13

Accounts of Banking Companies

Accounting procedure for banking companies differs from those of other joint stock companies. Despite the fact that banking companies are incorporated under the Companies Act, 1956, they have to strictly comply with the provisions of The Banking Regulations Act, 1949. In addition, the banking companies will have to adhere to the norms and guidelines issued by the Reserve Bank of India (RBI Act 1934). One has to understand all the important statutory provisions of these acts in order to prepare final accounts of banking companies. In this chapter, all such salient features have been discussed in detail and accounting procedure is explained in various illustrations.

13.1 DEFINITION AND MEANING OF BANK, BANKING AND BANKING COMPANY

Bank: In its broadest sense, the term “bank” is used to refer any institution, which is engaged in carrying on certain kinds of financial business. It may be defined as follows: “A bank is an organization that holds money, important documents and other valuables in safe keeping and the money being paid out on the customer’s order/request.” A bank deals with money. It acts in the same way as a trader buys and sells goods at a profit. It is involved in financial trading activities.

Banking: The Banking Regulation Act, 1949 [Section 5(b)] defines banking as, “accepting for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawals by cheque, draft or otherwise”.

Banking company: As per Section 5(c) of the Banking Regulation Act, banking company means any company, which transacts the business of banking in India.

13.2 FORMS OF BUSINESS OF BANKING COMPANIES

According to Section 6 of the Banking Regulation Act, a bank, in addition to banking business, may indulge in the forms of business, which are listed as follows:

1. Borrowing, raising or taking up money.
2. Lending or advancing money.
3. Drawing, making, accepting, discounting, buying, selling, collecting and dealing with bills of exchange, hundis, promissory notes and other instruments.
4. Granting and issuing of letters of credit, travellers’ cheques and circular notes.
5. Buying, selling and dealing with bullion.
6. Buying and selling, on commission, and underwriting and dealing with stock, shares, debentures, bonds, etc.
7. Receiving all kinds of scripts or valuables on deposit for safe custody.
8. Providing safe deposit vaults.
9. Collecting and transmitting money and securities.
10. Carrying on and transacting every kind of guarantee and indemnity business.
11. Undertaking and executing trusts.
12. Undertaking the administration of estates as executor, trustee or otherwise.
13. Contracting for public and private loans and negotiating and issuing the same.
14. Selling, improving, managing, developing, exchanging, leasing, mortgaging, disposing of or turning into accounts or otherwise dealing with all or any part of the property and rights of the company.
15. Doing all such things, which are incidental or conductive to the promotion or advancement of the business of the company.
16. Any other form of business, which the Central Government may, by notification in the “Official Gazette”, specify as a form of business in which it is for a banking company to engage.
17. Acquiring and undertaking the whole or any part of the business of any person or a company when such business is of a nature enumerated or described in this sub-section.

No banking company shall engage in any form of business other than those mentioned above, as per Section 6(2) of the Banking Regulation Act, 1949.

13.3 CLASSIFICATION OF COMMERCIAL BANKS

Commercial banks are classified into two: (1) scheduled banks and (2) other banks.

Scheduled bank: A scheduled bank is one which is included in the second schedule of Reserve Bank of India Act, 1934. A scheduled bank should comply with the following terms:

1. It must have paid-up capital and reserves as specified in the table below.
2. The activities to be carried out should not be detrimental to the interests of the depositors.
3. It should be incorporated under the Companies Act, 1956, that is, it should not be the sole trader for a partnership firm of business organization.

