10 Audit of Banks

CHAPTER

OVERVIEW

Introduction

Banking Operations

Accounting
Accounting system of Banks

Bank Audit Approach

Advances & T
Their
heir Audit

Audit of Reve
Revenue
nue Items
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.
Huge volume of bank transactions take place instantly, moneys are deposited and withdrawn from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!

Notes to Add

788 Auditing & Ethics PW

 INTRODUCTION
Back Bone
Economy Socio-Economic Growth
Financial Stability
Banking Sector

Mammoth  Amt. of Money

inance

Issuance
RBI Regulating Body Function Regulation
CG
Banker
SG
Central Bank
Dev. & Supervision Monetary Regulating
Policies Commercial Banks
Huge V ol. + Complexity
Peculiarities Wide geographical spread
Large range
Wide geographical spread
Large range
Use of technology
Strict vigilance

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
Audit of Banks 789
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.
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 as ‘Term-Lending Small Finance Banks.
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.
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.

Granting
Advances

Two Major
Accepting functions of
Deposits Banks

790 Auditing & Ethics PW

Accepting Deposits
Granting Advances
Two Major functions of Banks

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
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.

Audit of Banks 791

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.
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.

Statutory Audit Report ® as per SA 700, 705, 706

Types of Audit Reports Banks Long form Audit Report (LFAR)

Tax Audit Report as per the Income Tax Act, 1961

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.
792 Auditing & Ethics PW
(f) Report on whether any serious irregularity was noticed in the working of the bank which requires
immediate attention.
(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.

QUESTIONS

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.
Ans. (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.
Theory Questions
2. 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
Ans. 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 :-
1. Development and supervision of the constituents of the Indian financial
2. System (which comprises banks and non-banking financial institutions)
3. Determining, in conjunction with the Central Government, the monetary and credit policies
keeping in with the need of the hour.
4. Regulating the activities of commercial and other banks
Important functions of RBI are:
1. Issuance of currency;
2. Regulation of currency issue;
3. Acting as banker to the central and state governments; and
4. 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.

Audit of Banks 793

 UNDERSTANDING OF ACCOUNTING SYSTEM BANKS
‰ Any time – Anywhere Banking
‰ Core Banking Technology
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 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.

QUESTIONS

Correct/Incorrect
State with reasons (in short) whether the following statements are correct or incorrect:
3. In the computerised environment, the auditor need not be familiar with latest applicable RBI
guidelines.
Ans. (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.

794 Auditing & Ethics PW

Theory Questions
4. ‘‘The engagement team should hold discussions to gain better understanding of the bank and its
environment, including internal control, and to assess the potential for material misstatements
of the financial statement. All these discussion should be appropriately documented for future
reference’’. Explain.
Ans. 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
shoul hold dicussions 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 shouled be appropriately documented for future references.
Notes to Add

Audit of Banks 795

 BANK AUDIT APPROACH
Nature + Level Operation
(1) Drawing Audit Plan Based on Nature Adverse features

Level of Compliance P.Y.

Audit Risk
Perform Control
Who
Knowledge + Authority

What Evidence

When Frequency ? Enough?

(2) Control Env. Questions/Steps
A.E. Retained + Accessible
Where
How long
Why Controls
T ype of Errors P
D
Controls Performed
How Bypassed
Exceptions Identiied

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 Questions to be considered / answered
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?

796 Auditing & Ethics PW

 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;
(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).
Audit of Banks 797
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.

QUESTIONS

Correct/Incorrect
State with reasons (in short) whether the following statements are correct or incorrect:
5. The auditor can assume that the system generated information is correct and relied upon.
Ans. (Incorrect)
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 validation of the required parameters for the time being in force and applicable.
Theory Questions
6. Write a short note on reversal of income under bank audit.
Ans. 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.
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.
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).
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 interest charge and whether appropriate action has been
taken in this regard.
Notes to Add

798 Auditing & Ethics PW

 INCOME RECOGNITION POLICY
Should be Objective (on recovery) → rather than → Subjective by the books
Eg.: NPA → Immaturial Income → is recorded → when received → Not on Accrual Basis
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)

Notes to Add

Audit of Banks 799

 FORM AND CONTENT OF FINANCIAL STATEMENTS
Form & Content of Financial Statement

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.

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 apply to banking companies or the
Accounting Standards issued by the ICAI.

