[FAQs] Audit of Banks – Banking Operations, NPA Identification & Priority Sector Lending

Regulation of Banking Industry:
In India, banking industry is regulated by the Reserve Bank of India (RBI) known as the Central Bank. Major functions and responsibilities of RBI are:

• • development and supervision of the banks and non-banking financial institutions
  • determining, the monetary and credit policies.
  • issuance and regulation of currency;
  • acting as banker to the central and state governments, commercial and other types of banks including term-lending institutions.
  • to regulate the activities of commercial and other banks.

Principal Enactments governing Bank Audit:

(a) Banking Regulation Act, 1949;
(b) Reserve Bank of India Act, 1934;
(c) Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970;
(d) State Bank of India Act, 1955;
(e) State Bank of India (Subsidiary Banks) Act, 1959;
(f) Regional Rural Banks Act, 1976;
(g) Companies Act, 2013;
(h) Cooperative Societies Act, 1912 or the relevant State Cooperative Societies Acts;
(i) Information Technology Act, 2000;
(j) Prevention of Money Laundering Act, 2002;
(k) Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;
(l) Credit Information Companies Regulation Act, 2005; and
(m) Payment and Settlement Systems Act, 2007

Different types of banking institutions prevailing in India:

1. Commercial banks are the widest spread banking institutions in India, that provide a number of products and services to general public and other segments of economy. Two of its main functions are:

(a) accepting deposits and
(b) granting advances.

2. Regional Rural Banks known as RRBs are the banks that have been set up in rural areas in different states of the country to cater to the basic banking and financial needs of the rural communities. Examples are Punjab Gramin Bank, Tripura Gramin Bank, Allahabad UP Gramin Bank, Andhra Pradesh Grameena Vikas Bank, etc.

3. Co-operative Banks function like Commercial Banks only but are set up on the basis of Cooperative Principles and registered under the Cooperative Societies Act of the respective state or the Multistate Co-operative Societies Act and usually cater to the needs of the agricultural and rural sectors. Examples are The Gujarat State Co-operative Bank Ltd., Chhattisgarh Rajya Sahakari Bank Mayardit, etc.

4. Payments Banks are a new type of banks which have been recently introduced by RBI. They are allowed to accept restricted deposits but they cannot issue loans and credit cards. However, customers can open Current & Savings accounts and also avail the facility of ATM cum Debit cards, Internet-banking & Mobile banking. Examples are Airtel Payments Bank, India Post Payments Bank, Paytm Payments Bank, etc.

5. Development Banks had been conceptualized to provide funds for infrastructural facilities important for the economic growth of the country. Examples are Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), Small Industries Development Bank of India (SIDBI), etc.

6. Small Finance Banks have been set up by RBI to make available basic financial and banking facilities to the unserved and unorganised sectors like small marginal farmers, small & micro business units, etc. Examples are Equitas Small Finance Bank, AU Small Finance Bank, etc.

Although, the statutory branch auditor can request the branch to arrange for a visit to the borrowers unit availing Cash Credit limit, I would recommend that Audit teams visit the client location only where the account operations are under stress or is potential NPA and the auditor has doubts regarding its asset classification/going concern status, level of operations etc. or to reconfirm whether or not DCCO has been achieved. Else, if it is a Standard operating account, I will not advise any audit team to venture into such unit inspections as it will only result in wasting precious audit time.

RBI vide updated Master Circular-“Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances” of April 1, 2022 stipulates that NPAs with balance of ` 5 crore and above need to be subjected to Stock Audit at annual intervals.

“With a view to bringing down divergence arising out of difference in assessment of the value of security, in cases of NPAs with balance of ` 5 crore and above stock audit at annual intervals by external agencies appointed as per the guidelines approved by the Board would be mandatory in order to enhance the reliability on stock valuation. Collaterals such as immovable properties charged in favour of the bank should be got valued once in three years by valuers appointed as per the guidelines approved by the Board of Directors.”

