Bank Branch Statutory Audit

AUDIT OF ADVANCES
Paper Presented by : CA Ismail B. Sonawalla
200, Ashoka Shopping Centre, 2nd floor, L. T. Marg
Next to G. T. Hospital, Mumbai 400 001
Email – [email protected] Mobile – 0-98202 32172

Scope of the Topic

A. Various Laws Applicable
B. Major Master Circulars / Directions issued by RBI
C. Verification of Funded Advances
D. Verification of Non-Funded Advances

RBIs site – www.rbi.org.in - Check for various circulars

A. Various Laws Applicable or Whose Knowledge is Essential

2 sets of Laws
 Applicable to the Bank (Lender)
 Applicable to the Borrower

1) The Companies Act, 2013 or any other statute under which the Bank is registered.
(applicable to the Bank and the Borrower – registration of charge, resolutions, borrowing
powers etc.)

2) The Banking Regulation Act, 1949 (B. R. Act)

3) The Reserve Bank of India Act, 1934

4) The Foreign Exchange Management Act & FEDAI rules

5) The Income Tax Act, 1961 and its rules (TDS, Tax audit, Income tax)

6) The Goods & Service Tax law

7) The Stamp Act applicable to the respective State

and / or
The Indian Stamp Act

8) The Indian Contract Act, 1872

9) Transfer of Property Act, 1882

10) Sale of Goods Act, 1930

11) Negotiable Instruments Act, 1881

12) Limitation Act, 1963 (3 year’s limitation for documents)

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13) Memarts / Byelaws / Annual Closing Guidelines of the Bank

14) Accounting Standards - Policies & Guidelines

Certain features of these laws which need to be considered are follows:

Banking Regulation Act

 Sec.5A of B.R. Act - The provisions of the Banking Regulation Act override the ones in any
other Act or the Rules or Byelaws including the Companies Act, 2013.

 Sec. 14-A of B. R. Act - A Bank cannot create a floating charge on its assets.

 Sec.20 of B.R. Act – Bank cannot give loan against its own shares.

 Sec.20 of B.R. Act - Loans are not allowed to be given to directors (including members of
any committee) or firms or companies in which directors are directly or indirectly interested.
Further, under Sec 20A of B.R. Act – Remission of loans given to the above persons can be
done only with the prior approval of RBI. For further details, refer RBI’s Master Circular –
Loans & Advances – Statutory & Other Restrictions dated 1st July, 2015.

 Sec.29 of B.R. Act - Banks have to prepare Balance Sheet and Profit & Loss Account in Form
‘A’ and Form ‘B’ respectively as given in Third Schedule to the B.R. Act.

Stamp Acts
 For purpose of stamping of documents, Branch to follow law of the place where document
is executed and not where registered office of bank is situated. Eg., for stamping of
documents executed by a branch of Bank of India in Gujarat, The Gujarat Stamp Act to be
followed and not the Maharashtra Stamp Act, which is applicable to its registered office in
Mumbai.

 If certain provisions not available in State’s Stamp Act, provisions of the Indian Stamp Act,
which is a central act, to be followed. eg. provision for revenue stamp

Limitation Act
 Limitation Act, 1963 states that on a bill of exchange or promissory note payable on
demand and not accompanied by any writing restraining or postponing the right to sue, the
claim can be made within 3 years from the date of the bill or note.

Annual Closing Guidelines

 Major policies and rules that the Bank follows are given in the Annual Closing Guidelines.
Hence, very essential that the same is read before the audit of Advances is commenced. If
some of these guidelines are not in line with the Accounting Standards or other statutory
guidelines prescribed, the guidelines, as given by the Bank should be followed and the fact
about its deviation from the statutory guidelines to be given in the report.

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B. Major Master Circulars / Master Directions issued by RBI during F.Y. 2018-19
From January, 2016 RBI has started issuing Master Directions superseding instructions / Master
Circulars issued on those topics in the past. These Master Directions are also updated from
time to time and the details of the last update is also shown.
However, if no Master Direction has been issued on a particular topic, the last “Master Circular”
issued on that topic continues to be applicable.