Notes to Add

800 Auditing & Ethics PW

 AUDIT OF ACCOUNTS

Audit of Banks (Sec.30(1)

By Chartered Accountants ® Duly qualiied ® to be appointed as Auditor of a Co.

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.

Notes to Add

Audit of Banks 801

 ELIGIBILITY, QUALIFICATIONS AND DISQUALIFICATIONS OF AUDITOR
As per Sec.141 of The Companies Act, 2013
Applicable as to a Company Auditor
Appointment of Auditor
� Banking Co. → AGM
Prior approval of RBI
� Nationalised Bank → BoD
� SBI → C & AG in consultation with CG
� Subsidiaries of SBI → SBI
� RRB → RRB → With approval of CG

Remuneration
Remuneration of Auditor ::banking
of Auditor Co. →
bankingCo. As As
perper Sec.142
Sec.142 ofCompan
of the The Companies Act, 2013
ies Act, 2013
→
By Co. in

GM Manner determined in GM
Nationalised
Nationalised Banks RBI in consultation with CG
Banks RBI in consultation with CG
SBI
SBI

(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 company in general meeting or in such
manner as the company in general meeting may determine).
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.

Notes to Add

802 Auditing & Ethics PW

 POWERS OF AUDITOR
Same as Co. Auditor powers (5 Points)
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.

Notes to Add

Audit of Banks 803

 AUDIT REPORT
Audit Report:
Nationalised Banks + SBI  CG
P oints to be included
T rue and F air
(i) F.S.
Satisfactory  Info. + Explanation
(ii) Tra
(ii) nsaction done
Transaction done by
by bank
bank → were
werewithin
withinpowers
powersof
ofbank
bank
(iii)Returns required from Oficer Branches Adequate
(iii) Returns required from → Officer → Branches → Adequate
(iv) Any other Matter  as per CG
(iv) Any other Matter → as per CG
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.

Notes to Add

804 Auditing & Ethics PW

 FORMAT OF REPORT
Format of Audit Report : (Same as Ch. 8 (13 Points)
+
Complies with SA Info.
Unaudited branches Quantification of → Advances → Deposits
Interest → Income → Expense
Matters covered u/s 143 of The Companies Act, 2013
CARO 2020 → Not Applicable

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 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.
Long Form Audit Report
To be submitted in addition
• To be submitt to the above
ed in addition to the→
above 30othrJune
before bef e 30thevery year year
June every
Matters• toMatters
be included → specified
to be included by RBI
speciied by RBI

Advances Liquidity & Fund Internal control Capital

• Credit Appraisal Management • Written guidelines Adequacy
• Loan policy • Investment • Balancing Books
• Sanctioning / • SLR/CRR • Inter Branch Recognition
Disbursement • Cash • Fraud / Vegelence
• Dcomentation • ALM • Suspense A/c.
• Call Money
operations

Proitability System & Automation & Other

Control Computerisation Matters

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.

Audit of Banks 805

 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.
Ans. 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.

Notes to Add

806 Auditing & Ethics PW

 REPORTING TO RBI

� Consider SA 250– “Consideration of laws & Regulations in an Audit of F.S.”

¯ Statutte
Conidentiality is overridden by Law

Courts

SA 240– “Auditor’s Responsibility relating to Fraud in an audit of F.S.”

¯
Inform RBI+ Chairman / MD/ CEO of Bank

� Follow Sec. 143(12) of the companies Act, 2013

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:
“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.
Audit of Banks 807
 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.

CONDUCTING AN AUDIT

� SA-510 ‘Initial Engagement – Opening Balance’ → Mismatch → If not properly accounted →

Qualified / Adverse Opinion
� Assessment of Engagement Risk
� Establishing engagement team
� Understanding bank & its Environment → SA-315 ‘Identifying & Assessing the RoMM through
understanding the Entity & its environment
(2) SA-315 → Identifying & Assessing RoMM at

5. Understanding Risk Management Process

 Involvement & Oversight in the control process by TCWG → written policies
 Identification, Measurement & Monitoring Risk → Against pre-approved → limits → criterias
 Control Activities
 Monitorin activities
 Reliable Info. System

808 Auditing & Ethics PW

 6. Engagement team discussion
7. Establish overall audit strategy
Read all
8. Develop Audit Plan SA-300 → SA-220 → SA 210 these points
9. Audit Planning Memorandum after the
10. Determine Audit Materiality entire Audit
11. Consider going concern Syllabus
12. Assess Risk of Fraud including money laundering
13. Assess specific Risk
14. Risk associated with outsourcing of activities
15. SA-330 ‘Auditor’s Response to assessed Risk’
16. Stress Testing
17. Basel – III framework
18. Reliance on → Review of → other report
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).
(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
Audit of Banks 809
 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.
(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 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,

810 Auditing & Ethics PW

 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.