13.3.1 Minimum Paid-up Capital and Reserves

According to Section 11 of the Banking Regulations Act, the minimum limits of paid-up capital and reserve to be completed by a banking company are explained in the following table:

13.4 IMPORTANT LEGAL PROVISIONS OF BANKING REGULATION ACT 1949

Important legal provisions of Banking Regulation Act, 1949 are as follows:

1. Trading restrictions: As per Section 8, a banking company cannot directly or indirectly deal with the business of buying or selling or bartering of goods, except in connection with the realization of security given to or held by it or engage in any trade or buy, sell or barter goods for others otherwise than in connection with bills of exchange received for collection or negotiation or for the administration of estates as executor, trustee or otherwise.
2. Non-banking assets: In case of a failure of a debtor to repay the loan within the stipulated period, the bank can take possession of such assets mortgaged. As per Section 9, a banking company cannot hold any immovable property, however acquired, except for its own use, for any period exceeding 7 years from the date of acquisition there of. The gain or loss on the sale of such assets should be shown in the P & L A/c of the banking company separately.
3. Authorized capital, subscribed capital and paid-up capital:

   As per Section 12,

   1. The subscribed capital of a banking company must not be less than half (50%) of its authorized capital.
   2. Its paid-up capital must not be less than half (50%) of its subscribed capital.
   3. The share capital of a banking company should comprise of only equity or ordinary shares and such preference shares, which have been issued prior to 1 July 1944.
   4. The voting right of a shareholder on poll in respect of any shares held by him is limited to 10% of the total voting rights of all the shareholders of the company (w.e.f. 31 January 1994).
4. Payment of commission, brokerage, etc.:

   According to Section 13, a banking company cannot pay out directly or indirectly any commission, brokerage, discount or remuneration in any form in respect of any shares issued by it, exceeding 2½% of the paid-up value of the shares.

5. Charge on uncalled capital: As per Section 14, a banking company cannot create any charge on unpaid capital. Any such charge is null and void.

   According Section 14A, a banking company cannot create a floating charge on the undertaking or any property of the bank except with the written permission of the RBI certifying that the charge will not be detrimental to the interest of the depositors.

6. Payment of dividend: According to Section 15, a banking company cannot make payment of dividend until all of its capitalized expenses are completely written off. Payment of dividend out of profits is not proper when capitalized expenses are outstanding. Preliminary expenses, organization expenses, share-selling commission, brokerage, amounts of losses incurred and any expenditure not represented by tangible assets are examples for capitalized expenses.

   A banking company, however, may pay dividends on its shares without writing off the following:

   1. Depreciation in the value of its investments in approved securities where such depreciation has not been actually capitalized or otherwise accounted for as loss.
   2. Depreciation in the value of its investment in other than approved securities where adequate provision has been made to the satisfaction of the auditors of the company.
   3. Bad debts, if any, where adequate provision has been made.
7. Statutory reserve fund: According to Section 17, every banking company incorporated in India should create a reserve fund and transfer at least 20% of its profit to such reserve funds before any dividend is declared.

   According to RBI direction, every bank has to transfer 25% of the net profits to statutory reserve.

8. Cash reserves: Under Section 18, every non-scheduled bank shall maintain a cash reserve with itself or with RBI, a sum equivalent to at least 3% of its total time and demand liabilities in India on the last Friday of the second preceding fortnight and shall submit to the RBI before 20th day of every month a return showing the amount so held on alternate Fridays during a month with particulars of its demand and time liabilities in India on such Fridays or if any such Friday is a public holiday, at the close of the business on the preceding working day. From June 1994, banks are required to maintain with RBI a uniform average daily balance (cash reserve) of 15% of their entire net demand and time liabilities.

   It is important to note that from 22 June 2006 the RBI can prescribe the cash reserve ratio (CRR) for scheduled commercial banks without any ceiling rate. Hence, the statutory minimum CRR of 3% of the total demand and time liabilities no longer exist.

   At present CRR is 6% w.e.f. December 2010.

9. Liquidity requirements: As per the amendment envisaged to Section 24 by the Banking Regulation (Amendment) Act, 2007, effective from 2007, the RBI can prescribe the statutory liquidity ratio (SLR) for scheduled commercial banks in specified assets. The value of such assets of a scheduled commercial bank shall not be less than such a percentage not exceeding 40% of its total demand and time liabilities. The RBI can specify this norm from time to time. At present, the norm for SLR as per RBI is 24% from December 2010.

