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UNIVERSITY OF MUMBAI

PROJECT ON

INCOME RECOGNITION & ASSETS CLASSIFICATION OF BANKING COMPANIES.

MASTER OF COMMERCE (ADVANCED ACCOUNTING)

SUBJECT: FINANCIAL ACCOUNTING

SEMESTER 1 2012-13

In Partial Fulfillment of the Requirement under Semester Based Credit

and Grading System for Post Graduates (PG)

Programe under Faculty of Commerce

SUBMITTED BY

KAKUBHAI EBRAHIM MANNAN

ROLL NO: 10

PROJECT GUIDE

MS. SHAMIM SAYED

K.P.B.Hinduja College of Commerce, 315 New Charni Road, Mumbai

400004.


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CERTIFICATE

This is to certity that Mr. KAKUBHAI EBRAHIM MANNAN of M.Com.

Advanced Accounting Semester 1st [2012 - 2013] has successfully

completed the project on Income Recognition & Assets Classification

of Banking Companies. under the guidance of Ms Shamim Sayed

Project Guide -----------------------

Course Coordinator -----------------------

Internal Examiner -----------------------

External Examiner -----------------------

Principal ------------------------

Date: ---------------------

Place: Mumbai


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DECLARATION

I Mr. Kakubhai Ebrahim Mannan the student of M.Com ( AdvanceAccounting) 1st

Semester ( 2012 2013 ), hereby declare that I have completed the project on

Income Recognition & Assets Classification Of Banking Companies.

The Information submitted is true and original to the best of my knowledge.

Kakubhai Ebrahim Mannan

(signature)


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ACKNOWLEDGEMENT

The pleasure that follows the successful completion of an assignment would

remain incomplete without a word of gratitude for the people without whose co-

operation the achievement would have remained a distant dream. So I would like

to intend my immense in debtless to all of them who have guided and motivated

me through my research project.

I sincerely thank to all for their valuable contribution without which this projectreport would have not reached its goal. .

My sincere thanks go to my supervisor Ms. Shamim Sayed under whose help

and guidance I could successfully complete my project.

I would also like to thank my faculty of Advanced Accounting , for grooming meto with stand the challenges of professional career.


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TABLE OF CONTENTS


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INTRODUCTION

As a major element of the Financial Sector Reforms in India, RBI introducedprudential norms for banking regulation. Capital adequacy, exposure ceilings

for lending to individual and group of borrowers, marking to market of the

investment portfolio and, income recognition, asset classification and

provisioning norms for the loan portfolio (IRAC in short) formed the core of

prudential regulation. The IRAC norms serve two primary purposes

(i) to depict the true position of a bank's loan portfolio and

(ii ) to help arrest its deterioration. The Committee on Financial System(CFS), under the Chairmanship of Shri M. Narasimham, recommended a

policy of income recognition and asset classification based on record of

recovery and other objective criteria as also provisioning based on the

classification of assets into different categories. RBI largely accepted the

recommendations of the CFS and introduced the IRAC norms for the Urban

Cooperative Banks (UCBs) in a phased manner over a three-year period fromthe year 1992-93.


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Income recognition

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(i) Effective from April 1, 1992, banks cannot consider as income interest on

loan accounts, classified as Non-Performing Assets (NPA), unless actually

received. Such un realised interest on NPA taken as income in the earlier year

has to be provided for. In other words, income from NPA is booked as income

only when actually received, and not on accrual basis.

(ii) Accrued interest on NPA

Banks should not debit to the borrowers accounts interest accrued on NPA, but

show them separately under "Interest Receivable Account" and a

corresponding amount under "Overdue Interest Reserve Account" on the

assets and liabilities side of the balance sheet respectively. (The amount held

in the Overdue Interest Reserve Account, however, cannot be regarded as a

"reserve" or as part of the owned funds of the Bank as it is not created out ofincome actually received by the bank).