RISK MANAGMENT
IN BANKS

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.
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.

Audit of Banks 811

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 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 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.

812 Auditing & Ethics PW

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.

QUESTIONS

Correct/Incorrect
State with reasons (in short) whether the following statements are correct or incorrect:
7. 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.
Ans. 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.
8. Registered mortgage is effected by a mere delivery of title deeds or other documents of title with
intent to create security thereof.
Ans. Incorrect:
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.
9. Auditor of a Nationalised bank is to be appointed at the annual general meeting of the shareholders.
Ans. 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.
Theory Question
10. What are the general requirements of an effective Risk Management System in Banks?
Ans.
(a) Oversight and involvement in the control process by those charged with governance:
Those charged with governance (Board of Directors/Managing 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.
Audit of Banks 813
 (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.
Notes to Add

814 Auditing & Ethics PW

 ADVANCES
Advances


Money
Amt. of Given as Loan  from a Bank


Credit
to another party


Agreement  Money will be repaid


* Types of Advances
Non Funded
Funded




L.C.
Actual transfer of funds
B.G.


From Bank  T o Borrower

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.
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.

A Letter of Credit

Con it
Buyer trac ed
t Cr Advising Bank
Application r of
e
ett
AL

Buyer’s Bank
Seller
Issuing Bank

Audit of Banks 815

What do Advances comprise

Term Loans CC/OD/ Bills Risk sharing Staff

Demand Loans Basis Loans

®
Discounted Purchased Interest
bearing

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
Legal 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

Priority
Sector Wise
Non Priority

Secured
Classiication of Advances Security Wise
Unsecured

Standard
Prudential Norms

NPAs

816 Auditing & Ethics PW

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

Sector wise Security wise Prudential Norms wise

Priority Non-Priority Secured Unsecured Standard Assets Non-performing

sector Sector assets (NPA)

Standard Special Mention

Regular A/c. (SMA) Sub Loss
standard Doubtful Assets
Assets Assets
SMA-0 SMA-1 SMA-2
(A/c. showing (Overdue b/w . 31 (Overdue b/w
stress signal) to 60 days) 61 to 90 days) D1 D2 D3

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.

Primary ® Principal Security for an Advance

Nature of Security
Collateral  Additional Security

Audit of Banks 817

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

‰ Plantations (For Agricultural Advances)

‰ Third Party Guarantees

‰ Banker’s General Lien

‰ Life Insurance Policies

‰ Stock Exchange Securities and Other Instruments

Notes to Add

818 Auditing & Ethics PW

 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 deeds or other
documents of title with intent to create security thereof.
(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.
(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.
Audit of Banks 819
(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.

Notes to Add

820 Auditing & Ethics PW

 PRUDENTIAL NORMS ON INCOME RECOGNITION, ASSET CLASSIFICATION AND
PROVISIONING PERTAINING TO ADVANCES

(iii) Overdue  Amount not paid on the due date ixed by the bank
 Account regularised below B/s date  without subjectivity  NPA Deemed

Solitary or few credits
 If loan backed by CG  always standard asset  If guarantee continues

Could be NPA on Income recognition purpose
SG  Would be NPA  IF overdue > 90 days

Provisioning Income Purposes

Categories of NPA Provisions Required

Standard Asset 15%
NPA < 12 months
Doubtful Asset Secured + Unsecured
Substandard > 12 months 25% + 100%
D1 → up to 1 year 40% + 100%
D2 → 1 to 3 year 100% + 100%
D3 → more than 3 year
Loss Assets 100%
Certified by → Auditor → Bank → RBI
+
Amount has not been fully written off
Audit of Banks 821
 O/S

Classification of Advances as per RBI Prudential Norms

(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 term loan;
‰ 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.

822 Auditing & Ethics PW

(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.
(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.

BANK

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 (Secured + Unsecured) 25% + 100%
substandard category for a period of 12 months.
40% + 100%
Sub-categories:
Doubtful up to 1 Year (D1) Doubtful 1 to 3 100% + 100%
Years (D2) Doubtful more than 3 Years (D3)
‰ Loss Assets:

Would be one, where loss has been identified 100%

by the bank or internal or external auditors
or the RBI inspection but the amount has not
been written off wholly.

