Bank Audit-Issue of Reversal of Unrealised Interest on

NPA Accounts
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CA Sharad Jain, Ujjain

| Fema / RBI - Articles
07 Apr 2019
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CA Sharad Jain

1. INTRODUCTION :

Statutory audits of banks and their branches are under process. Various
issues relating to these audits are under discussion amongst the (auditors )
Chartered Accountants . One of such issues in bank branch audit is regarding
reversal of unrealized interest on loans / advances which have became NPA in the year
under audit. In this article an attempt has been made to discuss various aspects,
prevailing practices and difficulties being faced relating to the reversal of interest on NPA
accounts.

2. SYSTEM OF ACCOUNTING FOR CHARGING INTEREST :

The banks generally follow accrual system for charging interest on advances (Other than
those which are NPA). The interest on such advances is credited to the interest income
account (ultimately Profit and Loss Account) of the current year and is correspondingly
debited to the advance account of the borrower (on accrual basis irrespective of the fact
that whether the same has been realized from the borrower or not). The interest on NPA
accounts is not recognized as income on accrual basis but is credited to the Profit and
Loss Account only on its actual realization.

3. RESERVE BANK GUIDELINES FOR REVERSAL OF INTEREST ON NPA

ACCOUNTS:

As per the “Prudential norms on Income Recognition, Asset Classification and

Provisioning pertaining to Advances” issued by the Reserve Bank Of India, if an advance
account becomes NPA during the year, the entire interest which was credited to the
income account in the past period which could not be realized is to be reversed.

The relevant part of the circular containing the above guidelines is as under :

“3.2 Reversal of income

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3.2.1 If any advance, including bills purchased and discounted, becomes NPA, the entire
interest accrued and credited to income account in the past periods, should be reversed if
the same is not realized. This will apply to Government guaranteed accounts also.“

4. TYPE S OF UNREALIZED INTEREST:

The unrealized interest remains of two types i.e., unrealized interest pertaining to the
current year and the unrealized interest pertaining to the preceding years. The issue
regarding the accounting entries regarding reversal of such interest arrives first at bank
branch level.

5. REVERSAL OF UNREALISED INTEREST OF CURRENT YEAR :

The unrealized interest pertaining to the current year is the interest on NPA accounts
which has been credited to the income of the current year but could not be realized till
date when the account became NPA in the current year. The same can be reversed easily
by bank branch by debiting the interest income account and crediting the related advance
account (or by way of any other method as per the system followed by the concerned bank
but having the same effect as above).

6. REVERSAL OF UNREALISED INTEREST OF PRECEDING YEARS :

The unrealized interest pertaining to the preceding years is the interest on NPA accounts
which was credited to the interest income account (ultimately to the Profit and Loss
Account) in the preceding one or more years, but could not be realized till date when the
account became NPA in the current year.

The profits / losses of the bank branches are transferred yearly to their head offices.
Therefore, regarding reversal of such interest at branch level contains various difficulties.
No specific guidance is available regarding method / procedure / accounting entries to be
made for the above purpose. Therefore, various practices / views are prevailing in this
regard. The same have been discussed in the succeeding paras.

6.1 IGNORANCE OF UNREALISED INTEREST OF PRECEDING YEARS : One

of the view is to ignore reversal of such interest and to reverse only unrealized interest of
current year (to get rid of the difficulties). But this view is not correct and proper. The
same is not in accordance with the relevant guidelines of the Reserve Bank.

6.2 MAKING 100% PROVISION FOR UNREALISED INTEREST OF

PRECEDING YEARS : An another view is to make 100% provision for unrealized
interest of preceding years and provision at the applicable rate on the rest of the balance
in the advance account.

For example, The advance account balance on the date of becoming NPA is Rs. 1,00,000/-
and the same contains Rs. 10,000/- unrealized interest of preceding years and Rs.
5,000/- unrealized interest of current year. Then (i) to simply reverse Rs. 5,000/- (as

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discussed above) current years unrealized interest and ; (ii) to make 100% provision for
Rs. 10,000/- for unrealized interest of preceding years and ; (iii) to make provision at the
applicable rate say 15% (Substandard Secured).