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(iii) Accrued interest on performing assetsIn respect of loan accounts, classified as performing assets, accrued interest can

be debited to the

borrowers account and taken to income account. If the relevant credit facility

becomes NPA later, the

bank should provide for the interest accrued and credited to income account. In

such cases, while

making provision the amount held in "Overdue Interest Reserve Account" should

be deducted from the

advances outstanding.

(iv) Partial recovery of interestBanks can take partial recovery of interest on NPA to their income account,

provided such recovery

is not out of fresh / additional credit facilities sanctioned to the borrowers

concerned.

(iii) Accrued interest on performing assets

In respect of loan accounts, classified as performing assets, accrued interestcan be debited to the borrowers account and taken to income account. If

the relevant credit facility becomes NPA later, the bank should provide for

the interest accrued and credited to income account. In such cases, while

making provision the amount held in "Overdue Interest Reserve Account"

should be deducted from the advances outstanding.

(iv) Partial recovery of interest

Banks can take partial recovery of interest on NPA to their income account,

provided such recovery is not out of fresh / additional credit facilities

sanctioned to the borrowers concerned.


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Non-performing assets

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A credit facility is considered non-performing when it ceases to generate income

for the bank. Earlier, an asset was classified as NPA if interest and / or instalment

of principal remained past due for a specific period. Past due was replaced by

overdue with effect from the year ended March 31, 2001. Any dues to a bank

under a credit facility will be overdue if not paid by the due date fixed by the bank.RBI implemented the 90 days delinquency norm for NPA classification for the

UCBs from the year ended March 31, 2004. Given the heterogeneity of the sector,

RBI prescribed relaxed IRAC norms for smaller UCBs. Details of those

relaxations, together with relaxation in provisioning requirements, are in

the Annex. The criteria for treating a loan account as NPA depend on the nature offacility as under:


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(i) Term loan:A term loan is to be classified as NPA if interest and / or principal remained

overdue for more than 90 days.

(ii) Cash credit and overdraft account:A cash credit / overdraft account is classified as NPA if the account is out of

order for more than 90 days. An account is treated as out of order if the

balance outstanding is continuously in excess of the sanctioned limit or drawing

power (whichever is lower) or where the outstanding balance in the principaloperating account is within the sanctioned limit or drawing power, but there are

no credits continuously for 90 days as on the date of balance sheet, or creditsmade are not enough to cover the

interest debited during the same period.(iii) Bills purchased and discounted:

A bill is treated as NPA, if it remains overdue and unpaid for a period of more

than 90 days. Overdue interest should not be charged or taken to income

account in respect of overdue bills, unless it is realised.


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(iv) Other credit facilities:Any other credit facility is to be treated as NPA, if it remains outstanding for a

period of more than 90 days.

(v) Agricultural advances:In case of all direct agricultural advances, effective September 30, 2004 an

account should be treated as NPA if interest and / or installment of principal

remained overdue for two crop seasons from the due date for short duration

crops and one crop season from the due date for long duration crops. Long

duration crops have a crop season longer than one year and crops, which arenot long duration crops are treated as short duration crops. Depending upon

the duration of crops raised by a farmer, the above NPA norms would also be

applied to agricultural term loan availed of by him. The crop season for each

crop, which means the period up to harvesting, has to be decided by the State

Level Bankers Committee in each state. In respect of other activities like

horticulture, floriculture or allied activities such as animal husbandry, poultry

farming etc., NPA classification would be done on 90 days impairment norm asin the case of other advances.


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(v) Income recognition on investments classified as NPA

Investments also are subjected to prudential norms on income recognition. As

such, banks should not take to income interest on accrual basis in respect of

any security irrespective of the category in which it is included, where interest

/ principal in respect of which is in arrears for more than 90 days.

(vi) Others

Wherever the State Cooperative Societies Acts prescribe a more stringentaccounting procedure, the same should be followed. Further, where the bank

has a more stringent accounting procedure, it can continue to follow such a

procedure.


