AUDITING (PART-31)

UNIT- 5

AUDIT OF BANKING INSTITUTION

1. INTRODUCTION

Hello students, I welcome you on the lecture series of Auditing. Today we

shall take up Unit- V. and under unit-v, we are going to deal with special
audits. Today under special audit we will learn the audit of banking
institution. The objective of lecture is to have an introduction of the banking
institution which are working in India, so we will have a over view of banking
institution in India then we shall discuss the legislation relating to audit of
bank.

We shall also learn the various strategic which we will undergo while doing the
audit of a bank then we will learn the audit procedure to be applied pro
conducting the bank audit. That how various reports and LF AR report is being
framed. We shall learn in detail about the peculiar and most important
feature in the bank audit that is audit of advances and finally we will learn
about bank audit report to be furnished to the government as well as to the
banking members who appoint the auditor?

So let’s us start with the introductory part of the banking system in India.
Bank plays an important role in the functioning of organised money market.
The act has conducted for mobilizing funds and channelizing them for
productive purpose. In order to meet the different sections of society a large
network of banks have been stabilized. The volume of banking operation and
geographical spread of banks are steadily rising in India.

So we can say that bank is the most prominent feature in a money market.
Because the flow of money in an economy is being conducted by bank. The
primary function of bank is acceptance of deposit and giving the loan to public
at large. And it also performs the function of remittance. So in India there are
various types of banking institutions which are working.

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2. TYPES OF BANKING INSTITUTIONS

So basically there are four types of banking institution which we are going to
discuss in India firstly commercial bank, commercial bank main role is to do
the acceptance of deposit and granting loan to public at large plus they also
do the functioning of remittance that means transfer of funds and with the
upcoming advance technologies now the funds are being transferred using ECS
and NEFT and other short of transfer of fund can be done via online system.

So commercial banks are moving ahead adapting a new technologies and

integrated solution to do the banking. Next is the regional rural bank which
are being governed by their specific acts. There are cooperative banks which
are being framed or which are being established for during the transaction at
the smaller level and development banks are also working in India. Among all
these banks the reserve bank of India acts has the central bank of the country
because RBI considered to be the apex banks of the India. Section 29 of the
banking regulation act deals with the obligation of bank regarding the
maintenance of accounts and preparation of financial statements. According
to the provision of this section that is section 29 of banking regulation act.

What a bank is required to do is that every bank has to prepare balance sheet
and profit and loss account every year. In the forms set out in the third
schedule of the act or as near there to as the circumstances admit. Secondly
the balance sheet has to be prepared it vertically form and liability in the
assets will be classified as given in that form. So section 29 lays down to the
responsibility on the bank to prepare their balance sheet in this specific
format as given in the third schedule of the act that is third schedule of the
banking regulation act and that too they have to prepare in a vertical format.
Then there is a classification of assets and liability.

So assets and liability will flow as; it has been specified in the third schedule.
There cannot be changed in the position of various short of assets. They will
run as given in the schedule. So let us understand what are the various
liabilities and assets which are being classified under third schedule.
It might be possible that under certain circumstances some of the assets might
not be there with the bank. So here it is specify mentioned that if not exactly
as per third schedule. It should be near to the third schedule requirement. If
there is no assets, which is being mentioned in the third schedule obviously
there will be no space for such assets in the balance sheet.

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3. LIABILITIES AND ASSETS

So let’s us move ahead and learn about liabilities and assets. So first of all
while discussed in the forms and contains of the financial statement, which
are to be in accordance to the third schedule of banking regulation act the
capital and liabilities will run in the manner firstly there will be the capital so
the first features on the left and side of the balance sheet, which is being
prepared in the vertical format will be capital then there will be reserves and
surplus after that deposit shall be mentioned then borrowings and other
liabilities and provisions will come in the last.

Similarly assets list is also being specified first of all we need to write about
cash and balance with RBI. This cash and balance with RBI should reconcile
with all the annual returns or the speculated return which are required to
send by the bank to RBI to specific format and on this specific dates. So while
doing the compliance testing in the bank audit. We will have verification of
cash and bank balance. When that is important feature of the audit of the
bank is that cash verification is to be done. And we shall also clearly mention
that adhoc and random check of cash is being done by the bank authorities.

