Audit of Banks - Test 3: answer key

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

Scenario. M/s Sharma & Associates are the statutory branch auditors of Suryodaya Bank Ltd., auditing the Coimbatore branch for FY 2025-26. The branch extended a Cash Credit (CC) limit of Rs. 5 crore to Alpha Infotech Ltd., which is overdue for 95 days as of 31 March 2026. Alpha Infotech also has a Term Loan of Rs. 2 crore with the same branch, which is fully regular with no overdues. The branch manager has classified only the CC facility as a Non-Performing Asset (NPA) and kept the Term Loan as a Standard asset, arguing that the term loan is performing and generating income. Furthermore, the branch granted a short-duration crop loan to a farmer, which is currently overdue for one crop season. The branch has classified this agricultural advance as an NPA and stopped recognising interest. CA Sharma is also reviewing an overdraft account of Zenith Manufacturing where the outstanding balance is within the sanctioned limit, but there have been no credits for the past 100 days. Management insists the account is standard because the outstanding does not exceed the sanctioned limit. CA Sharma must resolve these classification and provisioning disputes before finalizing the audit report.

In the case of Alpha Infotech Ltd., how should the auditor classify the Term Loan of Rs. 2 crore?

1. As an NPA because asset classification is borrower-wise, not facility-wise. (correct answer)
2. As a Sub-standard Asset because the borrower's CC account is an NPA.
3. As a Doubtful Asset because the borrower has multiple facilities with the bank.
4. As a Standard Asset because the term loan is fully regular and generating income.

Answer: A — As an NPA because asset classification is borrower-wise, not facility-wise.

Explanation. As per RBI prudential norms, asset classification is borrower-wise and not facility-wise. If a borrower defaults on any credit facility, all facilities availed by the borrower from the bank are termed as NPA. Therefore, even though the Term Loan is regular, it must be classified as an NPA because the CC account of the same borrower is an NPA.

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

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

How should the auditor treat the short-duration crop loan that is overdue for one crop season?

1. It should be classified as an NPA because any overdue agricultural loan is immediately an NPA.
2. It should not be classified as an NPA because a short-duration crop loan requires an overdue period of two crop seasons to be classified as NPA. (correct answer)
3. It should be classified as an NPA because the overdue period exceeds 90 days.
4. It should be classified as a Loss asset since agricultural loans carry the highest risk.

Answer: B — It should not be classified as an NPA because a short-duration crop loan requires an overdue period of two crop seasons to be classified as NPA.

Explanation. RBI guidelines state that a loan granted for short-duration crops is to be treated as NPA only if the instalment of principal or interest remains overdue for two crop seasons. Since the overdue period is only one crop season, the branch's classification of this loan as an NPA is incorrect.

Where it goes wrong. Students often apply the standard 90-day rule to agricultural advances or confuse the one-crop-season rule for long-duration crops with short-duration crops.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Regarding the overdraft account of Zenith Manufacturing, what is the correct classification?

1. It is a Standard Asset because the outstanding is within the sanctioned limit.
2. It is a Sub-standard Asset because the overdraft is secured by stock.
3. It is an NPA because the account is 'out of order' due to no credits for 100 days. (correct answer)
4. It is an NPA only if the outstanding exceeds the sanctioned limit for 90 days.

Answer: C — It is an NPA because the account is 'out of order' due to no credits for 100 days.

Explanation. An overdraft/cash credit account is treated as 'out of order' if there are no credits continuously for 90 days as on the date of the balance sheet, even if the outstanding is less than the sanctioned limit. Since there have been no credits for 100 days, the account is out of order and must be classified as an NPA.

Where it goes wrong. Students may rely solely on the sanctioned limit comparison and overlook the 'no credits for 90 days' condition.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

What is the minimum general provision the bank must maintain on the Standard Asset (Term Loan of Alpha Infotech) if it had not been classified as NPA?

1. 0.25%
2. 2.00%
3. 1.00%
4. 0.40% (correct answer)

Answer: D — 0.40%

Explanation. As per RBI prudential norms, a general provision of 0.40% is required on standard assets (excluding certain specified sectors like commercial real estate which may have higher rates). Since the question asks for the standard rate for a general standard asset, 0.40% is the correct provision.

