Audit of Advances - A Perspective

Back to Basics

Like any audit, the audit of banks starts with a basic understanding of the business. So, what does a Bank do?

A bank, at its core, does only two activities:

1.   Accept Deposits

2.   Lend Money

All other activities of the bank are ancillary and supporting these primary activities.

Both activities involve two parties – The Bank and the Customer – and the parties are linked together by money.

As any transaction which involves money, the banks must take extreme caution as to from where or to whom their money is flowing. Hence, the two core activities of the bank give rise to three ‘Concerns’ for the Bank.

The Bank will take precautions to address these three concerns in all its transactions, and as auditors, it is our responsibility to verify whether the banks have taken all possible steps to protect its interest from these three concerns. If we are able to ensure this, our audit work is done.

The Three Concerns

I have broadly defined the three concerns that the Banks have while transacting with money as:

1.   Strangers

2.   Business Relations

3.   Trust Issues

Let us discuss this one by one

1.   Strangers: Assume a passer-by comes to you and asks for Rs. 1 Lakh as a loan. Now, you will not feel comfortable to loan him that amount. Why, Because he is a stranger to you. Likewise, banks deal with lakhs of customers every day who are strangers to it. How will the bank know whom it is dealing with? Hence, dealing with Strangers is the first concern.

2.   Business Relations: Assumer your friend comes to you and asks for a loan of Rs. 1 Lakh. Now, you would be okay to lend him the amount knowing he has a good credibility and would return the money. You might lend the money in good faith. But Banks is not working with friends, they work with strangers. More importantly, Banks are lending to earn money, they do not lend on faith. And hence, it is of utmost importance that transactions happen with clarity of terms and legally enforceable contracts. Maintaining a strict business relation, thus, is the second concern of the Bank.

3.   Trust Issues: When you lent your money to your friend, you lent the money considering that the money would be returned. You trusted your friend to return the money. Banks, as discussed earlier, do not work on trust; rather they do not trust. They have big ‘Trust Issues’. At all times the banks must be comfortable in answering the question - “How to ensure that the entire lent amount would be recovered in time with interest?” It is essential that the customer helps build enough confidence in the Bank that the Bank is comfortable to lend him its money.

Addressing the Concerns

The three concerns of the Bank are equally applicable to deposits it takes from customers and the advances it gives to borrowers. As we are discussing audit of advances, let us stick to that.

As auditors, it is our responsibility to verify whether the three concerns have been addressed by the bank in case of each advance.

The RBI has built protocols and procedures to help the Banks address the three concerns.

1.   Strangers: In order for a bank to know its customers, the RBI has issued “KYC” or “Know Your Customer” norms which ensure that the Banks obtain required information from customers to establish a bankable relation.

2.   Business Relations: All advances given by the bank are backed by legally enforceable contracts for mortgage, hypothecation and guarantees. Any and all documents with the bank are originals and contracts are registered with appropriate authorities.

3.   Trust Issues: As the Banks do not trust their customers, documents submitted by them are not considered valid unless backed by a government body. For Eg. Only govt. issued identity cards are accepted and contracts need to be registered with the registrar and notarised.

If auditors can verify that the KYC norms have complied, documentation is complete and all contracts are legally enforceable, comfort can be taken that the concerns are addressed and the money may be recovered by initiating legal action if required.

How to Check?

Till now, we discussed that basic objective of the audit. But the question of how to check and what to check in a loan file still remains. The objective, however, becomes the larger target to be achieved.

In order to achieve the target, it is important to understand three things about any loan:

1.   Purpose – Why is the loan taken?

2.   Amount – How much loan was required?

3.   Repayment Source – Who will repay it and how?

The audit of any loan file is complete, once the audit is comfortable with answers to these three questions.

The purpose of the loan tells you how the loan would be repaid or who would repay the loan.

Audit Procedure

The first step while auditing any advance is to identify the purpose of the loan. Once the purpose of the loan is identified, audit procedures must be adopted to verify whether the bank has vetted the repayment source and has obtained sufficient documents to justify the advance. Let’s discuss this in detail:

Purpose

I have divided loans into two types on the basis of the end-use of the money borrowed:

1.   Luxury Advances - Loans taken for luxury

2.   Business Advances - Loans taken for Need

Luxury Advances

Luxury Advances are those loans which are taken to finance a luxury i.e. the loans finance such assets/expenses which will not help in repaying the loans. Such loans include loans for personal vehicles, personal loans and home loans. Repayment of these loans is dependent on the capacity of the individual taking the loan and not on the asset the loan creates.

Business Advances

Business Advances are those loans which are taken to finance a business need. The assets created out of such finance normally help in repayment of the loan. These include loans for commercial vehicles, loans for plant & machinery, project finances, Working Capital loans etc. Repayment of these loans is highly dependant on the created asset and its efficient use. The capacity of the individual to repay the loan depends on how he utilises these assets.