Any banking company, scheduled or non-scheduled, is required to maintain cash, gold or unencumbered approved securities, which is not less than 25% of the total of its time and demand liabilities in India. This is also referred to “statutory liquidity ratio” (SLR).

Prescribed form: Under Sections 29–33 of the Banking Regulation Act, every banking company is required to prepare a balance sheet in accordance with Form A set out in the Third Schedule of the said Act and a P & L A/c in conformity with Form 15 of the same schedule. The formats have been revised with effect from 1 April 1991.

Accounting year: A banking company has to close its account on 31 March every year, i.e. the accounting year commences on 1 April and closes on 31 March next year.

Loans and advances: There are certain restrictions on the loans granted by banks to persons associated with their management. As per Section 20, the restrictions are as follows:

1. A banking company cannot grant loans and advances on the security of its own shares.
2. It should not grant any loan or advance to:
   1. Any of its directors.
   2. A firm in which any of its directors is interested as a partner, manager, or employee.
   3. Any company of which any of the directors of the banking company is a director, manager or guarantor.
   4. Any individual with whom any of its directors is a partner or a guarantor.

13.4.1 Unclaimed Deposits

Banking companies must submit the details regarding all the accounts, which could not be operated for 10 years. At the end of each calendar year, it should be submitted in the prescribed form to RBI. In case of fixed deposits, the said term of 10 years must be reckoned from the date of expiry (maturity) of such fixed deposit.

Limits as to investments in shares and debentures: RBI has removed the limits on investments made by the banks in the equity and debenture issues of 17 financial institutions such as LIC, UTI, IDBI, ICICI, IRBI and so on.

13.5 PRINCIPAL BOOKS OF ACCOUNTS

In order to understand the working of a bank, certain principal books of accounts have to be explained. The following are some of them:

13.5.1 Cash Book

The main activity of a bank is the transaction of money. Every transaction in cash should be entered in a book called cash book. Usually, a bank maintains two cash books: one is for receiving cash and the other is for paying cash. Receiving cashier records the following:

1. Serial number
2. Name of the depositor
3. The amount received

When a client deposits money, he pays it along with the duly filled in paying-in-slip. The cashier (receiving cashier) receives money and returns the counterfoil of the paying-in-slip to the client after signing and stamping it.

When payment is made, the paying cashier receives a token from the client given to him by another bank staff to whom the client gives the cheque/withdrawal slip to withdrawl the amount from his account. The paying cashier records the following in the cash book maintained by him:

1. Serial number
2. Name of the payee
3. Token number
4. The amount

On the basis of paying-in-slips received by the receiving cashier and the cheques and withdrawal slips received by the paying cashier, these transactions are first entered in the accounts of the customers (clients) and then day books are written.

Cash book is the master book. It is used to verify all accounts. This type of procedure provides a good control over cash transactions. This is also known as “Slip system of posting”.

Cash balance book, cash reserve book and day book are all important books of account with respect to cash transactions.

13.5.2 General Ledger

General ledger contains accounts of all personal ledgers, P & L A/c and accounts of all assets. From this, the trial balance and balance sheet may be prepared at ease. All transactions are first recorded in the books and then posted to ledger.

Accounts with respect to income items (revenue in nature) are entered in the general ledgers.

Some banks prepare P & L A/c in the general ledger and maintain separate books for revenue and expense items.

Some banks maintain summary of revenue accounts in the general ledger.

As the general ledger contains the total accounts of all ledgers it is an important book of accounts.

13.5.3 Subsidiary Ledgers

The following are the various types of ledgers for different purposes:

1. Receiving cashier’s (counter) cash book
2. Paying cashier’s (counter) cash book
3. Savings bank accounts ledger
4. Current accounts ledger
5. Recurring deposit accounts ledger
6. Fixed deposit accounts ledger
7. Fixed deposit interest ledger
8. Loan ledger and O/D register
9. Investment ledger
10. Cash certificate ledger
11. Bills discounted and purchased ledgers
12. Inward and outward bills for collection ledgers
13. Customers’ acceptances, endorsements and guarantee ledgers

13.6 REGISTERS

In addition to books and ledgers, banks maintain the following registers and other books to record various other transactions. It is important to note that these books and registers are not based on double-entry system.