Where it goes wrong. Students often confuse the 0.25% rate (which is an older rate or for specific categories) with the current standard 0.40% rate.

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 for FY 2025-26, CA Raman reviews the account of Beta Engineering Ltd., which has been classified as a Doubtful Asset (D1 category) by the bank. The outstanding balance is Rs. 10 crore, and the realisable value of the security is Rs. 4 crore. The bank has made a provision of Rs. 1 crore, arguing that since the account has been doubtful for less than a year, a flat 25% provision on the outstanding balance is sufficient. In another case, a loan to Gamma Constructions Ltd. with an outstanding balance of Rs. 8 crore has a realisable security value of just Rs. 0.5 crore, which is less than 10% of the outstanding. The branch has classified this as a Doubtful D2 asset and provided 40% on the secured portion. CA Raman is also concerned about the Long Form Audit Report (LFAR). The bank's management has requested that the LFAR be finalized and submitted by 15 July 2026, citing delays in receiving branch returns. Management has also asked the auditor to omit details of a recent fraud involving a cashier, arguing that it is an internal matter and should not be reported to RBI to avoid regulatory penalties.

Is the provision made by the bank for Beta Engineering Ltd. (D1 category, outstanding Rs. 10 crore, security Rs. 4 crore, provision Rs. 1 crore) correct?

1. No, the provision should be 25% of the secured portion and all of the unsecured portion, totaling Rs. 7 crore. (correct answer)
2. Yes, a flat 25% provision on the outstanding balance is correct for D1 assets.
3. No, the provision should be 40% of the secured portion and all of the unsecured portion, totaling Rs. 7.6 crore.
4. Yes, because the account has been doubtful for less than one year, the bank can choose the provision rate.

Answer: A — No, the provision should be 25% of the secured portion and all of the unsecured portion, totaling Rs. 7 crore.

Explanation. For a Doubtful asset up to 1 year (D1), the provision is 25% on the secured portion and full on the unsecured portion. Secured portion = Rs. 4 crore; unsecured = Rs. 6 crore. Provision = (25% of 4) + (all of 6) = 1 + 6 = Rs. 7 crore. The bank's provision of Rs. 1 crore (25% of total) is insufficient.

Where it goes wrong. Students often apply the 25% rate to the entire outstanding balance instead of bifurcating it into secured and unsecured portions.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

How should the loan to Gamma Constructions Ltd. be classified, given that the realisable value of security is less than 10% of the outstanding?

1. It should be classified as a Doubtful D2 asset with a 40% provision.
2. It should be classified as a Loss Asset and fully provided for. (correct answer)
3. It should be classified as a Sub-standard asset with a 15% provision.
4. It should be classified as a Standard asset because the security is still realisable.

Answer: B — It should be classified as a Loss Asset and fully provided for.

Explanation. RBI guidelines state that if the realisable value of the security, as assessed by the bank/approved valuers/RBI, 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 written off or provided for (full).

Where it goes wrong. Students may apply normal D2 provisioning (40% secured) and ignore the special <10% erosion rule that mandates Loss asset classification.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

What is the statutory deadline for submitting the LFAR to the bank?

1. 31st March
2. 30th September
3. 30th June (correct answer)
4. 31st December

Answer: C — 30th June

Explanation. The Reserve Bank of India mandates that the Statutory Central Auditors must submit the Long Form Audit Report (LFAR) to the banks latest by 30th June every year. This deadline allows the bank to review the findings before finalizing the financial statements and regulatory returns.

Where it goes wrong. Students often guess the date as 30th September (which is the deadline for tax audits) or 31st December, misremembering the specific LFAR requirement.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

What is the auditor's responsibility regarding the cashier fraud that management wants to keep internal?

