The Chartered Accountant • Journal of ICAI March 2021 • Vol. 69 • No. 9 • pp. 116–121 (Journal pp. 1140–1145)
BANK AUDIT

Importance of Advances in Bank Audit

CA. Nilesh Joshi The author is member of the Institute. He can be reached at nileshrsjoshi@gmail.com and eboard@icai.in.

“The revenue of the Banks is generated majorly through advances and investments. Hence, both areas form core areas of Bank Audit. As per RBI publication “Operations and Performance of Commercial Banks” dated December 24, 2019 Advances comprise around 58% of total assets of all Scheduled Commercial Banks put together for year ended March 31, 2019. This emphasize importance of Advances in the Banking. Hence, Advances also form an important area of Bank Audit. Read on…”

The advances portfolio consists of Fund Based and Non Fund Based Advances. Fund based advances include Term loans, Cash Credits, Housing Loans, Education Loan, Overdrafts, whereas non fund based advances include Bank Guarantee, Letter of Credit.

The various stages of advances are Appraisal, Sanctioning & Documentation, Disbursement, Monitoring and Repayment. The audit shall be carried out each of these stages. The revised LFAR issued by RBI consist questions on each of the above stage.

Selection of Sample

It is advisable that auditor should cover 60% to 70% of the total advances portfolio of the Branch, which covers all types of loan sanctioned by the Branch. As mentioned in Revised LFAR, for all accounts above 10% of outstanding aggregate balance of fund based and non-fund-based advances of the branch or ₹10 crores whichever is less, the transaction audit/account specific details to be seen and commented, whereas below the threshold, the process needs to be checked and commented upon.

The Auditor shall read Credit policy / Product Document, delegation of power and Manuals/ Circulars before commencing the audit of advances.

Brief Audit Process

Appraisal

The auditor shall review the appraisal note for sample advances which mainly contain information about Borrower, its business, sector of business, current financial position of the borrower, future financial projections. The auditor shall not only verify whether as part of appraisal process Branch has focussed on objective criteria like Current Ratio, Debt Service Coverage Ratio, Profitability, Debt Equity Ratio but also considered subjective criterias like present challenges to the industry which borrower belongs to, the overall market for the product, the geo political situation affecting borrower’s business, etc. If the Auditor finds factors like subjective factors mentioned above and notes that feasibility of achievement of projections, realizability of security, etc. are not commented in appraisal, the Auditor shall report the same in LFAR.

“Auditor should verify whether the advance has been sanctioned by the competent authority and any deviation from standard terms and conditions is approved.”

Sanctioning and Documentation

Auditor should verify whether the advance has been sanctioned by the competent authority and any deviation from standard terms and conditions is approved. The auditor should verify whether documents are executed as per manuals, circulars and product notes. The auditor should also verify that the executed documentation has been vetted by empanelled advocate or by legal department of the Bank. In respect of Bank Guarantees issued auditor should verify whether Guarantees issued in format other than prescribed by the Bank, the Branch has obtained approval of Bank’s legal department. The auditor should verify whether Letter of Credits issued by the Branch are as per the prescribed norms. Also, verify in case of foreign LCs, the Branch has carried out swift reconciliation with CBS on daily basis.

Disbursement

The auditor should verify whether masters have been correctly created in the core banking system as per the sanction letters. The maker checker control has been exercised while creating masters. Also, the auditor should verify whether Branch has ensured end use of funds as per the Sanction Letter.

Monitoring

Auditor should verify whether procedure laid down by the controlling authorities of the bank, for periodic review of advances, including periodic balance confirmation / acknowledgement of debts, followed by the branch. In respect of cash credit account, the Auditor should verify whether stock and book debt statements are received on regular basis and analysed by the Branch. The auditor should also analyse stock and book debt statements on sample basis to verify whether slow moving inventories, debtors beyond days mentioned sanction letter, creditors, unrealisable stock has been reduced while calculating Drawing Power. In respect of Cash Credit accounts on sample basis, the auditor should verify whether funds have been withdrawn for business only. The same can be conducted by extracting account statements in excel.

