Audit of Banks - Test 2: answer key

Question 1 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. M/s Sharma & Associates are the statutory branch auditors of Zenith Manufacturing Pvt Ltd.'s account at Suryodaya Commercial Bank. CA Sharma reviews the working capital facilities. Zenith has a sanctioned Cash Credit (CC) limit of Rs. 15 crore and a non-funded Bank Guarantee (BG) limit of Rs. 5 crore. As on 31 March 2026, the CC outstanding is Rs. 12 crore. The latest stock statement submitted by the borrower is dated 15 December 2025, showing paid stocks of Rs. 18 crore and sundry creditors of Rs. 2 crore, with a stipulated margin of 25%. The branch's DP register was last updated in November 2025. CA Sharma also finds that on 25 March 2026, the branch manager sanctioned an ad-hoc overdraft of Rs. 2 crore over and above the sanctioned limit to allow the borrower to honor an LC devolvement, without seeking approval from the next higher authority as required by the bank's Manual of Delegation of Powers. The branch manager argues that since the total exposure is temporary and the borrower is a prime client, the DP calculation and manual rules can be bypassed to avoid an NPA classification.

Based on the stock statement dated 15 December 2025, what is the correct drawing power (DP) calculation, and how should the auditor treat the CC account as on 31 March 2026?

1. DP is Rs. 12 crore, and the account is regular because the outstanding is within the sanctioned limit of Rs. 15 crore.
2. DP is Rs. 12 crore, and the account is regular because the stock statement is valid for up to six months under RBI norms.
3. DP is Rs. 12 crore, but the account is irregular because the stock statement is older than three months, and outstanding (Rs. 12 crore) touches the derived DP. (correct answer)
4. DP is Rs. 15 crore, and the account is irregular because the outstanding exceeds the DP based on current assets.

Answer: C — DP is Rs. 12 crore, but the account is irregular because the stock statement is older than three months, and outstanding (Rs. 12 crore) touches the derived DP.

Explanation. DP is calculated as (Paid stocks - Creditors) less margin = (18 - 2) = 16 crore, less 25% margin (4 crore) = Rs. 12 crore. Under RBI norms, stock statements relied upon for determining DP should not be older than three months. Since the statement is over three months old as of 31 March 2026, the account is deemed irregular, and the DP of Rs. 12 crore makes the outstanding balance of Rs. 12 crore fully stretched.

Where it goes wrong. Students often assume stock statements are valid for the whole financial year or compare the outstanding solely against the sanctioned limit.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 2 · 2 marks · Chapter 10: Audit of Banks · hard

How should the auditor respond to the branch manager's action of sanctioning the ad-hoc overdraft of Rs. 2 crore?

1. Accept it as a routine operational decision since it prevented the account from slipping into NPA status.
2. Report it as a serious violation of the laid-down procedures of the bank for the sanction of advances. (correct answer)
3. Ignore it because the total outstanding after the ad-hoc OD is still within the total sanctioned credit limits (CC + BG).
4. Classify the ad-hoc OD as a non-funded facility and exclude it from the audit purview.

Answer: B — Report it as a serious violation of the laid-down procedures of the bank for the sanction of advances.

Explanation. The sanction of ad-hoc limits over and above delegated powers violates the bank's internal control systems and the Manual of Delegation of Powers. The auditor is required to examine the efficacy of internal controls and ensure sanctions are by appropriate authorities. Such bypassing to prevent NPA classification is a serious irregularity that must be reported.

Where it goes wrong. Students may incorrectly condone the action because the loan quality was protected, missing the core control violation.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 3 · 2 marks · Chapter 10: Audit of Banks · medium

In the context of Zenith Manufacturing's facilities, how should the auditor verify the Bank Guarantee (BG) of Rs. 5 crore?

1. Treat the BG as a funded loan and verify the actual cash transfer to the borrower.
2. Verify that the BG commission is charged and check the adequacy of the margin maintained.
3. Ignore the BG as it is a non-funded facility and carries no credit risk.
4. Verify the sanction, the underlying contract, and the bank's contingent liability recorded in the books. (correct answer)

Answer: D — Verify the sanction, the underlying contract, and the bank's contingent liability recorded in the books.

Explanation. A Bank Guarantee is a non-funded credit facility. The auditor should verify the sanction conditions, the underlying contract, the authority of the signatories, and ensure the contingent liability is properly recorded and disclosed in the financial statements. It carries credit risk if invoked.