So cash in bank balance will be the first asset which is to be shown on the face
of the balance sheet on the assets side then balance with bank, money at
calling and short notice will be the second in list of assets. After that
investments are to be mentioned and whatever guidelines have been given by
the banking authorities in relation to the disclosure of the investment same
has to be adhered to by the banking while drafting the balance sheet then
advances which forms the major parts of the assets of the banking financial
statements are to be mentioned over here.

Then fixed assets if they are with the bank they need to the mentioned and
other assets. Sometimes what happens that fixed assets are being maintained
by the head office. So if a branch audit is there. So it might be possible that
there is no set of fixed assets being mentioned over there. However the
documentary prove of same has to be examined by the auditor and contingent
liabilities and will for discount that is aggregate amount to shown on the face
of the balance sheet and details by way of note.

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4. PROFIT AND LOSS ACCOUNT

Now after that we will discuss that what shall be form and contents of the
financial statement in relation to profit and loss account. That means what
precisely will be the income of the bank and what shall be the expenditure
which banks need to incur so that the correct position of the profit or loss can
be ascertained. First one is income from the credit side of the P&L account
the first item under the income head will be the interest earned because the
major income of a bank will be the difference between the income earned and
interest being paid.

So the interest earned will be major source of income for the man. Interest
earn will be the first feature on the P&L account, second would be the other
income. They can be on account of the locker and misc. or incomes. Next one
that is expenditure, Expenditure is a debit item. That means whatever
expenditure which is being borne by the bank to run the banking transaction
will fall under the borrowings and will fall under the expenditure. So interest
expended will be the interest which is being paid on the borrowings while
interest earned is interest which is being earned on the advances being given
to the public at large.

Then there shall be operating expenses like various operating expenses

necessary to run the business of the banking institution like electricity, rentals
and there can be many more depending upon the circumstances under which
the business is being carried on and the place is also going to put at impact on
the operating expenses details. Then provisions and contingencies would be
there. Because provision needs to maintain on the advances and assets. So
when the norms are being discussed.

We shall learn in detail that how provision on the doubtful assets and loss
assets are to be created on such advances then we will get to know about
profit and loss because difference between income and the expenditures will
give us the feature which is known as net profit or loss for the year. If interest
income which is being earned as exceeding the interest being paid by the
banks on borrowings officially. Banking scenarios will be enough, profitable
position and we will realize the net profit and there will be another portion
that is profit or loss brought forward. here brought forward means the profit
which is being reflected in the previous year balance sheet. It is being brought
forward to this year.

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After that there will be appropriation, because there are certain compulsory
transferrs out of the profit under banking scenario. So first of all there will be
transferred to statutory reserves and statutory reserve ratio is being defined
and bank has to adhere to the guidelines to transfer the funds to statutory
reserves then they can be transferred to other reserves transfer to
government or proposed dividend and remaining portion shall be carried
forward to the balance sheet. And it will be reflected under reserves and
surplus. Now important portion is that of the signature which is to be affixed
on the financial statements of the banking institution.

So financial statements of the banking institution incorporated in India is to be

signed by either manager or principle officer plus there will be sign of at least
three directors. Because Indian banks are considered as indian companies
being incorporated under the relevant act. Which is being prevalent in India.
So there is a requirement of signing of financial statements by at least three
directors. Because it is public sector under taking plus there is an requirement
for banking institution that there should be sign of four person that is principle
officer and three directors.

And that of foreign banking company to be signed by manager or agent of the

principle office in India.

5. APPOINTMENT OF AUDITOR

Now another features in relation to the bank audit is that of the appointment
of auditor. Appointment of auditor of a banking company to be appointed at
AGM of shareholders. AGM here means Annual General Meeting.

So shareholders are going to have an important role an appointed of auditor

because such auditor is being appointed in a annual general meeting. However
the approval of RBI is to be taken before the appointment of auditor. And the
face of the auditor is also being decided under AGM. Appointment of auditor
of nationalized bank can be done by bank concerned authorities acting
through its boards of director.