The logic given behind the above view is that since provision is made by way of debiting
the Profit and Loss Account, on one hand the Profits of the whole bank will get reduced
and on other hand the advance amount will also get reduced by the amount of unrealized
interest of preceding years.

However, due to change in the RBI guidelines, this method may not be presently relevant.
Because in earlier guidelines of the RBI there was mention regarding provisioning for the
unrealized interest. The earlier guidelines are as under :

“3.2 Reversal of income

3.2.1 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.” (emphasis supplied by us) Master Circular No.
DBOD.No.BP.BC. 17/21.04.048/2009-10 dated July 1, 2009.

But in the later master circular after the above, the method of “provisioning” has been
specifically removed. Now there is only mention of “reversing”. The relevant part of the
later circular is as under :

“3.2 Reversal of income

3.2.1 If any advance, including bills purchased and discounted, becomes NPA, the entire
interest accrued and credited to income account in the past periods, should be reversed if
the same is not realised. This will apply to Government guaranteed accounts also.”

Apart from the above, presently the MOC (Memorandum Of Changes) for reversal of
interest are to be prepared through the bank’s computer system. It is generally seen that
the same generally do not support preparation of the MOC in the above manner.

6.3 SIMPLY REVERSING THE PRECEDING YEARS’ UNREALISED

INTEREST IN THE CURRENT YEAR ITSELF : One of the view is to simply reverse
the preceding years’ unrealized interest also through current year’s interest income
account (ultimately Profit and Loss Account) itself (i.e., by debiting the unrealized interest
of preceding years to the current year’s interest income account and crediting the
concerned advance account).

However, there is a problem in following this method. It is a general accounting concept

that an amount in any account (here interest income account) can be reversed only if the
same has been credited in that account in the current year and is also laying there at the
time of passing the reversal entry. Here the amount intended to be reversed has never
been credited to the current year’s interest income account (as the same was credited to
the preceding years’ income accounts).

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The reluctance in adopting this method is that the amount which has never been credited
to the interest income of the current year will have to be debited to the current year’s
income. Due to this the current year’s interest income and profit appears to get disturbed
by preceding year’s unrealized interest amounts.

Though not mentioned in any authoritative pronouncement/guideline etc. but there is an

another aspect involved in this method. The effect of this method appears to be that of
treatment of unrealized past period interest like accounting treatment of any bad debt. In
case of any bad debt there may be instances where income is credited in earlier years
(income account is credited and receivable account is debited) and the profit and loss
account of subsequent year in which the debt is treated as bad is debited. But the same is
also debatable. One may say that why only preceding years’ unrealized interest part is
being considered as bad debt and not the whole amount of advances.

6.4 ACCOUNTING ENTRY THROUG HEAD OFFICE ACCOUNT : One of the view
is to reverse the unrealized interest of preceding years through Head Office account. The
logic given behind this view is that the above interest income was transferred to the Head
Office in the earlier years. Therefore, simply Head Office Account should be debited and
the concerned advance account should be credited in the branch. Thereafter, the Head
Office should pass the corresponding accounting entry of debiting its Profit and Loss
Account and crediting the concerned branch.

However, this method will have the same effect on the Profit and Loss Account of whole
bank as that of in the above method mentioned in para 6.3. In both the method the
current year’s profit / loss of the entire bank will get affected by the unrealized interest of
preceding years. Therefore, this method may involve duplicate work at both branch and
Head Office level.

CONCLUSION : The above issue requires guidance/clarification from the appropriate

authorities. In absence of the same the auditor will be required to make his own decision
considering the merits, demerits, system of the concerned bank etc. while choosing the
appropriate method for reversal of unrealized interest of preceding years.

Disclaimer: The information contained in the above article are solely for informational
purpose after exercising due care. However, it does not constitute professional advice or a
formal recommendation. The author do not owns any responsibility for any loss or
damage caused to any person, directly or indirectly, for any action taken on the basis of
the above article.

Tags: bank audit, NPA, Statutory Audit

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Author Bio

Name: CA Sharad Jain, Ujjain

Qualification: CA in Practice

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 Company: SHARAD JAIN

Location: UJJAIN, Madhya Pradesh, IN

Member Since: 27 Nov 2019 | Total Posts: 40

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