CHAPTER 10

AUDIT OF BANKS

LEARNING OUTCOMES

After studying this chapter, you would be able to:

 Understand the legal framework for the Bank audit.
 Gain the knowledge of financial statements of the banks in
brief.
 Understand the audit approach for items of profit and loss in
case of banks.
 Learn the important items such as Advances, NPAs etc. in the
context of Bank Audit
 Understand practicality of above concepts by studying
through examples and case studies

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 10.2 AUDITING AND ETHICS

CHAPTER OVERVIEW

Introduction

Banking Operations

Accounting system
of Banks

Bank Audit
Approach

Advances & Their

Audit

Audit of
Revenue Items

Sameer was very comfortable with mobile banking app and used to do most of his
banking activities from this very app. Payments of house electricity bills, Wi-fi rental
bill, payments of little gifts for her mother and younger sister were all made by him
using his mobile. Whenever he needed to transfer money to any of his friends as
common contribution for an evening get together, he used to send money through
UPI using Bhim app.

One day, he happened to visit local branch of the bank in which his account was
maintained. He got a feeling that banking operations are very complex and not as
simple as he used to think. Since cash deposit machine was out of order on that
day, he had to deposit cash by going to the counter. It made him realise that there
is a trail for every bank transaction.

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 AUDIT OF BANKS 10.3

Huge volume of bank transactions take place instantly, moneys are deposited and
withdrawn from accounts. One can access one’s account from any geographical
location. Banks work on “Core Banking Solution” platforms which make transactions
to happen on such a scale by ensuring customer ease. Deliberating upon it, he also
thought about processes, controls and automation which makes all this possible.

He was trying to understand broad working of a bank. A bank accepts deposits

from its customers and lends money to trade, industry, farmers, needy sections of
society and to members of general public. The rate at which a bank pays interest
on deposits to customers is lower than the rates at which it charges interest on
advances. The spread is used to meet establishment and administrative costs of a
bank leaving out profits. In making available money to different sections of society
including trade and industry, banks act as drivers of economic growth of country.

Lending of money by a bank leads to reflection of “assets” in form of advances in

financial statements of a bank. He had heard the term “non-performing assets”
(NPAs) quite a number of times. What do these denote and what is their
significance from the point of view of an auditor? Are there some regulatory norms
relating to NPAs? Meanwhile, his attention also moved towards encompassing
outreach of audit in case of banks. Audit of banks appeared to be special because
of huge volume of transactions, extensive use of technology, wide geographical
spread of banks and other factors peculiar to banks. Excited, he was thinking of
prospects to conduct audit of a bank some day in future!

INTRODUCTION
Banking sector is the backbone of any economy as it is essential for sustainable
socio-economic growth and financial stability in the economy. The banking
sector is also crucial as it deals with mammoth amounts of public monies and is
highly sensitive to reputational risk. Like all economic activities, the banking sector is
also exposed to various risks in its operations. It is of utmost importance to ensure
that banking sector stays healthy, safe and sound. For safe and sound banking
sector, one of the most important factors is reliable financial information
supported by quality bank audits.

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 10.4 AUDITING AND ETHICS

Types of Banks
There are different types of banking institutions prevailing in India which are as
follows:

Commercial Banks Regional Rural Banks

Co-operative Banks. Payment Banks.
Development Banks (more commonly known Small Finance Banks.
as ‘Term-Lending Institutions’).

1. Commercial banks are the most wide 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 Grameen 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 Cooperative Societies Act and usually
cater to the needs of the agricultural and rural sectors. Examples are :- The Gujarat
State Co-operative Bank Ltd., Chhatisgarh Rajya Sahakari Bank Maryadit, 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 &
Mobilebanking. 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.

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 AUDIT OF BANKS 10.5

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.

Diagram showing Two Major Functions of Banks

Source :- twitter.com

Reserve Bank of India: Regulating Body

The functioning of banking industry in India is regulated by the Reserve Bank of
India (RBI) which acts as the Central Bank of our country.
RBI is responsible for :-
 development and supervision of the constituents of the Indian financial
system (which comprises banks and non-banking financial institutions)
 determining, in conjunction with the Central Government, the monetary and
credit policies keeping in with the need of the hour.
 regulating the activities of commercial and other banks

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 10.6 AUDITING AND ETHICS

Important functions of RBI are :-

 issuance of currency;
 regulation of currency issue;
 acting as banker to the central and state governments; and
 acting as banker to commercial and other types of banks including term-
lending institutions. Besides, RBI has also been entrusted with the
responsibility of regulating the activities of commercial and other banks.
No bank can commence the business of banking or open new branches without
obtaining license from RBI. The RBI also has the power to inspect any bank.

Independent audit of financial statement of banks is important for a healthy, safe and
sound banking system.

Banking Operations - Conducted only at Branches

Banking operations are conducted only at the branches, while other
offices act as controlling authorities or administrative offices that lay down
policies, systems and internal control procedures for conduct of business, in
compliance with the statutory/ regulatory impositions and in compliance of accepted
accounting principles and practices that cover all transactions and economic events.
These controlling/ administrative offices also stipulate the delegation of
powers and fix responsibilities and accountability and these are involved generally
in effective supervision, monitoring and control over the business activities and
operations, including seeking faithful compliance of the bank’s laid down policies/
procedures/controls and deal with deviations therefrom.
Regulatory Framework

Banking Regulation Act, 1949. State Bank of India Act, 1955.

Companies Act, 2013.
Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970.
Regional Rural Banks Act, 1976.
Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980.
Information Technology Act, 2000. Prevention of Money Laundering Act, 2002.
Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest Act, 2002.

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 AUDIT OF BANKS 10.7

Credit Information Companies Regulation Act, 2005.

Payment and Settlement Systems Act, 2007.

Besides, the above enactments, the provisions of the Reserve Bank of India Act,
1934, (RBI Act) also affect the functioning of banks. The RBI Act gives wide
powers to the RBI to give directions to banks which also have considerable
effect on the functioning of banks.

Peculiarities involved:
□ Huge volumes and complexity of transactions;

□ Wide geographical spread of banks’ network;

□ Large range of products and services

□ offered; Extensive use of technology;

□ Strict vigilance by the banking regulator etc.

Types of Bank Audit Reports to be issued (generally):

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.

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 10.8 AUDITING AND ETHICS

(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.

1. UNDERSTANDING OF ACCOUNTING SYSTEM IN

BANKS
From the time that customers had to physically visit and deal with a bank, there is
a sea change in banking as use of technology and its continuous evolution has
enabled banks to reach their customers in providing them the convenience and
comfort of anytime-anywhere-banking by letting them access their
information/data on real time basis, as stored in a safe and secure environment on
the bank’s servers. With many customers having access to Internet and mobile
connectivity, monetary transactions from inception to finish have become
expeditious through E-banking; but for Core banking technology and extensive
advancement therein and the availability and extensive use of technology tools,
banks could not have achieved such phenomenal and accelerated growth, and
could not have ventured into and offered a wide range of innovative
products and services to their customers. The transactions in banks have become
voluminous and it needs to be ensured that in the system of recording, transmission
and storage of information/ data, integrity thereof is optimally maintained and control
systems ensure that the same is free of errors, omissions, irregularities and frauds.
Considering the challenges of technology, bank managements continuously
endeavor to make their internal control systems robust, safe and secure as well as
convenient and expeditious for the customers.

In the computerized environment, it is imperative that the auditor is familiar with

and satisfied that all the norms/parameters as per the latest applicable
RBI guidelines are incorporated and built into the system that generates
information/data having a bearing on the classification/ provisions and income
recognition. The auditor should not go by the assumption that the system
generated information is correct and can be relied upon without evidence that
demonstrates that the system driven information is based on the required
parameters. He should use Professional Skepticism and Prudence wherever he feels

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 AUDIT OF BANKS 10.9

that something manually needs to be performed to check the authenticity and

consistency of the information obtained from the systems and document the
results of such activities performed.

2. BANK AUDIT APPROACH

1. Drawing an Audit Plan: An audit plan should be drawn up based on :-
 the nature and level of operations,
 nature of adverse features,
 level of compliance based on previous reports and
 audit risks based on inadequacy in or breach of internal controls and the
familiarization exercise carried out,
2. Control Environment at the Bank: A bank should have appropriate controls
to mitigate its risks, including effective segregation of duties (particularly,
between front and back offices), accurate measurement and reporting of
positions, verification and approval of transactions, reconciliation of
positions and results, setting up limits, reporting and approval of exceptions, physical
security and contingency planning.
The following are certain common questions /steps, which have to be kept in mind
while undertaking/ performing control activities:

Nature of Questions to be considered / answered

Questions
Who □ Who performs the control?
□ Does the above person have requisite knowledge and
authority to perform the control?
What □ What evidence is available to demonstrate /prove that
the control is performed?
When □ When and with what frequency is the control performed?
□ Is the frequency enough to prevent, detect and correct risk
of material misstatements?

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Where □ Where is the evidence of performance of the control

retained?
□ For how long is the evidence retained?
□ Is the evidence accessible/ available for audit?
Why □ Why is the control being performed?
□ What type of errors are prevented or detected through the
performance of the control?
How □ How is the control performed?
□ What are the control activities?
□ Can these activities be bypassed?
□ Can the bypass, if any, be detected?
□ How are exceptions / deviations resolved on
identification?
□ What is the time frame for resolving the exceptions /
deviations?

