Pertinent Issues Concerning Statutory Bank Branch Audit

Presented By: CA Charanjot Singh Nanda

An audit is an independent examination of financial statement of an organization by the appointed auditors as per terms of appointment and statutory liabilities of auditor with a view to express his independent opinion.

Audit?

BANK AUDIT Bank auditing is the procedure of reviewing the services and procedures adopted by banks and other financial institutions. It is a routine procedure that all financial services entities must undergo in order to ensure that they are in compliance with industry standards and jurisdictional regulations.

Increase of efficiency.

Quick presentation of accounts.

Preparation of interim

accounts.

Knowledge of technical

details.

Wide coverage.

Regularity of clients staff.

Moral check.

Allocation of audit work.

To identify error and frauds.

Types of Banking Institutions

• Commercial Banks

• Regional Rural Banks

• Co-operative Banks

• Foreign banks

• Small Finance Banks

• EXIM Banks

• Payment Banks

• Development banks

Statutory Audit Statutory Audit of banks can be defined as an audit to ensure that the financial statements and books of account presented to the regulators and the public are fair and accurate. It is an audit that is prescribed by a different statute such as Income Tax, Reserve bank of India , Companies Act and So on. The Statutory audit of banks is mandatory and the RBI in association with the ICAI appoints Statutory Auditors for the same.

NON PERFORMING ASSETS

Non Performing Asset means a loan or an account of borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the directions or guidelines relating to asset

classification issued by RBI.

Non Performing Assets

Sub standard Assets

Doubtful Assets

Loss Assets

CATEGORIES OF NPA

• Standard Assets : Arrears of interest and the principal amount of loan does not exceed 90 days at the end of financial year.

• Substandard Assets : Which has remained NPA for a period less than or equal to 12 months.

• Doubtful Assets : Which has remained in the sub-standard category for a period of more than 12 months. – D1 i.e. up to 1 year : 25% provision is made by the bank – D2 i.e. 2 to 3 years : 40% provision is made by the bank – D3 i.e. more than 3 years : 100% provision is made by the bank

• Loss Assets : 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.

REASONS BEHIND RISE IN NPA

• Lack of proper pre-enquiry by the bank for

sanctioning a loan to a customer.

• Non performance of the business or the

purpose for which the customer has taken

the loan.

• Willful defaulter.

• Loans sanctioned for agriculture purposes.

• Change in govt. policies leads to NPA.

EFFECTS OF NPA ON BANKS & FI

• Restriction on flow of cash done by bank due to the provisions of fund made against NPA.

• Drain of profit.

• Bad effect on goodwill.

• Bad effect on equity value.

FACTORS IMPACTING RISE IN NPAs

External factors :

• Ineffective legal

framework & weak

recovery tribunals

• Lack of demand /

economic recession or

slowdown

• Change in Govt. policies

• Wilful defaults by

customers

• Alleged political

interferences

FACTORS IMPACTING RISE IN NPAs

Internal factors :

• Defective Lending process

• Inappropriate / non –use of technology like MIS , Computerization

• Improper SWOT analysis

• Inadequate credit appraisal system

• Managerial deficiencies

• Absence of regular industrial visits & monitoring

• Deficiencies in re-loaning process

• Alleged corruption

• Inadequate networking & linkages b/w banks

BANKER – SIDE

• Defective Sanction

• No post-sanction

supervision, etc

• Delay in releases

• Directed lending

• Slow decision

making process

BORROWER-SIDE • Lack of Planning

• Diversion of Funds

• No contribution

• No modernization

• Improper monitoring

• Industrial Relations

• Natural Calamities

WHY LOAN ACCOUNTS GO BAD?

Issues in Bank Audit – Advances

Area of Focus Key challenges/ Issues in bank audit

Valuation

of

Advances

• Review of assumptions underlying specific provisions computed by management

(e.g. retail advances) • Appropriateness of recognition and subsequent reversal of floating provisions

• Assessment of external factors impacting recoverability of portfolio, e.g. exposure to

Micro-Finance Institutions, impact of increase in oil prices on the portfolio, impact of

currency fluctuations, scams (real estate), etc.