C. Audit of Advances

General

Before commencing, desirable to study accounting system followed by Branch, especially if it is

computerized, since a large number of details required by the Auditor for verification as well as
LFAR reporting, can be generated from the system itself – no need to prepare one manually.

Some of the statements that could be generated by the system as on 31st March are as follows:
 Facilitywise / partywise list of accounts outstanding, alongwith the outstanding balance.
The aggregate total of these lists should first be tallied with the figure of total advances in
the Trial Balance to ensure that none of such statements have been missed out.
 Sanctioning powers of the branch officials and the higher authorities
 List of accounts where the regular facility or the adhoc facility is due for renewal, but has
not been renewed
 List of accounts where stock / book debt statements are in arrears
 List of accounts where no insurance or inadequate insurance has been taken.
 List of accounts overdrawn beyond the sanction / DP limit.
 List of accounts where stock audit is due, but has not been done
 List of accounts where inspection has not been carried out in the last 3 / 6 months.
 For CC / OD accounts, monthwise details of debit and credit transactions
 NPA statements, as prepared by the Branch

Discussion with Credit Officer may reveal information about further such statements which are
generated from the computer.

Type of Facilities

 Based on Funds – Funded – where actual money is given by the Bank and Non-Funded –
where only a guarantee or commitment or co-acceptance is given that a certain amount
would be paid on the occurrence of certain unknown events, or an accepted bill would be
honoured on presentation (Letter of Credit)

 Based on Geography – Inland and Export (Packing/Pre-shipment credit, Post-shipment

credit)

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 Based on Security – Secured and Unsecured

Secured - one granted against some security, while unsecured - one given against personal
surety only.
Secured can be further divided into hypothecation, pledge, mortgage, assignment etc. The
security could be tangible (goods) or intangible (bank / government guarantees).

 Based on Sector – Priority sector (40% by RBI) and Non-Priority sector

Priority sector is one in which persons with small means are engaged or which needs to be
supported / encouraged by the government.

Type of Advances (including Foreign Advances)

 Demand / Term loan - such advance, though called “demand loan” generally repayable in
pre-determined instalments. If repayment period exceeds 36 months, called Term loan.

 Cash Credit – this advance generally granted without any stipulation for repayment, but is
required to be renewed every year. Such advance, granted generally against security of
stock and book debts is called Cash Credit. When a borrower is allowed to draw beyond his
sanctioned limit or drawing power limit, the said amount is called “Temporary Overlimit –
TOL”. TOL secured by existing securities against which the Cash Credit sanctioned.

 Overdraft - advance similar to Cash Credit, except that either security is other than stock
and book debts – eg. FD receipts, NSC receipts, shares, LIC policies or no security is taken
(termed as “Unsecured Overdraft”) or, etc. When such secured or unsecured overdraft
granted to borrower to tide over temporary financial crisis, it is called “Temporary Overdraft
– TOD”. Unlike TOL, which is generally secured, TOD is generally unsecured.

 Bills Purchased / Discounted – when advance against sale bill is granted to seller with the
condition that the same should be repaid before the physical possession of the goods
passes on to the buyer, it is called “Bills Purchased” facility; when an advance is granted
against a sale bill, wherein the buyer has received the goods and has agreed to pay the
amount therein within a stipulated period, such a facility is called “Bills Discounted”.

Extent of Verification

 Based on existence and efficacy of internal control procedures (including concurrent audit)
Auditor to verify all large advances – constituting more than 5% of the outstanding
advance or Rs.2 crore, whichever is lower

 If NPAs are high or extensive problem is identified, percentage of check to be increased.

