STATUTORY AUDIT OF BANK BRANCHES

INTRODUCTION

Friends, I welcome you all in the seminar on Bank Audit. We have just stepped into a new financial year 2009 – 2010 and as usual we are going to start the new fiscal with Bank Branch Statutory Audit. This is not a new happening for us but what is new is the process of appointment of Auditors from this year in large banks. Bank has been given the autonomy to appoint auditors which has raised eyebrows from various quarters. By giving Banks autonomy to appoint their auditors, the Independence of Auditors has been put in question and today practically the Independence is at Risk since the auditors may feel obliged and the ultimate audit objective expected of us by our society gets defeated. This is ominous as it will foster favoritism, unwanted indulgence of management in audit conclusion. This has happened at a time, when there has been financial failures all over the globe and even in our country which is yet to get out of shock it received from Satyam fiasco, the greatest accounting and auditing disaster in our country. President of our Institute in his message dated 23rd March,2009, wrote on the Autonomy issue. Let me read the same for your knowledge.

Friends, Statutory audit of Bank branches involves voluminous work but time available to complete the same is very limited. Hence, there is every possibility of some important areas get escaped unless a planned procedure is followed. This planned procedure calls for in-depth knowledge of Standards on Auditing. Amongst them, the important one is SA 230 – which speaks of Documentation. SA-230 is revised but for our purposes of Bank audit, the pre revised SA-230 shall be applicable as the revised one is made effective from accounting period starting from 01.04.2009. Apart from these, there has been changes in restructuring of advances in prudential norms which shall be discussed in detail later on in my speech.

The Banking Industry has undergone sea change in the recent past. From manual system of accounting, it is shifting to ALPM, TBM and now to CBS Branches. ATM, internet banking is common now a days and audit of these areas require specialized knowledge. Although the basic objectives of audit don’t change whether the data is processed manually or by computers but the method of applying audit procedures may have to be changed depending on the circumstances. My subject today is a huge one. Although I have tried to cover all the aspects but on some points I have been very brief depending on its criticality.

I have divided my subject into five chapters, namely :

Chapter 1 : Acceptance of Audit : Initial Considerations.

Chapter 2 : Planning the Audit.

Chapter 3 : Conduct of Audit.

Chapter 4 : Long Form Audit Report.

Chapter 5 : Special purpose reports and certificates.

Chapter 6 : Audit under CIS environment.

Chapter 1 : Acceptance of Audit : Initial Considerations

After receiving the letter of Appointment, the Chartered Accountant should examine that :

He/She does not suffer from any of the disqualifications as mentioned in sec. 226 of the Companies Act, 1956. Among the five types of restrictions imposed by Sec. 226 of the Companies Act, 1956, the “Indebtedness” and “Holding of Security” criteria require a little mention here. The Indebtedness criterion says that if one is indebted to a Bank for a sum exceeding one thousand rupees or has given a guarantee or has provided any security in connection with the indebtedness of any third person for an amount exceeding Rupees one thousand, he cannot be appointed as auditor of the Bank. The expression indebtedness would cover, inter alia, the amounts outstanding in respect of credit cards issued by a bank. Thus where the credit card outstandings exceed the limit of Rs. 1000/=, the chartered Accountant in whose name the card is issued as well as the firm in which he is a partner would be disqualified for appointment as an auditor of the issuing Bank.

Holding of Security: Please ensure that you don’t hold any instrument which carries voting rights. Please check your D’mat A/C and Broker Pool A/C holdings as on date of acceptance of Bank audit.

There is no change in the constitution of the firm since the date of application to ICAI. If there is any, inform the Bank accordingly and await its confirmation before acceptance of the audit.

You are not associated with auditee branch in other capacity, such as concurrent auditor or internal auditor. There is a recent RBI circular in this respect. The RBI, vide its circular no. Ref. DBS.ARS.No.BC.02/ 08.91.001/2008-09 dated December 31 , 2008 on “ internal assignments in banks by statutory auditors”, decides that the audit firms should not undertake statutory audit assignment while they are associated with internal assignment in the Bank during the same year. In case the firms are associated with internal assignment, it should be ensured that they relinquish the internal assignment before accepting the statutory audit during the year.