Repayment

In respect of repayments of term loan, the auditor should verify whether Bank is exercising due diligence to verify the source of funds and in respect of credits in cash credit accounts, the receipts are business receipts only. Also, auditor shall verify the same on sample basis. In respect of closed accounts, auditor should verify whether account is closed in the CBS after following prescribed procedure. With respect to repayment received by debiting any office account, the auditor should verify the corresponding credit in the respective office account and source thereof. Also, review the process of operations and reconciliation of office accounts.

Restructuring of Advances

The current financial year 2020-21 has been a year with challenges for economy due to outbreak of pandemic. The first two months of financial year, the economic activity is at minimal due to lockdown. The same has adversely affected businesses and consequentially the repayment capacity of borrowers of the Bank. Hence, RBI has issued / extended following restructuring / resolution guidelines for stressed asset.

As per Income Recognition and Asset Classification circular, if the account is restructured, then the same shall be classified as non performing, however RBI has allowed to retain the account as standard by issuing following circulars:

  1. RBI/2018-19/100 DBR.No.BP.BC.18/21.04.048/2018-19 dated January 1, 2019 Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances and RBI/2019-20/160 DOR.No.BP.BC.34/21.04.048/2019-20 dated February 11, 2020 Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances [Hereinafter referred as “MSME Restructuring Circulars”]
  2. RBI/2020-21/16 DOR.No.BP.BC/3/21.04.048/2020-21 dated August 6, 2020 Resolution Framework for COVID-19-related Stress and RBI/2020-21/34 DOR.No.BP.BC/ 13 /21.04.048/2020-21 dated September 7, 2020 Resolution Framework for COVID-19-related Stress – Financial Parameters [Hereinafter referred as “Covid Relief Circulars”]

MSME Restructuring Circulars

1. Restructuring Under MSME Restructuring Circulars

Eligible Borrowers

Borrowers falling under category MSME borrowers. MSME is defined in the Micro, Small and Medium Enterprises Development (MSMED) Act, 2006.

Pre-Conditions

  • The aggregate exposure, including non-fund based facilities, of banks and NBFCs to the borrower does not exceed ₹25 crore as on March 1, 2020.
  • The borrower’s account was a ‘standard asset’ as on March 1, 2020.
  • The restructuring of the borrower account is implemented by March 31, 2021.
  • The borrowing entity is GST-registered on the date of implementation of the restructuring. However, this condition will not apply to MSMEs that are exempt from GST-registration. This shall be determined on the basis of exemption limit obtaining as on March 1, 2020.
  • Asset classification of borrowers classified as standard may be retained as such, whereas the accounts which may have slipped into NPA category between March 2, 2020 and date of implementation may be upgraded as ‘standard asset’, as on the date of implementation of the restructuring plan. The asset classification benefit will be available only if the restructuring is done as per provisions of this circular.
  • As hitherto, for accounts restructured under these guidelines, banks shall maintain additional provision of 5% over and above the provision already held by them.
  • Account should not have been already restructured in terms of the circular dated January 1, 2019.

Details of restructured accounts should be disclosed in notes to accounts in format specified in circular.

2. Covid Relief Circulars

Eligible Borrowers are borrowers other than:

  1. MSME borrowers whose aggregate exposure to lending institutions collectively, is ₹25 crore or less as on March 1, 2020.
  2. Farm credit as listed in Paragraph 6.1 of Master Direction FIDD.CO.Plan.1/04.09.01/2016-17 dated July 7, 2016 (as updated) or other relevant instructions as applicable to specific category of lending institutions.
  3. Loans to Primary Agricultural Credit Societies (PACS), Farmers’ Service Societies (FSS) and Large-sized Adivasi Multi- Purpose Societies (LAMPS) for on-lending to agriculture.
  4. Exposures of lending institutions to financial service providers.
  5. Exposures of lending institutions to Central and State Governments; Local Government bodies (eg. Municipal Corporations); and, body corporates established by an Act of Parliament or State Legislature.
  6. Exposures of housing finance companies where the account has been rescheduled in terms of para 2(1)(zc)(ii) of the Master Circular – The Housing Finance Companies (NHB) Directions, 2010 after March 1, 2020, unless a resolution plan under this framework has been invoked by other lending institutions. However, from the date of this circular, any resolution necessitated on account of the economic fallout of Covid-19 pandemic, shall be undertaken only under this framework.