Audit of Banks 823

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.
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 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.

824 Auditing & Ethics PW

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:
Illustrative Drawing Power for December 2022as 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

Audit of Banks 825

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
Notes to Add

826 Auditing & Ethics PW

 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 borrowal 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.

Notes to Add

Audit of Banks 827

 ADVANCES AGAINST TERM DEPOSITS, NSCS, KVPS/ IVPS, ETC.
T

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.
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.
Agricultural Advances Affected by Natural Calamities
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 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.
Advances to Staff
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.

828 Auditing & Ethics PW

Agricultural Advances
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.
Ans. 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 statutory authority in exchange of company
fulfilling some statutory obligations.
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.
Ans. 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.

QUESTIONS

Correct/Incorrect
State with reasons (in short) whether the following statements are correct or incorrect:
11. Bank recognize income on Non-performing assests on accrual basis
Ans. 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.
Audit of Banks 829
 12. Any amount due to the bank under any credit facility is ‘overdue’ if it is not paid within 90 days
of becoming due.
Ans. Incorrect:
An account should be treated as ‘out of order’ if the outstanding balance remains continuously in
excess of the sanctioned limit/drawing power.
Theory Question
13. The auditor should examine the efficacy of various internal controls over advances to determine
the nature, timing and extent of his substantive procedures. Explain this statement.
Ans. Auditing the Operating Expenses of a Bank:-
(a) Internal Controls: 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.
(b) Divergent Trends: The auditor should examine whether there are any divergent trends in
respect of major items of expenses.
(c) Substantive analytical Procedures: The auditor should perform substantive analytical
procedures in respect of these expenses. eg. assess the reasonableness of expenses by
working out their ratio to total operating expenses and comparing it with the corresponding
figures for previous years.
(d) Vouching & Verification: The auditor should also verify expenses with reference to supporting
documents and check the calculations wherever required.
14. CARD Ltd. is into the banking business and handles large amount of loans and advances of different
kinds. Nonperforming assets are on the rise since last two quarters. The management is concerned
with correct provisioning for the same. CA R is appointed to check whether correct provisioning
of NPA’s is being made by the bank or not. What are the aspects that will be verified by CA R for
this purpose?
Ans. Provisioning of Non-performing Assets:
CA R should verify that the classification of NPAs into sub-standard assets, doubtful assets and
loss assets is done depending upon prudential norms as per the RBI Guidelines. Further he should
also ensure that provis ion is being made for the same in accordance with the given table:
Categories of Non-Performing Assests: Substandard Assests: Provision required
Would be one, which has remained NPA for a period less than or equal
to 12 months
Doubtful Assets: 15
Would be one, which has remained in the substandard category for a
period of 12 months.
Sub-categories: (Secured + Unsecured
Doubtful up to 1 year (D1) 25%+ 100%
Doubtful 1 to 3 years (D2) 40% + 100%
Doubtful more than 3 years (D3) 100% + 100%
Loss Assets:
Would be one, where loas has been identified by the bank or internal
or external auditors or the RBI inspection but the amount has not been
written off wholly. 100%

830 Auditing & Ethics PW

Alternative Answer 1:
Aspects to be verified by CA R to check correct provisioning of NPAs: CA R should verify following
aspects while checking whether correct provisioning of NPAs is being made by bank: -
1. It should be verified whether classification of NPAs is in accordance with RBI guidelines. Such
guidelines require classification of NPAs into sub-standard assets, doubtful assets and loss assets
depending upon different criteria. Each classification requires different percentage of provisions.
Therefore, proper classification of NPAs would ensure that provisioning is correct.
2. It should be verified that doubtful assets have been further properly classified in D1, D2 and D3
categories. These three different categories require provision of 25%, 40% and 100% respectively
of secured portions of outstanding amount.
3. It should be verified that secured and unsecured portion in doubtful assets have been arrived at
properly. Unsecured portion of liability entails provision of 100%. Therefore, it is important to
verify that break-up of doubtful assets into secured and unsecured portions is proper.
4. As different kinds of loans and advances are handled by the bank, it should be ensured that loan
classification according to its purpose is properly made in the system. NPA norms vary for cash
credit accounts, term loans, bills purchased and agricultural loans. Any wrong classification can
lead to incorrect provisioning. For example, if an agricultural loan is wrongly classified, it would
lead to incorrect provisions.
Alternative Answer 2:
Aspects to be verified by CA R to check correct provisioning of NPAs:
1. For audit of Provisions, the auditor should ensure that the compliances for various regulatory
requirements for provisioning as contained in the various circulars have been fulfilled.
2. The auditor should 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.
3. The auditor may verify the loan classification on a sample basis.
4. The auditor should obtain the detailed break up of standard loans, non-performing loans and
agree the outstanding balances with the general ledger.