With respect to the policy with respect to Stock Audit of other accounts, audit teams would need to refer to the loan policy of the specific bank.

RBI vide para 9.1 of the

“Master Directions on Frauds – Classification and Reporting by commercial banks and select FIs”

dated July 1, 2016 (Updated as on July 3, 2017) stipulates as follows:

“Banks should subject the title deeds and other documents in respect of all credit exposures of ` 5 crore and above to periodic legal audit and re-verification of title deeds with relevant authorities as part of regular audit exercise till the loan stands fully repaid.”

A number of readers have over the past years raised queries regarding classification of regular limits of borrowers which were pending review/renewal for 180 days or more and had continued to be classified as “Standard” on account of having been subjected to “short review/quick review” for 90 days on each occasion. In cases queried, such accounts had been short reviewed/quick reviewed beyond the overall limit of 180 days stipulated as per the updated RBI Master Circular dated 1.4.2022. It was informed that such short/quick reviews were being carried out by banks on more than two occasions to effectively postpone the “due date” to a period of more than 180 days.

The issue raised was whether such expired credit limits could be short/quick reviewed on more than two occasions i.e. 3 or 4 times and continue to classify such accounts as “Standard”?

In my considered opinion, regular credit limit needs to be reviewed fully within the stipulated period of 180 days to avoid being classified as NPA in terms of the extant RBI norms since short/quick reviews cannot be treated as an original sanction. Logically, a maximum of two short/quick reviews for a period of 90 days each should be allowed by banks to ensure continuity of the overall limit of 180 days till such time the same is classified as NPA on expiry of the stipulated period.

It would also be pertinent to mention herein that Cash Credit limits automatically expire after a period of one year from the date of original sanction and the finacle software in such cases changes the limits to NIL requiring branch official(s) to sanction/authorise each payment thereafter till such time such limits are reviewed/renewed. To avoid this, some banks have a system of allowing “holding on operations” during the period of 180 days and subsequently classifying them as NPA in case holding on operations for 180 days does not result in regularisation of the expired limits.

Clean overdrafts and other limits can be sanctioned by the banks based on specific schemes as per their Loan Policy. However, there are no schemes relating to Clean Cash Credit limits which I am aware of.

Drawing Power can be calculated based on the specific margins and other terms and conditions contained in the Sanction letter. The general formula for calculating Drawing Power (DP) is as under:

Drawing Power = Net Value of Stock + Net Value of Debtors

Where,

Net Value of Stock = (Stock – Creditors)*(100% – % margin on stock)

Net Value of Debtors = (Debtors*(100% – % margin on debtors))

However, if the sanction letter has the following clause :

“In no case the Drawing Power against Book Debts should exceed more than 50% of the total debtors”

Then,

Value of Debtors = MIN (Debtors*(100% – margin% on debtors), Debtors*50%)

The final drawing power shall be lower of the sanctioned limit or the DP as calculated above.

In terms of the RBI guidelines, Drawing Power is required to be arrived at based on the stock statement which is current. 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. The outstanding in the account based on drawing power calculated from stock statements older that three months, would be deemed as irregular.

In terms of para 4.2. of RBI Master Circular No. RBI/2022-23/15DOR.STR.REC.4/21.4.048/2022-23 dated April 01, 2022

“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 non-availability of adequate drawing power based on the latest available stock statement, balance outstanding exceeding the limit temporarily, non-submission of stock statements and non-renewal of the limits on the due date, etc.”

However, it further states, “Regular and ad hoc credit limits need to be reviewed/regularised not later than three months from the due date/date of ad hoc sanction. In case of constraints such as non-­availability of financial statements and other data from the borrowers, the branch should furnish evidence to show that renewal/review of credit limits is already on and would be completed soon. In any case, delay beyond six months is not considered desirable as a general discipline.