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Few exceptions

(a) Housing loans to staff members:Housing loans or similar advances granted to staff members, where interest is

payable after recovery of principal should be classified as NPA only when there

is a default in payment of interest on due date.

(b) Project finance:In the case of project finance, (industrial) where moratorium is allowed for

payment of interest / principal, the respective amounts will become due only

after moratorium / gestation period is over.

(c) Credit facilities guaranteed by GovernmentCredit facilities backed by Central Government guarantee, though overdue,

should not be treated as NPA. Therefore, no provision is required to be made

on such accounts. Interest on such advances, however, should not be taken to

income account unless it has been actually realised. From the year

ended March 31, 2006, State Government guaranteed advances and

investments in State Government guaranteed securities would attract extant

IRAC norms, if interest and / or principal or any other amount due to a bank

remains overdue for more than 90 days. A bank is not required to invoke the

guarantee

before classifying such advances / investments as NPA.


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(d) Advances against Term Deposits, NSCs etc.Advances against fixed and other term deposits, National Savings

Certificates (NSCs), life policies, Indira Vikas Patras (IVPs) and Kisan Vikas

Patras (KVPs) need not be treated as NPA although interest

thereon is not paid. Interest on such advances may be taken to incomeaccount on the due dates, provided adequate margin is available in the

accounts.

(e) Advances affected by natural calamityWhere natural calamities impair the repaying capacity of the agricultural

borrower, UCBs may consideri) converting the crop loan in to an agricultural term loan or rescheduling the

repayment period and

ii) sanctioning fresh short-term loans. In such cases, the term loan or the

fresh short-term loan will be treated as current dues and need not be

classified as NPA. Asset classification of these loans will be governed by the

revised terms and conditions and these would be classified as NPA as per

the extant norms applicable for classifying agricultural advances as NPA.


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Asset Classification

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In order to facilitate assessment of quality of the advances portfolio and to

enable them to make adequate provisions, the UCBs should classify loan

assets into the following categories.CATEGORY FEATURE

1 Standard Assets, which do not disclose any problem

and do not carry more than the normal risk

attached to the business. Such assets are notNPA.

2 Sub-standard Effective from year ended March 31, 2005,

assets are classified substandard if they

remain non-performing for less than or equal

to 12 months. They have well defined credit

weaknesses and are characterized by the

distinct possibility that the bank will sustain

some loss if the deficiencies are not rectified.


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An account, where the terms of loan

agreement relating to payment of interest and

repayment of principal have been negotiated or

rescheduled after commencement of

production, should be classified as sub-standard and retained as such for at least one

year of satisfactory performance under the

renegotiated terms.

3 Doubtful

Effective from year ended March 31, 2005,

assets are classified doubtful if they remain non-performing for more than 12 months.

They have all the weaknesses inherent in sub-

standard assets with the added characteristic

that collection or liquidation of the dues is highly

improbable. As in the case of sub-standard

asset, rescheduling does not entitle a bank toupgrade the quality of the account automatically.


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4 Loss These are assets where loss has been

identified by the bank or internal / external

auditors or RBI inspection, but the amount hasnot been written off, wholly or in part. Such

assets are considered uncollectible and of so

little value that their continuance as bankable

assets is not warranted, even though there

may be some salvage or recovery value.


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Guidelines for assetclassification

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Assets are to be classified generally on the basis of well-defined credit

weaknesses and the extent of dependence on collaterals for realization of

dues. Net worth of borrower / guarantor should not be taken into account while

determining whether an advance is NPA. Banks should bear in mind the

following

RBI guidelines for asset classification.

(i) Identification of assets as NPA on on-going basisBanks should identify assets as NPA on an on-going basis. They should evolve

a system to eliminate the tendency to delay or postpone identification of NPA,

particularly in respect of high-value accounts. They should internally resolve

doubts regarding asset classification within one month of the date bywhich the account would have been classified as NPA as per prescribed

norms.