3. Engagement Team Discussions: All personnel performing an engagement,

including any experts contracted by the firm in connection with that engagement
are known to be the “Engagement Team”. The engagement team should hold
discussions to gain better understanding of the bank 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 between the members of the engagement team
and the audit engagement partner should be done on the susceptibility of the
bank’s branch financial statements to material misstatements. These discussions
are ordinarily done at the planning stage of an audit.

The engagement team discussion ordinarily includes a discussion of the

following matters:
(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;

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(f) Need to alert for information or other conditions that indicates that a material
misstatement may have occurred (e.g., the bank’s application of accounting
policies in the given facts and circumstances).

Advantages of such a discussion :-

 Specific emphasis should be provided to the susceptibility of the bank’s
financial statements to material misstatement due to fraud, that enables the
engagement team to consider an appropriate response to fraud risks, including
those related to engagement risk, pervasive risks, and specific risks.
 It further enables the audit engagement partner to delegate the work to the
experienced engagement team members, and to determine the procedures
to be followed when fraud is identified.
 Further, audit engagement partner may review the need to involve specialists
to address the issues relating to fraud.

3. INCOME RECOGNITION POLICY

The policy of income recognition should be objective and based on record of
recovery rather than on any subjective considerations. Income from non-
performing assets (NPA) is not recognized on accrual basis but is booked as income
only when it is actually received. (Dealt in detail later on)

4. FORM AND CONTENT OF FINANCIAL

STATEMENTS
Sub-sections (1) and (2) of Section 29 of the Banking Regulations Act, 1949 deal
with the form and content of financial statements of a banking company
and their authentication. These sub-sections are also applicable to nationalised
banks, State Bank of India, and Regional Rural Banks.

Every banking company is required to prepare a Balance Sheet and a

Profit and Loss Account in the forms set out in the Third Schedule to the Act or as
near thereto as the circumstances admit. Form A of the Third Schedule to the
Banking Regulation Act, 1949, contains the form of Balance Sheet and Form B
contains the form of Profit and Loss Account.

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Every banking company needs to comply with the disclosure requirements under
the various Accounting Standards, as specified under section 133 of the
Companies Act, 2013, read with Rule 7 of the Companies (Accounts) Rules 2014, in
so far as they

5. AUDIT OF ACCOUNTS
Sub-section (1) of section 30 of the Banking Regulations Act, 1949 requires that the
balance sheet and profit and loss account of a banking company should be
audited by a person duly qualified under any law for the time being in force to be an
auditor of companies.

6. ELIGIBILITY, QUALIFICATIONS AND

DISQUALIFICATIONS OF AUDITOR
Applicable as to a Company Auditor

7. APPOINTMENT OF AUDITOR
As per the provisions of the relevant enactments:-
 The auditor of a banking company is to be appointed at the annual general
meeting of the shareholders,
 The auditor of a nationalised bank is to be appointed by the bank concerned
acting through its Board of Directors.
(In either case, approval of the Reserve Bank of India is required before the
appointment is made.)
 The auditors of regional rural banks are to be appointed by the bank
concerned with the approval of the Central Government.

8. REMUNERATION OF AUDITOR
(a) The remuneration of auditor of a banking company is to be fixed in
accordance with the provisions of Section 142 of the Companies Act, 2013
(i.e., by the

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company in general meeting or in such manner as the company in general

meeting may determine).
(b) The remuneration of auditors of nationalised banks and State Bank of India is
to be fixed by the Reserve Bank of India in consultation with the Central
Government.

9. POWERS OF AUDITOR
The auditor of a banking company, nationalised bank, State Bank of India, or
regional rural bank has the same powers as those of a company’s auditor in the
matter of access to the books, accounts, documents and vouchers.

10. AUDITOR’S REPORT

In the case of a nationalised bank, the auditor is required to make a report to
the Central Government in which he has to state the following:
(a) whether, in his opinion, the financial statements present a true and fair view of
the affairs of the bank and in case he had called for any explanation
or information, whether it has been given and whether it is satisfactory;

(b) whether or not the transactions of the bank, which have come to his notice,
have been made within the powers of that bank;

(c) whether or not the returns received from the offices and branches of the bank
have been found adequate for the purpose of his audit; and
(d) any other matter which he considers should be brought to the notice of the
Central Government.
The report of auditors of State Bank of India is also to be made to the Central
Government and is almost identical to the auditor’s report in the case of a
nationalised bank.

10.1 Format of Report

The auditors, central as well as branch, should also ensure that the audit report
issued by them complies with the requirements of Standards on Auditing discussed
in Chapter 8 on Audit Report. The auditor should ensure that not only information

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 10.14 AUDITING AND ETHICS

relating to number of unaudited branches is given but quantification of

advances, deposits, interest income and interest expense for such unaudited
branches has also been disclosed in the audit report. Such disclosure in the
audit report is not only in accordance with the best international trends but also
provides useful information to users of financial statements.

It may be noted that, in addition to the aforesaid, the auditor of a banking company
is also required to state in his report the matters covered by Section 143 of the
Companies Act, 2013. However, it is pertinent to mention that the reporting
requirements relating to the Companies (Auditor’s Report) Order, 2020 is not
applicable to a banking company, as defined in clause (c) of
Section 5 of the Banking Regulation Act, 1949.

10.2 Long Form Audit Report

Besides the audit report as per the statutory requirements discussed above, the
terms of appointment of auditors of public sector banks, private sector banks and
foreign banks (as well as their branches), require the auditors to also furnish a long
form audit report (LFAR). The matters which the banks require their auditors to deal
with in the long form audit report have been specified by the Reserve
Bank of India.

The Statutory Central Auditors are required to submit the LFAR to the banks latest by
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.

Test Your Understanding 1

The financial statements of a bank are prepared in a specified format. Discuss legal
provisions in this regard as applicable to financial statements of a nationalized
bank.

10.3 Reporting to RBI

1. The RBI issued a Circular relating to implementation of recommendations of
Committee on Legal Aspects of Bank Frauds applicable to all scheduled commercial
banks (excluding Regional Rural Banks). Regarding liability of accounting and
auditing profession, the said circular provided as under:

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“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”.

As per the above requirement, the member shall be required to report the kind of
matters stated in the circular to RBI.
2. Auditor should also consider the provisions of SA 250, “Consideration of
Laws and Regulations in an Audit of Financial Statements”. The said Standard
explains that the duty of confidentiality is over-ridden by statute, law or courts.

3. SA 240, “The Auditor’s Responsibilities Relating to Fraud in an Audit of

Financial Statements“ 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.

It must be noted that auditor is not expected to look into each and every
transaction but to evaluate the system as a whole. Therefore, if the auditor while
performing his normal duties comes across any instance, he should report the
matter to the RBI in addition to Chairman/Managing Director/Chief Executive of
the concerned bank.

11. CONDUCTING AN AUDIT

The audit of banks or their branches involves the following stages –
1. Initial consideration by the statutory auditor

(i) Declaration of Indebtedness: The RBI has advised that the banks, before
appointing their statutory central/branch auditors, should obtain a
declaration of indebtedness. Indebtedness refers to the situation of owing
money to the bank in any case, whatsoever.
(ii) Internal Assignments in Banks by Statutory Auditors: The RBI decided that
the audit firms should not undertake statutory audit assignment
while they are associated with internal assignments in the bank during the
same year, like Concurrent audits (Internal Audit of Banks conducted monthly
during the year)
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 10.16 AUDITING AND ETHICS

(iii) Planning: Standard on Auditing (SA) 300, “Planning an Audit of Financial

Statements” requires that the auditor shall undertake the following activities
prior to starting an initial audit:

(a) Performing procedures required by SA 220, “Quality Control for Audit

Work” regarding the acceptance of the client relationship and the
specific audit engagement; and

(b) Establish understanding of terms of engagement as per SA 210,

“Agreeing the Terms of Audit Engagements”.
(iv) Communication with Previous Auditor: As per Clause (8) of the Part I of the
First Schedule to the Chartered Accountants Act, 1949, a Chartered
Accountant in practice cannot accept position as auditor previously held by
another chartered accountant without first communicating with him
in writing. He should get a NO Objection Certificate (NOC) from the previous
auditor through this communication as to know whether he has any
objections to such an appointment made, for any valid reasons.

(v) Terms of Audit Engagements: SA 210, “Terms of Audit Engagements”

requires that for each period to be audited, the auditor should agree on the
terms of the audit engagement with the bank before beginning
significant portions of fieldwork. It is imperative that the terms of the
engagement are documented, in order to prevent any confusion as to the
terms that have been agreed in relation to the audit and the respective
responsibilities of the management and the auditor, at the beginning of an
audit assignment.