Compliance

with RBI

norms

Income Recognition, Asset Classification and Provisioning

• Challenges in complying with borrower wise provisioning norms, e.g. portfolio buy-

outs, accounts written off • Timing of application of restructuring guidelines e.g. Approval of scheme verses

Implementation of scheme

•Maintenance of Provision Coverage Ratio (PCR)

Exposure Norms

• Compliance with Priority Sector Limits, Commercial Real Estate, Capital Market

exposure, Single and Group Borrower Limits

Issues in Bank Audit – Investments, Nostro balances and Sundry/Suspense

accounts Area of Focus Key challenges/ Issues in bank audit

Valuation of

Investments

• MTM valuation of ‘Available for Sale’ and ‘Held for Trading’ investments (e.g. linear

interpolation for intermediate tenors) • Assessment of ‘Other than temporary’’ impairment on ‘Held to Maturity’ investments

• Trade date verses Settlement date accounting

• Amortisation of premium on AFS and HFT investments

Reconciliation of

Nostro balances

• Review of significant unreconciled debit and credit entries • Existence of balances (obtain external bank confirmations)

Sundry /Suspense

accounts

• Review and provision of aged balances

Issues in Bank Audit – Other areas

Area of Focus Key challenges/ Issues in bank audit

TAXATION

Impact of Direct

and Indirect tax

laws on business/

transactions

Direct Tax

•Extent of deduction which can be claimed for Head Office Expenses (applicable to

foreign bank branches)

•Transfer Pricing implications on cross border transactions

•Extent of disallowance under Section14(A) of Income Tax Act, 1961

Indirect Tax

• VAT on assets repossessed and bullion transactions

INFORMATION TECHNOLOGY

Information

Technology –

Security

• Data security and confidentiality

• IT systems/ infrastructure to be housed onshore

Issues in Bank Audit – Presentation and Disclosure

Area of Focus Key challenges/ Issues in bank audit

Format of Balance Sheet

, Profit and Loss

Account, and

Disclosures in Notes to

Accounts

• Compliance with the format prescribed under Schedule III of Banking

Regulation Act, 1949

• Compliance with Master Circular on Disclosure in Financial Statements – Notes

to accounts (dated 1 July 2010)

Presentation in

financial statements

• Classification of advances in Schedule 9 – Secured and Unsecured Advances ,

e.g. advances where security documentation is incomplete

• Gross verses Net presentation of assets and liabilities, e.g. mark to market

receivables and payables on derivatives

Specific Disclosures in

Notes to Accounts

• Challenging assumptions used for disclosure of Maturity pattern of assets and

liabilities

• Compliance with disclosures required under Accounting Standards (AS), e.g.

Segment Reporting (AS 17) , Related Party Transactions (AS 18), Provisions,

Contingent Assets and Contingent Liabilities (AS 29), etc.

• Disclosure on Movement in Non Performing Assets - monthly/ quarterly/ annual

movement – consistency required in internal and external reporting

• Disclosure of exposure to Priority Sector, e.g. buy out loans

Issues in Bank Audit – Statutory Certifications

Auditors are required to issue 9 statutory certificates to the Bank as prescribed by RBI, namely

• Prudential norms on income recognition, asset classification and provisioning

• Prudential norms on classification, valuation and operation of investment portfolio

• Capital Adequacy

• Cash Reserve Ratio and Statutory Liquidity Ratio

• Significant frauds reported during the year

• Serious Irregularities

• Export Interest Subvention Claim on Rupee Export Credit

• Compliance on Key Areas (as notified by RBI)

• Ratios and Disclosures

Area of Focus Key challenges/ Issues in bank audit

Capital Adequacy • Rating of SME counterparties not obtained by the Bank – risk weight of 100%

assigned (for unrated) • Grossing of derivative MTM receivables and payables

Cash Reserve Ratio (CRR)

and Statutory Liquidity

Ratio (SLR)

• Accrual of operating expenses, provision of staff retirement liabilities, etc. is ignored for computation on NDTL - may result in understatement of liabilities

Significant Risk Areas in Banks

RISK AREAS IN BANK AUDIT

• Loans/ Advances against hypothecation of stock.

• Housing Loan Cases

• Submission of forged documents including letter of credit

• Escalation of overall cost of the property to obtain higher loan amount.

• Over Valuation of mortgaged properties at the time of sanction

• Grant of loan against forged FDR’s.

• Over-invoicing of export bills resulting in concessional bank finance, exemptions from various duties, etc.

• Frauds stemming from house keeping deficiencies.

Significant Risks Impacting Banks

Risk Category Key Areas of Focus

Credit Risk Risk that a borrower will be unable to meet its obligations

• Assessment of recoverability of Advances, Investments, Derivatives and Other Assets

Liquidity Risk Risk that the bank’s obligations to repay liabilities or fund new loans exceeds the banks ability to raise funds from either the liquidation of assets or the acceptance of new deposits

• Review of maturity pattern of assets and liabilities

Market Risk Financial impact on a bank resulting from movements in exchange rates and interest rates

• Review of stress testing performed on the portfolio

Regulatory Risk Non Compliance / violation of Regulations resulting in penalties and fines

• Assessment of compliance with Banking Regulation Act, 1949, guidelines and notifications issued by RBI for conduct of operations, accounting of transactions and disclosures

Other risks impacting banking operations include operational risk and legal risk

RISKS IN CIS ENVIRONMENT

• Potential for errors and irregularities due to:

• Invisibility of data. • No visible evidence for

unauthorized access to data. • Errors in system handled

transactions remain undetected due to no human intervention.