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(ii) Treatment of accounts as NPA

a) Record of recoveryThe classification of an asset as NPA has to be done on the record of

recovery. Banks should not classify an account as non-performing due to

the existence of temporary deficiencies such as balance exceeding limit,

non-availability of adequate drawing power, non-submission of stock

statement or non-renewal of accounts on due date. If an account is

regularized before the balance sheet date by repayment of overdue

through genuine sources (not by sanction of additional facilities or transfer

of funds between accounts), the account need not be treated as

NPA. It should, however, be ensured that the account remains in ordersubsequently and a solitary credit made in the accounts near about the

balance sheet date to extinguish the overdue interest or installment

of principal is not reckoned as the sole criterion for treating the account as

a standard asset. In other genuine cases, banks must furnish to the

Statutory Auditor / RBI Inspecting Officer satisfactory

evidence of regularisation of the account.b) Borrower-wise and not facility-wiseWhere one credit facility extended to a borrower becomes NPA, all the

other facilities, even if the operations in those accounts are satisfactory,

are required to be treated as NPA.


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(iii) Potential threats to recovery

In respect of accounts where there are potential threats to recovery on accountof erosion in the value of security or existence of factors such as frauds

committed by borrowers, such accounts should be straightway classified as

doubtful or loss asset, as the case may be, irrespective of the period for which

they have remained as NPA. Similar treatment should be provided to accounts

where there is significant erosion in value of security, i. e. less than 50% of the

value assessed by the bank or accepted by RBI at the time of last inspection.

(iv) Classification as NPA for arrears in submission of stock statements

Outstanding in the account based on drawing power calculated from stock

statements older than three months would be considered as irregular. A

working capital account will be classified as NPA if such irregular drawings are

allowed for more than 90 days.


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(v) Classification as NPA for non-review or non-renewal of limits

An account where regular / ad-hoc credit limits are not reviewed or not

renewed within 90 days from the due date or date of ad-hoc sanction will be

classified as NPA.

(vi) Treatment of loss assets

If the realizable value of the security, as assessed by the bank or approved

value or RBI, is less than 10% of the outstanding in the borrowers account,

existence of security should be ignored and the account should be classifiedstraightway as a loss asset.

(vii) Classification of accounts under consortium

Asset classification of accounts under consortium will be done on the record

of recovery in individual banks. However, where remittances by the borrowerunder consortium lending arrangements are pooled with one bank, and that

bank does not part with the share of a member bank, the account in

the member bank will be treated as not having been serviced and will be

treated as NPA as per extant norms.


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Banking Non Performing Assets 23

(viii) Fixing realistic repayment schedules

UCBs should fix monthly / quarterly installments for repayment of gold

loans for non-agricultural purposes after taking in to account the incomegeneration pattern and repayment capacity of the borrower. Such gold

loans should be classified as NPA if interest and / or installment remain

overdue for more than 90 days. In case of gold loans for agricultural

purpose, interest has to be charged at yearly intervals as per the Supreme

Court judgement and payment should coincide with harvesting. Such

advances will be NPA only if installment and / or interest become overdueafter the due date.


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Provisioning

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(i) In conformity with prudential norms, UCBs should make provisions on the

NPAs based on classification of assets in to prescribed categories as detailed

in paragraph 4 above. Considering the time lag between an account becoming

doubtful of recovery, its recognition as such, the realisation of the security and

erosion in the value of security over time, banks are required to make

provisions as detailed below against loss, doubtful and sub-standard assets:


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Non Performing Assets 25


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ii) Provision on Standard Assets

UCBs were required to make a general provision of 0.25% on standard assets

from the year ended March 31, 2000. The general provisioning requirement

on standard assets, barring UCBs direct advance to agriculture and SMEsector, was raised to 0.40% in November 2005. In order to ensure

maintenance of asset quality in the context of high credit growth, RBI raised

the general provisioning requirement for UCBs on standard advances in

respect of personal loans, loans and advances qualifying as capital

market exposure and commercial real estate loans from 0.40% to 1.0% in

June 2006. Certain categories of loans continued to experience high growth;personal loans witnessed a higher default rate. Therefore, provisioning

requirement in respect of personal loans, loans and advances qualifying as

capital market exposure and commercial real estate loans (excluding

residential housing loans) was raised from 1% to 2% in February 2007.

