BANK BRANCH AUDITS A C2C INITIATIVE CONCEPT TO COMPLETION CA P R SURESH CA SRIPRIYA KUMAR

1. BANK BRANCH AUDITS A C2C INITIATIVE CONCEPT TO COMPLETION CA P R SURESH CA SRIPRIYA KUMAR

2. Presentation Path • Overview -Objective and Scope of Audit • Understanding Perspective • Bank Audit Unique Dynamics • Understanding P&L, B/S and certificates • Engagement formalities • Understanding CBS environment • Master Circular on IRAC norms • Case Studies on advances • MS Excel in bank audits • Audit Planning and sampling • Audit Program & documentation – • A Check list driven approach • Reporting and closure • Precautions

3. Bank Branch Audits – An overview – Scope and objective • The basic objective of Bank Branch audits is to provide an opinion on True and Fair status of the financial statements as at the Balance Sheet date • The key reports issued are : • Branch Auditors Report • Certified Copies of the Balance Sheet and Profit and Loss Account • Long Form Audit report • Tax Audit report under Section 44AB of the Income Tax Act • Special reports and certificates • A Unique feature in a bank audit is that unlike in corporates, we are also required to confirm if the transactions of the branch which have come to our notice have been within the powers of the bank.

4. Bank Branch Audits – The Auditors Perspective • Audit as you would if you OWNED the branch, then it is very simple ! • All bank audit documents that are certified are mostly directed only at the these four perspectives at the Core of True and Fair • In a limited sense, LFAR, Ghosh and Jilani are like CARO in a Corporate audit

5. Bank Branch Audits – Unique Dynamics • The Branch Auditors Report is an objective certification of the True and Fair position of the P&L and the Branch Balance Sheet • Additionally, we are required to provide assurance on status of regulatory compliances and internal controls in the following sign offs namely the : • LFAR • Ghosh Committee recos • Jilani Committee recos

6. Bank Branch Audits – Unique Dynamics • Most of us have no familiarity with the branch and we somehow need to hit the ground running • We can however derive strong comfort from the following documents which would be available at the branch • Concurrent Audit reports • Inspection Reports • Risk based internal audit reports where the branches are objectively rated

7. The Landscape

8. Bank Branch Audits – The delicate balance

9. Understanding Financial statements • Balance Sheet of a Bank as finally presented Schedule –1 Capital Schedule –2 Reserve and surplus Schedule –3 Deposits Schedule –4 Borrowings Schedule –5 Other Liabilities and provisions Schedule –6 Cash and bank balance with RBI Schedule –7 Balance with bank and money at call and short notice Schedule –8 Investments Schedule –9 Advances Schedule –10 Fixed Assets Schedule –11 Other Assets Schedule –12 Contingent Liability

10. Engagement formalities • Receipt of appointment letter • Address qualifications and disqualifications of auditors - (Concurrent ,Internal, Revenue, Stock, System, Credit Risk or other Special Audits conducted in same previous year) • The following category of persons ( Section 226(3) of Companies Act 1956) • Body Corporate • An officer or employee of the Bank • A person who is a partner, or who is in the employment, of an officer or employee of the Bank • A person who is indebted to the Bank for an amount exceeding one thousand rupees, or who has given any guarantee or provided any security in connection with the indebtedness of any third person to the bank for an amount exceeding one thousand rupees • person holding any security of that bank, Security means an instrument which carries voting rights. • Member associated with bank in the capacity as concurrent auditor, stock auditor, revenue auditor etc., except systems auditor. • Communication with Previous Auditor by Registered AD (clause 8 of First Schedule to the Chartered Accountants Act, 1949 • Expected date of submission of reports

11. What we certify - an indicative checklist Make your own checklist of what is expected as the end state deliverable in order to ensure that we understand what we are to do and to ensure that there are no omissions

12. What we certify - an indicative checklist Make your own checklist of what is expected as the end state deliverable in order to ensure that we understand what we are to do and to ensure that there are no omissions

13. Understanding CBS environment • Core Banking solutions are integrated farmeworksthat automates all aspects of core banking operations across entities, languages and currencies. • Master data , transaction data , access restrictions and business process logic is all in built in the CBS platform minimising and mostly eliminating need for manual intervention beyond input stages • Core banking solutions helps banks with: • Entire range of banking products including savings, checking, overdraft and deposit accounts • Entire range of lending products • Complement of transactional services including remittance, foreign exchange, cards and trade finance • Accessibility through multiple channels, including mobile banking and web • Full integration of front-, middle-, and back-office processes • Accurate, timely and actionable information about customer relations • Single view between bank and customer • “Anytime anywhere” banking

14. Understanding CBS environment • CBS does not obviate the need for bank branch audits because • NPA classifications are system driven, however cannot replace human intelligence • Work flow integration for documentation aspects is not complete across all banks. Hence documentation and security cover lapses may still impair asset quality • No scale and complexity of automation can substitute human intuition • Window dressing and borderline cases – analytical reviews • CBS is a good audit enabler as it permits simple views of large transactions , by excel manipulation of text files and helps us to profile and stratify data for sample selection

15. Master Circular on IRAC norms • The classification of assets of banks has to be done on the basis of objective criteria, which would ensure a uniform and consistent application of the norms. • The provisioning should be made on the basis of the classification of assets based on the period for which the asset has remained non-performing and the availability of security and the realisable value thereof. • Master Circular dated 1st July 2012 on IRAC Norms. • Other Circulars : Master Circular on Capital Adequacy norms • Master Circular on Priority sector lending • Master Circular on SLR / CRR • Master Circular on Fraud • Definition of Infrastructure lending.