(vi) Initial Engagements: The auditor needs to perform the audit procedures as
mentioned in SA 510 “Initial Audit Engagements-Opening
Balances” and if after performing that procedures, the auditor concludes that
the opening balances contain misstatements which materially affect
the financial statements for the current period and the effect of the
same is not properly accounted for and adequately disclosed, the auditor
should express a qualified opinion or an adverse opinion, as
appropriate.
(vii) Assessment of Engagement Risk: The assessment of engagement risk is a
critical part of the audit process and should be done prior to the acceptance
of an audit engagement since it affects the decision of accepting the
engagement and also in planning decisions if the audit is accepted.
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(viii) Establish the Engagement Team: The assignment of qualified and

experienced professionals is an important component of managing
engagement risk. The size and composition of the engagement team would
depend on the size, nature and complexity of the bank’s operations.
(ix) Understanding the Bank and its Environment: SA 315 “Identifying
and Assessing the Risks of Material Misstatement Through
Understanding the Entity and Its Environment” lays down that the
auditor should obtain an understanding of the entity and its environment,
including its internal control, sufficient to identify and assess the risks of
material misstatement of the financial statements whether due to fraud
or error and sufficient to design and perform further audit procedures.

2. Identifying and Assessing the Risks of Material Misstatements: SA 315

requires the auditor to identify and assess the risks of material misstatement at the
financial statement level and the assertion level for classes of
transactions, account balances and disclosures to provide a basis for designing
and performing further audit procedures.

3. Understanding the Bank and Its Environment including Internal Control:

An understanding of the bank and its environment, including its internal control,
enables the auditor:

□ to identify and assess risk;

□ to develop an audit plan so as to determine the operating
effectiveness of the controls and to address the specific risks.

4. Understanding the Bank’s Accounting Process: The accounting process

produces financial and operational information for management’s use and
it also contributes to the bank’s internal control. Thus, understanding of the
accounting process is necessary to identify and assess the risks of material
misstatement whether due to fraud or not and to design and perform further
audit procedures.
5. Understanding the Risk Management Process: Management develops
controls and uses performance indicators to aid in managing key business and
financial risks. An effective risk management system in a bank generally
requires the following:

(a) Oversight and involvement in the control process by those charged with
governance: Those charged with governance (Board of Directors/Managing
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 10.18 AUDITING AND ETHICS

Director) should approve written risk management policies. 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 regards as acceptable.
(b) Identification, measurement and monitoring of risks: Risks that
could significantly impact the achievement of bank’s goals should be
identified, measured and monitored against pre-approved limits and
criteria.
(c) Control activities: A bank should have appropriate controls to mitigate its
risks including effective segregation of duties (particularly between front and
back offices), accurate measurement and reporting of positions,
verification and approval of transactions, reconciliation of positions and
results, setting up limits, reporting and approval of exceptions, physical
security and contingency planning.

(d) Monitoring activities: Risk management models, methodologies and

assumptions used to measure and mitigate risk should be regularly assessed
and updated. This function may be conducted by the independent risk
management unit.
(e) Reliable information systems: Banks require reliable information systems
that provide adequate financial, operational and compliance information
on a timely and consistent basis. Those charged with governance and
management require risk management information that is easily understood
and that enables them to assess the changing nature of the bank’s risk profile.

source – educba.com

6. Engagement Team Discussions: The 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.

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7. Establish the Overall Audit Strategy: SA 300 “Planning an Audit of

financial Statements’’ states that the objective of the auditor is to plan the
audit so that it will be performed in an effective manner. For this purpose, the
audit engagement partner should:

□ establish the overall audit strategy, prior to the commencement of an audit; and
□ involve key engagement team members and other appropriate specialists
while establishing the overall audit strategy, which depends on the
characteristics of the audit engagement.

8. Develop the Audit Plan: SA 300 deals with the auditor’s responsibility to
plan an audit of financial statements in an effective manner. It requires the
involvement of all the key members of the engagement team while planning an
audit.
9. Audit Planning Memorandum: The auditor should summarise the audit plan
by preparing an audit planning memorandum in order to:

□ Describe the expected scope and extent of the audit procedures to be

performed by the auditor.

□ Highlight all significant issues and risks identified during their

planning and risk assessment activities, as well as the decisions concerning
reliance on controls.
□ Provide evidence that they have planned the audit engagement appropriately
and have responded to engagement risk, pervasive risks, specific risks, and
other matters affecting the audit engagement.

10. Determine Audit Materiality: The auditor should consider the relationship
between the audit materiality and audit risk when conducting an audit. The
determination of audit materiality is a matter of professional judgment and
depends upon the knowledge of the bank, assessment of engagement risk and the
reporting requirements for the financial statements.
11. Consider Going Concern: While obtaining an understanding of the bank, the
auditor should consider whether there are events and conditions which may cast
significant doubt on the bank’s ability to continue as a going concern.
12. Assess the Risk of Fraud including Money Laundering: As per SA 240
“The Auditor’s Responsibilities Relating to Fraud in an Audit of
Financial
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 10.20 AUDITING AND ETHICS

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.

13. Assess Specific Risks: The auditors should identify and assess the risks of
material misstatement at the financial statement level which refers to risks that
relate pervasively to the financial statements as a whole and potentially
affect many assertions.

14. Risk Associated with Outsourcing of Activities: The modern day banks
make extensive use of outsourcing as a means of both reducing costs as well as
making use of services of an expert not available internally. There are, however, a
number of risks associated with outsourcing of activities by banks and therefore, it
is quintessential for the banks to effectively manage those risks.
15. Response to the Assessed Risks: SA 330 “The Auditor’s Responses to
Assessed Risks” requires the auditor to design and implement overall responses
to address the assessed risks of material misstatement at the financial
statement level. The auditor should design and perform further audit
procedures whose nature, timing and extent are based on and are responsive to the
assessed risks of material misstatement at the assertion level.
16. Stress Testing: Stress testing is a software testing activity that determines the
robustness of software by testing beyond the limits of normal operation. Stress
testing is particularly important for "mission critical" software, but is used for all
types of software (Source – Wikipedia). RBI has required that all commercial banks
shall put in place a Board approved ‘Stress Testing framework’ to suit their individual
requirements which would integrate into their risk management systems.
17. BASEL III framework: Basel norms or accords are the International
Banking regulations issued by the BCBS. The Basel Committee on Banking
Supervision (BCBS) and the Financial Stability Board (FSB) has undertaken an

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 AUDIT OF BANKS 10.21

extensive review of the regulatory framework in the wake of the sub-prime crisis. In
the document titled ‘Basel III: A global regulatory framework for more resilient banks
and banking systems’, released by the BCBS in December 2010, it has inter alia
proposed certain minimum set of criteria for inclusion of instruments in the new
definition of regulatory capital. The set of agreement by the BCBS, which mainly
focuses on risks to banks and the financial system are called Basel accord.

18. Reliance on / review of other reports: The auditor should take into account
the adverse comments, if any, on advances appearing in the following-

□ Previous year’s audit reports.

□ Latest internal inspection reports of bank officials.

□ Reserve Bank’s latest inspection report.

□ Concurrent / Internal audit report.

□ Report on verification of security.

□ Any other internal reports specially related to particular accounts.

□ Manager’s charge-handing-over report when incumbent is changed.

The above reports should be reviewed in detail. The Statutory Central Auditors must
review the Annual Financial Inspection report of RBI relating to the bank and ensure
that the variations in provisions, etc. reported by RBI have been properly considered
by the bank management.

12. ADVANCES
In carrying out his substantive procedures, the auditor should examine all large
advances while other advances may be examined on a sampling basis. The accounts
identified to be problem accounts, however, need to be examined in detail unless
the amount involved is insignificant. The extent of sample checking would
also depend on the auditor’s assessment of efficacy of internal controls. What
constitutes a ‘large advance’ would need to be determined in the context of volume of
operations of the branch e.g. an advance may be considered to be a large advance
if the year-end balance is in excess of ` 10 crore or 10% of the aggregate year-end
advances of the branch, whichever is less.

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 10.22 AUDITING AND ETHICS

Lending constitutes a major activity of a bank besides the investment function. The
core business of banks is accepting deposits for onward lending. Advances are
amount of money or credit, given as a loan from a bank to another party with
an agreement that the money will be repaid. All Bank Loans are made at interest
which is a compensation for borrowing. Advances, generally, constitute the largest
item on the assets side of the balance sheet of a bank and are major source of its
income. Audit of advances is one of the most important areas covered by auditors
in bank audit. It is necessary that auditors should have adequate knowledge of the
banking industry and the regulations governing the banks. Auditors must be aware
of the various functional areas of the bank/branches, its processes, procedures,
systems and prevailing internal controls with regard to advances.