Hence, an account where the regular/ad hoc credit limits have not been reviewed/renewed within 180 days from the due date/date of ad hoc sanction will be treated as NPA.

A cash credit limit is taken to finance the working capital deficit/finance the day to day operations of the borrower. Accordingly, if the borrower pays the term loan instalment through a cash credit limit, it would be perfectly in order provided the borrower has not already availed the limits to its maximum. In case the limit is already utilised or is overdrawn as on date and the borrower repays the Term Loan instalment to regularize the Term loan by further debiting the overdrawn CC limit, the audit teams would need to ignore such repayment of the Term loan and classify the same based on extant IRAC norms.

Some recommended audit procedures:

(a) Identify overdue PCs from the corresponding report generated from finacle/other bank software.

(b) Ensure that the EPC/PCFC availed by the borrower is set off either through export bill realisations (Collection) or Bills purchased by the branch.

(c) Export Orders should be verified for each PC availed.

(d) In case of a running PC account, one PC can be adjusted by any export invoice.

(e) Outstanding PCFC should be converted into INR as per the closing rates issued by FEDAI.

(f) Verify whether in terms of the sanction, the borrower is required to hedge the operations.

(g) If PCFC has been settled by discounting the export bills, whether corresponding discounting charges have been collected by the bank.

(h) Verify whether unexpired discount has been properly accounted for.

(i) Ensure that EPC/PCFC has been used for export only and has not been diverted for domestic sales etc. In that case, not only would it result in non-compliance with the sanctioned terms, but would also require application of interest as per inland finance instead of the subsidized interest rate applicable to exports.

All banks have scheme codes for differentiating different type of advances. Audit teams need to request the branch to provide them with the Scheme Code File with details of the scheme code, scheme description and GL Sub-Code based on which the agricultural advances can be identified. The audit teams would also have to carry out further audit procedures including mapping the loan with those listed in Annexure II to the RBI Master Circular on IRAC dated April 1, 2022 before deciding upon the exact nature.

If the account is not reviewed within the stipulated time, normally penal interest would be levied in terms of the sanction. Please refer to the sanction letter, banks loan policy and relevant circulars.

Credit balance in a cash credit account needs to be disclosed as a liability under “Current deposits” and should not be netted off from gross advances.

Para 3.3.2 of the RBI Master Circular on

“Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances” of April 1, 2022 prescribes the rule for appropriation of recoveries in NPAs:“In the absence of a clear agreement between the bank and the borrower for the purpose of appropriation of recoveries in NPAs (i.e. towards principal or interest due), bank should adopt an accounting principle and exercise the right of appropriation of recoveries in uniform and consistent manner.”

Hence, apportionment of credits in an account between charges, interest and principal would solely depend on the policy adopted by bank under audit. Audit teams are accordingly advised to refer to the order prescribed in the Significant Accounting Policy (SAP) of the bank under audit and ensure compliance thereof.

Yes, CERSAI registration is required for both movable and immovable assets.

The auditor needs to bring the same to the notice of the management, RBI and the Statutory Central auditors by reporting the same in the branch LFAR.

No. Since the credits are through genuine credits and the account is not ‘out of order’ in terms of para 2.2.1 of the RBI Master Circular on IRAC pertaining to Advances dated April 1, 2022, the account will not be treated as NPA.’

Yes. In case the same was not realized till the date of classification of the account as NPA. Para No. 3.2 of the RBI Master Circular on IRAC pertaining to Advances dated April 1, 2022 stipulates the regulation in this respect.

Yes. The account will have to be classified as NPA in terms of Para No. 2.2.1 (ii) of the RBI Master Circular on IRAC pertaining to Advances dated April 1, 2022. Further, in terms of para 2.3.1 of the said Master Circular, the account will have to classified as NPA as part of the day end process when there are no credits continuously for 90 days.