Where it goes wrong. Students often mistakenly treat non-funded limits as carrying no risk or requiring cash transfer verification.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 4 · 2 marks · Chapter 10: Audit of Banks · hard

What is the primary internal control deficiency highlighted by the state of the DP register in the scenario?

1. The branch failed to collect the insurance premium on the hypothecated stock.
2. The branch did not verify the debtors' ageing schedule before calculating DP.
3. The branch failed to inspect the godowns for the physical existence of the stock.
4. The DP register was not updated monthly and checked by an officer to ensure adequate security cover. (correct answer)

Answer: D — The DP register was not updated monthly and checked by an officer to ensure adequate security cover.

Explanation. According to the study material, an essential internal control over advances is that the Drawing Power Register should be updated every month to record the value of securities hypothecated, and these entries should be checked by an officer. The failure to update it since November 2025 is a clear internal control breakdown.

Where it goes wrong. Students may jump to other valid audit procedures (like godown inspection) without addressing the specific deficiency mentioned in the scenario.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 5 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. M/s V. Raman & LLP has been appointed as the statutory auditor of Pinnacle Bank Ltd. During the audit of advances, CA Raman reviews a consortium term loan of Rs. 150 crore to Alpha Infotech Ltd., where Pinnacle Bank is a member with a 10% share (Rs. 15 crore). The lead bank recently conducted a stock audit and submitted a report indicating that the realisable value of the primary security has eroded significantly to just Rs. 1.2 crore, which is less than 10% of the outstanding balance. Pinnacle Bank's branch manager claims they do not need to review the lead bank's stock audit report as they are not the lead bank, and they have classified the account as 'Sub-standard' merely based on the days past due. Additionally, the engagement partner notes that a term loan of Rs. 11 crore sanctioned to Beta Engineering Ltd. was not examined in detail by the team, citing time constraints, even though the branch's total advances are Rs. 95 crore. The RBI inspection team had previously flagged Beta Engineering for weak end-use of funds.

Given that the realisable value of the security for Alpha Infotech Ltd. has eroded to less than 10% of the outstanding, how should Pinnacle Bank classify its share of the advance?

1. Classify as a Loss Asset, ignoring the existence of the security, and make a full provision. (correct answer)
2. Classify as Doubtful D1 and make a 25% provision on the secured portion.
3. Classify as Sub-standard as the account is in default, with a 15% provision.
4. Classify as Standard as it is a consortium loan and the lead bank is responsible for recovery.

Answer: A — Classify as a Loss Asset, ignoring the existence of the security, and make a full provision.

Explanation. As per RBI prudential norms on erosion of security, if the realisable value of the security is less than 10% of the outstanding in the borrower accounts, the existence of security should be ignored, and the asset should be straight-away classified as a Loss Asset. It must be fully provided for or written off.

Where it goes wrong. Students may apply normal time-based classifications (Sub-standard) or 50% erosion rules (Doubtful) without noticing the strict <10% Loss Asset rule.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 6 · 2 marks · Chapter 10: Audit of Banks · hard

Regarding the stock audit report of the consortium, what is the correct position for Pinnacle Bank?

1. Pinnacle Bank is exempt from reviewing the report because its individual share is below Rs. 5 crore.
2. Pinnacle Bank should obtain the stock audit report from the lead bank and review the comments on valuation and DP calculation. (correct answer)
3. Pinnacle Bank should conduct its own independent stock audit since it is a member bank.
4. The stock audit report is only relevant for the lead bank's books and has no bearing on Pinnacle Bank.

Answer: B — Pinnacle Bank should obtain the stock audit report from the lead bank and review the comments on valuation and DP calculation.

Explanation. As per RBI guidelines, branches should obtain the stock audit reports from the lead bank in cases where the bank is not the leader of the consortium of working capital. The report submitted by the stock auditors should be reviewed during the course of the audit, with special focus on comments regarding valuation of security and calculation of drawing power.

Where it goes wrong. Students may mistakenly assume that only the lead bank needs to review the stock audit, or that member banks need to order separate audits.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 7 · 2 marks · Chapter 10: Audit of Banks · medium

Was the auditor correct in conducting only a test check for the term loan of Rs. 11 crore to Beta Engineering Ltd.?

1. No, it constitutes a 'large advance' and must be examined in detail, especially since the RBI flagged it. (correct answer)
2. Yes, as long as the total sampling covers 10% of the branch's aggregate advances.
3. Yes, because Beta Engineering is not classified as an NPA as of the balance sheet date.
4. No, all term loans above Rs. 5 crore must be substantiated full under the Banking Regulation Act.