Simultaneously, RBI decided to increase provisioning for loans and advances

to Non-Deposit Taking Systematically Important Non-Banking Finance

Companies (NBFC-ND-SI) from 0.40% to 2% (A systematically important

NBFC is defined as an Non-Deposit Taking NBFC with an asset size of

Rs.100.00 crore or more as per the last audited balance sheet). The standard

asset provisioning requirements for UCBs, after the above changes, stand as

summarized below:


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The provision towards standard assets need not be netted from gross

advances but should be shown separately as Contingent Provision towardsStandard Assets under Other Funds and Reserves in the Balance Sheet.

In case a bank is having provision in excess of what is required for non-

performing assets under Bad & Doubtful Debt Reserve (BDDR), additional

provision required for standard assets may be segregated from BDDR and

parked under Contingent Provision towards Standard Assets with

the approval of the Board of Directors. This contingent provision will beavailable for inclusion in Tier II capital.


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(iii) Guidelines for Provisions

a) Advances covered by DICGC / ECGC guarantee

In respect of advances guaranteed by ECGC/DICGC, provisioning is to bemade only for the balance exceeding the amount of guarantee. Further, while

arriving at the provision for Doubtful assets, realiable value of the securities

should be deducted from the outstanding balance before the

guarantee is set off

.

b) Additional facilities under rehabilitation packageIf under a rehabilitation package approved by BIFR / term lending institution,

banks allow additional credit facilities to a unit, which has been categorized as

sub-standard or doubtful, they need not make provisions for a period of one

year from the date of disbursement of such additional facilities. Similar

treatment should be made in respect of sick SSI units under a nursing

programe. However, banks should make provisions on existing credit facilities

classified as sub-standard or doubtful in both the cases.


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c) Certain advances exemptedAdvances against banks own term deposits, NSCs, KVPs, IVPs and life

policies are exempted from provisioning requirements. However,

advances against gold ornaments, government securities and all othersecurities attract provisioning.

d) Valuation of securityTo have uniform assessment of valuation of security and reduce

divergence in provisioning requirements, banks should undertake annual

stock audit of current assets by external agencies in respect of NPAs withbalance of Rs.10.00 lakh and above. Besides, immoveable property

charged to the bank should be valued once in three years by the banks

approved valuers.


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ANNEXRelaxed Prudential Norms on Asset Classification and

Provisioning for certain categories of UCBs

Unit banks i.e. banks having a single branch / Head Office with deposits up toRs.100 crore and banks having more than one branch within a single district

with deposits up to Rs.100 crore are exempted from the extant asset

classification and provisioning norms as under:


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Commercial Banking : NPAs


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Bank Credit (% to GDP)


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Bank Credit (% to GDP)


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Why Loan accounts go bad ?

BORROWER-SIDE Lack of Planning

Diversion of Funds

Disputes within

No contribution No modernisation

Improper monitoring

Industrial Relations..

Natural Calamities ...

BANKER SIDE Defective Sanction

No post-sanctionsupervision, etc

Delay in releases Directed lending

Slow decisionmaking process

Etc etc etc .


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Asset Classification 4 way - 1993

Standard Assets All regular loan accounts &

investments (Performing Assets)

Non-Performing Assets

1. Sub-Standard Assets

2. Doubtful Assets

3. Loss Assets

Performing Asset defined


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Performing Asset defined

An account (loan or investment) is

classified as Performing Asset if itdoes not disclose any problems andcarry more than normal riskattached to the business

All loan facilities which are regular !


