Examination of Accounting and Valuation
Investments in securities now-a-days constitute a substantial part of total assets of many banks. Method of valuation of investments followed by a bank may, therefore, have a significant effect on its balance sheet and profit and loss account. The auditor should examine whether the method of accounting followed by the bank in respect of investments, including their yearend valuation, is appropriate, consistent and in conformity to RBI guidelines as laid down in the Master Circular.
The auditor should examine the appropriateness of accounting policies followed by the bank. In case any of the accounting policies are not appropriate, the auditor should consider the effect of adoption of such policy on the financial statements and, consequently, on his audit report. In this regard, it may be noted that Accounting Standard (AS) 13, “Accounting for Investments”, does not apply to banks.
According to RBI guidelines, in respect of shares which are unquoted or for which current quotations are not available, the market value has to be determined on the basis of break-up value (excluding Revaluation Reserves, if any) as per the latest balance sheet of the company (which should not be more than 18 months prior to the date of valuation). This might create a problem in the case of new companies whose first annual reports are not yet available. It appears that in such a situation, it would be appropriate to value the shares at cost except where the evidence available indicates the deterioration in the value.
RBI guidelines require that individual scrip in the available-for-sale (‘AFS’) category should be marked to market at quarterly or more frequent intervals. It is further required that net depreciation in respect of each of the categories in which investments are presented in the balance sheet should be provided for and net appreciation should be ignored. As regards the scrips in Held for Trading (HFT) category, the same should be marked to market at monthly or at more frequent intervals in the similar manner, except in the following cases:
i) Equity shares should be marked to market preferably on daily basis, but at least on a weekly basis;
ii) Banks which undertake short sale transactions, the entire HFT portfolio including the short position should be marked to market on daily basis.
The book value of the individual script would not undergo any change after mark to market exercise is conducted at the balance sheet date.
It is pertinent to note that though intra-category netting off of depreciation and appreciation is permitted, the same (netting off) is not permitted inter-category. The provision for depreciation would be made on anaggregate basis for HFT and AFS category separately without changing thebook value of individual scrips.
As regards the investments in HTM category, the same need not be marked to market except in case wherein the diminution in the value is other than temporary in nature or impairment of the investments due to specified circumstances. As regards the other HTM securities, if the acquisition cost / book value is more than face value, the premium should be amortised over the period of residual maturity period using constant yield method or straight line method.
In determining the market value of debt securities under HFT and AFS categories, interest accrued up to the balance sheet date should be reduced from the market price, if the market price includes the accrued interest, to avoid its double counting of interest – first as accrued interest and secondly as a part of market value.
The auditor should examine the process of valuation followed by the Bank and perform checks to examine that the market rates taken by the bank for valuation of investment securities are in accordance with the RBI guidelines. The auditor should also examine the accounting entries passed for marked to market depreciation, to ascertain, whether RBI guidelines pertaining to inter-category netting off are followed. Further, the auditor should include investment from each class of investment in its sampling technique in accordance with SA 530 “Audit Sampling “so as to ensure that the valuation policy of all classes of investments gets validated. Audit sampling can be applied using an either statistical or non statistical sampling approach which is a matter of auditor’s judgment. Particular focus should be on investments which involve management judgment or are not simple rule based valuations (preference shares and pass through certificates). While the auditor checks the valuation of investment securities across products in line with RBI prescribed methodology, they should also carefully focus on assessing the appropriateness of inputs used in various valuation models / formulae. This would include a check of:
Use of appropriate cash flows (for instruments such as PTCs)
Use of appropriate risk free rates (depending on maturity of instrument)
Use of appropriate risk spreads
Use of appropriate ‘ratings’ for bonds
Receipt of dividend (for preference shares)
Validity of various inputs like call/put option date, redemption premium, staggered redemption, etc
Arithmetical accuracy of a valuation (using ‘re-performance’ technique)
In case of banks which have automated means of valuing the investments (for example, system computes values), the auditor should also check system controls and if deemed necessary, consider involving an expert to check the integrity of system logic (to avoid, ‘garbage in garbage out’ kind of output).
In case the bank does not have automated means of valuation of investments (for example, valuation is computed over excel spreadsheets), the auditor should check end user computing controls over such spreadsheet usage. This would include a check of access controls over such files, change management controls, etc. This would help auditor conclude that the files for valuation of investments are not manipulated. This can also be classified as an anti-fraud control.
The auditor should examine whether the profit or loss on sale of investments has been computed properly. The carrying amount of investments disposed off should be determined consistently on similar basis. In case of HTM investments, Net Profit on sale of investments in this category should be first taken to the Profit & Loss Account, and thereafter be appropriated to the ‘Capital Reserve Account’ net of taxes and Net Loss will be recognised in the Profit & Loss Account.
The classification of investments into held-to-maturity, held-for-trading and available-for-sale categories is based on the intention with which the respective investments have been acquired by the bank. The auditor should examine whether the investments have been properly classified into the three categories at the time of acquisition based on such intention as evidenced by dealers’ pad or equivalent, along with reference to the decision of the competent authority such as Board of directors, ALCO or Investment
Committee.
As per RBI guidelines, investments classified under held-for-trading category should be sold within 90 days of their acquisition, failing which they should be shifted to the available-for-sale-category. The auditor should accordingly ascertain that no investments purchased more than 89 days before the balance sheet date have been classified under this category.
In respect of debt securities, interest accrued upto the balance sheet date is usually recognised as income in the profit and loss account. One of the essential conditions for accrual of income is that it should not be unreasonable to expect ultimate collection thereof.
A change in the method of valuation of investments constitutes a change in accounting policy and adequate disclosure regarding the fact of the change along with its financial effect should be made in the balance sheet.
If the valuation of Investment is outsourced to an agency, certain audit procedures would need to be applied at such processing agency also.
Some of the typical audit procedures would include:
obtaining list of investment as at reporting period from Bank and ascertaining completeness of the same by reconciliation process as highlighted above.
checking the carrying amount of investments and ensuring that same is calculated on consistent basis. This is normally calculated by system, hence need to check IT controls and calculation on sample basis for ensuring accuracy.
In case quotes are available, checking source of capturing market price/ fair value as at reporting date.
In case quotes are not available, checking calculation for fair value as at reporting date to ensure compliance with RBI guidelines.
checking calculation of Marked to Market Gain/ loss and accounting for same in compliance with RBI guidelines.