Answer: A — No, it constitutes a 'large advance' and must be examined in detail, especially since the RBI flagged it.

Explanation. An advance may be considered a 'large advance' if the year-end balance is in excess of Rs. 10 crore or 10% of the aggregate year-end advances of the branch, whichever is less. Here, 10% of Rs. 95 crore is Rs. 9.5 crore. Since Rs. 11 crore exceeds Rs. 9.5 crore, it is a large advance. Furthermore, accounts adversely commented upon by RBI need to be examined in detail.

Where it goes wrong. Students often only use the Rs. 10 crore absolute threshold and miss the '10% of aggregate advances, whichever is less' rule.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 8 · 2 marks · Chapter 10: Audit of Banks · hard

What is the significance of the RBI inspection team flagging Beta Engineering for weak end-use of funds?

1. It requires an immediate provision for standard assets at 5%.
2. It means the account should automatically be classified as a Non-Performing Asset.
3. It mandates the auditor to resign from the audit engagement.
4. It requires the auditor to include this account in the review and examine the end-use of funds in detail. (correct answer)

Answer: D — It requires the auditor to include this account in the review and examine the end-use of funds in detail.

Explanation. The auditor's review should generally include advances that are adversely commented on by the RBI inspection team, concurrent auditors, or internal inspection. The auditor should review such reports in detail and verify the end-use of funds. Flagging by RBI does not automatically make it an NPA unless the 90-day default criteria are met.

Where it goes wrong. Students may think an RBI flag automatically means an NPA classification or requires an immediate standard asset provision.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 9 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. An auditor is verifying a cash credit facility against the hypothecation of stock. Which of the following is a fundamental internal control the auditor should evaluate?

An auditor is verifying a cash credit facility against the hypothecation of stock. Which of the following is a fundamental internal control the auditor should evaluate?

1. The borrower's income tax return is filed on time.
2. The bank has taken physical possession of the hypothecated stock.
3. The drawing power register is updated monthly and entries are checked by an officer. (correct answer)
4. The borrower has submitted a letter of comfort from its parent company.

Answer: C — The drawing power register is updated monthly and entries are checked by an officer.

Explanation. For hypothecated stock, neither ownership nor possession is transferred to the bank. A critical control is the monthly updating of the Drawing Power register to reflect the current value of securities and the checking of these entries by an authorized officer. Physical possession is relevant for pledge, not hypothecation.

Where it goes wrong. Students confuse hypothecation with pledge and incorrectly expect the bank to have physical possession of the stock.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 10 · 2 marks · Chapter 10: Audit of Banks · hard

Scenario. A borrower's stock statement submitted to the bank for calculating drawing power is 4 months old. How does this affect the account's status?

A borrower's stock statement submitted to the bank for calculating drawing power is 4 months old. How does this affect the account's status?

1. The outstanding balance based on drawing power calculated from such an old statement is deemed irregular. (correct answer)
2. The stock statement is valid for 6 months, so the account remains regular.
3. The bank must immediately classify the account as a Non-Performing Asset.
4. The bank can accept it if the borrower provides a chartered accountant's certificate.

Answer: A — The outstanding balance based on drawing power calculated from such an old statement is deemed irregular.

Explanation. RBI norms state that stock statements relied upon by the banks for determining drawing power should not be older than three months. The outstanding in the account based on drawing power calculated from stock statements older than three months is deemed as irregular.

Where it goes wrong. Students often assume 6 months is the validity period for stock statements, confusing it with other regulatory validity periods.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 11 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. During the audit of a bank, the auditor finds that shares are held as security for a loan. What specific control should the auditor ensure?

During the audit of a bank, the auditor finds that shares are held as security for a loan. What specific control should the auditor ensure?

1. The shares are kept in the bank's locker along with the loan agreement.
2. The ownership of the shares is transferred in the name of the bank and effective control is retained. (correct answer)
3. The dividend on the shares is credited to the borrower's loan account.
4. The market value of the shares is updated annually in the drawing power register.

Answer: B — The ownership of the shares is transferred in the name of the bank and effective control is retained.

Explanation. When securities are in the form of shares or debentures, internal controls require that the ownership of the same should be transferred in the name of the bank, and the effective control of such securities be retained as part of documentation. This ensures enforceability in case of default.