 Due to stressed business environment, banks have been extensively resorting to

restructuring of advances. All such accounts, as well as all accounts which have heavy NPAs
should be selected for verification.
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Reporting of Verification

 Statutory Auditors have to report about discrepancies noted in the Advances in two
separate reports – one is the Statutory Audit Report for ‘Major / Critical Discrepancies’ and
the other is a detailed report in the Long Form Audit Report (LFAR) under para I-5 –
Advances.

 Before commencing verification of Advances, Auditor to devise query noting format, so that
requirements of above two reports are also complied with simultaneously.

Stages of Verification (COMMON SENSE IS THE MOST IMPORTANT INGREDIENT)

It is suggested that for verification of Advances especially the big ones, all the stages of
verification should be done by the same person to enable him to get a bird’s eye view of the
account.

RBI has also issued a Master Circular – “LOANS & ADVANCES – STATUTORY & OTHER
RESTRICTIONS” dated 1st July, 2015. The same needs to be read.

(i) Credit Appraisal & Sanction

 Documents required – documents required vary based on the profile of the
borrower; however, certain documents that need to be checked are: Statement of
accounts, debtors, creditors and stock, projected balance sheet and profit and loss
account, visit report by the branch, valuation report or proforma invoice for plant
and machinery, vehicle, etc., credit appraisal report of the bank, papers showing net
worth of the borrower and guarantors, CIBIL report showing the credit history of the
borrower and guarantors, confidential report from other banks, ratio analysis, etc.,
various licences as required by that business, proforma invoice for purchase of
machinery / equipments, financial papers of guarantors, confidential report from
previous bankers, if any; for partnership firms – partnership deed; for companies -
memarts, resolution, etc.

 Sanction Letter – authority to sanction / terms of sanction – whether complied

 Prudential Norms – prescribed by RBI, state that the maximum amount that can be
advanced to one borrower (funded & non-funded) should not exceed 15% of the
bank’s Capital Fund for individuals and 40% for groups

 Loans against security of shares, bonds, etc. to an individual not to exceed Rs.10/20
lacs, if the securities are held in physical / demat form respectively.

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Uniform margin of 50 per cent to be applied on all advances / financing of IPOs /

issue of guarantees on behalf of stockbrokers and market markers. A minimum
cash margin of 25 per cent (within the margin of 50%) to be maintained in
respect of guarantees issued by banks for capital market operations

 Previous adverse comments - Any adverse comments on the account in previous

statutory audit, internal inspection, concurrent audit etc.

(ii) Disbursement
 Documents by the Bank – A-DP Note, B-Hypothecation / Pledge / Mortgage
documents, C-Letter of Guarantee etc. – No tick marks on documents

 Stamping (as per the law applicable)

 Documents to be obtained – Charge Noting with ROC / RTA / Co-op. Housing

Society, Assignment of Policies, Transfer of shares, NSC, FDR, Insurance etc.

 Insurance – all immovable and movable properties – assignment in favour of Bank

 Special Conditions – Mode of disbursement (direct payment), clearing of dues,

processing charges etc.
(iii) Review of Operations – MOST IMPORTANT

 RBI – Any transaction susceptible to fraudulent transaction to be directly

reported to RBI by the Auditors.

 Intelligent scrutiny of the bank statement (debit / credit entries, cash /

cheque, transfer from / transfer to accounts, frequent return of cheques,
excessive withdrawals / deposit in cash, no / inadequate payments by
cheque for purchases, no / inadequate deposits by cheque for sale
proceeds, turnover in the account disproportionate to the sale / turnover
of business, payment to persons or for items not related to this business
or transfer of funds to personal accounts of owner or sister concerns etc.
(diversion of funds)

 Drawing power (DP) limits – based on the stock and book debts of the
borrower, monthly / quarterly drawing power limits are fixed, which are
equal to or less than the sanctioned limits; the auditor has to verify
whether the account is frequently / continuously overdrawn over the DP
limits; at times, DP limits are enhanced for temporary period by sanction
of adhoc limits. Incidentally, this verification is also necessary for NPA
classification of the borrower.