Types of Advances: Funded Loans & Non-Funded Loans

 Funded loans are those loans where there is an actual transfer of funds from
the bank to the borrower. Examples of funded loans are Term loans, Cash
credits, Overdrafts, Demand Loans, Bills Discounted and Purchased,
Participation on Risk Sharing basis, Interest-bearing Staff Loans.
 Non-funded facilities are those which do not involve such transfer. Examples
of non-funded loans are Letters of credit, Bank guarantees, etc.

source :- opentoexport.com

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 AUDIT OF BANKS 10.23

12.1 What do ADVANCES comprise:

Advances comprise of funded amounts by way of:

□ Term loans
□ Cash credits, Overdrafts, Demand Loans
□ Bills Discounted and Purchased

□ Participation on Risk Sharing basis

□ Interest-bearing Staff Loans

12.2Legal requirements of Disclosure in the Balance Sheet:

A. (i) Bills purchased and discounted
(ii) Cash credits, Overdrafts and loans repayable on demand

(iii) Term Loans

B. (i) Secured by tangible assets

(ii) Covered by Bank/Government guarantees

(iii) Unsecured

C. I. Advances in India: C. II. Advances outside India:

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

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 10.24 AUDITING AND ETHICS

12.3 Classification of Advances

12.3.1 Sector Wise
RBI issues common guidelines for lending to Priority Sector which banks are
required to follow. These guidelines cover rate of interest; service charges, receipt,
sanction, rejection, disbursement Register; issue of Loan Application
Acknowledgement. RBI also issues targets for banks for lending to Priority Sector.
Examples of Priority Sectors are Agriculture , MSME , Education , Housing ,
etc.

source:-neoioscape.com

12.4 SECURITY WISE

Banks ask Security or Collateral while lending to assure that the Borrower will return
the money to bank in prescribed time else the Banks have legal authority to sell the
collateral to recover its money.
Nature of Security
A. 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.

B. 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

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 AUDIT OF BANKS 10.25

□ Plantations (For Agricultural Advances)

□ Third Party Guarantees

□ Banker’s General Lien

□ Life Insurance Policies

□ Stock Exchange Securities and Other Instruments

12.5 Mode of Creation of Security

Depending on the nature of the item concerned, creation of security may take the
form of a mortgage, pledge, hypothecation, assignment, set-off or lien as follows:-

(i) Mortgage: Mortgage are of several kinds but the most important are the
Registered Mortgage and the Equitable Mortgage.

□ Registered Mortgage can be affected by a registered instrument called

the ‘Mortgage Deed’ signed by the mortgagor. It registers the property to the
mortgagee as a security.
□ Equitable mortgage, on the other hand, is effected by a mere delivery
of title

(ii) Pledge: A pledge thus involves bailment or delivery of goods by the borrower
to the lending bank with the intention of creating a charge thereon as security for
the advance. The legal ownership of the goods remains with the pledger while the
lending banker gets certain defined interests in the goods. The pledge of
goods constitutes a specific (or fixed) charge.

(iii) Hypothecation: The hypothecation is the creation of an equitable charge

(i.e., a charge created not by an express enactment but by equity and reason),
which is created in favor of the lending bank by execution of hypothecation
agreement in respect of the moveable securities belonging to the borrower.
Neither ownership nor possession is transferred to the bank. However, the borrower
holds the physical possession of the goods as an agent/trustee of the bank.
The borrower periodically submits statements regarding quantity and value of
hypothecated assets (stocks, debtors, etc.) to the lending banker on the basis of
which the drawing power of the borrower is fixed.

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 10.26 AUDITING AND ETHICS

(iv) Assignment: Assignment represents a transfer of an existing or future debt,

right or property belonging to a person in favor 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 moveable property) 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.

(v) 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. The 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 (i.e., the capacity of the account
holder in both the accounts should be the same).

For the purpose of set-off, all the branches of a bank are treated as one single
entity. The right of set-off can be exercised in respect of time-barred debts also.

(vi) 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.

12.6 Prudential norms on Income Recognition, Asset

Classification and Provisioning pertaining to Advances:
Classification of Advances as per RBI Prudential Norms

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 AUDIT OF BANKS 10.27

(i) Non-performing Assets: An asset becomes NPA when it ceases to generate

income for the Bank.

A non-performing asset (NPA) is a loan or an advance where -:

□ interest and/ or installment of principal remain overdue for a period of more

than 90 days in respect of a termloan;
□ the account remains ‘out of order’ in respect of an Overdraft/Cash Credit (OD/
CC);
□ the bill remains overdue for a period of more than 90 days in the case of bills
purchased and discounted.
(ii) 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
 In cases where the outstanding balance in the principal operating account is
less than the sanctioned limit/drawing power, but there are no credits
continuously for 90 days as on the date of Balance Sheet ; or
 credits are there but are not enough to cover the interest debited during the
same period, these accounts should be treated as ‘out of order’.
Example

A Ltd. has been sanctioned a Cash Credit Facility by ADB Bank Ltd. for INR 50
lacs but as per the Stock Statements furnished for the last quarter, the Bank
has calculated the Drawing power to be INR 42 Lakhs. In this case, the
account would be termed as OUT OF ORDER if :-
 the outstanding balance remains continuously in excess of the INR 50
lacs/42 lacs whatever the case may be; or
 The outstanding balance in the account is less than INR 42 lacs but there
are no credits or any payments deposited into this account continuously
for 90 days as on the date of Balance Sheet; or
 credits are there upto say INR 2 lakhs but are not enough to cover the
interest debited during the same period which is around INR 5 lakhs.

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 10.28 AUDITING AND ETHICS

(iii) 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.

Source :- business-standard.com
Source :- inventiva.co.in

Categories of Non-Performing Assets: Provision required

□ Substandard Assets:
Would be one, which has remained NPA for a 15%
period less than or equal to 12 months.
□ Doubtful Assets:
Would be one, which has remained in the
substandard category for a period of 12 (Secured + Unsecured)
months.
25% + 100%
Sub-categories:
40% + 100%
Doubtful up to 1 Year (D1)
100% + 100%
Doubtful 1 to 3 Years (D2)
Doubtful more than 3 Years (D3)
100%
□ Loss Assets:
Would be one, where loss has been
identified by the bank or internal or external
auditors or the RBI inspection but the amount
has not been written off wholly.

Note :-
1. Classification as NPA should be based on the record of recovery.
Availability of security or net worth of borrower/guarantor is not to be taken into
account for purpose of treating an advance as NPA or otherwise.

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 AUDIT OF BANKS 10.29

2. Asset classification would be borrower-wise and not facility-wise. All

facilities including investments in securities would be termed as NPA.
Example

Mr. Raman has availed two Loan facilities - a Car Loan as well as a Housing
Loan from XYZ Bank Ltd. He is regular in depositing the Housing loan EMI
but has not deposited the last 4 EMI’s of the Car Loan due to paucity of funds.
Hence, in this case, not only the Car loan but the Housing Loan would also
be treated as an NPA, although it is going good and there are no
irregularities because the NPA classification is Borrower wise (Mr. Raman)
and not Facility wise (Car & Housing Loan individually).

(iv) Accounts regularized near the Balance Sheet Date: The asset
classification of borrower 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 the data
available, the account should be deemed as NPA. The auditor should check for
sample transactions immediately before the closing of the Financial Year and
immediately after the closing of the Financial year to get a knowledge of the
objective behind the transactions if they have any relation to each other in the
Borrower accounts or if any/some transactions are being reversed during the first few
days after closing which might show an arrangement to prevent the Borrower
account(s) from slipping into the NPA category.

(v) Government Guaranteed advances:-

 Central Govt. guaranteed Advances, where the guarantee is not invoked/
repudiated would be classified as Standard Assets, but regarded as
NPA for Income Recognition purpose.
 The situation would be different if the advance is guaranteed by State
Government, where advance is to be considered NPA if it remains overdue
for more than 90 days for both Provisioning and Income recognition
purposes.
(vi) Advances under Consortium:
Consortium advances mean advancing loans to a borrower by two or 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

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 10.30 AUDITING AND ETHICS

with a higher share will lead the 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.

source :- marketbusinessnews.com

Note:- Drawing Power Allocation in case of Consortium Cash Credit Account:

The Lead Bank would be responsible for computing the drawing power (DP) of the
borrower and allocate the same to member banks. In certain special circumstances,
at the request of the Borrower, the Lead Bank may allot a higher or lower share of
drawing power to the member bank, as against their share of advances. The
proforma DP Allocation Letter is presented hereunder for reference:

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 AUDIT OF BANKS 10.31

Illustrative Drawing Power for December 2022

as per Stock Statement November, 2022

(` in Crores)
Description of Stocks Market Value Margin Advance Value
Raw Materials 636.27 25 477.20
Finished Goods 372.75 25 279.56
Stock in process 659.35 25 494.51
Stores and Spares 124.51 25 93.38
Book Debts (Upto 120/180 days) 37379.90 35 24296.94
Stock in Transit 52.31 25 39.23
Total 39225.09 25680.82
Less: Unpaid Stocks under LC 0.00 100 0.00
Total 39225.09 25680.82

(` in Crores)
BANKS Share % LIMIT/D.P.
State Bank of India 32.25 500.00
Bank of Baroda 2.58 40.00
Bank of India 6.45 100.00
Canara Bank 5.16 80.00
Standard Chartered Bank 9.03 140.00
Union Bank of India 6.45 100.00
HSBC 13.87 215.00
Citi Bank 6.45 100.00
Bank of America 1.29 20.00
BNP Paribas 1.94 30.00
Punjab National Bank 6.45 100.00
ICICI Bank 4.84 75.00
IDBI Bank 3.23 50.00
Unallocated
TOTAL 100.00 1550.00

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 10.32 AUDITING AND ETHICS

12.7 Accounts where there is erosion in the value of

security / frauds committed by borrowers
Erosion means the gradual destruction or diminution of something not prudent
to follow stages of asset classification. It should be straight-away classified as
doubtful or loss asset as appropriate as follows :-
(i) Erosion in the value of security can be reckoned as significant when the
realisable value of the security is less than 50 per cent of the value assessed
by the bank or accepted by RBI at the time of last inspection, as the case may
be. Such NPAs may be straight-away classified under doubtful category
and provisioning should be made as applicable to doubtful assets.
(ii) If the realisable value of the security, as assessed by the bank/ approved
valuers/ RBI is less than 10 per cent of the outstanding in the borrower
accounts, the existence of security should be ignored and the asset should be
straight-away classified as loss asset. It may be either written off or
fully provided for by the bank.