Reference date: 1st March 2020

Date of Invocation: date on which both the borrower and lending institution have agreed to proceed with a resolution plan under this framework. Date of invocation shall not be later than 31 December 2020.

Board Approved Policy: Board of Directors of Bank should lay down Board Approved Policy (include eligibility criteria for borrowers & due diligence consideration).

Personal Loans

Personal Loan refers to loans given to individuals and consist of (a) consumer credit, (b) education loan, (c) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and (d) loans given for investment in financial assets (shares, debentures, etc.).

Conditions

  • Standard, but not in default for more than 30 days with the lending institution as on March 1, 2020.
  • Resolution framework must be implemented within 90 days from the date of invocation.
  • Resolution under this framework may be invoked not later than December 31, 2020.
  • The concessions / moratorium under resolution plans shall be subject to a maximum of two years.

Criteria for Implementation of Resolution Plan

  • Execution of Documentation.
  • Changes are updated in system/ books.
  • Borrower is not in default with the lending institution as per the revised terms.

Asset Classification & Provisioning

  • Lending institutions shall keep provisions from the date of implementation, which are higher of the provisions held as per the extant IRAC norms immediately before implementation, or 10 percent of the renegotiated debt exposure of the lending institution post implementation.

Reversal of Provision

  • Half of the above provisions may be written back upon the borrower paying at least 20 per cent of the residual debt without slipping into NPA post implementation of the plan, and the remaining half may be written back upon the borrower paying another 10 per cent of the residual debt without slipping into NPA subsequently.

Loans Other than Personal Loans referred above

Conditions

  • Standard, but not in default for more than 30 days with the lending institution as on March 1, 2020.
  • In case of multiple lending institution Resolution framework is approved by lenders having 75% of total outstanding (FB + NFB) and 60% of lending institution in numbers.
  • Resolution framework must be implemented within 180 days from the date of invocation.
  • Resolution under this framework may be invoked not later than December 31, 2020.
  • The concessions / moratorium under resolution plans shall be subject to a maximum of two years.
  • The Reserve Bank shall constitute a committee to decide financial parameters which, in their opinion would be required to be factored into the assumptions that go into each resolution plan, and the sector specific benchmark ranges for such parameters (Expert Committee). The financial parameters are prescribed in RBI/2020-21/34 DOR.No.BP.BC/ 13 /21.04.048/2020-21 dated September 7, 2020.
  • Expert Committee shall also have the responsibility of vetting the resolution plans in respect of all accounts where the aggregate exposure of the lending institutions at the time of invocation of the resolution process is ₹1500 crore and above.
  • The concessions / moratorium under resolution plans shall be subject to a maximum of two years.
  • The Resolution Plan may involve any action / plan / reorganization including, but not limited to, regularisation of the account by payment of all over dues by the borrower entity, sale of the exposures to other entities / investors, change in ownership and restructuring except compromise settlement.
  • The securities, if any received by Lending Institution by conversion of Debt into security shall be governed by extant instructions on investments.

Valuation of Equity Shares Received

The valuation of Equity Shares received as per resolution plan shall be as under:

  1. Equity instruments, where classified as standard: shall be valued at market value, if quoted, or else, should be valued at the lowest value arrived using the following valuation methodologies:
    1. Book value (without considering ‘revaluation reserves’, if any) which is to be ascertained from the company’s latest audited balance sheet. The date as on which the latest balance sheet is drawn up should not precede the date of valuation by more than 18 months. In case the latest audited balance sheet is not available the shares are to be collectively valued at Re.1 per company.
    2. Discounted cash flow method where the discount factor is the actual interest rate charged to the borrower on the residual debt post restructuring plus a risk premium to be determined as per the board approved policy considering the factors affecting the value of the equity. The risk premium will be subject to a floor of 3 per cent and the overall discount factor will be subject to a floor of 14 per cent. Further, cash flows (cash flow available from the current as well as immediately prospective (not more than six months) level of operations) occurring within 85 per cent of the useful economic life of the project only shall be reckoned.
  2. Equity instruments, where classified as NPA: shall be valued at market value, if quoted, or else, shall be collectively valued at Re.1.
  • In case the lending institutions convert any portion of the debt into any other security, the same shall collectively be valued at Re.1.
  • Resolution plans in respect of accounts where the aggregate exposure of the lending institutions at the time of invocation of the resolution process is ₹100 crore and above, shall require an independent credit evaluation (ICE) by any one credit rating agency (CRA).
  • Additional Lending and Repayment should be routed through escrow mechanism.