Notes to Add

Audit of Banks 831

 COMPUTATION OF DRAWING POWER
Computation of Drawing Power
‰ All accounts → Kept under → SL / DP
Exceptions / Against unapproved securities → Inform Mgt. / HO
‰ Current Assets → Adequate →IF DP in working capital
DP based up on → Current Stock statement →not exceeding 3 months
‰ Stock statement → to be scrutinized → in detail
‰ Annual report → Compare ← Monthly stock statement
↓
Deviation to be ascertained
‰ Stock audit of Borrower → by bank → If Advance > ₹ 5 crore
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.
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 having funded
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

832 Auditing & Ethics PW

 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

QUESTIONS

Correct/Incorrect
State with reasons (in short) whether the following statements are correct or incorrect:
15. An account should be treated as ‘out of order’ if the outstanding balance remains continuously
in excess of the sanctioned limit/drawing power.
Ans. Incorrect: An account should be treated as ‘out of order’ if the outstanding balance remains
continuously in excess of the sanctioned limit/drawing power.
16. An account should be treated as ‘out of order’ if the outstanding balance remains continuously
in excess of the sanctioned limit/drawing power.
Ans. 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.
Theory Question
17. In a bank, all accounts should be kept within the drawing power and the sanctioned limit. The
accounts which exceed the sanctioned limit or drawing power should be brought to the notice of
the management regularly. Analyse the following points to be considered in the computation of
drawing power in case of bank audit.
(i) Bank’s Duties (ii) Auditor’s concern
(iii) Computation of DP (iv) Stock audit
Ans. Computation of Drawing Power:

Audit of Banks 833

 (i) 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.
(ii) 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.
(iii) 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.
(iv) Stock Audit: The stock audit should be carried out by the bank for all accounts having funded
exposure of more than I 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.
18. Compute the Drawing Power for Cash Credit A/c of S Limited for the month of March 2022 with
following information:
(Amount in ₹)
Stock 50,000
Debtors 45,000
(Including Debtor of ₹ 5,000 for an invoice dated 17.11.2021)
Sundry creditors 15,000
Sanctioned Limit 45,000
Margin on stock is 20% and on debtors is 50%.
Note: Debtors older than 3 months are ineligible for calculation of DP. 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.
Ans. Computation of Drawing Power:
Computation of Drawing Power for CC A/c of S Ltd.
Particular of current assets Amount(`) DP Amt(`)
(A) Stocks
Stocks at realizable value 50,000
Less: Unpaid stocks:
– Sundry creditors 15000 15000

834 Auditing & Ethics PW

 Particular of current assets Amount(`) DP Amt(`)
Paid for stocks 35000
Margin @ 20% 7000 28000
(B) Debtors:
Total Debtors 45000
Total Debtors 5000
Eligible debtors 40000
Margin @ 50% 20000 20000
Total Drawing Power 48000
The sanctioned limit given in the question is ₹ 45000 whereas drawing power as per the above
working is ₹ 48000.
So, drawing power would be restricted to sanctioned limit i.e., ₹ 45000
19. Explain the audit approach you would follow to check the Operating Expenses of a Bank.
Ans. 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:
1. 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.
2. All the necessary documents (e.g., agreements, demand promissory notes, letters of
hypothecation, etc.) should be executed by the parties before advances are made.
3. The compliance with the terms of sanction and end use of funds should be ensured.
4. 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.
Notes to Add

Audit of Banks 835

 AUDIT OF ADVANCES

Classiied

Substantive procedures  Large Scale Advances

(2) Apply
Sampling procedures  Small advances
Sactioned during the year
(3) Advances Include in auditor’s Review
Adversely Commented by

RBI Concurrent Internal

Auditor Inspection

(4) Evaluation of Internal Control (IC)

Credit Executed Compliance Suficient Transfers Registration

worthiness Documents with T & C margin of of names of security
of borrower of Loan security of shares in Bank’s
against loan if kept as name
security

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 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:

836 Auditing & Ethics PW

(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.
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.