1. Comply with management's request as it is a minor internal matter.
2. Report the matter only if the amount involved exceeds the materiality threshold.
3. Disclose it only in the notes to accounts and not in the LFAR.
4. Report the fraud to the Reserve Bank of India (RBI) in addition to the bank's Chairman/Managing Director/Chief Executive. (correct answer)

Answer: D — Report the fraud to the Reserve Bank of India (RBI) in addition to the bank's Chairman/Managing Director/Chief Executive.

Explanation. RBI's circular on frauds explicitly requires that if an auditor finds anything susceptible to fraud or fraudulent activity, they should refer the matter to the regulator (RBI). Any deliberate failure on the part of the auditor renders them liable for action. Reporting to management alone is insufficient, and confidentiality is overridden by this statutory requirement.

Where it goes wrong. Students may think materiality applies to fraud reporting or that client confidentiality prevents reporting to RBI.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. A term loan instalment is due on 1st January 2026. The borrower fails to pay. On which date will the account be classified as a Non-Performing Asset (NPA)?

A term loan instalment is due on 1st January 2026. The borrower fails to pay. On which date will the account be classified as a Non-Performing Asset (NPA)?

1. 1st April 2026 (correct answer)
2. 31st March 2026
3. 1st April 2026, if the overdue period exceeds 90 days as of that date.
4. On the 91st day past the due date, i.e., 1st April 2026.

Answer: A — 1st April 2026

Explanation. An asset becomes an NPA if interest and/or instalment of principal remain overdue for a period of more than 90 days in respect of a term loan. If the due date is 1st January, 90 days end on 31st March (depending on precise calculation, Jan 31 + Feb 28 + Mar 31 = 90 days). The account becomes NPA the day it exceeds 90 days, which is 1st April 2026.

Where it goes wrong. Students often struggle with the precise day count, forgetting that the account becomes NPA *after* exceeding 90 days (i.e., on the 91st day).

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. What is the prescribed provisioning rate for a Sub-standard asset, and how is it applied?

What is the prescribed provisioning rate for a Sub-standard asset, and how is it applied?

1. 10% on the secured portion and full on the unsecured portion.
2. 15% on the total outstanding balance (both secured and unsecured). (correct answer)
3. 25% on the secured portion and full on the unsecured portion.
4. full on the total outstanding balance.

Answer: B — 15% on the total outstanding balance (both secured and unsecured).

Explanation. For Sub-standard assets, the provisioning requirement is a flat 15% on the total outstanding balance, regardless of whether it is secured or unsecured. The secured/unsecured bifurcation becomes relevant only for Doubtful assets.

Where it goes wrong. Students often incorrectly apply the secured/unsecured bifurcation rule (which applies to Doubtful assets) to Sub-standard assets.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. An asset has been classified as Doubtful for more than 3 years (D3). What is the required provisioning rate?

An asset has been classified as Doubtful for more than 3 years (D3). What is the required provisioning rate?

1. 40% of the secured portion and all of the unsecured portion.
2. 25% of the secured portion and all of the unsecured portion.
3. all of the secured portion and all of the unsecured portion. (correct answer)
4. 15% of the total outstanding balance.

Answer: C — all of the secured portion and all of the unsecured portion.

Explanation. For a Doubtful asset that has remained in the doubtful category for more than 3 years (D3), the provision requirement is all of the secured portion plus all of the unsecured portion, effectively resulting in a full provision on the total outstanding.

Where it goes wrong. Students may confuse the D3 rate with the D2 rate (40% secured + full unsecured) or the D1 rate (25% secured + full unsecured).

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. An account has been overdue for 45 days. Under the Special Mention Account (SMA) framework, how should it be classified?

An account has been overdue for 45 days. Under the Special Mention Account (SMA) framework, how should it be classified?

1. SMA-0
2. Non-Performing Asset (NPA)
3. SMA-2
4. SMA-1 (correct answer)

Answer: D — SMA-1

Explanation. Under the RBI's SMA framework, SMA-1 applies to accounts with overdue between 31 to 60 days. SMA-0 is for overdue up to 30 days, SMA-2 is for overdue between 61 to 90 days, and NPA is for overdue exceeding 90 days. Since the overdue is 45 days, it falls under SMA-1.