Criteria for Implementation of Resolution Plan

  • Execution of ICA within 30 days by lenders having 75% of total outstanding (FB + NFB) and 60% of lending institution in numbers.
  • Changes are updated in system/ books.
  • Borrower is not in default with the lending institution as per the revised terms.

Asset Classification & Provisioning

  • Additional Finance standard till implementation of resolution plan – Standard, if not implemented within 180 days then classification based on extant guidelines for additional finance or based on original facility whichever is worse.
  • In case where Resolution plan is implemented:
    • For lending institutions which signed ICA within 30 days: higher of the provisions held as per the extant IRAC norms immediately before implementation, or 10 percent of the total debt, including the debt securities issued in terms of clause 30, held by the ICA signatories post-implementation of the plan (residual debt).
    • Lending institutions which did not sign the ICA within 30 days of invocation: shall, immediately upon the expiry of 30 days, keep provisions of 20 per cent of the debt on their books as on this date (carrying debt), or the provisions required as per extant IRAC norms, whichever is higher. Even in cases where the invocation lapses on account of the thresholds for ICA signing not being met, in terms of clause 18 of RBI circular, such lending institutions which had earlier agreed for invocation but did not sign the ICA shall also be required to hold 20 percent provisions on their carrying debt.

Reversal of Provision

  • In respect of ICA signatories within 30 days: Half of the above provisions may be written back upon the borrower paying at least 20 per cent of the residual debt without slipping into NPA post implementation of the plan, and the remaining half may be written back upon the borrower paying another 10 per cent of the residual debt without slipping into NPA subsequently.
  • In respect of the others: while half of the provisions may be reversed upon repayment of 20 percent of the carrying debt, the other half may be reversed upon repayment of another 10 per cent of the carrying debt subject to the required IRAC provisions being maintained.

Performance Monitoring

  • Default within monitoring period (i.e. 10 percent of the residual debt, subject to a minimum of one year from the commencement of the first payment of interest or principal (whichever is later)) shall trigger review period of 30 days.
  • If default continues then downgraded to NPA from the date of implementation of the resolution plan or the date from which the borrower had been classified as NPA before implementation of the plan, whichever is earlier.

Extension for Resolution of Stressed Assets

RBI has issued direction ‘Prudential Framework for Resolution of Stressed Assets’ vide circular RBI/2018-19/ 203 DBR.No.BP.BC.45/21.04.048/2018-19 dated June 7, 2019 with a view to providing a framework for early recognition, reporting and time bound resolution of stressed assets.

The RBI circular RBI/2019-20/219 DOR.No.BP.BC.62/21.04.048/2019-20 dated April 17, 2020 on COVID19 Regulatory Package – Review of Resolution Timelines under the Prudential Framework on Resolution of Stressed Assets states as under:

  • In respect of accounts which were within the Review Period as on March 1, 2020, the period from March 1, 2020 to May 31, 2020 shall be excluded from the calculation of the 30-day timeline for the Review Period. In respect of all such accounts, the residual Review Period shall resume from June 1, 2020, upon expiry of which the lenders shall have the usual 180 days for resolution.
  • In respect of accounts where the Review Period was over, but the 180-day resolution period had not expired as on March 1, 2020, the timeline for resolution shall get extended by 90 days from the date on which the 180-day period was originally set to expire.
  • The requirement of making additional provisions specified in paragraph 17 of the Prudential Framework shall be triggered as and when the extended resolution timeline expires.
— CA. Nilesh Joshi