However here also approval of RBI is to be taken before appointment of such

auditor and their fees is being determined by RBI in consultation with central
govt. so let’s us learn a chart by which we can understand that what are the
authorities, who are going to appoint the auditor and under which institution
how it is being appointed.

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So we have prepared this chart where there are names of the banks and the
appointing authorities in relation to the appointment of auditor. In the case of
nationalized banks and board of directors which to appoint the auditor.

Under banking companies that means where banking institution is being

framed as a company and registered the company act and the banking
regulation act then shareholders in AGM are going to appoint the auditor.
Then state bank of India will appointed auditor in consultation with the RBI
and central Government. Subsidiary of state bank of India where it is to
appoint a auditor.

The state bank of india is going to appoint the auditor of its subsidiary. In the
case of regional rural bank concerned bank with the approval of central
government is going to appointed auditor. So this is the jest of various
scenarios under which appointment of auditor can be made for a banking
institution.

6. VARIOUS STAGES OF BANK AUDIT

Now let us discuss various stages which we need to undergo while going for
the audit of a banking unit. So this is the stages which are being mentioned for
audit of bank. First one is preliminary work is to be done. Secondly evaluation
of internal control system.

Thirdly preparation of audit programs for substantive test and its evaluations.
And lastly there will be preparation and submission of audit report. In the case
of the first steps that is preliminary work. A auditor should ensure himself
with all the requirements which are being necessary. We should update with
the guidelines which are being given by the concerned authorities of the
banking unit for which is connecting the audit.

That how financial accounts are being drafted. What are the statutory ratio
which are being given? And what are the norms or prudential norms which are
being given for making provisions or NPA .

All these field work is to be done before starting up the audit of a bank. there
is a guideline which is being given by the government to the auditor. He
should comply with the guideline while conducting the audit.

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And he should also ensure that which x are going to put their impact under
banking regulation act. Whether there is a proper compliance of the TDS
provisions or not. So all these things have to be done and the form of a
preliminary work and before going for the audit. He should prepare in detail
the audit plan and audit program. So rest of the features are quite similar in
case of a general audit and that of a banking audit.

There should be evaluation of internal control system. Because on the

strength of the internal control system an audit can decide the nature timing
and extend of its audit work. So it is a preliminary feature that internal
control system should be reviewed and they should be evaluated. We have
already discussed in detail about internal control system and its evaluation. So
same principle would be applied in the case of a banking institution audit also.
Similarly audit program was substantive test will be prepared in the similar
fashion however detail program for the audit of the advances and borrowings
can be done in relation to the audit of a banking unit then finally there will be
preparation and submission of audit report.

7. AUDITOR’S REPORT

So let us discuss something about the preparation and submission of audit

report in the case of banking company. First of all for nationalized bank. It
needs to be given to the central govt. that means audit report has to be given
to central govt. and what needs to be stated in it that balance sheet is full
and properly drawn up and true and fair of view presented. Then transaction
of banks are within their power that means the banking authorities or
principle officers has not exceeded the powers given to him. And he has
worked according to the guidelines.

There is no window dressing or any other teaming and lading function. Which
is being done so up to and fair view is being presented. All these things are to
be mentioned specifically on audit report. Return received from offices and
branches of the banks are adequate. There are certain returns which are to be
given by the branches to the head office and they are being received in the
timeline which are being given and they are received in a proper form.

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Profit and loss shows the true balance of profit and loss that means P&L
account should represent the profit or loss in a bank in the correct manner
complying with the guidelines, which is being given to them for framing the
profit and loss a/c. the fundamental principle, which are being given for the
recognition of the revenue and to write off the expenditure are being adult to
by the banking authorities.

Which needs to be complied and it is to be given under auditor reports. For

banking company in addition to reporting under session 227 also to state
whether information and explanations are satisfactory transaction of the
companies are within the power of the company. Return received from branch
and adequate, P&L shows to profit and loss position and any other matter to
brought to notice or the shareholders of the company. So they are the
additional information. Which are to be required to be given under the audit
report of a banking company?