Where it goes wrong. Students often confuse the SMA brackets (SMA-0: 1-30 days, SMA-1: 31-60 days, SMA-2: 61-90 days).

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. A loan is granted for a long-duration crop. The instalment is overdue for one crop season. How should this be classified?

A loan is granted for a long-duration crop. The instalment is overdue for one crop season. How should this be classified?

1. It should be classified as an NPA because the overdue period for long-duration crops is one crop season. (correct answer)
2. It should not be classified as an NPA because the overdue period must exceed two crop seasons.
3. It should be classified as SMA-2 until it crosses 90 days.
4. It should be classified as a Standard asset because agricultural loans are exempt from NPA norms.

Answer: A — It should be classified as an NPA because the overdue period for long-duration crops is one crop season.

Explanation. RBI norms specify that a loan granted for long-duration crops (crops with a season longer than one year) will be treated as an NPA if the instalment of principal or interest remains overdue for one crop season. Since the overdue period is one crop season, it correctly qualifies as an NPA.

Where it goes wrong. Students often mix up the two-crop-season rule (for short-duration crops) with the one-crop-season rule (for long-duration crops).

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. Which of the following is a key reporting requirement under the Long Form Audit Report (LFAR) for banks?

Which of the following is a key reporting requirement under the Long Form Audit Report (LFAR) for banks?

1. The auditor's opinion on the effectiveness of the bank's internal financial controls over financial reporting.
2. An assessment of the bank's credit appraisal systems, NPA classification, and adequacy of provisions for advances. (correct answer)
3. The adequacy of provisions made for taxes and the computation of deferred tax assets.
4. The number of board meetings held during the year and attendance details.

Answer: B — An assessment of the bank's credit appraisal systems, NPA classification, and adequacy of provisions for advances.

Explanation. The LFAR specifically requires auditors to report on various operational and regulatory aspects of the bank, including the adequacy of credit appraisal systems, the correctness of NPA classification, the adequacy of provisions, and compliance with RBI prudential norms. While IFCR is reported separately, LFAR focuses on these banking-specific operational areas.

Where it goes wrong. Students might select general company audit reporting items (like board meetings or tax provisions) instead of the bank-specific operational checks required in LFAR.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. When an advance is first classified as an NPA, what is the required accounting treatment for the interest accrued and credited to the income account in the previous year but not realized?

When an advance is first classified as an NPA, what is the required accounting treatment for the interest accrued and credited to the income account in the previous year but not realized?

1. It should be retained in the income account and disclosed as a contingent asset.
2. It should be transferred to a memorandum account and recognized as income on a cash basis.
3. It should be reversed or provided for, as it is no longer expected to be collected. (correct answer)
4. It should be capitalized by adding it to the principal outstanding balance.

Answer: C — It should be reversed or provided for, as it is no longer expected to be collected.

Explanation. When a credit facility is classified as non-performing for the first time, the interest accrued and credited to the income account in the corresponding previous year, which has not been realized, should be reversed or provided for. This prevents the overstatement of income and assets.

Where it goes wrong. Students may think the interest is simply moved to a memorandum account without reversing the income, missing the requirement to reverse or provide for it.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. An advance is assured by the Central Government, and the guarantee has not been invoked or repudiated. The loan is overdue for more than 90 days. How should it be treated?

An advance is assured by the Central Government, and the guarantee has not been invoked or repudiated. The loan is overdue for more than 90 days. How should it be treated?

1. Classified as an NPA for both provisioning and income recognition.
2. Classified as a Standard asset for both provisioning and income recognition.
3. Classified as an NPA for provisioning and treated as a Standard asset for income recognition.
4. Classified as a Standard asset for provisioning and treated as an NPA for income recognition. (correct answer)

Answer: D — Classified as a Standard asset for provisioning and treated as an NPA for income recognition.

Explanation. For Central Government assured advances where the guarantee is not invoked/repudiated, the advance is classified as a Standard Asset for provisioning purposes but is regarded as an NPA for income recognition. This means no provision is required, but accrued interest cannot be recognized until realized.