 Verification of stock / book debt statements - compare movement of

stock / book debts from month to month with turnover in account and
purchase and sale declared by the borrower in the stock statements; the
stock and book debts declared in the statement for March of the previous
year to be compared with similar figures given in the audited or
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unaudited financial statements of the concern; book debts statement to

be certified by a chartered accountant on a quarterly basis; for non-
submission of these statements, penalty is charged; necessary to verify
whether the stock includes unpaid stock (represented by Sundry
Creditors), stock under L/C, stock under Packing Credit, etc., since all
these stocks being “unpaid stock” have to be deducted from the total
stock considered for DP limit. Specifically verify the genuineness of stock-
in-transit.

 Account with other banks – is it permitted, purpose, details of

transactions etc.

 Audit and audit reports – compulsory for non-corporate entities, with

sanctioned limits above Rs.10 lacs, to get their accounts audited.

 Recovery of instalments & its source / turnover in accounts – frequent

overdrawings.

 Special conditions – in case of advance against exports, the same has to

be informed by the bank to Export Credit Guarantee Corporation (ECGC)
to cover the said advance under its insurance scheme. Further,
concessional rate of interest is charged to the borrower, provided certain
conditions are fulfilled and the advance is liquidated within a specified
time limit out of the export proceeds. If the same does not happen, the
benefit of concessional rate of interest is withdrawn.

 Balancing of books (General ledger with Subsidiary ledgers) – Major

frauds take place

(iv) Renewal / Enhancement / Reschedulement / Balance Confirmation

 Generally at the end of one year, unless it is an adhoc advance or it is otherwise

specified in the sanction letter; non-renewal can make the account a non-
performing asset (NPA).

 For limits re-aligned or enhanced, necessary documents to be executed. Even if the

limit is sanctioned for a temporary period, proper stamping and execution of the
necessary documents is mandatory.

 Where a project gets delayed or temporary crisis arise in the business of the
borrower, the loan repayment amount and its time is rescheduled. Reschedulement
is permitted, but sanction for the same from the appropriate authority is necessary.

 To avoid documents becoming time-barred, Letter of Acknowledgement of Debt

(LAD) to be obtained, preferably every year; applicability of Law of Limitation.

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(v) Physical Inspection of Securities (Visit to office / factory & verification of accounts)

 Stock / Machinery (obsolete stock, non-working machinery) –

generally Statutory Auditors do not go for inspection, but rely on
report of stock / concurrent / internal auditors – adverse
comments to be looked into. Stock audit mandatory above a
certain limit of advance prescribed by bank. Further, if account is
NPA, mandatory for bank to obtain stock audit report from an
external agency every year in cases, with o/s balance of Rs.5 crores
and above. Auditor to examine these reports to see if there are any
adverse comments and its rectification. Special attention to non-
moving stock & obsolete machinery included in stock statements
on the basis of which DP limit is determined.

 Demat or physical shares / TDR / Other Scrips with Branch

 Valuation of securities – in case of loan against shares, bank to

prepare periodical statement of valuation of shares pledged to
check whether margin is still maintained. In case of NPA accounts,
it is mandatory for the bank to obtain valuation report for all
immovable properties / machinery mortgaged / hypothecated to
the bank atleast once in 3 years.

(vi) Verification of charges due on the advances

Following charges recoverable at rates prescribed. Auditor to test check recovery.
 Charges for processing of loan, stamping, insurance etc.
 Interest / charges on the advance, including “withdrawals against
effects” (WAE), temporary overlimit etc.
 Charges for late / non-submission of stock / QIS statements, non-
renewal of limits, inspection, valuation, etc.

Certain Indicators which could lead to identify Irregular Accounts / Frauds

While verifying loans and advances, the auditor has to take cognisance of certain indicators,
which may lead to irregular accounts / frauds.