After the above considerations, the next duty is to communicate with the previous auditor. The communication would be :

a. in writing

b. sent by registered post with Acknowledgement or by hand

against a written acknowledgement or by any other mode

which provides positive evidence of delivery.

A mere posting of a letter under certificate of posting is not enough as it does not establish any communication with the previous auditor.

After communication with the previous auditor, its time to actually accept the appointment. If there is no prescribed format for communication of acceptance , the letter of acceptance should be given by means of an Audit engagement letter in line with the Standard on Auditing – 210 of ICAI on “Terms of Audit Engagement”. But if there is any prescribed format for communication of acceptance, then in addition to the acceptance letter, we are also required to send audit engagement letter as per SA-210. The basic purpose of issuing an engagement letter is that the auditor and the client should agree on the terms of engagement. Since the objective and scope of Bank audit and the auditor’s obligations are laid down in the statute , it shall be sufficient compliance with SA-210, if the engagement letter is sent and the evidence thereof is retained by the auditor. There is no necessity that the letter should be acknowledged by the auditee and returned back to auditor so as to establish the terms of engagement.

CHAPTER – 2 : PLANNING THE AUDIT

Planning is a prerequisite to effective conduct of Audit. The better the Plan is , the easier would the audit be. Similarly, a bad planning or lack of planning is inversely related to effectively accomplish the audit objective. One would find himself in a sea of requirements and there will be duplication of works and finally the targeted date of signing audit report may not be achieved. I’ll request my fellow members to formulate his own planning after knowing what we have to deliver and when as each of us has his own style of work. A good planning is a continuous process which gets refined as we gain experience in Bank audit year after year. My planning Steps start as under :

First, open a master file. We can call it the permanent file. Contents of this file may be :

The appointment letter;

Communication with the previous auditor;

The letter of acceptance;

The letter of engagement;

RBI master circular.

A copy of the Banking Regulation Act, 1949

A record of study and evaluation of the internal controls related to the accounting system of the branch.

The audit programme;

Circulars and instructions received from the Bank;

Create working paper file for each branch which contains :

The audit programme; This is perhaps the most valuable document framed in-house and saves various duplication of work on site. So be meticulous in preparing the same.

A record of nature, timing and extent of auditing procedures performed and the rests of such procedures.

All our workings, audit reports, LFAR, Tax audit report, MOC and other necessary papers.

Send a questionnaire to the branch calling for specific details to be prepared well in advance and requesting to submit at the time of our visit. Once we take the pain to prepare the questionnaire, I believe, it will save much time at the time of preparation of audit reports. Friends, it is beyond dispute that sufficient time is required to complete the audit process without compromising with its quality yet we are given very limited time and expected to complete the audit work without compromising with the quality of audit. This is paradoxical but not beyond achievement. Hence, every moment of our onsite visit needs to be methodical.

The specimen questionnaire is sent. Now prepare a comprehensive audit programme. The audit programme, among other things, must contain two points :

Assessment of Control risk – Compliance test in regard to internal control.

Based on the results of compliance test, assess the level of substantive test.

Standard on Auditing (SA) – 315 on identifying and assessing the risk of material misstatement through understanding the entity and its environtment” may please be referred in this connection.

Audit Programme should cover all areas of checking, LFAR, Tax Audit, Certification works and the names of persons who will carry out the same.

So our in-house works are ready. Its time to sit with the assistants to appraise them of the latest circulars, changes etc. and remind them of the dos and don’ts. Take round stamp, Partner stamp, letter heads, ICAI Guidance note, Income tax ready reckoner, the permanent and current file, calculator, mobile and charger, and also ticket and money and move for actual performance, i.e., conduct of Audit.

CHAPTER – 3 : CONDUCT OF AUDIT

Before starting the work, ask for the :

Profit & Loss Account

Balance – Sheet

All returns and statements to be certified as per appointment letter

Account closing branch guidelines and circulars issued by head office

The latest copies of Inspection Reports, Concurrent Audit Report, RBI Inspection, Revenue Audit report, System audit report and reports of other audits carried out at the branch.

