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A Hand Book On Statutory Bank Branch Audit - Rajkumar S. Adukia

Audit Procedures in bank

 

The auditor may perform the following procedures in bank audit: 

  1. Inspection and observation

  2. Inquiry and confirmation;

  3. Computation; and

  4. Analytical procedures.

They are discussed in detail  in the following paragraphs.

  1. Inspection and observation

Inspection consists of examining records, documents, or tangible assets. The auditor inspects in order to:

  • Be satisfied as to the physical existence of material negotiable assets that the bank holds; and

  • Obtain the necessary understanding of the terms and conditions of agreements (including master agreements) that are significant individually or in the aggregate in order to:

  • Consider their enforceability; and

  • Assess the appropriateness of the accounting treatment they have been given.

Examples of areas where inspection is used as an audit procedure are:

  • Securities;

  • Loan agreements;

  • Collateral; and

  • Commitment agreements, such as:

  • Asset sales and repurchases

  • Guarantees.

In carrying out inspection procedures, the auditor remains alert to the possibility that some of the assets the bank holds may be held on behalf of third parties rather than for the bank’s own benefit. The auditor considers whether adequate internal controls exist for the proper segregation of such assets from those that are the property of the bank and, where such assets are held, considers the implications for the financial statements.

  1. Inquiry and Confirmation

Inquiry consists of seeking information of knowledgeable persons inside or outside the entity.  Confirmation consists of the response to an inquiry to corroborate information contained in the accounting records. The auditor inquires and confirms in order to:

  • Obtain evidence of the operation of internal controls;

  • Obtain evidence of the recognition by the bank’s customers and counter parties of amounts, terms and conditions of certain transactions;

  • Obtain information not directly available from the bank’s accounting records.

A bank has significant amounts of monetary assets and liabilities, and of off balance- sheet commitments. External confirmation may an effective method of determining the existence and completeness of the amounts of assets and liabilities disclosed in the financial statements.

 

Examples of areas for which the auditor may use confirmation are:

  • Collateral.

  • Verifying or obtaining independent confirmation of, the value of assets and liabilities that are not traded or are traded only on over-the-counter markets.

  • Asset, liability and forward purchase and sale positions with customers and counter parties such as:

  • Outstanding derivative transactions;

  • Nostro and vostro account holders;

  • Securities held by third parties;

  • Loan accounts;

  • Deposit accounts;

  • Guarantees; and

  • Letters of credit.

  • Legal opinions on the validity of a bank’s claims.

  1. Computation

Computation consists of checking the arithmetical accuracy of source documents and accounting records or of performing independent calculations. In the context of the audit of a bank’s financial statements, computation is a useful procedure for checking the consistent application of valuation models.

  1. Analytical Procedures

Analytical procedures consist of the analysis of significant ratios and trends including the resulting investigation of fluctuations and relationships that are inconsistent with other relevant information or deviate from predicted amounts.

 

A bank invariably has individual assets (for example, loans and, possibly, investments) that are of such a size that the auditor considers them individually. However, for most items, analytical procedures may be effective for the following reasons.

  • Ordinarily two of the most important elements in the determination of a bank’s earnings are interest income and interest expense. These have direct relationships to interest bearing assets and interest bearing liabilities, respectively. To establish the reasonableness of these relationships, the auditor can examine the degree to which the reported income and expense vary from the amounts calculated on the basis of average balances outstanding and the bank’s stated rates during the year. This examination is ordinarily made in respect of the categories of assets and liabilities used by the bank in the management of its business. Such an examination could, for example, highlight the existence of significant amounts of non-performing loans or unrecorded deposits. In addition, the auditor may also consider the reasonableness of the bank’s stated rates to those prevailing in the market during the year for similar classes of loans and deposits. In the case of loan assets, evidence of rates charged or allowed above market rates may indicate the existence of excessive risk. In the case of deposit liabilities, such evidence may indicate liquidity or funding difficulties. Similarly, fee income, which is also a large component of a bank’s earnings, often bears a direct relationship to the volume of obligations on which the fees have been earned.
     