 The branch has 1 or 2 major borrowers constituting more than 50% to 75% of the total
advances of the branch, to whom the branch goes out of its way to give continuous
overlimits or withdrawals against uncleared effects or does not pursue recovery of
overdue bills or stock statements are not received in time and yet drawing power limit is
continued or account is not renewed on due date or adhoc limits are not cleared and yet
facility is continued, etc. etc.

 While verifying CC a/c, OD a/c and bills a/c, the following observations are made
 account remains continuously overdrawn;

 a number of cheques are bounced due to insufficient funds;

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 cheques deposited are not honoured and returned unpaid;

 the account has been granted continuous TOL by the branch – for 20 to 25 days
every month moreover, such TOLs have been granted by the Branch Manager, at
times, without having the power to do so;

 the 12 month’s turnover in the account does not commensurate with the sale and
purchase shown in 12 monthly stock statements or the statement of accounts
submitted;

 the realisation of bills purchased / bills discounted is not received on the due date
and subsequently the same are cleared by debit to the borrower’s CC / OD a/c;

 as soon as the above bills are cleared, fresh bills are purchased / discounted;

 the facility has not been renewed on the due date and the reason given is that the
borrower has not submitted the necessary papers;

 all overdue CC limits, OD limits, unrealised bills, unrealised interest are bundled
together and the borrower is granted WCTL – Working Capital Term Loan to avoid
the account becoming NPA. Such bullet loan is an indicator that the account is having
problems;

 for certain accounts, when papers are asked for, the branch is unduly slow in
producing the same or makes a plea that the same have been sent to some authority
and hence is unavailable at the branch;

 in certain cases, the branch just does not produce the papers, pleading that the same
are not traceable;

 in case of certain accounts, the Branch Manager pleads not to put any adverse
remark in the report and that he shall get it rectified after the audit is over;

 While verifying monthly / quarterly stock statements submitted, the following

observations are made
 generally stock statements are not submitted on time;

 the itemwise details of stock is not given and instead lumpsum figures are shown
without quantitative details;

 if itemwise details are given, a comparison of statements submitted over a period of

time shows that the same stock is repeated over and over again with the same
quantity and value;

 there is heavy “sundry creditors” indicating unpaid stock, but the said amount has
not been deducted from the stock value, before determining the DP – drawing power
limit of the borrower;

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 the stock statement contains details of stock, which have actually financed by the
branch under LC limit or Packing Credit limit or some other limits;

 there is a huge difference in closing stock shown in the stock statement of 31st
March, 2017 and audited/unaudited accounts submitted subsequently or better still,
the borrower does not submit the stock statement of March or the same is
untraceable in the branch;

 the stock statement reflects an unusually high amount of “stock in transit” every
month, which does not commensurate with the monthly purchases or the monthly
turnover in the accounts;

 though mandated, the Branch has not obtained the “stock audit report”;

 the stock audit report has adverse comments, but

 the Branch has not taken any corrective steps; OR

 the Branch Manager states that subsequently he has visited the unit and
everything is rectified and regularised;

 the stock inspection done by the branch is superfluous and does not record the
details of the stock verified – a few direct indepth questions to the branch staff, who
went for the concerned stock inspection would reveal the quality of the inspection
done;

 While verifying monthly / quarterly book debts statements submitted, the following
observations are made
 book debts due for more than 90 days are not segregated, though the same is
mandated in the Sanction letter;

 a comparison of last 10-12 month’s statement reveals that there are a number of
book debts, which probably are being shown for more than 8-10 months and may be
bad debts or recovered, but not deducted from the statement;

 A comprehensive 10-12 month’s analysis of monthly sales, purchase and stock as shown
in the stock statements, the book debts, the turnover in the accounts and the audited
financial statements may reveal that the stock statements submitted every month are
highly inflated.