The auditor in such cases needs to review the account from other points of operation i.e. genuineness of credits, annual turnover as per books and GST returns, review of Stock Audit reports, Audited financial statements etc including compliance with Para. 2.2.1 (i) and (ii) of the RBI Master Circular on IRAC pertaining to Advances dated April 1, 2022. In case there are no indications of ever greening and any noticeable inherent weakness in the account operations etc, the account can continue to be classified as Standard, The fact of non-furnishing of relevant details in the Stock statement needs to be reported by the auditors under the relevant LFAR para.

In terms of para 2.2.1 (ii) of the RBI Master Circular on IRAC pertaining to Advances dated April 1, 2022, the account will be treated as ‘out of order’ in case credits are not enough to cover the interest debited during the previous 90 days period. Hence, as an auditor, you will need to compare the credits during the previous 90 days period as at 31st March 2023 with the interest debited during the same period (including interest debited for March 2023) and in case the same has not been recovered, account will need to be classified as NPA as at 31st March 2023.

Since the customer id is the same and it is to the same borrower, in my considered opinion, the Housing loans should also be classified as fraud. Although there is no specific guidance in this regards in the RBI regulations, the fact that it is to the same borrower with the same customer id, all accounts need to be classified as frauds and provided for accordingly.

Construction of Godown has not been included in the activities eligible for crop season linked asset classification norms in Annexure 2 to the RBI Master Circular on IRAC pertaining to Advances dated April 01, 2022. Accordingly, the relaxed delinquency norms will not apply and the classification of the account will have to be made on the 90 days norm. Accordingly, the said account will have to be classified as NPA.

Although there is no specific clarification whether the 180 days norms apply for renewal of KCC accounts. In my considered opinion, the norm of 1 year and 2 crops seasons/1 crop season (short/long duration crops) is more relevant for such renewal. Please also refer to the RBI Master Circular on KCC Scheme dated July 3, 2017 where the system of sanction of KCC limits clarifies that it is automatic and is linked to the crop season. In this respect, reference may also be sought from Annexure 2 to the RBI Master Circular on IRAC and provisioning pertaining to Advances dated April 1, 2022 wherein KCC loans have been linked to crop season linked asset classifications norms.

In my considered opinion, in the absence of any specific RBI guidelines, valuation of house properties is not required every three years except in the case of NPAs of ` 5 crore and above as provided in the RBI Master Circular on IRAC pertaining to Advances dated April 1, 2022.

Although, there are no specific regulatory guidelines with respect to short reviews etc. logically, a maximum of two short/quick reviews for a period of 90 days each should be allowed by banks to ensure continuity of the limits till such time the same is classified as NPA on expiry of the stipulated period of 180 days.

Refer to FAQ No. 31 hereinabove under Advances.

Since the financial statements together with the asset classification statements as audited and signed by the branch auditors are “as of a particular date”, subsequent recoveries will not alter the classification of the account as on the audit date. Accordingly, the branch auditor is advised to continue to classify the account as NPA in terms of the IRAC norms. The account will automatically be upgraded by the system in the next quarter/financial year provided the recoveries are sufficient.

In terms of the extant RBI guidelines contained in Part B1 – Framework for Resolution of Stressed Assets” the master circular on “Prudential Norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances” dated April 1, 2022 lenders need to recognise incipient stress in loan accounts, immediately on default, by classifying such assets as special mention accounts (SMA) as per the following categories:

(i) For Term Loans.

(ii) For revolving credit facilities like cash credit/overdraft.

The above-mentioned instructions on classification of borrower accounts into SMA categories are applicable for all loans (including retail loans), other than agricultural advances governed by crop season-based asset classification norms, irrespective of size of exposure of the bank.

Para 8.4 has been added to the updated master circular which states

“Classification of borrower accounts as SMA as well as NPA shall be done as part of day-end process for the relevant date and the SMA or NPA classification date shall be the calendar date for which the day end process is run. In other words, the date of SMA/NPA shall reflect the asset classification status of an account at the day-end of that calendar date.”