Where it goes wrong. Students may confuse the physical storage of share certificates with the legal transfer of ownership needed for enforceability.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 12 · 2 marks · Chapter 10: Audit of Banks · hard

Scenario. According to RBI guidelines, for which of the following accounts is a stock audit mandatory by the bank?

According to RBI guidelines, for which of the following accounts is a stock audit mandatory by the bank?

1. All cash credit accounts with an outstanding balance above Rs. 1 crore.
2. All accounts that have been classified as Non-Performing Assets.
3. Accounts having a sanctioned limit above Rs. 5 crore, regardless of outstanding.
4. Accounts having a funded exposure of more than Rs. 5 crore. (correct answer)

Answer: D — Accounts having a funded exposure of more than Rs. 5 crore.

Explanation. The study material explicitly states that the stock audit should be carried out by the bank for all accounts having funded exposure of more than Rs. 5 crore. The criteria are based on 'funded exposure' rather than just the sanctioned limit or NPA status.

Where it goes wrong. Students might select the sanctioned limit or outstanding balance criteria instead of the specific 'funded exposure' threshold.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 13 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. While auditing a bank, the auditor examines a Letter of Credit (LC) facility. What is the primary risk associated with this non-funded facility?

While auditing a bank, the auditor examines a Letter of Credit (LC) facility. What is the primary risk associated with this non-funded facility?

1. The borrower may not utilize the LC, resulting in lost commission for the bank.
2. The LC may be devolved if the borrower fails to pay the beneficiary, converting it into a funded liability. (correct answer)
3. The LC is recorded off-balance sheet and therefore cannot be examined under statutory audit.
4. The LC automatically converts into a term loan after 90 days.

Answer: B — The LC may be devolved if the borrower fails to pay the beneficiary, converting it into a funded liability.

Explanation. Letters of Credit are non-funded credit facilities. The primary risk is that if the borrower fails to make payment to the beneficiary upon presentation of compliant documents, the bank must honor the LC and it devolves into a funded liability (an advance) for the bank.

Where it goes wrong. Students may incorrectly assume non-funded facilities carry no risk and overlook the devolvement risk.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 14 · 2 marks · Chapter 10: Audit of Banks · hard

Scenario. The auditor notices that the bank has sanctioned a term loan where the borrower utilized the funds to repay a loan of a sister concern instead of purchasing the machinery. What is the primary concern here?

The auditor notices that the bank has sanctioned a term loan where the borrower utilized the funds to repay a loan of a sister concern instead of purchasing the machinery. What is the primary concern here?

1. Diversion of funds and failure of the end-use check control. (correct answer)
2. The borrower has not maintained adequate drawing power.
3. The sister concern should have paid a higher interest rate.
4. The bank has violated the consortium lending guidelines.

Answer: A — Diversion of funds and failure of the end-use check control.

Explanation. A crucial part of credit appraisal and monitoring is ensuring the 'end-use of funds' complies with the sanctioned terms. Diverting funds to a sister concern instead of purchasing the specified machinery indicates a failure of internal controls and poses a significant credit risk.

Where it goes wrong. Students may focus on other technical terms like drawing power (which is for working capital) or consortium rules without addressing the core 'end-use' violation.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 15 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. A term loan account is overdue for 95 days. The realisable value of the security is 45% of the outstanding balance. How should this asset be classified?

A term loan account is overdue for 95 days. The realisable value of the security is 45% of the outstanding balance. How should this asset be classified?

1. Sub-standard asset with a 15% provision.
2. Straight-away classified as a Doubtful asset as there is a significant erosion of security. (correct answer)
3. Loss asset with a full provision.
4. Standard asset because the security cover is more than 25%.

Answer: B — Straight-away classified as a Doubtful asset as there is a significant erosion of security.

Explanation. The account is an NPA as it is overdue for more than 90 days. Furthermore, erosion in the value of security is considered significant when the realisable value is less than 50% of the value assessed by the bank. As the security is 45%, it falls below the 50% threshold, requiring straight-away classification as a Doubtful asset, skipping the Sub-standard stage.

Where it goes wrong. Students may classify it as Sub-standard just based on the 90-day rule and ignore the special rule for significant erosion in security value (<50%).

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 16 · 2 marks · Chapter 10: Audit of Banks · hard

Scenario. Under what circumstances would an auditor use a stock statement older than three months for calculating drawing power?

Under what circumstances would an auditor use a stock statement older than three months for calculating drawing power?