12.8 Advances Against Term Deposits, NSCs, KVPs/ IVPs, etc.

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

12.9 Agricultural Advances Affected by Natural Calamities

Master Circular issued by the RBI deals elaborately with the classification
and income recognition issues due to impairment caused by natural calamities.
Banks may decide on their own relief measures, viz., 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 the guidelines contained in RBI’s
latest Master Circular on Prudential Norms on Income Recognition, Asset
Classification and provisioning pertaining to Advances. In such cases, the NPA
classification would be governed by such rescheduled terms.

12.10 Advances to Staff

Interest-bearing staff advances as a banker should be included as part of advances
portfolio of the bank. In the case of housing loan or similar advances granted to

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 AUDIT OF BANKS 10.33

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 the respective due dates. The staff
advances by a bank as an employer and not as a banker are required to be included
under the sub-head ‘Others’ under the schedule of Other Assets.

12.11 Agricultural Advances

As per the guidelines, Agricultural Advances are of two types:

(1) Agricultural Advances for “long duration” crops; and

(2) Agricultural Advances for “short duration” crops.

The “long duration” crops would be crops with crop season longer than one year
and crops, which are not “long duration” crops would be treated as “short duration”
crops.

The crop season for each crop, which means the period up to harvesting of the
crops raised, would be as determined by the State Level Bankers’ Committee in
each State.

The following NPA norms would apply to agricultural advances (including

Crop Term Loans):

□ A loan granted for short duration crops will be treated as NPA, if the
instalment of principal or interest thereon remains overdue for two crop
seasons; and

□ A loan granted for long duration crops will be treated as NPA, if the instalment
of principal or interest thereon remains overdue for one crop season.

Test Your Understanding 2

Ranjana Ceramic Private Limited is sanctioned a cash credit facility of `100 lacs from
a branch of LMO Bank. Besides, branch has also sanctioned a one-time bank
guarantee of ` 10 lacs on behalf of the company in favour of a statutory authority.
Discuss, what type of credit facilities have been sanctioned by branch of LMO bank
to the company along with probable purpose for each of credit facility.

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 10.34 AUDITING AND ETHICS

Test Your Understanding 3

During course of audit of branch of a nationalized bank, you find that system has
generated a report marking ten term loan accounts as SMA. Discuss, meaning of
SMA accounts and significance of such a classification.

13. COMPUTATION OF DRAWING POWER

1. Meaning:- Drawing Power generally addressed as “DP” is an important
concept for Cash Credit (CC) facility availed from banks and financial
institutions. Drawing power is the limit up to which a firm or company can
withdraw from the working capital limit sanctioned.
2 Different from Sanctioned Limit:- The Sanctioned limit is the total
exposure that a bank can take on a particular client for facilities like cash credit,
overdraft, export packing credit, non-funded exposures etc. On the other
hand, Drawing Power refers to the amount calculated based on primary security
less margin as on a particular date.
3. Considerations:- All accounts should be kept within both the drawing power
and the sanctioned limit at all times. The accounts which exceed the sanctioned limit
or drawing power or are against unapproved securities or are otherwise irregular
should be brought to the notice of the Management/Head Office regularly.

4. Bank’s Duties:- Banks should ensure that drawings in the working capital
account are covered by the adequacy of the current assets. Drawing power is
required to be arrived at based on current stock statement. 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 than three months is deemed as irregular.

5. Auditor’s Concern:- The stock statements, quarterly returns and other

statements submitted by the borrower to the bank should be scrutinized in detail.
The audited Annual Report submitted by the borrower should be scrutinized
properly. The 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.

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6. Computation of DP:- It needs to be ensured that the drawing power is

calculated as per the extant guidelines formulated by the Board of Directors of the
respective bank and agreed upon by the concerned statutory auditors. Special
consideration should be given to proper reporting of sundry creditors for the
purposes of calculating drawing power.

7. Stock Audit:- The stock audit should be carried out by the bank for all
accounts havingfunded exposure of more than 5 crores. Auditors can also advise
for stock audit in other cases if the situation warrants the same. Branches should
obtain the stock audit reports from lead bank in the cases where the Bank is not
leader of the consortium of working capital. The report submitted by the stock
auditors should be reviewed during the course of the audit and special focus should
be given to the comments made by the stock auditors on valuation of security and
calculation of drawing power.

Particulars of current assets DP

(A) Stocks
Stocks at realizable value 1000
Less: Unpaid stocks:
- Sundry creditors 300
- Acceptances/LCs etc. 300 600
Paid for stocks 400
Margin @ 25% 100 300
(B) Debtors
Total Debtors 1000
Less: Ineligible debtors 200
Eligible debtors 800
Margin @ 40% 320 480
Total DP 780

14 AUDIT OF ADVANCES
Advances generally constitute the major part of the assets of the bank. There are
large number of borrowers to whom variety of advances are granted. The audit of

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 10.36 AUDITING AND ETHICS

advances requires the major attention from the auditors.

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.

The auditor can obtain sufficient appropriate audit evidence about advances
by study and evaluation of internal controls relating to advances, and by:

□ examining the validity of the recorded amounts;

□ examining loan documentation;

□ reviewing the operation of the accounts;

□ examining the existence, enforceability and valuation of the security;

□ checking compliance with RBI norms including appropriate classification and

provisioning; and

□ carrying out appropriate analytical procedures.

In carrying out his substantive procedures, the auditor should examine all large
advances while other advances may be examined on a sampling basis. The
accounts identified to be problem accounts, however, need to be examined
in detail unless the amount involved is insignificant.

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Advances which are sanctioned during the year or which are adversely commented
by RBI inspection team, concurrent auditors, bank’s internal inspection, etc. should
generally be included in the auditor’s review.

Source : maillie.com

Evaluation of Internal Controls over Advances: The auditor should examine the
efficacy of various internal controls over advances to determine the nature, timing
and extent of his substantive procedures. In general, the internal controls over
advances should include, inter alia, the following:

□ The bank should make an advance only after satisfying itself as to the credit
worthiness of the borrower and after obtaining sanction from the appropriate
authorities of the bank.
□ All the necessary documents (e.g., agreements, demand promissory notes,
letters of hypothecation, etc.) should be executed by the parties before
advances are made.
□ The compliance with the terms of sanction and end use of funds should be
ensured.
□ Sufficient margin as specified in the sanction letter should be kept
against securities taken so as to cover for any decline in the value thereof.
The availability of sufficient margin needs to be ensured at regular
intervals.
□ If the securities taken are in the nature of shares, debentures, etc., the
ownership of the same should be transferred in the name of the bank and the
effective control of such securities be retained as a part of
documentation.
□ All securities requiring registration should be registered in the name of the
bank or otherwise accompanied by documents sufficient to give title
to the bank.
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 10.38 AUDITING AND ETHICS

□ In the case of goods in the possession of the bank, contents of the packages
should be test checked at the time of receipt. The godowns should be
frequently inspected by responsible officers of the branch concerned,
in addition to the inspectors of the bank.
□ Drawing Power Register should be updated every month to record the value
of securities hypothecated. These entries should be checked by an
officer.
□
The accounts should be kept within both the drawing power and the
sanctioned limit.
□
All the accounts which exceed the sanctioned limit or drawing power or are
otherwise irregular should be brought to the notice of the controlling
authority regularly.
□
The operation of each advance account should be reviewed at least once a
year and at more frequent intervals in the case of large advances.
Test Your Understanding 4
CA P is conducting stock audit of a borrower availing cash credit facility of `100
lacs from branch of a bank. The cash credit facility is against security of paid stocks
and debtors up to 90 days. Margin stipulated is 25% for stocks and 40% for debtors.
Following further information is available as on 31.12.22: -

Value of stocks ` 125 lacs

Value of stocks (fully damaged) included in above 5 lacs
Value of debtors 50 lacs
Value of debtors exceeding 90 days included in above 10 lacs
Value of creditors for goods 50 lacs

Is Drawing Power computed by CA P for ` 82.50 lacs proper?

15. AUDIT OF REVENUE ITEMS - PROFIT AND

LOSS ACCOUNT
Sub–section (1) of Section 29 of the Banking Regulation Act, 1949, requires the
preparation of Profit and Loss Account in Form B of Third Schedule to the Act or as
near thereto as the circumstances admit.