• Errors in design or modification of programs may remain undetected.

• Manual controls depend upon system generated reports, hence error in report will affect even manual records.

FRAUDS IN BANKS

NIRAV MODI SCAM

During the last year, one fraud now commonly known as Nirav Modi scam has shaken up the whole banking industry. In this fraud involving over Rs 14000 crore of banks’ funds, a concurrent auditor of the concerned bank has been arrested for failing to report the fraud . Besides, the CSAs of the bank have also been questioned by the external investigating agency.

• The fraud occurred due to failure of the bank to link the Swift system with its CBS resulting in creation of buyers credit liability on bank without the same being reflected in its books of accounts. This system failure on part of the bank was a gross violation of RBI’s guidelines which required the banks to link their swift system with CBS.

• As a Bank auditor, it is important for us not only to carry out routine audit procedures but also to look for such system weakness which may result in loss to the banks and point the same to the management and CSAs for corrective action.

• In addition to the above system failure, one more important aspect in which the bank failed and which helped in this fraud of such magnitude to have happened is “ Staff Rotation”.

• A part of the branch audit statements to be certified by the bank branch auditor is one innocuous looking questionnaire called “Ghosh and Jilani report” which is generally taken lightly by the branch auditors.

• However, its importance has come to the light in this episode since one of the question pertained to staff rotation being done at prescribed intervals which was answered in affirmative.

• As a policy, the banks are required to rotate the staff from one work to other to ensure that one particular staff does not carry the same function beyond the prescribed period,.

• This serves a dual purpose since it ensures sufficient exposure to all staff members. Besides, in case of any fraudulent activity being carried by the staff now being rotated , the new staff member is able to detect the same at the earliest.

• However, in the present case. the staff member involved remained at the same seat for over 7 years in complete violation of prescribed banking procedures as this enabled the concerned staff member to carry on the fraud without detection.

Vijaya Mallya Scam Background

• USL is an Indian alcoholic beverage company, the worlds second largest by volume.

• However Mallya suffered major losses after Kingfisher was grounded.

• In this whole process Mallya’s company took loan from 17 banks ,which got got outstanding of over INR 7000/- crores, with State bank of India being the biggest lender with INR 1600/- crores.

Siphoning of Funds

• VM borrowed money from many banks to allegedly fund Kingfisher Airlines (KFA), but siphoned off the money to buy properties and teams across the world.

• He pledged the Kingfisher brand and borrowed further money. When KFA was a huge loss making company, IDBI lent it INR 900 crores under pressure from the Congress Government.

• When the banks were after him, he became a Rajya Sabha member, sponsored by the congress. The banks stopped chasing him.

Willful Defaulter

• On 21 November, 2015; Mallya was declared “willful defaulter” by SBI.

• This declaration came after SBI’s grievance redressal committee quashed the arguments made by Mallya’s legal representatives.

• Then, on 14 February 2016, SBI decided to auction Kingfisher house to clear a debt of INR 6,963 crores.

RESTRUCTURING OF BANK LOANS

• Restructuring is an act in which a lender, for economic or legal reasons relating to the borrower's financial difficulty, grants concessions to the borrower. Restructuring would normally involve modification of terms of the advances / securities, which would generally include, among others, alteration of repayment period / repayable amount / the amount of installments / rate of interest / rollover of credit facilities / sanction of additional credit facility / enhancement of existing credit limits / compromise settlements where time for payment of settlement amount exceeds three months..

RESTRUCTURING OF BANK LOANS ( Contd.)

• The quarterly financial results of various public sector banks have shown losses. This has been a result of large Non-Performing Assets (NPAs) in their loan books. If you are just wondering what a NPA is, it is that loan which has failed to pay its installments even after 90 days of such installment becoming due. While RBI categorizes loans into various complex categories and has different NPA classification criteria for them, we are sticking to the most basic definition for the sake of simplification.

WAYS FOR RESTRUCTURING OF BANK LOANS

Rescheduling the Loan Repayment: The borrower can offer to just restructure the loan

repayment schedule to match the operational cash flows. There might be situations when the business goes through long operating cycles and the cash flows may be skewed to some specific months instead of being spread evenly over the year. Similarly, the cash inflows may be lower in the earlier years but higher during the later years of the project. As such, rescheduling the loan repayment can help tide over such genuine operational issues.

Reducing the Interest Rates: It may so happen that the interest rate at which

the loan had been taken is higher than what it ideally should be. This change may have happened due to some regulatory changes or changes in the market for the product. Higher interest rates are not desirable and thus, the borrower may approach the bank to reduce the interest rates so that the loan continues to be in good standing. Reduction in the interest rates directly impacts the project cost favorably making it viable.