 Verification of other records at the branch

 verification of immovable property documents under ultra violet rays can reveal
whether the document is genuine or a photo copy;

 in immovable property loans, the branch has not obtained “search report” of the
property from the Registrar’s office, or the adverse comments in such report have
been ignored;

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 the branch has not obtained NOC from the builder / society or such NOC has been
personally brought by the borrower to the branch instead of the same being directly
obtained by the branch from the builder / society;

 in case of loans to limited companies, details of previous charges have not been
obtained or if any adverse observations have been made, the same are ignored – for
eg. the report shows that the borrower has borrowed from other banks without the
knowledge / permission of the existing banker, old charges which were supposed to
have been cleared have not been done indicating that old loans are still outstanding;

 there is correspondence on record, which states that on the same immovable

property, the borrower has obtained loans from more than one bank;
 the branch has filed a suit against the borrower to recover the amount.

D. Verification of Non-Funded Advances

Generally, verification of funded and non-funded advances done simultaneously; certain
components of non-funded advances need to be looked into. Reserve Bank of India has issued
a Master Circular dated 1st July, 2015 under the heading “Guarantees and Co-acceptances”

Non-funded advances called “Off Balance Sheet” items, as their value not reflected in Balance
Sheet. They form “Contingent Liability”. However, for purpose of keeping a control over these
items, banks pass contra entries in its books of accounts at branch level & hence these items get
reflected on liability as well as asset side of Trial Balance. However, while preparing Balance
Sheet of the bank as a whole, value of these items reflected in “Notes to Accounts”.

RBI has mandated banks not to do non-fund business (guarantees, co-acceptances, LCs) with
persons, who do not enjoy credit facilities with the bank.

(i) Guarantees
 Two types – financial guarantee, wherein guarantor (bank) promises to pay stated
amount to beneficiary, if person for whom guarantee is given, fails to pay the same
(invoking the guarantee); performance guarantee, wherein guarantor promises to pay
beneficiary a stated sum, if the person for whom guarantee is given, fails to perform, as
expected, in a given period of time. Banks generally discouraged from issuing
Performance guarantees.

 Comprises of two independent, but related components – one guarantee issued by

banker (of buyer) to beneficiary (i.e. seller) and other is counter guarantee given by
buyer to his banker.

 Since invoked Guarantees become funded advance, banks not to encourage borrowers
to over extend their commitments solely on the basis of guarantees.

 Guarantees for specific transaction (specific guarantee) or for multiple transactions

within a specific time frame (continuing guarantees); should be for short durations –
maximum maturity period - 10 years.

 Unsecured Guarantees to a particular borrower not to exceed 10% of total exposure

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 Banks not to concentrate its unsecured Guarantees to a particular borrower or a group.

 Ghosh Committee recommended precautions to be taken by banks while issuing

Guarantees.

 Guarantees issued by keeping margins, either as cash / term deposit or some other
security.

 Guarantees issued on behalf of share and stock brokers - RBI has advised banks to
obtain minimum margin of 50% (with 25% being cash margin)

 RBI restrictions on guarantees of inter-company deposits / loans and inter-institutional

guarantees.

 RBI - extensive guidelines on issue of guarantees on behalf of exporters and importers.

(ii) Letter of Credit (LC)

 LC a promise by banker to honour payments to be made by its customer (buyer or
importer) to seller or exporter. Generally used in international trade.

 At request of buyer, his banker opens an LC, which is sent to seller. Based on such LC,
seller despatches goods and sends bills through his banker to the buyer’s banker to
make payment of the bill. Buyer makes payment and routes it through his banker to
seller’s banker.

 In case buyer fails to make payment (devolvement of LC), buyer’s banker, who has
opened the LC, liable to make payment to seller.

 RBI has mandated banks not to discount bills drawn under LCs or otherwise for
beneficiaries, who are not their regular clients.

(iii) Co-acceptance of bills

 Seller despatches goods and raises bill on buyer. Buyer accepts the bill and then it is co-
accepted by buyer’s banker. The seller’s banker then discounts this bill.

 Facility often used by customers to float accommodation bills (i.e. bills which are not
supported by genuine sale and purchase of goods) and hence auditors should be
careful while examining such bills.

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