8. ADVANCES

Now next topic of discussion is the advances. We have already discussed that
advances is the major component under the list of the assets of a banking
company. Because major source of income in relation to the interest is
advances which are being given by the bank to the public at large. So let us
understand various guidelines and peculiar feature of the advances. Advances
usually constitution maximum amount of the assets normally the banks
sanction advance against the security of the tangible assets. The bank may
also require that the borrower should furnish guarantee of third party
repayment of advance in some cases the bank also grants advances without
any security.

There are certain distinction which are being imposed by banking regulation
act for granting advances. They are three important section, section-20,
section 20 A and section 21. So let us learn in detail; what are being given?
What are the restriction, which are being imposed for sanctioning the
advances to any party. A bank cannot make loan or any advance on the
securities of its own shares. Because it is being specifically mentioned that
advances are being given on certain security of the tangible assets. So in the
list of such assets banks own shares are being excluded. A bank is also not
permitted to enter into any commitment for granting loan or an advances to
or in behalf of any of its director.

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A firm in which director is interest as partner, manager, employer or
guarantor. Similarly a company in which any of its director have substantial
interest where he is a partner, manager, employer or guarantor. He should not
have a substantial interest also and individual in respect of home any of its
director is partner or guarantor. So under the four circumstances; there is a
restriction and guaranting loan or advances. Now what section 20A says, it
says that a bank is prohibited from remitting the whole or any of debt due to
its certain percent. That is any director of bank, firm or a company in which
any such director is a director or partner or employee or guarantor or an
individual to whome any director of banks is a partner or guarantor without
prior approval of RBI.

So here a prior approval of RBI is required where such circumstances are being
prevalent, so in that case remitting of the debts is not possible until a prior
approval of RBI is being taking up. And under section 21 the RBI has the power
to determine the policy in relation to advance to be followed by the banks
generally or by bank regarding the purpose for which advances may or may not
be given the margin to be maintained the maximum amount of advance to any
other party the rate of interest or other terms and conditions of advances. So
here there can be certain parameter which can specified by the RBI in relation
to advances. The rate of interest can be fixed, the amount can be fixed. So
these are the guidelines which are being given under section 21 which imposes
certain restriction on the granting of loans and advances.

9. CLASSIFICATION OF ADVANCES

Now other next part which we are going to discuss in relation to the advances
is classification of advances. Advances are broadly being classified into two
categories; standard advances and Non performing advances. So under
standard advances, these are the advances which does not disclose any
problem and does not carry more than normal risk associated with the banking
business. The level of risk associated with such assets or such advances is very
low and they are considered as standard advances. So there is no requirement
of making any provisions in relation to them. They are being considered as
pure advances having a lesser amount of risk with them.

Under non-performing advances what happens that they are the advances
other than standard advances that means risk element is associated with
them. Non-performing advances are further to classified in three categories.
So depending upon the time period for which they are being under non-
performing category.

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They are being again sub-categorised. So let us understand these categories.
First one is sub-standard advances, second is doubtful advances and third is
loss advances. Sub-standard advances is one, which has been classified as NPA
for a period not exceeding twelve month. That means they are under the
category of non-performing advances for less than twelve months.

While doubtful advances are those sub-standard advances which are under this
category for twelve months and loss advances, they are being identified by
banks or by internal or external auditor or by RBI inspection but the amount
have been written off. So they are considered as loss advances or where we
can say that its very risky to get back the fund which is being blocked or there
is a lesser chance of recovery of the amount either of principle or interest
thereon.

And under loss advances they are being identified by the bank or by the
external or internal auditor of the bank or by RBI inspection but the amount
have not been written off. That means they are somewhat irrecoverable, the
amount in relation to the principle or interest might be blocked for a longer
period of time and it is being ascertained that there is very lesser chance of
there being recovered. So they are considered as loss assets. So we have
learned in detail about the classification of advances.

10. SUMMARY

Now we are summing up our lecture of today. Under today’s lecture we have
learned in detail about the banking institutions, the four major institutions
which are prevalent in India. We have learned various stages to under gone
while conducting the bank audit. Or we have learned also that what are the
signitory authorities and how they are being required to fixed their signature
or financial statements. We have learned in detail about the major
components of the assets of the banking institution that how advances are
being classified. And what are the restriction which are being imposed for
granting loans or advances under the banking scenario.

With this we are ending up our discussion on special audit in relation to the
banking institution.

Thank You!

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