Bank accounts — certain recent trends

THANKS TO the committee set up with representatives from the Reserve Bank of India and the Institute of Chartered Accountants of India (ICAI) as members, many of the problems in the adoption of certain Accounting Standards in banking were sorted out last April. There are yet some issues / aspects that require attention. Making this committee a permanent body may not be a bad idea to take care of issues that may arise in the days to come.

Even in the clarifications issued in an RBI circular in April, there has been some confusion among members of the ICAI as to whether the institute mandates them to follow the clarifications given. This has arisen because though the ICAI published the circular in its magazine, it did not put forth its views plainly on the matter, leaving the members to second guess. This perhaps was the reason why many financial statements of banks carried qualifications relating to those Accounting Standards. Hence for a start, it would be better for the ICAI to make things distinctly clear on its stand regarding the issues already purportedly sorted out.

Differences arise between the regulator and members of the audit fraternity, more because of their respective goals - safety in the case of the regulator and adherence to accounting practices on the part of the auditors. On disclosures, perhaps, both have no qualms. Take the case of the current practice in many banks of building up, what they call, `floating provisions', that is, provisions not related to specific advances, to guard against possible loan losses. The regulator encourages this practice from the angle of safety.

Floating Provisions

The RBI has this to say on `floating provisions'. "Some of the banks make a `floating provision' over and above the specific provisions made in respect of accounts identified as NPAs. The floating provisions, wherever applicable, could be set off against provisions required to be made as per the above stated provisioning guidelines.

Considering that higher loan loss provisioning adds to the overall financial strengths of the banks and the stability of the financial sector, banks are urged to voluntarily set apart provisions much above the minimum levels as a desired practice". Banks have gleefully adopted this practice as it brings down the percentage of net non performing assets substantially.

The audit fraternity, on the other hand, is not amused. As per basic accounting, any provision in excess of what is required takes the character of a reserve. While a provision is a charge on profits, reserves are built as appropriations from post tax profits. But they do not merely remain an accounting sleight of hand. They invariably lead to what is infamously called as `cookie jar accounting'.

The managements of banks, to even out spikes in their performance or to reach targeted profits, dip into these floating provisions time and again to meet their specific loan loss provisioning. Thus the actual performance of a bank does not get revealed and an investor is led to believe in a performance level that is different from reality.

The Security and Exchange Commission (SEC) of the U.S. frowns on this practice of `cookie jar accounting' to even out spikes between two periods — whether quarters or years — and has initiated enquiries in several cases. However, the regulator in India has given its support more from the angle of safety.

If the RBI is convinced of the need to create floating provisions, it should also ensure that such provisions once created stay as such and re not used to set off specific loan loss provisions required during the year.

Uniformity in notes and disclosures

Secondly, there is news in the air that the regulator is reviewing the format of financial statements so as to bring in some uniformity in the notes and disclosures as well. While on this job, it would do well to dwell upon a couple of aspects.

Funds borrowed to support Tier II Capital as subordinated debt are inexplicably required to be disclosed under `Other Liabilities and Provisions' and not under "Borrowings". Perhaps as a counterbalance, `Nostro' balances that are in credit due to effects pending clearance in banks' books, are required to be shown as "Borrowings" and that too from outside India (Interestingly it has the ICAI's sanction as well). In short, specific borrowings get classified as `other liabilities' while balances which go into credit in a transitional period end up being shown as borrowings. A rethink is necessary and if the regulator has a specific reason for the current style of treatment, it may be made explicit.

Guidance notes

The ICAI on its part needs to make it clear to its members as to the status of the guidance note issued by it on the audit of banks. In the material issued on Peer Review, members are asked to give a high priority to the guidance note. Having done so, the guidance note should provide clear cut pathways. For example, while reckoning income on investments under `Held for Trading' category as of a cut off date, say the year end, banks book income on accrual basis up to the date of cut off. They also value those investments as per the market rate. Investments classified under `Held for Trading' category are those which the banks expect to dispose of within 90 days from the date of such classification.

The guidance note argues that since the intention of the bank is not to hold on to those investments till the date of actual servicing of interest on the due date, there is an uncertainty that surrounds the actual receipt of interest accrued up to the balance sheet date and hence reckoning the interest on accrual basis will be in violation of Accounting Standard 9 (Revenue recognition). The guidance note fails to appreciate that the uncertainty referred to in AS-9 is in relation to the ability of the issuer of such bonds/ securities in servicing the interest and the probability of the holder disposing of such assets before the date when interest on them falls due is certainly not one of them.

Uncertainties referred to in AS-9 are cases where

(I) It is unreasonable to expect ultimate collection;

(ii) Uncertainty relating to collectability arises after the time of rendering the service;

(iii) Consideration is not determinable;

(iv) It is difficult to assess ultimate collection with reasonable certainty.

None of these look at the transaction from the angle of the receiver of the income disposing of the asset on hand.

Further, categorising investments under the HFT category is not sacrosanct and the board can reclassify them under the Available for Sale (AFS) category or under Held to Maturity (HTM), of course after following the necessary procedure. The guidance note does not really "guide" the members further on this matter. Coming to investments under the AFS category, the guidance note argues that the market rates factor in the interest accrual too and therefore reckoning income on accrual up to the balance sheet date and valuing them at market rates will amount to inflating the income to an extent. The truth is that market rate depends on a number of factors and it will be just difficult to assess as to how much of the interest accrued influences the market.

There are cases where even after the add on of the interest accrued, the market value falls short. In any case, over a period of time these spikes get evened out and splitting hairs does not provide any solution. Interestingly none of the financial statements of banks so far have carried any remark on this count from the audit fraternity, a few of whom should have had a hand in the preparation of the guidance note as well.

The guidance note further points out certain accounting treatments recommended by the regulator that are against accepted accounting principles. The aspects referred to here are:

Non-inclusion of incidental charges such as brokerage in the cost of investment classified under `Available for Sale' and `Held to Maturity' categories;

Non-recognition of decline other than permanent in the valuation of investments under Held to Maturity category;

Charging of broken period interest up to the date of acquisition to the profit and loss account. But unfortunately, the guidance note does not indicate as to what should be done in such circumstances.

So, before the next fiscal year end, one expects these matters to be sorted out so that banks and auditors can rest easy and focus on the job on hand more fruitfully.

"Even when the experts all agree, they may well be mistaken." - Bertrand Russell

P. S. V. Chari & P. S. Narasimhan

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