Copy of GLB as on 31.03.2009

The replies to the questionnaire already sent to the branch.

Let’s start our work with the verification of Cash & bank balances.

1. Verification of Cash & bank balance

Verify the balance as on date of visit. Prepare a reconciliation statement to arrive at the cash balance as on 31.03.2009. Obtain a certificate from the branch manager indicating denomination wise cash balance on the date of visit.

If the branch is having a currency chest, we need not physically verify the balance at chest but the auditor should perform compliance test to evaluate the effectiveness of the system of operation of the currency chest, recording of transactions relating to deposits into and withdrawal from the currency chest. Daily reporting of transactions to link office of the Bank which maintains the account of the Reserve Bank.

ATM Balances: At the time of physical verification, the ATM machine needs to be shut off. At that point take a print out of “ADMIN SLIP” where cash balance is noted. Count the balance and reconcile with the admin slip. Ask the branch management to reconcile the balance at the point of verification on the date of audit to the point of verification as on 31.03.2009. For this, point to point cash replenishment, withdrawal statement is necessary. If that can be furnished by the branch people, there would be no hardship on our part and in the absence of the same, report on the basis of ADMIN SLIP.

Verify balance confirmation certificates for balances with other banks and check the reconciliation statement to ascertain whether there are any unreconciled items of revenue and if so whether those are provided for or not. Take a copy of the balance confirmation certificates and keep in current file but before that be assured that the certificate is original.

ADVANCES :

Advances constitute the largest item of assets of a Bank. This is the most important aspect of Bank Branch Audit. In the Balance Sheet, Advances are disclosed from three different angles:

i. Nature of Advance : Bills purchased and discounted, Cash credits and

overdrafts, and Term Loans;

ii. Nature and extent of Security : Secured position, unsecured position and

covered by bank/govt guarantees;

iii. Place of making advance : Advances in India and advances outside India.

Please note that the amount receivable from Government of India under Agricultural Debt Waiver Scheme,2008 should be shown as mentioned in the RBI circular No. DBOD. No. BP. BC. 26/ 21.04.048/ 2008-09 Dt. July 30, 2008.

Branch auditors are to examine all large advances and test check other advances. Hence, first work out the amount of large advance. Its 5% of total advances or Rs. 2 Crore whichever is less. Ask for all files of large advances and randomly select other cases of advances to be checked. Note down the names of the parties, A/C no., nature of loan, balance outstanding as on 31st March, observations in writing in the working paper file.

Audit procedure

Examining the validity of the recorded amounts : The total of balances as per the statement of advances should tally with the balance in the subsidiary ledger and the control account in the general ledger. Further the Auditor should also check the balances of the accounts selected for examination as per statement of advances with the subsidiary ledger.

Examination of Loan Documents : Auditor should check the document file thoroughly and ascertain whether all the conditions as laid down in the sanction letter have been fulfilled or not. The auditors need to apply his mind while checking of documents. Say, in the case of loans to companies, if the securities are in the form of mortgages, the evidence of registration of charge with ROC should be in the document file. A study of the Inspection report, concurrent audit report may prove very helpful in this regard.

Review of Operation of Account : Carefully review the operation of the account to ascertain balance exceeding sanctioned limit, A/C not stagnant, turnover in the account etc. Apart from this, the auditor should also check :

i. Periodic stock statement

ii. Latest financial statement

iii. Inspection of borrowal unit

iv. Audit report if the limit is RS. 10 lacs or above

v. Copy of Insurance policies

vi. Review/renewal of accounts

Verification of security against advances: Auditor should examine the classification of advances into secured or unsecured loans. If it is shown as secured loans, the examination of security should be done. If it is secured against hypothecation of stock, latest stock statement should be examined. Advances against book debts should be related to their current debts and not old/doubtful debts. The auditor should check the insurance policy for validity, adequacy of the sum insured with the bank clause appended in the policy.

The audit programme in respect of Advances needs to be drafted so meticulously that no duplication of work takes place. So at time of audit of advances, we can take care of the points to be covered in LFAR.

