assignment. An assignment gives the assignee absolute right over the moneys/debts assigned to him.
(e) 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.
(f) 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.

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.

Funded Loans:
Funded loans are those loans where there is an actual transfer of funds from the bank to the borrower. Advances comprise of funded amounts by way of:

(i) Term loans
(ii) Cash credits, Overdrafts, Demand Loans
(iii) Bills Discounted and Purchased
(iv) Participation on Risk Sharing basis
(v) Interest-bearing Staff Loans

Reporting of Cash credit Facility:

• • An Advance will be classified as non-performing advance if:

(a) It ceases to generate income for a bank; or
(b) Interest and/or instalment of principal in respect of such an advance have remain overdue or out of order for a specified period of time

• • An account is said to be ‘Overdue’, if it is not paid on the due date fixed by the Bank. An account should be treated as ‘Out-of-order’ if the 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 balance sheet date or the credits are not enough to cover the interest debited during the same period.
  • In the given case, though outstanding balance of INR 75 Lakhs is within the drawing power but, the amount credited in the account (i.e. INR 2.5 Lakhs) is not enough to cover the interest charged in the account (i.e. INR 3.5 Lakhs).
    Conclusion: Auditor should report the account as non-performing advance in the report.

Income Recognition norms w.r.t. Advances:

• • Any income which exceeds

1. one per cent of the total income of the bank if the income is reckoned on a gross basis
or
2. one per cent of the net profit before taxes if the income is reckoned net of costs,
should be considered on accrual as per AS-9 (subject to certainty as to their ultimate collection). Other incomes may be recognised when received.

• • In case of NPA, RBI guidelines require that banks should not recognize income until it is actually realised.
  • Interest on advances against Term Deposits, National Savings Certificates (NSCs), Indira Vikas Patras (IVPs), Kisan Vikas Patras (KVPs) and Life policies may be taken to income account on the due date, provided adequate margin is available in the accounts.
  • In the case of outstanding bills purchased and discounted the discount received thereon should be properly apportioned.
  • Fees and Commission earned by the bank as a result of rescheduling of advances should be recognized on accrual basis over the period covered by the rescheduled extension of credit period.

Reversal of Income:

(a) First time NPAs: If a Loan/Advance is treated as NPA for the first time, interest accrued which has not been realized but credited to the Income Account should be reversed or provided for.
(b) Commission/other Income: If interest income is recognized on cash basis, then Commission and other such income with respect to the same Borrower, which has been recognized on accrual basis in the previous year but has not been realized, should be reversed or provided for with respect to previous year.
(c) Finance Charge of 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.

Verification of Interest Expenditure:

(a) Obtain from the bank an analysis of various types of deposits outstanding at the end of each quarter and compute a weighted average interest rate. The rate so computed should be compared with the actual average rate and enquire into the difference, if material.
(b) Compare the average rate of interest paid on deposits with the corresponding figures for the previous years and enquire into the difference, if material.
(c) Verify the calculation of interest and ensure the following:

• • • Interest has been provided on all deposits upto the date of the balance sheet and determine whether there is any excess or short credit.
    • Interest rates are in accordance with the bank’s internal regulations, RBI directives and agreements with the depositors;
    • In relation to fixed deposits, examine whether the interest rate in the accounting system are same as mentioned in the Fixed Deposit Receipt/Certificate.
    • Interest on Savings Account should be checked on a test check basis in accordance with the rules framed by the bank.
    • Interest on inter-branch balances has been provided at the rates prescribed by the head office.
    • Interest on overdue/matured term deposits should be estimated and provided for.

(d) Ascertain whether there are any changes in interest rate on saving deposits and term deposits during the period.

It is advisable that audit teams carry out the physical verification of cash during the branch audit and document the same with a statement of physical verification duly signed by the cashier/other branch officials and the audit team members.

Audit teams need to review the significant accounting policy of the bank to verify whether such BG commission is being accounted for on cash basis or on accrual basis. Accordingly, if the BG commission is accounted for on accrual basis auditors need to ensure that the BG commission is amortised over the period of the Bank Guarantee and the commission reversed in case of premature closure of the Bank Guarantee.

The MOCs issued at branch level are not accounted for at the branch during the same financial year since the pre MOC financial statements of the branch get consolidated at the Zone/Circle/Head Office level. Instead, the MOCs issued by the branch auditors are consolidated at the Zone/Circle/Head Office level so as to ensure impact of such MOCs in the financial statements of the bank on a global basis.

Accordingly, rent entries may appear in the books of the corresponding branch during the current year. However, the said entry will always have a corresponding contra entry at Head Office to negate its effect. It shall accordingly not be treated as a prior period expense.

Most banks generally account for locker charges on receipt basis which may be confirmed with the Significant Accounting Policy (SAP) of the bank. Accordingly, unless locker charges are being accounted for on accrual basis by the bank, MOC would not be required to be issued.