  • The accurate processing of the high volume of transactions entered into by a bank, and the auditor’s assessment of the bank’s internal controls, may benefit from the review of ratios and trends and of the extent to which they vary from previous periods, budgets and the results of other similar entities.
     

  • By using analytical procedures, the auditor may detect circumstances that call into question the appropriateness of the going concern assumption, such as undue concentration of risk in particular industries or geographic areas and potential exposure to interest rate, currency and maturity mismatches.

A useful starting point in considering appropriate analytical procedures is to consider what information and performance or risk indicators management use in monitoring the bank’s activities.

Examples of the most frequently used ratios in the banking industry.

There are a large number of financial ratios that are used to analyze a bank’s financial condition and performance. While these ratios vary somewhat between banks, their basic purpose tends to remain the same, that is, to provide measures of performance in relation to prior years, to budget and to other banks. The auditor considers the ratios obtained by one bank in the context of similar ratios achieved by other banks for which the auditor has, or may obtain, sufficient information.

 

These ratios generally fall into the following categories:

  • Asset quality;

  • Liquidity;

  • Earnings;

  • Capital adequacy;

  • Market risk; and

  • Funding risk.

Many other, more detailed ratios are ordinarily prepared by management to assist in the analysis of the condition and performance of the bank and its various categories of assets and liabilities, departments and market segments.

  1. Asset quality ratios:

  • Loan losses to total loans

  • Non-performing loans to total loans

  • Loan loss provisions to non-performing loans

  • Earnings coverage to loan losses

  • Increase in loan loss provisions to gross income

  • Size, credit risk concentration, provisioning

  1. Liquidity ratios:

  • Cash and liquid securities (for example, those due within 30 days) to total assets

  • Cash, liquid securities and highly marketable securities to total assets

  • Inter-bank and money market deposit liabilities to total assets

  1. Earnings ratios:

  • Return on average total assets

  • Return on average total equity

  • Net interest margin as a percentage of average total assets and average earning assets

  • Interest income as a percentage of average interest bearing assets

  • Interest expense as a percentage of average interest bearing liabilities

  • Non-interest income as a percentage of average commitments

  • Non-interest income as a percentage of average total assets

  • Non-interest expense as a percentage of average total assets

  • Non-interest expense as a percentage of operating income

  1. Capital adequacy ratios:

  • Equity as a percentage of total assets

  • Tier 1 capital as a percentage of risk-weighted assets

  • Total capital as a percentage of risk-weighted assets

  1. Market risk:

  • Concentration of risk of particular industries or geographic areas

  • Value at risk

  • Gap and duration analysis (basically a maturity analysis and the effect of changes in interest rates on the bank’s earnings or own funds)

  • Relative size of engagements and liabilities

  • Effect of changes in interest rates on the bank’s earnings or own funds

  1. Funding risk:

  • Clients’ funding to total funding (clients’ plus inter bank)

  • Maturities

  • Average borrowing rateT

Other Pages from This e-book

HISTORY OF BANKING | TYPES OF BANKS AND BANKING ACTIVITIES | GLOSSARY OF TERMS USED IN BANKS | Bank audit process  | PROVISIONS RELATING TO AUDITOR | LETTERS SEEKING INFORMATION | LAWS APPLICABLE TO BANK | ACCOUNTING SYSTEM IN BANKS | Banking Softwares | GENERAL INTERNAL CONTROL IN BANKS | INTERNAL CONTROLS IN AN EDP ENVIRONMENT | Asset Classification Income Recognition and Provisioning | FOREIGN EXCHANGE TRANSACTIONS | SALIENT FEATURES OF JILANI, GHOSH |  COMMITTEES AND LFAR | Audit Planning  | Audit Procedures in bank | CHECKLISTS | DOCUMENTS TO BE TAKEN FROM MANAGEMENT | MANAGEMENT REPRESENTATION LETTERS | BANK BRANCH AUDIT REPORTS | DISCLOSURES MANDATED BY RBI IN NOTES TO ACCOUNTS | ANNEXURE A | ANNEXURE B | ANNEXURE C | ANNEXURE D | ANNEXURE E | About the Author