Now check advances as per prudential norms of RBI. The latest master circular in this respect is DBOD. NO. BP. BC. 20/21 .04. 048/2008-09 DATED JULY1, 2008 which is available in the RBI website www.rbi.org.in. It’s a very lengthy circular containing in detail the prudential norms for Income recognition, asset classification and provisioning norms pertaining to advances. I have already mailed the Master circular to the email IDs I have with me.

MASTER CIRCULAR ON INCOME RECOGNITION, ASSET CLASSIFICATION AND PROVISIONING NORMS - DBOD. NO. BP. BC. 20/21 .04. 048/2008-09 DATED JULY1, 2008 : Discuss.

CIRCULAR ON RESTRUCTURING AND RESCHEDULEMENT OF LOANS :

The provisions relating to restructuring/ reschedulement of advances were previously contained in the Master circular on IRAC itself. But from this year, the RBI, vide its circular no. DBOD. NO. BP. BC. 37/21 .04. 132/2008-09 DATED AUGUST 27, 2008 issued prudential guidelines on restructuring of advances by the Banks. Previously upon restructuring, borrowers engaged in industrial activities only continued to enjoy the same classification as before restructuring. Let me explain it in detail.

DBOD. NO. BP. BC. 37/21 .04. 132/2008-09 DATED AUGUST 27, 2008

DBOD. NO. BP. BC. 93/21 .04. 132/2008-09 DATED DECEMBER 8, 2008

DBOD. NO. BP. 104/21 .04. 132/2008-09 DATED JANUARY 2, 2009

DBOD. NO. BP. BC. 105/21 .04. 132/2008-09 DATED FEBRUARY 4, 2009

All these circulars are available in the RBI website www.rbi.org.in. Go to the notification menu and find the circular you want.

OTHER ASSETS

This is a very important head in the Bank Balance – Sheet. There are two major heads 1. Inter branch adjustment and 2. Others. There are other heads under this subheads such as suspense account, stationery & Stamp account and sundry assets. Carefully scrutinize these accounts specially the sundry assets a/c. While auditing this head, be forensic in your attitude.

Deposits

See that Dr. balance in current accounts are not netted out on the liability side but are appropriately included Under the head “ADVANCE”. This may increase your audit fees too if the debit balance is of substantial amount.

Inoperative accounts are a common area of frauds in Banks. See whether the revived accounts are under proper authority or not.

Check the KYC norms on a sample basis.

CONTINGENT LIABILITIES :

Obtain a certificate from the branch management that all contingent liabilities are disclosed and that the disclosed contingent liability donot include any contingencies which are likely to result in a loss and which therefore require adjustment.

CHAPTER – 4 : LFAR

The first duty is to collect the information required to be provided in the LFAR from the Branch Manager duly certified. We sent the questionnaire well in advance to the branch. So, I hope the information has been furnished to me.

LFAR is a detailed questionnaire, the format of which is designed by RBI and used since 1985. It was revised in 1992-93 and latest revision was made in the year 2003. This is a separate report to the management. Both LFAR and main Audit Report should preferably be submitted simultaneously but submission of main report should not be delayed merely because LFAR is not complete.

There are many points in the LFAR which do not have any special point for discussion. Rather, I will discuss the points which in my opinion merit a discussion.

Insurance cover for cash : A bank generally obtain a global insurance policy in respect of cash and cash in transit. If this policy is available at the branch, the auditor should check the adequacy of insurance cover for cash with reference to the cash balance generally carried by the branch and not the retention limit. If the policy is not available at the branch, report that the bank has taken a global insurance policy regarding cash and cash in transit. Regarding commenting on the adequacy of the same, well, its your call, how you report it.

Balances with RBI, SBI and other Banks : There are three clauses under this item. See the last clause. In case any item deserves special attention of the management, the same be reported here : Persistent defaults by the branch in not following the procedure for obtaining balance confirmation certificates and/or preparing reconciliation statements should be reported here.