Where it goes wrong. Students often assume the government guarantee makes it fully standard, or they apply the State Government rule (where it is NPA for both).

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. An advance is assured by a State Government and is overdue for more than 90 days. What is the correct classification?

An advance is assured by a State Government and is overdue for more than 90 days. What is the correct classification?

1. NPA for both provisioning and income recognition. (correct answer)
2. Standard asset for both provisioning and income recognition.
3. Standard asset for provisioning and NPA for income recognition.
4. NPA for provisioning and standard for income recognition.

Answer: A — NPA for both provisioning and income recognition.

Explanation. Unlike Central Government guarantees, if an advance is assured by a State Government and remains overdue for more than 90 days, it is considered an NPA for both provisioning and income recognition purposes. The special exception only applies to Central Government guarantees.

Where it goes wrong. Students often apply the Central Government guarantee exception to State Government guarantees as well.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. The auditor notices a large credit entry in a cash credit account on 28th March, which reduces the outstanding balance, but a corresponding debit reverses the entry on 5th April. What is the primary concern for the auditor?

The auditor notices a large credit entry in a cash credit account on 28th March, which reduces the outstanding balance, but a corresponding debit reverses the entry on 5th April. What is the primary concern for the auditor?

1. The bank has not charged sufficient interest on the temporary credit.
2. The borrower is trying to 'window dress' the account to avoid NPA classification. (correct answer)
3. The borrower has engaged in fraudulent foreign exchange transactions.
4. The bank's cash management system has a technical glitch.

Answer: B — The borrower is trying to 'window dress' the account to avoid NPA classification.

Explanation. The RBI guidelines specifically state that asset classification of borrower accounts where a solitary or few credits are recorded just before the balance sheet date should be handled with care. Such transactions, followed by reversals after the year-end, indicate window dressing to prevent the account from slipping into the NPA category.

Where it goes wrong. Students may ignore the timing of the transactions and accept the year-end balance at face value, missing the red flag of window dressing.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. An asset is classified as a Loss Asset. Which of the following actions is most appropriate?

An asset is classified as a Loss Asset. Which of the following actions is most appropriate?

1. Make a full provision for the asset but continue accruing interest.
2. Make a 50% provision and write off the remaining balance in the next financial year.
3. Write off the asset entirely or make a full provision, as it is considered uncollectible. (correct answer)
4. Classify it as Doubtful D3 and apply a 40% provision on the secured portion.

Answer: C — Write off the asset entirely or make a full provision, as it is considered uncollectible.

Explanation. A Loss Asset is one where a loss has been identified by the bank, internal/external auditors, or RBI inspection, but the amount has not been written off wholly. It must be either written off or fully provided for (full provision). Continuing to accrue interest or applying partial provisions would violate RBI norms.

Where it goes wrong. Students may confuse Loss assets with Doubtful D3 and apply partial provisioning instead of the full full write-off or provision.

Authority. Banking Regulation Act 1949; RBI IRAC Norms

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

Scenario. During the audit of advances, the auditor finds that the bank has recognized interest on an NPA on an accrual basis. What is the correct course of action for the auditor?

During the audit of advances, the auditor finds that the bank has recognized interest on an NPA on an accrual basis. What is the correct course of action for the auditor?

1. Accept the practice as it adheres to the matching concept of accounting.
2. Classify the account as a Standard asset to justify the accrual of interest.
3. Report the issue only if it exceeds the materiality threshold for the branch.
4. Ask the bank to reverse the interest or provide for it, as income on NPAs should be recognized only on actual receipt. (correct answer)

Answer: D — Ask the bank to reverse the interest or provide for it, as income on NPAs should be recognized only on actual receipt.

Explanation. The policy of income recognition should be objective and based on the record of recovery. Income from NPAs is not recognized on an accrual basis but is booked as income only when it is actually received. The auditor must ensure that the bank reverses the accrued interest or makes an appropriate provision.

Where it goes wrong. Students often apply standard accrual accounting principles without considering the specific RBI override for NPAs, which requires cash basis recognition.

Authority. Banking Regulation Act 1949; RBI IRAC Norms