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ASSET TYPE


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ASSET TYPE

STANDARD ASSET / PERFORMINGASSET

The account is not non-performing and doesnot carry more than the normal risk

attached to the business.

NON-PERFORMING ASSET (NPA)The asset ceases to generate income for thebank. (Para 2 of the Master Circular)

IDENTIFICATION OF NPA


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IDENTIFICATIONOFNPACash Credit / Overdrafts Account remains

out of order for 90days or more.

The account is treated as out oforder if :

* Outstanding Balance remains continuously inexcess of sanction limit/drawing power for 90days or more.

* No credit continuously for 90 days or more ason the date of Balance Sheet.

* Credits in the account are not sufficient to coverinterest debited during the same period.



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Term Loans Interest and/or instalmentremains overdue for 90days or more.

Bills Purchased and Bill remains overdue for 90Discounted days or more.

Agricultural Advances Interest and/or installment

remains overdue for twoharvest seasons for shortduration crop, one harvestseason for long durationcrop.

Others Any amount to be receivedremains overdue for 90 days

or more .

CLASSIFICATION NORMS


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Standard Asset

The account is not non-performing.

Sub-Standard AssetA sub standard Asset is one which has remained NPA

for a period less than or equal 12 months. (w.e.f.31st March 2005)

Loss Assets

These are accounts, identified by the bank or internal

or external auditors or by RBI Inspectors as whollyirrecoverable but the amount for which has not beenwritten off.



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CLASSIFICATIONNORMS

Doubtful Asset - Three Categories

Category Period

Doubtful - I up to One Year

Doubtful - II Up to Three Years

Doubtful - III More than Three Years

INCOME RECOGNITION


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INCOME RECOGNITION

Income RecognitionFor NPA accounts income should be recognised on realisation basis.

When an account becomes non-performing, unrealised interest of theprevious year to be derecognised/ reversed.

Adjustment of Recoveries - PriorityUnrealised Expenses

Unrealised Interest

Amount of Principal Outstanding

Clarification vide Master Circular - in the absence of clear agreement

between the Bank and the Borrower, an appropriate policy to befollowed in uniform and consistent manner.

DISCLOSURE


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DISCLOSURE

At Branch Level Auditor needs to report the compliance with IRAC norms of RBI with

respect to classification & provisioning for NPA and incomerecognition in Long Form Audit Report (LFAR) of the branch.

At Head Office Level Advances are disclosed net off NPA provisions & Interest

Suspense.

Accounting policy for classification, provisioning & incomerecognition need to be disclosed.

Disclosure needs to be made as required in terms of the guidelinesissued by the Reserve Bank of India in connection with Percentage

of Net NPAs to Net Advances, Provision for Standard Assets & NPAs,Movements in NPAs, Movement in Provision for NPAs.


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Developments in 2004


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p

Revised Definition of NPA to 90 Days

Banks managed to bring down NPAs < 3% SARFAESI Act, 2002 amended in Dec 2004

To set up Asset Reconstruction Companies

Take possession of secured assets of borrowers

Right to lease out, sell and realize such assets

Right to take over the management of borrowers

60 days notice by lenders is adequate

No appeal permissible unless borrowers deposit50% amount due and approach DRT / DRAT

NPAs in Banks : March 2005 (Rs in Cr)


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( )

Banks Total

Assets

Gross

NPAs

Net NPAs

Public(27)

16,76,847 46,380 16,135

Private(29) 4,25,802 8,715 4,038

Foreign(31)

IDBI Bank 81,360 1,216 848

Economic Times dt Jan 05, 2006


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Economic Times dt Jan 05, 2006

Bad Loans cross 16% of Indias GDP

ARCIL puts figure at Rs. 2,36,000 crores Says unlocking value from NPAs will help

banks meet additional capital requirements

Gr NPAs in financial sector Rs 1,11,000crores; Restructured Standard Assets Rs.27,000 crores; Corporate DebtRestructring Rs. 65,000 crores; BadLoans Written off by Banks Rs. 77,000 crs.

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