1. Bills for collection register
2. Securities register (securities against loan granted)
3. Demand drafts, telegraphic transfers and mail transfers registers
4. Safe deposit vault register
5. Jewellery register
6. Standing-order register
7. Cheques and dishonoured cheques
8. Document register
9. Letters of credit register
10. Letter of guarantee register

13.7 SYSTEM OF BANKING ACCOUNTING

13.7.1 Salient Features

Procedure for banking accounting is entirely different from that of trading concerns. Salient features of banking accounting are as follows:

1. Slip system (or voucher system): Considering the emergent exigencies of recording the transactions immediately, slip system of posting to ledger is adopted. (This system is explained in detail in the forthcoming pages.)
2. Voucher summary sheets: Transactions are entered in the accounts of customers straight from the vouchers. Then, they are summarized on summary sheets. After that total of these vouchers are posted to the control accounts in the general ledger.
3. Self-balancing system: Banking companies used to maintain the ledgers on the self-balancing system. The general ledger contains control accounts or total accounts relating to subsidiary ledgers. At regular intervals, the total balances of individual accounts are compared with the balances of control accounts.
4. Daily trial balance: The general ledger entries are extracted and got tallied every day.
5. Double voucher system: Two different vouchers are used to record non-cash transactions: (1) Debt vouchers and (2) Credit vouchers.

13.7.1.1 Slip System (or) Voucher System of Ledger Posting

“Slip system of ledger posting” is defined as a method of instant posting of books of accounts on double-entry system.

In this system, entries are recorded in the accounts of the customers in the ledgers straight from different slips and not from subsidiary books or journals. After that, a day book is written up. Then, entries in the accounts of the customers are tallied with those in the day book.

Thus, the posting in the ledger accounts and writing of the day book are done simultaneously.

Slips are loose leaves of journals or cash books.

A slip is nothing but a voucher. Some of such slips are: pay-in-slips, cheques, withdrawal forms and dockets.

Slip system is essential for the following reasons:

1. It is essential for a bank to know at any time its position in relation to each individual customer, and the transactions have to be recorded immediately without loosing much time gap. This system is a boon to fulfil its aim.
2. This system facilitates the banks to keep their customers’ accounts accurate and up to date—may be up to time.
3. It saves time and labour, as all the slips (except dockets) are filled in by the customers themselves.
4. It serves as objective evidence of records, as they are filled in by the customers.

Advantages of slip system: The following are the advantages of slip system:

1. Reduction of work load: The workload of the staff (mainly clerical) is reduced to a great extent, as all the slips (except dockets) are filled in by the customers themselves.
2. Saves time: Much time is saved as all transactions are recorded on the basis of slips.
3. Division of labour: This system paves the way of division of work among the bank staff.
4. Responsibility with accountability: The slip system fixes the responsibility of each employee and the errors made by any one can be easily accounted for.
5. No interruption: This type of procedure is carried out by the employees without any interruption.
6. Eliminates subsidiary books: As posting is done on the basis of slips, there is no need to maintain subsidiary books.
7. Easy and early detection of errors: Each transaction is entered in different books by different employees. At the end of the day, each book gets tallied. If it does not tally, the errors can be easily spotted on the same day and rectified immediately.
8. Accurate and trustworthy: All books are maintained on self-balancing system. Hence it is accurate and trustworthy.
9. Facilitates auditing: An important function of auditing is “vouching”. Vouchers facilitate the task of auditing to a great extent.
10. Objective evidence: It serves as an objective evidence of record for transactions as slips are entered and signed by the customers themselves.