Branch Auditors can refer to the SMA reports to carry out further review in such accounts to enable identification of potential NPA/NPAs.

In terms of Para 28 (a) of the RBI Master Circular on “Income Recognition and Asset Classification Norms pertaining to Advances” dated April 01, 2022 :

The provisioning in respect of existing loan/exposures of banks to companies having director/s (other than nominee directors of government/financial institutions brought on board at the time of distress), whose name/s appear more than once in the list of wilful defaulters, will be 5% in case standard accounts; if such account is classified as NPA, it will attract accelerated provisioning as under :

RBI regulations require all accounts of the same borrower (same customer Id) to be classified as NPA and not of the same group etc. Since the borrower in both the instances is the individual, both accounts would require to be classified as NPA.

There may be instances where the same borrower (carrying same PAN) has different customer ids for different bank accounts i.e. for his/her personal loans (Housing, Vehicle etc.) and his/her proprietary firms. In all such cases the auditor needs to ensure that classification of all borrowers with the same PAN is similar.

Both the accounts would be classified as Standard.

Both the accounts would be classified as Non-Performing Asset (NPA).

Both accounts would be classified as Non-Performing Asset (NPA).

RBI regulations stipulate that all borrower accounts with the same customer id need to be classified under the same asset classification. Accordingly, since the HUF account has a separate legal entity as compared to an individual, both accounts would require to be separately classified in terms of extant IRAC norms with no correlation.

Validity period of Valuation reports in respect of Standard Assets are governed by the banks loan policy. Accordingly, audit teams are advised to refer to the banks loan policy and/or guidelines in this respect.

However, in respect of NPAs, the validity is governed by para 5.3.3 of the RBI Master Circular on IRAC pertaining to Advances dated April 1, 2022.

“With a view to bringing down divergence arising out of difference in assessment of the value of security, in cases of NPAs with balance of ` 5 crore and above stock audit at annual intervals by external agencies appointed as per the guidelines approved by the Board would be mandatory in order to enhance the reliability on stock valuation. Collaterals such as immovable properties charged in favour of the bank should be got valued once in three years by valuers appointed as per the guidelines approved by the Board of Directors.”

Accordingly, in respect of NPAs of ` 5 crore and above, Stock audit is mandatory at annual interval and in respect of immovable properties once in 3 years.

There are no specific RBI guidelines for the basis on which the value of primary security can be considered by the bank for arriving at the gross security available towards the provision to be made in respect of NPAs. Accordingly, the value thereof would be subjective and based on the circumstances of the specific NPA.

Based on past experience, one can conclude that under the following circumstances, it would be appropriate to consider the value of inventories, book debts etc. as Security in NPAs. Else, normally primary security would be negligible/Nil in NPAs:

(a) Where the unit is operational and is submitting the stock statements every month together with Stock Audit being done annually;

(b) Where the forensic audit report specifies existence of inventory charged to the bank;

(c) Where the unit is operational and is submitting the Book Debt statements duly certified by a Chartered Accountant;

(d) Where the unit is operational, and the value of the Book Debt statements is corroborated by the GST Returns on a proportionate basis;

(e) Where the unit is under Resolution under IBC and the Resolution Professional (RP) has certified the existence and realisable value of Inventories, Book debts etc.; and

(f) Any other basis on which the realisable value of the primary security could be assessed including the existence thereof.

Recoveries are made from the salary payable to the staff members. Hence the question of classifying such advances to working staff members as NPA would normally not arise. However, where the staff member has retired and recoveries are not being made on account of termination, fraud, litigation in a court of law etc. then such accounts would need to be classified as NPA in terms of the extant IRAC norms.

In terms of the RBI Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances of April 1, 2022 states that a non-performing asset (NPA) is a loan or advance where interest and/or instalment of principal remains overdue for a period of more than 90 days in respect of a term loan. Hence, even if part of the instalment has not been recovered and is overdue for a period of more than 90 days, the account will need to be classified as a NPA.