Clause 5a of LFAR on credit appraisal of Advance accounts (regarding loan application, renew/review of advances etc.) : At the time of audit of advance accounts, see that document files contain loan applications in appropriate forms. The exceptions are to be reported here. Also check that accounts are reviewed and renewed in time. Working capital advances are generally granted for one year at a time and require renewal if the borrower seeks continuation of facility. Loans repayable over a period of time in installments are not renewed. However, some banks have a system of reviewing these loans from time to time primarily with the objective of risk evaluation. The accounts which are due for renewal and not renewed should be reported here.

Clause 5 d (ii) of LFAR on regular submission of stock statements : Please don’t give a blanket remark that parties are not submitting stock statements regularly.Because as per the Master circular of RBI on IRAC, a working capital advance a/c would be deemed as irregular if the outstanding in the account based on the drawing power calculated from stock statements are older than three months. A working capital borrowal a/c will become NPA if such irregular drawings are allowed for a continuous period of 90 days. Hence, imagine the situation and act accordingly.

Clause 5 d (III) on Stock Audits : (Read page no III – 10) of guidance note. The guidance note on Bank Audit is silent in which cases stock audit reports are to be obtained. On a reading of the guidance note, it appears that stock audit reports are to be obtained in the cases of large advance as has been described elsewhere in the LFAR. The RBI vide its circular dt. 30.05.2002 on willful defaulters have asked all scheduled commercial banks to introduce system of periodical stock audit in case of working capital finance. Hence, every Bank fixes a suitable “Cut-off Limit” above which all CC a/cs are to obtain stock audit reports .As the Auditor, we are to first ascertain the cut-off limit for stock audit and then see whether the same has been carried out by all the eligible cases.

Last point of LFAR ; Comments on any other item : One can give comments on additional items which are not covered in the LFAR as the LFAR is indicative in nature , like, KYC compliances, security arrangements, locker, ATM, operations in dmat a/c, risk build audit, BCTT, Service tax , etc.

Observation on comments given in LFAR : It is noticed that certain comments given in the LFAR is not well defined or vague in nature. The SCA cannot understand what is actually meant by this remark. For example : In 30 cases, letter of acknowledgement of debt has not been obtained. By this comment, The SCA cannot understand, if the account is time barred, what in case the account is NPA, whether the security will be considered or not. Frequent overdrawing in accounts, the SCAs donot know whether frequent overdrawing affects NPA status or not. Creditors are not reduced in calculation of wing power, The SCAs would ask whether reduction in drawing power would affect NPA status. Hence, it is important to be specific in giving comments in LFAR. Auditors generally does not give qualificatory audit reports or issue MOC due to management pressure and instead masquerades it in the LFAR. This does not absolve him of his responsibilities of certifying the fairness of the accounts.

Lastly, if any adverse remarks are to be reported in LFAR, the auditor should examine its impact on the main audit report. He should decide whether a qualification is necessary in the main audit report. It should not, however, be assumed that every adverse remarks in the LFAR would necessarily result in a qualification in the main audit report. In deciding whether a qualification in the main audit report is necessary, the auditor should use his judgement in the facts and circumstances of the case. But if any adverse remarks are given in the LFAR, the auditor should give the reasons for the same. Also, where relevant, instances of situations giving rise to their reservation or adverse remarks should also be given.

GHOSH & JILANI COMMITTEE RECOMMENDATIONS :

Ghosh Committee recommendations deal with aspects related to fraud and malpractices in Banks and whereas Jilani committee recommendations deal with the EDP environments and the inspection/internal audit system in the Bank.

GHOSH COMMITTEE : A high level committee set up under the leadership of Sri Amitabh Ghosh to enquire into the various aspects of Fraud and malpractices in the Bank and to make recommendations to reduce such instances. Out of 97 recommendations made by Ghosh Committee, 27 are required to be reported at branch level.

JILANI COMMITTEE : A working group formed under the leadership of Rashid Jailani to review the internal control and inspection/audit system in Bank. A format of 25 questions was issued to indicate the answer as either “implemented” or “Not Implemented”.