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 AUDIT OF BANKS 10.39

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 10.40 AUDITING AND ETHICS

15.1 Income
The following items are included under this head:

Interest Earned Other Income

□ Interest/ Discount on □ Commission, Exchange and Brokerage:
Advances/ Bills: This item comprises of the following:
□ Interest Income on (a) Commission on bills for collection.
Investments: (b) Commission/exchange on
□ Interest on Balances remittances and transfers, e.g.
with RBI and Other demand drafts, NEFT, RTGS, etc.
Inter–bank Funds: (c) Commission on letters of credit and
□ Others: This includes guarantees, letter of comforts.
any other (d) Loan processing, arranger and
interest/discount syndication fees.
income not included in (e) Mobile banking fees.
the above heads (f) Credit/Debit card fee income
including annual fee income,
merchant acquiring income,
interchange fees, etc.
(g) Rent from letting out of lockers
(h) Commission on Government business.
(i) Commission on other permitted
agency business including
consultancy and other services.
(j) Brokerage on securities.
(k) Fee on insurance referral.
(l) Commission on referral of mutual
fund clients.
(m) Service/transaction banking charges
including charges levied for
transaction at other branches.
(n) Income from rendering other services
like custodian, demat, investment
advisory, cash management and
other fee based services.
□ Profit on Sale of Investments

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□ Profit/Loss on Revaluation of
Investments
□ Profit on sale of Land, Buildings and
Other
Assets:
□ Profit/Loss on Revaluation of Fixed
Assets
□ Profit on exchange transactions: This
includes revaluation gains/losses on forward
exchange contracts and other derivative
contracts, premium income/expenses on
options, etc.
□ Income earned by way of dividends, etc.,
from subsidiaries and joint ventures
abroad/in India.
□ Miscellaneous income.
15.1.1 Audit Approach and Procedures

□ Auditor’s Concern:- In carrying out audit of income, the auditor is primarily

concerned with obtaining reasonable assurance that the recorded income
arose from transactions, which took place during the relevant period and
pertained to the bank, there is no unrecorded income and the income is
recorded at appropriate amount.

□ RBI’s Directions:- RBI has advised that in respect of any income which
exceeds one percent of the total income of the bank if the income is reckoned
on a gross basis or one percent of the net profit before taxes if the
income is reckoned net of costs, should be considered on accrual as per
Accounting Standard 9.
□ Materiality:- If any item of income is not considered to be material as per
the above norms, it may be recognised when received and the auditors need
not qualify their report in that situation.
□ Revenue Certainty:- Banks recognise income (such as interest, fees and
commission) on accrual basis, i.e., as it is earned. It is an essential condition
for accrual of income that it should not be unreasonable to expect its ultimate
collection. In modern day banking, the entries for interest income on
advances are automatically generated through a batch process in the CBS
system.

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□ Revenue Uncertainty:- In view of the significant uncertainty regarding

ultimate collection of income arising in respect of non-performing assets,
the guidelines require that banks should not recognize income on non-
performing assets until it is actually realised. When a credit facility is
classified as non-performing for the first time, interest accrued and
credited to the income account in the corresponding previous year which has
not been realized should be reversed or provided for. This will apply to
Government guaranteed accounts also.
□ Advances against Securities:- 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.
□ Bills Purchased:- In the case of bills purchased outstanding at the close of
the year the discount received thereon should be properly apportioned
between the two years. [The Unexpired discount/ rebate on bills discounted
i.e., where part of receipt comprising discount charges on bills purchased
relate to the period beyond the year-end, should be recorded as “Other
Liabilities”]. Interest (discount) component paid by Bank/Branch on
rediscount of bills from other financial institutions, is not to be netted
off from the discount earned on bills discounted.
□ Bills for Collection:- In the case of bills for collection, the auditor should also
examine the procedure for crediting the party on whose behalf the bill has
been collected. The procedure is usually such that the customer’s account is
credited only after the bill has actually been collected from the drawee either
by the bank itself or through its agents, etc. This procedure is in consonance
with the nature of obligations of the bank in respect of bills for collection.
The commission of the branch becomes due only when the bill has been
collected.
□ Renegotiations:- Fees and commissions earned by the banks as a result of
re-negotiations or rescheduling of outstanding debts should be recognised
on an accrual basis over the period of time covered by the re-negotiated or
rescheduled extension of credit. Test check the interest earned by the banks
for the sample selected. Test check the fees and commissions earned by the
banks made for commission on bills for collection, letters of credit and bank
guarantees.

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Reversal of Income:

(a) If any advance, including bills purchased and discounted, becomes NPA as at
the close of any year, the entire interest accrued and credited to income account
in the past periods, should be reversed or provided for if the same is not realised.
This will apply to Government guaranteed accounts also.

(b) In respect of NPAs, fees, commission and similar income that have accrued
should cease to accrue in the current period and should be reversed or provided
for with respect to past periods, if uncollected.

(c) Further, in case of banks which have wrongly recognised income in the past
should reverse the interest if it was recognised as income during the current year
or make a provision for an equivalent amount if it was recognized as income in the
previous year(s).

(d) Furthermore, the auditor should enquire if there are any large debits in the
Interest Income account that have not been explained. It should be enquired
whether there are any communications from borrowers pointing out differences
in

On leased assets: The component of finance income (as defined in AS 19 –

Leases) on the leased asset which was accrued and credited to the income account
before the asset became non-performing and remaining unrealised, should be
reversed or provided for in the current accounting period.

On Take-out finance: A takeout loan is a method of financing whereby a loan that

is procured later is used to replace the initial loan. More specifically, a takeout loan,
or takeout financing, is long-term financing that the lender promises to provide at a
particular date or when particular criteria for completion of a project are met.
Takeout loans are commonly used in property development (Source :- Investopedia).
In the case of take-out finance, if based on record of recovery, the account is
classified by the lending bank as NPA, it should not recognize income unless
realised from the borrower/taking-over institution (if the arrangement so provides).

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 10.44 AUDITING AND ETHICS

OBJECTIVE OF TAKEOUT FINANCE

To expand sources of Finance for

infrastructure projects by facilitating
participation of new entities

To address sectoral/group/entity
exposure issues and asset liabillity
in mis-match concerns of tenders

To boost the availability of longer

tenor debt finance for projects

Source :- slideshare.net

On Partial 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), banks are required to adopt an accounting policy and exercise the right of
appropriation of recoveries in a uniform and consistent manner. The appropriate
policy to be followed is to recognise income as per AS 9 when certainty attaches to
realisation and accordingly amount reversed/derecognised or not recognised in the
past should be accounted.

Interest partly/fully realised in NPAs can be taken to income. However, it should be

ensured that the credits towards interest in the relevant accounts are not out of
fresh/additional credit facilities sanctioned to the borrowers concerned.

Memorandum Account: On an account turning NPA, banks should reverse the

interest already charged and not collected by debiting Profit and Loss account and
stop further application of interest. However, banks may continue to record such
accrued interest in a Memorandum account in their books for control purposes. For
the purpose of computing Gross Advances, interest recorded in the Memorandum
account should not be taken into account.

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 AUDIT OF BANKS 10.45

Income from Investments

Interest Income on Investments: This includes all income derived from

Government securities, bonds and debentures of corporates and other
investments by way of interest and dividend, except income earned by way of
dividends, etc., from subsidiaries and joint ventures abroad/in India. Broken period
interest paid on securities purchased and amortisation of premium on SLR
investments is net off
from the interest income on investments.
Profit on Sale of Investments: Investments are dealt in the course of banking
activity and hence the net profit or loss on sale of investments is taken
to profit and loss account.
Profit/Loss on Revaluation of Investments: In terms of guidelines
issued by the RBI, investments are to be valued at periodical intervals and
depreciation or appreciation in valuation should be recognised and taken
to profit and loss account.

15.2 Expenses
Expenditure is to be shown under three broad heads:

(1) Interest expense

(2) Operating expense
(3) Provisions and contingencies.

The following items are included under this head:

Interest Expense Operating Expenses Provisions and Contingencies

 Interest on  Payments to and  Provisions made in respect
Deposits Provisions for of the Non-performing
Employees assets.
 Interest on  Rent, Taxes and  Provisions for Taxation
Reserve Bank of Lighting
India/Inter–Bank  Printing and
Borrowings Stationery

 Others  Advertisement  Provisions for Diminution in

and Publicity the value of investments
 Depreciation on  Provisions for contingencies
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 10.46 AUDITING AND ETHICS

Bank’s Property
 Directors’ Fees,
Allowances and
Expenses
 Auditors’ Fees
and Expenses
 Legal expenses
 Postage,
Telegrams,
Telephones,
etc.
 Repairs and
Maintenance
 Insurance
 Marketing
Expenses
 Other Expenses

15.2.1 Audit Approach and Procedures

□ In carrying out an audit of interest expense, the auditor is primarily concerned

with assessing the overall reasonableness of the amount of interest expense
by analysing ratios of interest paid on different types of deposits and
borrowings to the average quantum of the respective liabilities during the
year. In modern day banking, the entries for interest expenses are
automatically generated through a batch process in the CBS system.

□ The auditor should obtain from the bank an analysis of various types of
deposits outstanding at the end of each quarter. From such information, the
auditor may work out a weighted average interest rate. The auditor may then
compare this rate with the actual average rate of interest paid on the relevant
deposits as per the annual accounts and enquire into the difference,
if material.