Para 4.2.6 of the

“RBI Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances”

dated April 1, 2022 specifies with respect to accounts regularised near the Balance Sheet date that

“The asset classification of borrowal accounts where a solitary or a few credits are recorded before the balance sheet date should be handled with care and without scope for subjectivity. Where the account indicates inherent weakness on the basis of data available, the account should be deemed as NPA.”

Please refer to Identification of NPAs for a detailed discussion on the aforesaid under CC/OD accounts – Special Checks.

The fact that there are counter guarantees would not impact the asset classification of the accounts as the same would be based on the “record of recovery” in terms of the extant IRAC norms in each account. However, the counter guarantee could impact the security of the accounts (both being financed units) which would have to be reviewed and reported upon in the LFAR depending on the seriousness of the irregularities observed by the audit teams.

The contra entries would need to be ignored since they were made with the sole intention of circumventing the system classification of the account as NPA account and accordingly the asset classification would be downgraded as NPA through MOC.

Further, since the contra entries were made with an intention to deceive the system by the official(s) concerned, the fact would need to be reported in the LFAR and also to the top management/Vigilance department in case the number of such contra entries at the branch were substantial.

The grant of a fresh loan to regularise an existing loan is clearly a non-compliance of the extant regulatory guidelines with respect to asset classification. Accordingly, the auditor would need to downgrade the accounts as NPA through MOC.

Further, since the fresh loan was sanctioned with the purpose of avoiding classification of the account as NPA, the fact would need to be reported in the LFAR and also to the top management/Vigilance department in case the number of such instances at the branch were substantial.

Yes, debit balances in Savings account would need to be classified as NPA in case the same have been outstanding for a period of more than 90 days.

If the primary security is Nil, the account will need to downgraded as NPA on account of the drawing power (DP) being zero in view of para (a) below of para 2.2.1 of the RBI Master Circular on IRAC pertaining to Advances of April 1, 2022:

When either of the following conditions is satisfied as on the date of the Balance Sheet (Para 2.2.1 of the Master Circular), a Cash Credit/Overdraft (CC/OD) account needs to be classified as a non-performing asset (NPA) in terms of para 2.1.2 of the RBI Master Circular:

(a) The outstanding balance in the CC/OD account remains continuously in excess of the sanctioned limit/drawing power for 90 days, or

(b) The outstanding balance in the CC/OD account is less than the sanctioned limit/drawing power but there are no credit continuously for 90 days, or the outstanding balance in the CC/OD account is less than the sanctioned limit/drawing power but credits are not enough to cover the interest debited during the previous 90 days period

Short Provision in NPA accounts would require to be corrected by issuing MOC provided the amount thereof is above the materiality level prescribed in the Closing Circular of the bank.

No, non-fund based limits being off Balance Sheet items/Contingent liabilities of the bank do not form part of the bank’s books of account and are accordingly not subject to the extant asset classification guidelines.

Priority Sector includes following categories:

(i) Agriculture (Farm Credit, Agricultural infrastructure and ancillary activities).

(ii) Micro, Small and Medium Enterprise.

(iii) Export Credit.

(iv) Education.

(v) Housing.

(vi) Social Infrastructure.

(vii) Renewable Energy.

(viii) Others.

For classification under priority sector, no limits are prescribed for bank loans sanctioned to Micro, Small and Medium Enterprises engaged in the manufacture or production of goods under any industry specified in the first schedule to the Industries (Development and Regulation) Act, 1951 and as notified by the Government from time to time. The manufacturing enterprises are defined in terms of investment in plant and machinery under MSMED Act, 2006.

Bank loans to Micro, Small and Medium Enterprises engaged in providing or rendering of services and defined in terms of investment in equipment under MSMED Act, 2006, irrespective of loan limits, are eligible for classification under priority sector, w.e.f. March 1, 2018.