Disadvantages of slip system:

1. Risk of loss: As transactions are huge, and each such transaction is based on loose slip, there is a chance of loss of slips.
2. Maintenance: Maintaining a large number of slips is an arduous task. Keeping a date-wise record is not an easy affair.
3. Easy to manipulate: Dishonest employees can misuse by destroying the slips.
4. No verification: In case if a slip is lost or destroyed wilfully by a dishonest personnel, it will be very difficult to verify it.
5. Customer’s role: As each customer may not be well versed in filling up the variety of forms, their role has become vital. Any negligence on their part will mar the entire accounting process.

13.8 PREPARATION AND PRESENTATION OF FINAL ACCOUNTS

A strange feature is that banking companies are not required to prepare their final accounts as per Schedule VI of the Companies Act, 1956. But according to Section 29 of the Banking Regulation Act, they have to prepare these accounts in accordance with Form A (for balance sheet) and Form B (for P & L A/c) of Schedule III annexed to Banking Regulation Act, 1949.

First, let us discuss the preparation of P & L A/c of the banking companies.

 

 

	Year Ended on 31 March ….. (Current Year)	Year Ended on 31 March…..(Previous Year)
I. Interest/Discount on Advances/Bills	…	…
II. Income on Investments	…	…
III. Interest or Balances with RBI and Other Inter-bank Funds	…	…
IV. Others	…	…
Total:	…	…

	As on 31 March…..(Current Year)	As on 31 March…..(Previous Year)
I. Commission, Exchange & Brokerage	…	…
II. Profit on Sales of Investments Less: Loss on Sale of Investments	…	…
III. Profit on Revaluation of Investments Less: Loss on Revaluation of Investments	…	…
IV. Profit on Sale of Land, Building and Other Assets Less: Loss on Sale of Land, Buildings & Other Assets	…	…
V. Profit on Exchange Transactions Less: Loss on Exchange Transactions	…	…
VI. Income Earned by Way of Dividends, etc. From Subsidiaries/Companies and/or Joint Ventures Abroad/in India	…	…
VII. Miscellaneous Income	…	…
Total:	…	…

 

	As on 31 March….. (Current Year)	As on 31 March….. (Previous Year)
I. Interest of Deposits	…	…
II. Interest on RBI/Inter-bank Borrowings	…	…
III. Others	…	…
Total:	…	…

	As on 31 March…..(Current Year)	As on 31 March…..(Previous Year)
I. Payments to and Provisions for Employees	…	…
II. Rent, Taxes and Lighting	…	…
III. Printing and Stationery	…	…
IV. Advertisement and Publicity	…	…
V. Depreciation on Bank’s Property	…	…
VI. Directors’ Fees, Allowances and Expenses	…	…
VII. Auditors’ Fees and Expenses (Including Branch Auditors’ Fees and Expenses)	…	…
VIII. Law Charges	…	…
IX. Postages, Telegrams, Telephone, etc.	…	…
X. Repairs and Maintenance	…	…
XI. Insurance	…	…
XII. Other Expenditure	…	…
Total:	…	…

13.9 GUIDELINES OF RBI FOR PROFIT AND LOSS ACCOUNT

1. Schedule 13—Interest earned:
   1. Interest/discount on advances/bills:

      The following items are to be included under this head:

      Interest and discount on all types of loans and advances such as (i) cash credits; (ii) demand loans; (iii) overdrafts, (iv) export loans, (v) loans, (vi) domestic and foreign bills purchased and discounted and rediscounted, (vii) overdue interest and (viii) interest subsidy with respect to such advances and/or bills.