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 AUDIT OF BANKS 10.47

□ The auditor should also compare the average rate of interest paid on the
relevant deposits with the corresponding figures for the previous
years and analyse any material differences. The auditor should
obtain general ledger break-up for the interest expense incurred on deposits
(savings and term deposits) and borrowing each month/quarter. The auditor
should analyse month on month (or quarter on quarter) cost analysis and
document the reasons for the variances as per the benchmark stated. He
should examine whether the interest expense considered in the cost analysis
agrees with the general ledger. The auditor should understand the process of
computation of the average balance and re-compute the same on sample
basis.

□ The auditor should, on a test check basis, verify the calculation of interest and
ensure that:

(a) Interest has been provided on all deposits upto the date of the balance
sheet;

(b) Interest rates are in accordance with the bank’s internal regulations, the
RBI directives and agreements with the respective deposit holder;

(c) Interest on savings accounts are in accordance with the rules framed by
the bank/RBI in this behalf.

(d) Interest on inter–branch balances has been provided at the rates

prescribed by the head office/RBI.

The auditor should ascertain whether there are any changes in interest rate on
saving accounts and term deposits during the period. The auditor should obtain
the interest rate card for various types of deposits and analyse the interest cost for
the period accordingly. The auditor should examine the completeness that interest
has been accrued on the entire borrowing portfolio and the same should agree with
the general ledgers. The auditor should re-compute the interest accrual i.e., by
referring to the parameters like frequency of payment of interest amount, rate of
interest, period elapsed till the date of balance sheet, etc. from the term sheet, deal
ticket, agreements, etc. and ensure that the recomputed amount is tallying with the
amount as per books of accounts without any significant difference.
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 10.48 AUDITING AND ETHICS

For audit of Operating expenses, the auditor should :-

 study and evaluate the system of internal control relating to expenses,
including authorization procedures in order to determine the nature, timing
and extent of his other audit procedures.
 should examine whether there are any divergent trends in respect of major
items of expenses.
 perform substantive analytical procedures (proforma given below for
reference) in respect of these expenses. e.g. assess the reasonableness of
expenses by working out their ratio to total operating expenses and comparing
it with the corresponding figures for previous years.
 verify expenses with reference to supporting documents and check the
calculations wherever required.
For audit of Provisions and contingencies the auditor should :-
 ensure that the compliances for various regulatory requirements for
provisioning as contained in the various circulars have been fulfilled.
 obtain an understanding as to how the bank computes provision on standard
assets and non-performing assets. It will primarily include checking the basis
of classification of loans and receivables into standard, sub-standard,
doubtful, loss and non-performing assets. The auditor may verify the loan
classification on a sample basis.
 obtain the detailed break up of standard loans, non-performing loans and
agree the outstanding balances with the general ledger.
 obtain the tax provision computation from the bank’s management and verify
the nature of items debited and credited to profit and loss account
to ascertain that the same are appropriately considered in the tax provision
computation.
 examine the other provisions for expenses vis-a-vis the circumstances
warranting the provisioning and the adequacy of the same by discussing and
obtaining the explanations from the bank’s management.

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INCOMES

INTEREST
OTHER
INCOME
INCOME

INTEREST/DISCOUNT/BILLS
COMMISSION , EXCHANGE,
INTEREST INCOME ON INVESTMENT BROKERAGE
INTEREST ON BALANCES WITH PROFIT ON SALE OF INVESTMENT
RBI OTHER PROFIT ON REVALUATION OF FIXED
ASSETS

EXPENSES

INTEREST PROVISIONS AND OPERATING

EXPENSE CONTINGENCIES EXPENSES

INTEREST ON DEPOSITS
INTEREST ON BANK
BORROWING
OTHERS

15.3 Disclosure of the prior period items

Since the format of the profit and loss accounts of banks prescribed in
Form B under Third Schedule to the Banking Regulation Act, 1949 does
not specifically provide for disclosure of the impact of prior period items on the
current year’s profit and loss, such disclosures, wherever warranted, may be given.
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Test Your Understanding 5

You are verifying interest on deposits paid by branch of a nationalized bank.
Discuss, any two “analytical procedures”, to verify interest on deposits paid by
branch.

CASE STUDY
CA M is conducting statutory audit of branch of MMC Bank. During the course of
audit, it is noticed as under:-
(i) Loans under “Kisan credit card” are given by Bank to farmers to meet their
short-term credit needs for cultivation of crops.
In respect of one agricultural advance classified under “Kisan Credit Card”
having an outstanding balance of ` 20 lacs as at year end, there is no
transaction in account since last 90 days. The said loan has been granted for
cultivation of paddy which is harvested in a period of 3-4 months from
sowing. The branch has classified the said advance as “Standard asset”.

(ii) It is also observed that account of one borrower availing cash credit limit of
`50 lacs was taken over from another bank. The proposal was sanctioned by
branch manager instead of immediate next higher authority as required in
“Manual of Delegation of Powers” of Bank.

(iii) It is noticed that head office of bank has flagged a savings account
maintained in branch in which interest was wrongly paid at higher rate due
to wrong data feeding entry. Now, situation has been rectified by debiting
excess interest paid in the account. Since there was little balance in savings
account, a debit balance of `1.50 lac was created in the said savings account
due to above reversal. The matter was immediately informed to account
holder. However, he has not turned up for payment since matter was
informed to him about six months ago.

(iv) There are many cash credit accounts in the branch. Such borrowers are
required to submit monthly stock statements to branch showing calculation
of drawing power.

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(v) One borrower has availed a housing loan and a car loan from the branch.
Housing loan EMIs are overdue for 120 days as on date of Balance sheet. Car
loan EMIs are overdue for 60 days as on date of Balance sheet.

Based on above, answer following questions:

(1) As regards description of agricultural advance, which of the following
statements is most appropriate in this regard?
(a) The branch has erred in making classification as per RBI norms. It is a
“Sub-standard” asset.

(b) The classification made by branch is proper. However, there are no

transactions in account since last 90 days, it is SMA.
(c) The classification made by branch is proper.

(d) The branch has erred in making classification as per RBI norms. It is a
“doubtful” asset.
(2) Regarding taken over account from another bank, which of following
statements is most appropriate?
(a) It is an internal issue of Bank and auditor is not concerned with it.
(b) It is an internal issue of Bank. However, the auditor may, at his
discretion, report it.
(c) It is a serious violation of laid down procedures of bank for sanction of
advances and should be reported by auditor without fail.

(d) There is no issue involved as credit facility was properly sanctioned.

(3) As regards debit balance of ` 1.50 lacs in Savings account, which of the
following is correct from point of view of an auditor?
(a) The situation does not attract RBI norms on asset classification.

(b) The debit balance of `1.50 lacs should be classified as NPA.

(c) The situation does not attract RBI norms on asset classification as no
credit facility was granted.
(d) The bank cannot demand excess interest paid to account holder.

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(4) Which of the following statements is not true about “drawing power” (DP)?
(a) Drawing Power refers to the amount calculated based on primary
security less margin as on particular date.

(b) It is always less than sanctioned limit.

(c) It can be different from sanctioned limit.
(d) Creditors for goods are reduced for purpose of calculating Drawing
Power.
(5) Considering housing loan and car loan availed by a borrower, which of the
following statements is appropriate?

(a) Both Housing loan as well as car loan should be classified as “Non-
Performing Assets” in accordance with RBI norms on asset classification.
(b) Housing Loan should be classified as “Non-Performing Asset” in
accordance with RBI norms on asset classification. However, Car loan
should be classified as Standard asset.
(c) Car Loan should be classified as “Non-Performing Asset” in accordance
with RBI norms on asset classification. However, Housing Loan should
be classified as Standard asset.
(d) Both Housing as well as car loans should be classified as Standard
assets.

Answers to Questions involving case study

1. c 2. c 3. b 4. b 5. a

SUMMARY
 Commercial banks are the most wide spread banking institutions in India,
that provide a number of products and services to general public and other
segments of economy. Their main functions are accepting deposits and
granting advances.
 Banking operations are conducted only at the branches, while other
offices act as controlling authorities or administrative offices that lay
down policies, systems and internal control procedures for conduct of
business, in

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 AUDIT OF BANKS 10.53

compliance with the statutory/ regulatory impositions.

 Banking operations are peculiar due to huge volume and complexity of
transactions, extensive use of technology and wide geographical spread of
banks network etc,The approach to a bank audit among other things includes
understanding the bank, its environment including internal control, gaining
knowledge about bank’s accounting system, its risk assessment process,
establishing a sound audit strategy and developing the audit plan.
 Lending constitutes a major activity of a bank. The core business of banks is
accepting deposits for onward lending.
 An asset becomes non-performing (NPA) when it ceases to generate income
for the Bank.
 RBI has stipulated prudential norms for income recognition, asset
classification and provisioning pertaining to advances which are to be
followed by Banks.
 Non-performing assets have been further classified into sub-standard,
doubtful (D1, D2 and D3) and loss assets.
 The auditor should examine the efficacy of various internal controls over
advances to determine the nature, timing and extent of his substantive
procedures.
 The auditor is also concerned with audit of items of income and expenditure
appearing in profit and loss account of a bank Suitable substantive
procedures and analytical procedures should be designed and performed by
auditor in this regard.