16. Asset Type • STANDARD ASSET / PERFORMING ASSET The account is not non-performing and does not carry more than the normal risk attached to the business. • NON-PERFORMING ASSET (NPA) • The asset ceases to generate income for the bank. • Higher risk than normal risk attached to business. • Non performing as per criteria for various types of loans.

17. Identification of Account as NPA

18. Identification of Account as NPA ...

19. Identification of Account as NPA ... • Cash Credit / Overdrafts Account remains ‘out of order’ The account is treated as ‘out of order’ if : • Outstanding Balance remains continuously in excess of sanctioned limit/drawing power for 90 days or • No credit continuously for 90 days as on the date of Balance Sheet or • Credits in the account are not sufficient to cover interest debited during the same period.

20. Exceptions / Clarifications • Temporary Deficiencies: • TOD : Outstanding Balance in account based on the drawing power calculated from stock statements older than 3 months would be deemed as irregular & if such irregular drawing are permitted for a period of 90 days, account needs to be classified as NPA. • Non-renewal/ Non-regularisation of regular/ adhoc limit within 180 days from the due date would also qualify for NPA • Advances against term deposits, NSCs, IVPs, KVPs and Life Insurance Policies need not be treated as NPAs, till security cover is sufficient to cover outstanding balance. • Income to be recognised subject to availability of margin. • Advance against gold ornaments / Government securities not exempt.

21. Exceptions / Clarifications … • Central Government guaranteed advance to be classified as NPA only if Government repudiates the guarantee when invoked. • Classification Qua Borrower - All facilities granted to a borrower shall be treated as NPA & not only that facility which has become irregular. Exception: Credit facility to Primary Agricultural Credit Society (PACS) and Farmers Service Societies (FSS) under on lending arrangement. • Consortium Advance - Member banks shall classify the accounts according to their own record of recovery. Bank needs to arrange to get their share of recovery or obtain an express consent from the Lead Bank

22. Exceptions / Clarifications … Straightaway Classification • Where realisable value of security is less than 50% of the value assessed, account to be straightaway classified as Doubtful Asset. • Where realisable value of security is less than 10% of outstanding balance, account to be straightaway classified as Loss Asset. Valuation of Securities • In respect of NPAs with the balance of Rs. 5.00 crores & above, bank needs to formulate policy for annual stock audit by external agencies & in respect of immovable properties, valuation to be carried out once in 3 years by approved valuer.

23. Exceptions / Clarifications … Solitary Credit Entry • Care should be taken that a solitary or few credits in the account made at/near the balance sheet date extinguishing the overdue interest/principal is not the only criteria for classifying the asset as standard. Regularisationof Account • Account need not be classified as NPA if account has been regularised by the date of Balance sheet by payment of overdue through genuine sources & not by sanction of additional facility or transfer of funds between accounts.

24. Income Recognition • For NPA accounts income should be recognised on realisation basis. • When an account becomes non-performing, unrealised interest of the previous periods should be reversed or provided. • Interest income on additional finance in NPA account should be recognised on cash basis. • In project loan, funding of interest in respect of NPA if recognised as income, should be fully provided. • If interest due is converted into equity or any other instrument, income recognised should be fully provided.

25. Income Recognition… Adjustment of Recoveries - Priority Unrealised Expenses Unrealised Interest Amount of Principal Outstanding Clarification vide Master Circular - in the absence of clear agreement between the Bank and the Borrower, an appropriate policy to be followed in uniform and consistent manner.

26. Classification Norms • Standard Asset The account is not non-performing. • Sub-Standard Asset A sub standard Asset is one which has remained NPA for a period of less than or equal to 12 months. • Loss Assets These are accounts, identified by the bank or internal or external auditors or by RBI Inspectors as wholly irrecoverable but the amount for which has not been written off.

27. Classification Norms… • Doubtful Asset - Three Categories CategoryPeriod Doubtful - I up to One Year Doubtful – II One to Three Years Doubtful - III More than Three Years

28. Provisioning Norms Standard Asset • Agricultural and SMEs Sectors 0.25% • Housing Loan with teaser rates of interest 2.00% • Restructured Advances 2.00% • Commercial Real Estate (CRE) Section 1.00% • Others 0.40% • Restructured Advances upgraded as Standard advance 2.00% Sub-standard Asset • Secured exposure - 15% of total outstanding • Unsecured Expsoure – Infrastructure – 20% of total outstanding • Unsecured – other than Infrastructure - 25% of total outstanding unsecured

29. Provisioning Norms… Doubtful Assets: Period Provision (Secured + Unsecured) Up to 1 year 25%+ 100% 1to 3 years 40% + 100% More than 3 years 100% + 100% Loss Asset: 100% should be provided for

30. Provisioning Norms Provision Under Special Circumstances • Advance under rehabilitation programme approved by BIFR / Institutions, Provision should be continued to be made on existing facilities. • Additional facilities no provision for a period of one year. • In case of advances guaranteed by CGTSI/ECGC, Provision should be made only for balance in excess of the amount guaranteed by these corporations.