Amount of Loan/Propriety

The auditor must verify the amount of loan required by the borrower considering the asset to be financed or the project to be set up. Alternatively, the auditor may also verify how much loan was the borrower eligible for.

Luxury Advances:

In case of luxury advances, the auditor must verify the propriety of the cost of the asset/expense to be financed and also verify whether the income (repayment source) of the borrower is sufficient to repay the loan. The banks usually calculate the MPBF or the Maximum Permissible Bank Finance to arrive at this amount. The auditor may verify if the calculations are correct as per applicable norms.

Business Advances:

In the case of Business Advances, the approach of appraisal of the loan varies as per the type of loan. In the case of term loans for projects, the project report submitted by the borrower is perused. The auditor may question the assumptions in the report and compare the projected cash flows with actuals. The viability of the projects may be affected over time.

In the case of Working Capital Loans, the auditor must verify calculations of the working capital cycle and understand if the assumptions appear realistic.

Repayment Source

Primary Source

Luxury Advances:

As discussed, the repayment source of a Luxury advance is the earnings of the borrower. This may include his income from businesses, rent, salary etc. Hence, documents substantiating the repayment capacity of the individual must be obtained. These include

1.   Income Tax Returns

2.   Salary Slips

3.   Rent Agreements etc.

The auditor must verify whether the earnings of the individual justify the loan amount or not.

Business Advances:

Repayment source of a Business Advance is the business for which the loan is taken. Hence, the Bank must obtain all documents that substantiate that the business is running, and the money was utilised for business. Also, that the business is earning enough revenues to repay the loan. These would include:

1.   Financial Statements of the Business

2.   Tax Compliances (Returns)

3.   Stock Statements

4.   Stock Audit Reports

5.   Inspection Reports

6.   Ownership of the Assets

The auditor must verify whether the documents have any indications that the amount lent may not be recovered by the bank.

Secondary Source

As we discussed, the Bank has “Trust Issues” and does not believe so easily. What if the primary source fails? What if the borrower loses his job? What if the business does not earn enough revenues?

In such a case, the Banks want to ensure the money is repaid and hence they take some security for the loan amount. These securities include both – Primary Security & Collateral Security.

Primary Security is the asset the loan finances. It could be the vehicle in case of a vehicle loan, the Plant & machinery in case of a Loan for P&M, Stock & Debtors in case of working capital loans and guarantors in case of personal loans.

Collateral Security is a security which is not directly linked with the purpose of the project. In the case of business advances, collateral security in the form of land & building or investments is accepted by banks. The percentage of coverage of the collateral security depends on how much comfort the bank has on the primary security.

As auditors, it is important to verify whether such securities can be liquidated to recover the advance if the need arises. Hence, audit procedures must be performed to address the second concerns of the bank – Business Relations.

But the trust issues do not end here. What if the asset is destroyed? The Banks ensure that the mortgaged assets are insured for a value which is more than the loan amount and that the insurance policy states that the amount would be paid to the bank in case the asset is destroyed.

Key elements of a valid security

For security to be valid, the auditor must establish three things–

1.   Ownership of the Asset: The asset must be owned by the borrower i.e. he must be legally eligible to mortgage the asset.

Check: This can be established from documents like registered sale deeds, invoices, certificates etc.

2.   Value of the Security: The security must have enough value to cover the loan amount. The Bank must be able to recover its money by liquidating the asset.

Check: Recent valuation reports (not older than 3 years)

3.   Enforceability: The mortgage of the asset must be legally enforceable by the bank i.e. the Bank must be able to initiate legal action against the borrower if he does not co-operate in the liquidation process.

Check: Registration of the mortgage deed, the inclusion of relevant clauses, the jurisdiction of the court, proper execution of deed etc.

Summarising

All the aspects discussed above – the purpose of the loan, primary repayment source and secondary repayment provisions can all be understood from the Sanction Letter.

The auditor must spend enough time to read and understand the sanction letter. He must discuss the reasoning behind the sanction and the terms at which the sanction was given.

The following audit approach may be adopted to ensure systematic and logical audit of advances:

1.   Understand the Purpose of the Loan.

a.   Verify Propriety of the Loan

b.   Verify credit requirement

c.   Identify the Primary Source of Repayment.

2.   Verify revenue sources

a.   Verify repayment capacity

b.   Verify Project assumptions and perform variance analysis

3.   Identify Fall Back Arrangement.

a.   Ownership

b.   Valuation

c.   Enforceability

d.   Insurance

If an auditor follows the basic audit approached discussed in this article, audit of advances can be completed with better understanding of the transaction and with a better control over the aspects to be covered.