The Auditor should check the concurrent audit report, internal inspection report before reporting thereon. The responsibility of the Statutory Auditors is only to report upon the status of implementation of the recommendations of Ghosh & Jilani Committees. As such, the audit procedures would comprise mainly of inquiry and confirmation. The format requires the Auditor to answer in yes or no, however, the auditor, if unable to form any opinion on any of the points can disclaim over the same, the reasons for disclaimer may be given as annexure or as footnote.

Where the status report, as prepared by the management indicates that any of the recommendations have not been implemented, the auditor should request the concerned management to give a written representation as to why the particular recommendations have not been implemented. The review of the Ghosh & Jilani committee recommendations as prepared by the branch would also help the Auditor to focus on areas which are susceptible to fraud/malpractices and whether his findings have any material impact on the true and fair view of the financial statement of the branch.

Compliance with requirements relating to Statutory Liquidity Ratio :

Section 24 of the Banking regulation Act requires that every Banking Company shall maintain in India in Cash, Gold or unencumbered approved securities an amount not less that 25% or such other percentage not exceeding 40% of the total of its Demand and Time Liabilities in India as on the last Friday of the second preceding fortnight. This is referred to as “Statutory Liquidity Ratio”. Previously, all commercial banks were to maintain a uniform SLR of 25% of their total net demand and time liabilities but vide circular dt. 03.11.2008, the ratio has been reduced to 24%.

The RBI has asked all Banks to advise their SCAs to verify the compliance with SLR requirements on 12 odd dates in different months of a Financial Year not being Fridays. SLR is verified at H.O. level. But SCAs require certificates from Branch Auditors in this respect.

Let me explain the SLR mechanism. Suppose out of the 12 dates where SLR would be verified, one date is Feb1, 2008. Hence the DTL position to be examined will be as on last Friday of the second preceding fortnight, i.e., Jan, 12, 2008. Hence the branch auditor are to verify DTL position as on Jan 12, 2008 and cash position as on Feb 1, 2008. We are to verify the cash position only as branches normally do not hold Gold or other securities. Now these 12 odd dates of different months of a financial year are selected by the SCAs and informed to the Branch Auditors well in advance so as to enable the branch auditors to draw their audit programme accordingly. Please see your guidelines for closing returns where these dates are mentioned. So we are to check :

Cash balance as on 12 non Fridays of different months of a financial year;

DTL position of 12 last Fridays of second preceding fortnights.

CAPITAL ADEQUACY RATIO UNDER BASEL – II :

This area is very important since on the basis of our certificates , Basel II computation of capital is done and which is subsequently disclosed under “ Notes on Accounts” to the Balance-Sheet. First, let us understand what is Capital Adequacy Ratio . The term, Capital Adequacy Ratio(CAR) is used to describe the adequacy of capital resources of a bank in relation to the risks associated with its operations. Under Basel I , the bank need to maintain equal capital irrespective of the level of credit risk but under Basel II, credit risk will be computed separately for each class of customers and accordingly capital requirements will be calculated. Higher the risk profile, higher will be the need for capital. From Bank’s perspective, there is always a cost of capital hence it will try to leverage by maintaining suffent capital only. In India, The foreign banks and those Indian Banks which have operations outside India have already migrated to New Capital Adequacy framework by implementing Basel – II w.e.f.31.03.2008, i.e., last year and in respect of other Banks it will be effective from 31.03.2009 as per RBI guidelines.

Overview of Basel II : Basel is a place in Switzerland. In 1974, the G-10 contries formed a committee on banking supervision comprising of central bank governors of the participating countries. This is not a regulatory body but provides guidelines and recommendations in the expectation that individual authorities will take steps to implement them. The first accord was signed in Basel in Switzerland in 1988.

From Auditors point of View : Basel II computation on capital adequacy is done at head office level based on the data provided by the branches. The statutory Central auditors verify the computation of capital adequacy as part of their attest function. We being Statutory Branch auditors need to verify the data provided by the branch as one of the certificates we sign at the branch is in regard to this, i.e. “ Data required for computation of capital Adequacy”. Hence, from auditor’s point of view, we need not go into the complexities of capital adequacy computation but we will definitely pay sometime to the verification of Data required for computation at H.O. level. I described this coz we need to be familiar with the term which we hear so frequently.