   2. Income on investments: All types of income derived from investment portfolio by way of interest and dividend are to be included in this category.
   3. Interest on balances with RBI and other bank funds: It includes interest on balances with RBI and other banks, call loans, money market placements and so on.
   4. Others: It includes any other discount/interest income not included in the above three categories.
2. Schedule 14—Other income:
   1. Commission, exchange and brokerage: It includes all types of remuneration on services such as commission on collections, commission/exchange on remittances and transfers, commission on Govt. business, commission on other permitted agency business including consultancy and other services, brokerage, etc. on securities. It does not include foreign exchange income.
   2. Profit on sale of investment: Less—Loss on sale of investments.
   3. Profit on revaluation of investments: Less—Loss on revaluation of investments. Net profit/loss on revaluation of assets has to be shown.
   4. Profit on sale of land, buildings and other assets: Less—Loss on sale of land, buildings and other assets. It includes profit/loss on sale of securities, furniture, land and buildings, motor vehicles, gold, silver and so on. If the net position is a loss, it is to be shown as a deduction.
   5. Profit on exchange transactions: Less—Loss on exchange transactions. It includes profit/loss on dealing with foreign exchange; all income earned through foreign exchange and the commission and charges on foreign exchange transactions excluding interest. Only the net position should be shown.
   6. Income earned by way of dividends from subsidiary companies and joint ventures abroad and in India.
   7. Miscellaneous income: It includes recoveries from constituents for godown rents, income from bank’s properties, security charges, insurance, etc. and any other miscellaneous income. In case, if any item under this head exceeds 1% of the total income, then such particulars may be given in the notes.
3. Schedule 15—Interest expended:
   1. Interest on deposits: It includes interest paid on all types of deposits from banks and other institutions.
   2. Interest on RBI/Inter bank borrowings: It includes discount/interest on all borrowings and refinance from RBI and other banks.
   3. Others: It includes discount/interest on all borrowings reference from financial institutions. All other payments like interest on participation certificate and panel interest paid may be included in this category.
4. Schedule 16—Operating expenses:
   1. Payment to and provisions for employees: It includes staff salaries/wages, allowances, bonus and other staff benefits like provided fund, pension, gratuity, leave fare concessions, staff welfare, medical allowances to staff and so on.
   2. Rent, taxes and lighting: It includes rent paid by the banks on buildings, municipal and other taxes paid (excluding income tax and interest tax), electricity and other similar charges and levies. House rent allowance and other similar payment to staff should appear under the head “payment to and provisions for employees”.
   3. Printing and stationery: It includes expenditure on books and forms and stationery used by the bank and other printing charges, which are not incurred by way of publicity expenditure.
   4. Advertisement and publicity: It includes expenditure incurred by the bank for advertisement and publicity purposes including printing charges of publicity matter.
   5. Depreciation on bank’s property: It includes depreciation on bank’s own property, motor cars and other vehicles, furniture, electric fittings, vaults, lifts, leasehold properties, non-banking assets and so on.
   6. Directors’ fees, allowances and expenses: It includes sitting fees and all other items of expenditure incurred on behalf of directors. The daily allowance, total charges, conveyance charges, etc., which though in the nature of reimbursement of expenses incurred may be included under this head. Similar expenses of local committee members may also be included under this head.
   7. Auditor’s fees and expenses (including branch auditor’s fees and expenses): It includes the fees paid to the statutory auditors and branch auditors for professional services rendered and all expenses for performing their duties, even though they may be in the nature of reimbursement of expenses. If external auditors have been appointed by banks themselves for internal inspections and audits and other services the expenses incurred in that context including fees may not be included under this head but shown under “other expenditure”.
   8. Law charges: It includes all legal expenses and reimbursement of expenses incurred with respect to legal service.
   9. Postage, telegrams, telephone, etc.: It includes all postal and courier charges, telegrams, telephones, fax, e-mail, internet expenses and so on.
   10. Repairs and maintenance: It includes repairs to bank property, their maintenance charges and so on.
   11. Insurance: It includes insurance charges on bank’s property, insurance premia paid to deposit insurance and Credit Guarantee Corporation, etc. to the extent they are not recovered from the concerned parties.
   12. Other expenditure: All expenses other than those not included in any of the other heads like license fees, donations, subscriptions to papers, periodicals, entertainment expenses, travel expenses, etc. may be included under this head. If any particular item under this head exceeds 1% of the total income, particulars are made for bad and doubtful debts, provision for taxation and provision for diminution in the notes.
5. Provisions and contingencies: It includes all provisions made for bad and doubtful debts, provision for taxation, provision for diminution in the value of investments, transfers to contingencies and other similar items.