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:

Audit of Banks 837

‰ 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.
‰ 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?

Ans. 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

838 Auditing & Ethics PW

 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.

QUESTIONS

Correct/Incorrect
State with reasons (in short) whether the following statements are correct or incorrect:
20. Banks recognize income on Non-Performing Assets on accrual basis.
Ans. 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.
Notes to Add

Audit of Banks 839

 AUDIT OF REVENUE ITEMS - PROFIT AND LOSS ACCOUNT

Incomes Expenditure

(1) Reasonable Assurance

Transaction No unrecorded Recorded in Allocated to

of Relevant Income proper proper
period amounts period

(2) As per RBI  Income to be recorded on Accrural basis as per AS-9

 Total Income as per Gross Income
which exceeds 1% of
NPBT if recorded as per Net of cash basis
(3) Items may be recorded on cash basis  If not material
(4) Revenue Certainity  Reasonable to expect

Ultimate Collection

Accrual Basis
(5) Revenue Uncertainity  Cash Basis
Provided adequate margin

(6) Advances against securities  Interest  On Due Date

Term NSCs IVPs KVPs Life

Deposits Policies
(FD)

840 Auditing & Ethics PW

 • Partial Recoveries in NPA Bank
 In absence of Agreement
Borrower

Adopt A/c Right of appropriation of recoveries

Policy

AS-9 Uniform Consistent

Memorandum A/c.
Income on NPA should not be recorded or reverse if already recorded

But can be recorded in memorandum A/c.  for control purposes

But not to be included for calculation of Advances

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.
;Fkk 31 ekpZ] 2016 dks lekIr o"kZ dk ykHk o gkfu •krk
PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MARCH 20
vuqlwph Schedule ;Fkk 31-03-2015 dks ;Fkk 31-03-2016 dks
lekIr o"kZ lekIr o"kZ
For the Year ended For the Year ended
31-03-201 (`000) 31-03-201 (`000)
I. vk; @ INCOME
vftZr O;kt @ INTEREST EARNED 13
vU; vk; @ OTHER INCOME 14
tksM @ TOTAL
II. vki @ EXPENDITURE
O;; fd;k x;k C;kt@ INTEREST 15
EXPENDED
16
ifjpkyu O;; @ OPERATING EXPENSES
çko/ku vkSj vkdfLed O;;@ PROVISIONS
AND CONTINGENCIES
tksM+ @ TOTAL
III. o"kZ dk fuoy ykHk @ NET PROFIT FOR
THE YEAR

Audit of Banks 841

 vuqlwph Schedule ;Fkk 31-03-2015 dks ;Fkk 31-03-2016 dks
lekIr o"kZ lekIr o"kZ
For the Year ended For the Year ended
31-03-201 (`000) 31-03-201 (`000)
IV. fofu;kstu @ APPROPRIATIONS
fuEukafdr dks varj.k @ TRANSFERS TO
lkafof/d vkjf{kr fuf/;k¡ @ STATUTORY
RESERVES
iw¡th vkjf{kr fuf/;k¡ @ CAPITAL RESERVES
fuos'k vkjf{kr fuf/ •krk @ INVESTMENT
RESERVE ACCOUNT
jktL; vkjf{kr fuf/ @ REVENUE RESERVE
fo'ks"k vkjf{kr fuf/;k¡ @ SPECIAL RESERVE
varfje ykHkka'k @ INTERIM DIVIDEND
çLrkfor ykHkka'k @ PROPOSED DIVIDEND
ys•kadu uhfr;k¡ @ ACCOUNTING POLICIES
ykHkka'k dj @ DIVIDEND TAX
tksM+ @ TOTAL
ys•k laca/h fnIif.k;k¡ @ NOTES ON 17
ACCOUNTS
çfr 'ks;j vtZu (ewy o uuqdwy) @ 18
EARNINGS PER SHARE (BASIC AND
DILUTED) (`esa @ in`)

Notes to Add

842 Auditing & Ethics PW

 INCOME
The following items are included under this head:
Interest Earned Other Income
‰ Interest / Discount on Advances / Bills: ‰ Commission, Exchange and Brokerage: This

‰ Interest Income on Investments: item comprises of the following:

