Bank Branch IRAC Review: NPA Classification, Provisioning and Income Recognition
The Jeewan branch of a scheduled commercial bank is finalising its figures for 31 March 20X5. Two accounts are under scrutiny.
M/s Trilok Steel holds a cash credit limit of ₹1,20,00,000; the outstanding is ₹96,00,000. Principal has been overdue since 15 November 20X4 and the account has not been operated for eleven months. Interest of ₹7,40,000 debited during the year remains unpaid. Stock hypothecated is valued at ₹70,00,000 but is expected to realise only ₹52,00,000; a collateral flat worth ₹45,00,000 may realise ₹38,00,000. The branch manager has kept the account 'standard' because the promoter has promised to pay by June, has taken the entire ₹7,40,000 of interest to income, and has made no provision, proposing instead to net any provision against the advance in the balance sheet.
Mr Rao's term loan shows ₹18,00,000 outstanding and has been an NPA for fourteen months; the realisable value of the security is ₹6,00,000. Standard advances of the branch total ₹8,00,00,000, against which a general provision of ₹2,50,000 is already held.
1. Classify both accounts as on 31 March 20X5 and compute the provisioning required, including the general provision on standard advances.
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Trilok Steel. The account became an NPA 90 days after the due date of 15 November 20X4, i.e. on 13 February 20X5, so it is an NPA on the reporting date. The promoter's promise is irrelevant - classification follows the record of recovery, not assurances. Age of NPA is under 12 months, so it is substandard. Provision: 15% of the total outstanding, with no deduction for the realisable value of security or guarantees - 96,00,000 × 15% = ₹14,40,000.
Mr Rao. NPA for fourteen months: substandard for the first twelve months, then doubtful - up to one year (25%). For doubtful assets, the realisable value of security is deducted first, using realistic values and applying the bank's haircut: (18,00,000 − 6,00,000) × 25% = ₹3,00,000.
Standard advances. General provision at 0.40% of ₹8,00,00,000 = ₹3,20,000; already held ₹2,50,000, so a further ₹70,000 is required.
Total additional provision = 14,40,000 + 3,00,000 + 70,000 = ₹18,10,000.
Note the asymmetry, which is the point of the exercise: for substandard assets security is not deducted, but for doubtful assets it is - so a bank cannot improve its provisioning by reclassifying an ageing account downward, nor by claiming security is ample while it remains substandard.
2. Advise on the income recognition and balance sheet presentation issues raised by the branch manager.
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Interest income. On an NPA, income is recognised on realisation, not on accrual. The ₹7,40,000 debited to the borrower's account and taken to income must be reversed - debit interest income, credit the customer account (or park it in an interest-suspense account). Income for the year falls by ₹7,40,000. Future interest on the account is credited to income only when actually received. This is not a departure from accrual; it is accrual correctly applied, because where recovery is doubtful there is no accrued asset.
No netting. The ₹14,40,000 provision cannot be deducted from the advance. Advances are shown gross in Schedule 9 and provisions in Schedule 12, 'Other liabilities and provisions'. Netting would understate both the bank's assets and its risk and would distort the capital adequacy calculation.
Aggregate effect. Provision ₹18,10,000 plus reversal of interest ₹7,40,000 = ₹25,50,000 charged against the branch's result before tax. The branch should also confirm that the ₹7,40,000 has not already been capitalised into the outstanding, since that would overstate both the advance and the loss.
Audit angle. Under the statutory audit and the long-form audit report, the auditor must report on compliance with RBI prudential norms. The branch's file should record the classification, the computation and the reason for the classification - the manager's contrary view, if unsupported, is a reportable matter.
3. The branch manager proposes to upgrade the Trilok Steel account in July once the borrower pays ₹15,00,000. Advise when an NPA may be upgraded and how the payment should be applied.
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An account is upgraded from NPA to standard only when the entire arrears of interest and principal have been paid. Partial payment, a fresh sanction, a restructuring, or a promise to pay is not sufficient. A payment of ₹15,00,000 in July would clear part of the overdue principal but leave both the balance of arrears and the unpaid interest of ₹7,40,000; the account must therefore stay substandard.
Application of the payment. The bank's stated appropriation policy governs, and for cash credit accounts it normally applies recoveries first to charges and expenses, then to interest, then to principal. On that basis the ₹15,00,000 would first clear the suspended interest, and only the residue would reduce principal - so the outstanding principal falls by roughly ₹7,60,000 and the account remains an NPA. The branch cannot treat the receipt as principal repayment to force the numbers down.
Upgradation policy. Even once all arrears are cleared, RBI norms require no record of default, and prudent practice is to keep the higher provision until the account has performed for a defined period (commonly two to three quarters) before writing it back. Any write-back is a policy decision, not an automatic consequence of a single receipt.
Documentation. Record in the audit file the classification, the provision, the amount received, the appropriation made, and the reason for not upgrading, so that the position can be defended at the next inspection.