13.10 SPECIAL TRANSACTIONS

Some items require special treatment while preparing the final accounts of a banking company.

13.10.1 Interest on Doubtful Debts

When a loan is granted to a customer, the accounting treatment is

1. The customer’s loan account is debited (with amount of loan) in the accounts book of the bank. The interest accrued is to be entered in the debit side of his account. This is to be adopted till he returns the money on the maturity date. This holds good if the financial position of the customer is sound and the bank is in full confidence that the loan will be discharged on the maturity date. The accounting entry for such cases would be: Entry for interest will be :

    

   Customer’s Loan A/c	Dr	…
   Interest A/c			…

    

2. When a loan is granted to a customer and uncertainty arises as to the settlement of the loan, such a debt becomes doubtful. Then in such cases, interest on doubtful debts cannot be treated as an income. The interest on the doubtful debts may be treated in the following ways:
   1. Interest suspense method
   2. Cash basis
   3. Accrual method

1. Interest suspense method: Under this method, interest on doubtful debts is credited to interest suspense A/c and debited to customer’s loan A/c.

    

   Entry:
   Customer’s Loan A/c	Dr.	…
   To Interest Suspense A/c			…

   In the balance sheet, “interest suspense A/c” is to be shown on the liabilities side under “Schedule 5: Other Liabilities and Provisions”. Customer’s loan A/c with interest will be shown on the assets side. After sometime, when the loan is repaid fully or partially with interest, then entry is:

   

   To the extent, interest is received in cash and the amount is transferred to interest account and the balance to the loan account.

   For closure:

   

   Note: As doubtful debts fall under the category of non-performing assets (NPA), interest income on doubtful debts should not be taken to P&L A/c.

2. Cash Basis: Till the cash is received, no entry is to be passed.
3. Accrual method: Under this method, interest account is to be credited with full amount of interest due on doubtful debts. But, at the same, i.e. simultaneously an adequate provision for bad and doubtful debts is to be created and credited.

    

   Entry:
   Interest and Discount A/c	Dr.
   To Provision for Bad and Doubtful Debts

   When bad debt is recovered partially:

   

Illustration 13.1

Model: Interest on doubt debts

While closing the books of a bank on 31 December 2010, you find in the loan ledger an unsecured balance of 5,00,000 in the account of one customer Mr. X whose financial condition is reported to you as bad. Interest on the same account amounted to 50,000 during the year. During the year 2011, the bank accepted 80 paise in the rupee on account of the debt up to 31 December 2010. Give journal and ledger to record these transactions under alternative accounting policies.

Solution

“Alternative accounting policies”: Given in the question denotes the three different methods adopted to treat “interest on doubtful debts”, as described above.

Method 1—Interest suspense method

 

Method 2—Cash basis

 

Method 3—Accrual basis method

 

[Bad debts provision has to be reduced to 4,40,000 for 2011.]

 

13.10.2 Bills of Exchange

13.10.2.1 Bills for Collection

In buying and selling process, usually the sellers of the goods used to draw bills on their customers (buyers) for acceptance or bills are endorsed to the sellers.

These bills, also known as hundees, are sent to the banks for collection.

The banks hold these bills till their dates of maturity. When the banks realize the amount, the entry will be:

 

Cash A/c	Dr.	…
To Customer’s Current A/c			…

Cash A/c is debited with full amount mentioned in the bill and customer’s current A/c is credited with the amount after deduction of bank’s commission.

These are the outstanding bills for collection and are recorded in a subsidiary book known as “outstanding bills for collection register” and the entry is to be made only when bills are collected.

Treatment in final accounts:

Bills held for collection will be shown as a note to the balance sheet.

13.10.2.2 Discounting of Bills

Making payment for the bills before its maturity date is referred to as “discounting of bills”. Sellers of the goods may discount these bills with the bankers or sell these to their bankers.