‰ Interest on Balances with RBI and Other (a) Commission on bills for collection.
Inter–bank Funds: (b) Commission/exchange on remittances
‰ Others: This includes any other and transfers, e.g. demand drafts, NEFT,
‰ Not included in the above heads RTGS, etc.
(c) Commission on letters of credit and
guarantees, letter of comforts.
(d) Loan processing, arranger and
syndication fees.
(e) Mobile banking fees.
(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.
¾ Profit on Sale of Investments

¾ Profit/Loss on Revaluation of Investments

¾ Profit on sale of Land, Buildings and

Other Assets:
¾ Profit/Loss on Revaluation of Fixed
Assets Profit on exchange transactions:

Audit of Banks 843

 ¾ This includes revaluation gains/losses
on forward exchange contracts and
other derivative contracts, premium
income/expenses on options, etc.
¾ Income earned by way of dividends,
etc., from subsidiaries and joint
ventures abroad/in India.
¾ Miscellaneous income.

Notes to Add

844 Auditing & Ethics PW

 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.
‰ 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.

Audit of Banks 845

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 interest charge and whether appropriate action has been
taken in this regard.
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 longterm
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).

Notes to Add

846 Auditing & Ethics PW

 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 inance

for projects

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.

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.

Audit of Banks 847

 EXPENSES

(I) Test Check

(a)
(b)
(c)

(d)

(a)

(b)

(c)

(d)

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

848 Auditing & Ethics PW

Interest Expense Operating Expenses Provisions and Contingencies
‰ Others ‰ Advertisement and Publicity ‰ Provisions for Diminution in
the value of investments
‰ Depreciation on Bank’s ‰ Provisions for contingencies
Property

‰ Directors’ Fees, Allowances

and Expenses
‰ Auditors’ Fees and Expenses
‰ Legal expenses
‰ Postage, Telegrams,
Telephones, etc.
‰ Repairs and Maintenance
‰ Insurance
‰ Marketing Expenses
‰ Other Expenses
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.
‰ 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.
Audit of Banks 849
 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.
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.
INCOMES

Interest Income Other Income

Interest/Discount/Bills Commission, Exchange,

Interest Income on Brokerage Proit on Sale of
Investment Interest on Investment Proit on
Balances With RBI other Revaluation Of Fixed Assets

850 Auditing & Ethics PW

 EXPENSES

Interest Expense Provisions And Contingencies Operating Expenses

Interest On Deposits
Interest On Bank
Borrowing Others

Notes to Add

Audit of Banks 851

 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.
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.
Ans. 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.

QUESTIONS

Correct/Incorrect
State with reasons (in short) whether the following statements are correct or incorrect:
21. Auditor of a Nationalised bank is to be appointed at the annual general meeting of the shareholders.
Ans. Incorrect: Auditor of a nationalized bank is to be appointed by the bank concerned acting through
its Board of Directors and approval of the Reserve bank is required before the appointment is
made.
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.
852 Auditing & Ethics PW
 (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.
(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.
CASE STUDY
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.
Ans. (c)
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.
Ans. (b)
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.
Ans. (b)

Audit of Banks 853

 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.
Ans. (a)

QUESTIONS

Multiple Choice Questions (MCQ)

Test Your Knowledge
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
(d) Credit Card Fees
Ans. (a)
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
Ans. (b)
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
Ans. (a)
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.

854 Auditing & Ethics PW

 (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.
Ans. (b)
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.
Ans. (c)
Theory Questions
22. What are the general requirements of an effective Risk Management System in Banks?
Ans.
(a) Oversight and involvement in the control process by those charged with governance: Those
charged with governance (Board of Directors/Managing 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.
23. Explain the audit approach you would follow to check the Operating Expenses of a Bank.
Ans. Auditing the Operating Expenses of a Bank:-
(a) Internal Controls:- 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.
(b) Divergent Trends:- The auditor should examine whether there are any divergent trends in
respect of major items of expenses.

Audit of Banks 855

 (c) Substantive analytical Procedures:- The auditor should perform substantive analytical
procedures in respect of these expenses, eg. assess the reasonableness of expenses by
working out their ratio to total operating expenses and comparing it with the corresponding
figures for previous years.
(d) Vouching & Verification:- The auditor should also verify expenses with reference to
supporting documents and check the calculations wherever required.
24. The auditor should examine the efficacy of various internal controls over advances to determine
the nature, timing and extent of his substantive procedures. Explain this statement.
Ans. 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.
 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.
qqq

856 Auditing & Ethics PW