TEST YOUR KNOWLEDGE

MCQs based Questions
(1) Which of the following is included in “Interest Earned” in Profit & loss A/c of a
bank?

(a) Discount on Bills

(b) Loan Processing fees
(c) Commission on bills for collection

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(d) Credit Card Fees

(2) While auditing advances of a bank as statutory auditor, which of the following
is not a likely concern of auditor?

(a) Appropriate documentation of advances

(b) Ensuring budgeted targets of advances given by bank management
(c) Compliance of sanctioned terms and conditions

(d) Operations in advance accounts

(3) Any amount due to the bank under any credit facility is ‘overdue’ if: -
(a) it is not paid on the due date fixed by the bank

(b) it is not paid within 30 days of due date fixed by the bank
(c) it is not paid within 60 days of due date fixed by the bank
(d) it is not paid within 90 days of due date fixed by the bank

(4) Which of the following statement is true regarding appointment of statutory

branch auditor of a nationalized bank?
(a) The appointment is made by bank acting through its board of directors
with prior approval of Central govt.
(b) The appointment is made by bank acting through its board of directors
with prior approval of RBI

(c) The appointment is made by bank acting through its board of directors
with prior approval of ICAI
(d) The appointment is made by shareholders in AGM.

(5) Identify the correct statement: -

(a) Income from non-performing assets is recognized on accrual basis
(b) Income from non-performing assets is never recognized.

(c) Income from non-performing assets is recognized on basis of actual

recovery
(d) Income from non-performing assets is recognized only when such assets
are upgraded to standard assets

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Correct/Incorrect
State with reasons (in short) whether the following statements are correct
or incorrect:
(1) RBI has been entrusted with the responsibility of regulating the activities of
commercial banks only.
(2) In the computerised environment, the auditor need not be familiar with latest
applicable RBI guidelines.

(3) The auditor can assume that the system generated information is correct and
relied upon.
(4) Collateral security refers to the security offered by the borrower for bank
finance or the one against which credit has been extended by the bank.
(5) Registered mortgage is effected by a mere delivery of title deeds or other
documents of title with intent to create security thereof

(6) Any amount due to the bank under any credit facility is ‘overdue’ if it is not
paid within 90 days of becoming due.
(7) An account should be treated as 'out of order' if the outstanding balance
remains continuously in excess of the sanctioned limit/drawing power.
(8) Banks recognize income on Non-Performing Assets on accrual basis.
(9) Auditor of a Nationalised bank is to be appointed at the annual general
meeting of the shareholders.
(10) Reporting of fraud of INR 150 Lakhs by auditor will be done within three days
of the fraud coming to the knowledge of the auditor to the Board or the Audit
Committee along with remedial action taken in case of audit of ABA Bank Ltd.
(11) Central Govt. guaranteed Advances, where the guarantee is not invoked/
repudiated would be classified as Standard Assets.

Theoretical Questions
1. Discuss outline of audit approach including audit procedures while auditing
“provisions and contingencies” in financial statements of a bank.
2. Discuss importance of implementation of KYC norms by a bank from
perspective of an auditor of bank.

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3. List out any four points which highlight peculiarities involved in banking
operations.
4. Is statutory auditor of a bank required to report on the requirements relating
to Companies (Auditor’s Report) Order, 2020?
5. Account of a borrower availing cash credit facility from branch of a bank has
become “Out or order.” Discuss the term “Out of order”.

6. The functioning of banking industry in India is regulated by the Reserve Bank

of India (RBI) which acts as the Central Bank of our country. Explain
7. “The engagement team should hold discussions to gain better understanding of
the bank 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”. Explain
8. Write a short note on reversal of income under bank audit.

ANSWERS/SOLUTIONS
Answers to the MCQs based Questions
1. a 2. b 3. a 4. b 5. c

Answers to Correct/Incorrect
(1) Incorrect. RBI has been entrusted with the responsibility of regulating the
activities of commercial and other banks. All the Banks and even NBFC’s fall
under the regulatory function of RBI.

(2) Incorrect. In the Computerised environment, it is imperative that the auditor

is familiar with, and is satisfied that, all the norms/parameters as per the latest
applicable RBI guidelines are incorporated and built into the system that
generates information/data having a bearing on the classification/ provisions
and income recognition.

(3) Incorrect. The auditor should not go by the assumption that the system
generated information is correct and can be relied upon without evidence

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that demonstrates that the system driven information is based on validation

of the required parameters for the time being in force and applicable.

(4) Incorrect. 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. Collateral security is in
addition to the Primary security.

(5) Incorrect. Registered Mortgage can be affected by a registered

instrument called the ‘Mortgage Deed’ signed by the mortgagor. It registers
the property to the mortgagee as a security. Equitable mortgage, on the other
hand, is effected by a mere delivery of title deeds or other documents of
title with intent to create security thereof.

(6) Incorrect. 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 and 90 days of becoming
overdue.

(7) Correct. An account should be treated as 'out of order' if the outstanding

balance remains continuously in excess of the sanctioned limit/drawing
power or In cases where the outstanding balance in the principal operating
account is less than the sanctioned limit/drawing power, but there are no
credits continuously for 90 days as on the date of Balance Sheet ; or credits
are there but are not enough to cover the interest debited during the same
period.

(8) Incorrect: Income from non-performing assets (NPA) is not recognised on

accrual basis due to its uncertainty but is booked as income only when it is
actually received i.e. on actual receipt basis.

(9) Incorrect- Auditor of a nationalized bank is to be appointed by the bank

concerned acting through its Boards of Directors and approval of the Reserve
bank is required before the appointment is made.

(10) Incorrect- The auditor shall report the matter to the Board or the Audit
Committee, as the case may be, immediately but not later than 2 days of his
knowledge of the fraud, seeking their reply or observations within 45 days.

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 10.58 AUDITING AND ETHICS

The Banking Company is bound to disclose remedial action taken in Board’s

report.

(11) Correct: Central Govt. guaranteed Advances, where the guarantee is not
invoked/ repudiated would be classified as Standard Assets, but regarded as
NPA for Income Recognition purpose.

Answers to Theoretical Questions

1. Refer to topic on “Audit of provisions and contingencies”

2. Refer to topic on “Conducting an audit- Assessing the risk of Fraud---"

3. Refer to topic on “Banking Operations”

4. Refer to topic on “Format of report”

5. Refer to topic on “Prudential norms on income recognition, asset

classification and provisioning pertaining to advances
6. Refer Introduction paragraph
7. Refer Para 2

8. Refer Para 15.1

Answers to Questions involving Test Your Understanding

1. Sub-sections (1) and (2) of Section 29 of the Banking Regulations Act, 1949
deal with the form and content of financial statements of a banking company
and their authentication. These provisions are also applicable to nationalised
banks. Every banking company is required to prepare a Balance Sheet and a
Profit and Loss Account in the forms set out in the Third Schedule to the Act
or as near thereto as the circumstances admit. Form A of the Third Schedule
to the Banking Regulation Act, 1949, contains the form of Balance Sheet and
Form B contains the form of Profit and Loss Account.

2. Cash credit facility sanctioned by bank to company is in nature of funded

credit facility. Its purpose is to meet working capital requirements of business.
Bank guarantee sanctioned to the company is in nature of non-funded credit
facility. Its probable purpose could be requirement of a guarantee by a

©The Institute of Chartered Accountants of India

 AUDIT OF BANKS 10.59

statutory authority in exchange of company fulfilling some statutory

obligations.
3. Special Mention Account (SMA) is an account which is exhibiting signs of
incipient stress resulting in the borrower defaulting in timely servicing of debt
obligations, though the account has not yet been classified as NPA as per the
RBI guidelines.
In the given case, ten term loan accounts have been classified as SMA. It
means that there are overdues in the accounts for a period of 0 to 90 days.
Since period of 90 days has not been exceeded as on the date, such accounts
have not been classified as NPA as per RBI norms.
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.
4. The computation of Drawing power is as under: -
Value of stocks as on 31.12.22 ` 125 lacs
Less: value of damaged stocks ` 5 lacs
` 120 lacs
Less: creditors for goods as on 31.12.22 ` 50 lacs
Value of Paid stocks ` 70.00 lacs
Less: Margin @ 25% `17.50 lacs
Drawing power (A) ` 52.50 lacs
Value of debtors as on 31.12.22 ` 50 lacs
Less: debtors exceeding 90 days ` 10 lacs
`40 lacs
Less: Margin @ 40% ` 16 lacs
Drawing Power (B) ` 24 lacs
Drawing Power (A+B) ` 76.50 lacs

The drawing power calculated by CA P is not proper. Drawing Power comes

to ` 76.50 lacs.

©The Institute of Chartered Accountants of India

 10.60 AUDITING AND ETHICS

5. The auditor should obtain from the bank an analysis of various types of
deposits outstanding at the end of each quarter. From such information, the
auditor may work out a weighted average interest rate. The auditor may then
compare this rate with the actual average rate of interest paid on the relevant
deposits as per the annual accounts and enquire into the difference, if
material.

The auditor should also compare the average rate of interest paid on the
relevant deposits with the corresponding figures for the previous years and
analyse any material differences.

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