Waiver of Overdue Interest:

The borrower may not have paid a couple of installments due to

genuine financial issues. As a result of such default, banks generally charge some delayed/overdue interest to compensate for such delay. Such cost directly adds to the project costs. Further, bank policies are such that they generally adjust the overdue interest first at the time of regular installment. Hence, the borrower enters the vicious circle of some amount remaining overdue always and causing the overdue interest to continue increasing. In case the borrower makes regular payments subsequently, he can also approach the bank for waiver of overdue interest. Considering better and regular repayment history, banks are inclined to waive such amounts to encourage the borrower to stay regular in repayment.

JILANI COMMITTEE RECOMMENDATIONS

• Objective of Jilani Committee is to review the

efficacy and adequacy of internal control, inspection and audit system in a bank with a view to strengthening the supervisory system and reliability of data

• There are three categories of recommendations

a. EDP environment in banks

b. Inspection/Internal audit in the banks

c. Miscellaneous aspect of functioning of a bank

Jilani committee recommendations: -

• Broad guidelines to establish accountability for inspectors/auditors should be laid down

• A copy of the booklet incorporating RBI circulars to be supplied to each inspecting/audit official by inspection and audit department periodically.

• Banks should have system for ratings of its branches on the basis of inspection reports

• Major irregularities detected during concurrent audit to be immediately taken up with Head office

• Various test to be carried out to ensure that EDP applications have resulted in consistent and reliable system for inputting, processing and generation of output of data

• Entire domain of EDP activities to be brought under scrutiny of inspection and audit including financial aspect

• Regular checking by inspectors/auditors to verify correctness of information complied/furnished by branches

Responsibility for implementation and Auditors Role

• Management is responsible for the

implementation of Jilani committee recommendations.

• The responsibly of the statutory auditor is to verify and report on the status of implementation of these recommendations and no further

• The results of the verification carried out by the statutory auditor and his comments would be given in separate report

GHOSH COMMITTEE

• The recommendations of Ghosh Committee are divided into Groups A,B,C,D with 2 parts each, Group C having one part. Out of 97 Recommendations 27 are required to be reported at Branch level, 43 at RO/ZO/HO level and 27 at both levels.

• They are further categorized on implementation basis as follows: -

– Group A -Recommendations which have to be implemented by the banks immediately

– Group B- Recommendations requiring RBI approval

– Group C- Recommendations requiring approval of Government of India

– Group D- Recommendations requiring further examination in consultation with IBA

Main objectives of Ghosh Committee

• Safety of assets

• Compliance with laid down policies and procedures

• Accuracy and completeness of accounting and other records

• Proper segregation of duties and responsibilities of staff

• Timely prevention and detection of frauds and malpractices

Long Form Audit Report

Long Form Audit Report to include matters specified in RBI Circular

Long Form Audit Report dated 17 April 2002 (e.g. Control environment,

Liquidity and funds management, Advances, etc) LFAR to be submitted by 30th June following the year end Key issues include: • Commentary on Large Advances (where outstanding amount

is in excess of 5% of the aggregate advances of the branch or Rs.20 million, whichever is less)

• Commentary on compliance with recommendations made by Jilani, Ghosh, Mitra and Goiporia Committee

It is also not a part of the Main Audit report

LFAR doesn’t substitute the Main Audit report

Matters reported in LFAR are illustrative and not exhaustive.

However every adverse comment may not result into Qualification in Main Audit report

MEMORANDUM OF CHANGES (MOC)

• MOC is an important document enclosed with the Bank Audit Report whenever the Auditor observes significant issues effecting the Financial Statements of the Bank.

• Usually, in case of other entities, first the accounts are audited and then the financial statements are drawn up adhering to all the regulatory principles as formulated by the laws of the land. Whereas in case of Banks, audit report is sent after the internal authorities have drawn up the final accounts which are already sent for compilation at Zonal levels.

Points have to be noted about MOC

• There should be clear justification for every change suggested by auditor i.e. the nature of change as well as the quantification of suggested change and it impact otherwise.

• The format of MOC in most banks will have both sides like a trial balance. It should be ensured that total of changes suggested in balance sheet and profit and loss account is tallied on both accounts.

• The total of reclassification of the advances suggested in secured , unsecured ,guaranteed advance and sector wise advance should be correctly brought out in the MOC and total of both sides should tally.

• In case of change suggested as per prudential norms on income recognition, the impact, if any on the provisioning of the assets is also to be looked into.

• It is to be ensured that a NIL MOC is invariably forwarded, even if there are no change to report.

• Branch manager are required to report on each item reported in MOC.

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CA Charanjot Singh Nanda