1. When the borrower is a government entity.
2. When the loan is fully secured by a Central Government guarantee.
3. When the account is classified as a Standard asset and the borrower has a high credit rating.
4. Under no circumstances, as RBI guidelines strictly prohibit relying on statements older than three months. (correct answer)

Answer: D — Under no circumstances, as RBI guidelines strictly prohibit relying on statements older than three months.

Explanation. RBI guidelines clearly state that considering the difficulties of large borrowers, stock statements relied upon by the banks for determining drawing power should not be older than three months. The outstanding in the account based on older statements is deemed irregular. There are no exceptions based on entity type or credit rating.

Where it goes wrong. Students may invent exceptions based on borrower reputation or government ownership, missing the strict 3-month rule.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 17 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. During an audit, the engagement partner finds an advance that exceeds both the sanctioned limit and the drawing power. How should this be reported?

During an audit, the engagement partner finds an advance that exceeds both the sanctioned limit and the drawing power. How should this be reported?

1. It should be brought to the notice of the management/Head Office regularly as it is an irregular account. (correct answer)
2. It should be immediately written off as a bad debt.
3. It should be treated as a non-funded facility for reporting purposes.
4. It should be ignored if the excess is rectified within 30 days.

Answer: A — It should be brought to the notice of the management/Head Office regularly as it is an irregular account.

Explanation. The study material specifies that all accounts which exceed the sanctioned limit or drawing power, or are otherwise irregular, should be brought to the notice of the controlling authority/management regularly. Immediate write-off is not the standard procedure for mere excesses.

Where it goes wrong. Students may think a temporary excess is ignored or requires immediate write-off, rather than being reported to management.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 18 · 2 marks · Chapter 10: Audit of Banks · hard

Scenario. An auditor is verifying advances and observes that a borrower has been granted a 'Demand Loan' against the security of gold ornaments. Which mode of security creation is applicable here?

An auditor is verifying advances and observes that a borrower has been granted a 'Demand Loan' against the security of gold ornaments. Which mode of security creation is applicable here?

1. Hypothecation
2. Mortgage
3. Pledge (correct answer)
4. Assignment

Answer: C — Pledge

Explanation. A pledge involves the bailment or delivery of goods by the borrower to the lending bank with the intention of creating a charge. Gold ornaments are physically handed over to the bank's custody. Hypothecation does not involve the transfer of possession, and mortgage applies to immovable property.

Where it goes wrong. Students often confuse hypothecation and pledge. Pledge requires physical transfer of possession, which is typical for gold loans.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 19 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. A borrower has taken a housing loan and a car loan from the same bank. The car loan EMI is overdue for 100 days, but the housing loan is fully regular. How should the bank classify these accounts?

A borrower has taken a housing loan and a car loan from the same bank. The car loan EMI is overdue for 100 days, but the housing loan is fully regular. How should the bank classify these accounts?

1. Only the car loan is NPA; the housing loan remains Standard.
2. Both the car loan and housing loan should be classified as NPA. (correct answer)
3. Both loans should be classified as Sub-standard.
4. The car loan is Sub-standard, and the housing loan is SMA-2.

Answer: B — Both the car loan and housing loan should be classified as NPA.

Explanation. RBI guidelines state that asset classification is borrower-wise and not facility-wise. If a borrower defaults on one facility, all facilities including investments in securities availed by the borrower from the bank are termed as NPA. Therefore, both the car loan and the housing loan must be classified as NPA.

Where it goes wrong. Students often apply facility-wise classification, assuming that a regular loan remains standard even if another loan of the same borrower defaults.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

Question 20 · 2 marks · Chapter 10: Audit of Banks · hard

Scenario. What is the maximum amount of indebtedness to a bank beyond which a Chartered Accountant is disqualified from being appointed as its auditor?

What is the maximum amount of indebtedness to a bank beyond which a Chartered Accountant is disqualified from being appointed as its auditor?

1. Rs. 1 lakh
2. Rs. 2 lakh
3. Rs. 10 lakh
4. Rs. 5 lakh (correct answer)

Answer: D — Rs. 5 lakh

Explanation. Under Section 141(3)(d) of the Companies Act, 2013, a person who is indebted to the company for an amount exceeding Rs. 5 lakh is disqualified from being appointed as an auditor. The banking audit eligibility also aligns with this limit. Exceeding this threshold makes the auditor ineligible.

Where it goes wrong. Students may confuse this with other materiality thresholds or penalties in the Act.

Authority. Section 141