31. Guidelines on Restructuring of Advances • Restructuring divided in following four categories; • Industrial Units. • Industrial Units under CDR Mechanism • SMEs • All other advances. Infrastructure lending Special Regulatory Treatment ( Para 14 of Master Circular)

32. Guidelines on Restructuring of Advances… • Eligibility • Any account classified as standard, sub standard or doubtful. • Restructuring cannot be done retrospectively and usual asset classification norms would continue to apply. • Restructuring should be subject to customer agreeing to terms and conditions. • Financial viability should be established. • Borrowers indulging in frauds and malfeasance or in eligible. • BIFR cases eligible for restructuring subject to approval from BIFR.

33. Guidelines on Restructuring of Advances… • Asset Classification Norms • Restructuring of accounts could take place in following stages: • Before commencement of commercial production • After commencement of commercial production / operation but before the asset has been classified as ‘Sub Standard’. • After the commencement of commercial production / operation but after the asset has been classified as ‘Sub Standard’ or doubtful.

34. Guidelines on Restructuring of Advances… • Asset Classification Norms (Cont’d) • Standard Asset would get reclassified as sub standard and account which is already NPA would continue to have the same classification. • Additional finance would be treated as standard upto a period of one year. • All restructured accounts, classified as NPA upon restructuring would be eligible for upgradation after observation of satisfactory performance for the period of one year.

35. Guidelines on Restructuring of Advances… • Provisioning Norms • Total provision required would be normal provision plus provision in lieu of diminution in fair value of advances. • Diminution in fair value would be required to be recomputed on each balance sheet date. • Banks have option of notionally computing the diminution in fair value and providing at 5% in case of all restructured accounts where the total dues to bank is less than one crore.

36. Guidelines on Restructuring of Advances… • Special Regulatory Treatment for asset classification. • Not available to following categories of advances: • Consumer and personnel advances • Advances is classified as capital market exposure • Advances classified as commercial real estate exposure. • Incentive for quick implementation of package The asset classification status may be restored if the approved package is implemented : • Within in 120 days from the date of approval under CDR • Within 90 days from the date of receipt of application by Bank in other cases.

37. Guidelines on Restructuring of Advances… II. Asset classification benefits a. Standard advance will not be reclassified as sub standard upon restructuring if following conditions are satisfied. • Dues of the bank are fully secured by tangible security (except SSI borrower with outstanding upto Rs.25 lacs & infrastructure projects) • Unit becomes viable in 10 years, if it is engaged in infrastructure activities and in 7 years in case of other units.

38. Guidelines on Restructuring of Advances… • Repayment period including moratorium does not exceed 15 and 10 years for infrastructure and other projects respectively ( 10 years ceiling won’t apply to restructured hosing loan accounts) • Promoters sacrifice and additional funds brought by them should be a minimum of 15% of bank’s sacrifice (Ref RBI Circular dated 7th October 2010) • Personal guarantee is offered by promoters. • The restructuring is not ‘repeated restructuring’ . During the specified period the asset classification of sub standard / doubtful accounts will not deteriorate, if satisfactory performance is demonstrated during the specified period.

39. Need for MS Excel in bank audits And to top it all a Very complex regulatory framework

40. USING MS EXCEL

41. Practical Issues in audit of advances • Drawing Power • Classification Date of NPA • Realisable Security Value • Inter Company transactions • Ever greening/ Restructured Advances • Temporary Deficiencies - renewal • Temporary Deficiencies – Stock Statements • Term Loans • EMI Concepts • Circular Credits • SARFAESI notice • Financial Statement Analysis - threat of recovery • Sale of Assets – Threat of recovery

42. Practical Issues in audit of advances • Diversion of Funds. • Devolved Letters of Credit / Bank Guarantees invoked • Borrower Wise Classification • Knowledge of business • Physical Stock Verification • Government Guaranteed Advances • Agricultural Advances • Continuous Overdrawing – Discretionary power • Staff Advances against Shares • Window dressing • Premises Loans • PMRY Loans

43. Case Studies on Advances – Drawing Power

44. Case Studies on Advances – Classification Date of NPA

45. Case Studies on Advances – Realisable Security Value

46. Case Studies on Advances – Realisable Security Value (Cont…)

47. Case Studies on Advances – Inter Company Transaction

48. Case Studies on Advances – Ever Greening / Restructured Accounts

49. Case Studies on Advances – Temporary Deficiency - Renewal of Cash Credit, Overdraft and Demand Loans.

50. Case Studies on Advances – Temporary Deficiency - Renewal of Cash Credit, Overdraft and Demand Loans.