Accounting entry in the books of account of the banking company will be as follows:

 

Bills Discounted A/c	Dr.	…
To Customer A/c			…
To Discount A/c			…

In the final accounts, bills discounted account is to be shown in the balance sheet under the head: “Advances” and details should be given in Schedule 9 annexed to the balance sheet.

13.10.2.3 Rebate on Bills Discounted

This is also called “unexpired discount” or “discount received but not earned”.

When a bank discounts or purchases a bill, it is credited to discount A/c, treating this as item of income of the accounting period. But at times, bills discounted may mature on a date beyond the relevant accounting period. This is the unearned amount received for such bills, which will mature after the date of preparation of final accounts. Hence, it cannot be treated as income of the current accounting period. The illustrate, if a bills is discounted on 1 December 2010 for 3 months at 9000 and accounts are closed on 31 December 2010, 6,000 is the unexpired discount as it is related to 2 months, i.e. January and February in 2011, the next accounting period.

If the discount A/c is created with the full amount of discount (earned and unearned) and appears in trial balance, then the entry will be as follows:

In final accounts, rebate on bills discounted is shown on the liabilities side of the balance sheet under the head “Other Liabilities and Provisions”. Details are given in Schedule 5.

In the next accounting period, it is transferred to discount A/c and closed thereby.

Note: In case, if rebate on bills discounted is given an adjustment outside the trial balance, then it has to be transferred to provisions account and deducted in P & L A/c.

Illustration 13.2

Model: Rebate on bills discounted.

On 31 March 2010, a bank held the followng bills discounted by it earlier:

You are required to calculate the rebate on bills discounted. Also show the necessary journal entry for the rebate.

Solution

STAGE I:    Basic calculations

(A) Calculation of discount after 31 March 2010 for bill value of 10,95,000.

Step 1:    No. of Days After 31 March 2010

Step 2:    Discount Amount for 50 Days:

where p is the value of the bill, r is the rate of discount and n is the period.

(B) Calculation of Discount After 31 March 2010 for Bill Value of 25,55,000:

Step 1 :    No. of Days After 31 March 2010:

Step 2:    Discount Amount for 40 days:

(C) Calculation of Discount After 31 March 2010 for Bill Value of 51,10,000.

Step 1 :    No. of Days After 31 March 2010:

Step 2:    Discount Amount for 73 days:

These are transferred to the following table:

Illustration 13.3

Model: Rebate on bills discounted

The following information is available in the books of AZ Bank Limited as on 31 March 2010.

 

Bills Discounted	1,20,11,350
Rebate on Bills Discounted (1 April 2009)	3,15,550
Discount Received	12,22,450

Details of bills discounted are as follows:

Value of Bill	Due Date	Rate of Discount(%)
15,00,000	12 June 2010	14
20,00,000	9 July 2010	12
50,00,000	29 July 2010	15
80,00,00	28 August 2010	18

Calculate the rebate on bills discounted as on 31 March 2010 and give necessary journal entries.

Solution

 

Step 1:	No. of days after 31 March 2010 for each bill is calculated as explained in illustration 13.2.
	The amount for unexpired period is to be calculated and tabulated as follows:

Step 2:	Rebate on Bills Discounted (1 April 2009)	3,15,550
Step 3:	Add: Discount Received (Given)	12,22,450
		15,38,000
Step 4:	Less: Rebate on Bills Discounted (31 March 2010)	9,46,109
Step 5:	Amount on Rebate on Bills Discounted for the Year to
	Be Transferred to P & L A/c	5,91,891
Step 6:	Journal entries

 

Illustration 13.4

Model: Rebate on bills discounted

The trial balance of BC Bank Ltd. as on 31 March 2011 shows the following balances:

 

Interest and Discount	37,27,170
Rebate on Bills Discounted (1 April 2010)	7,150
Bills Discounted and Purchased	2,27,500

The unexpired discount as on 31 March 2011 is estimated to be 24,125. Draft necessary adjusting entries and calculate the amount of interest and discount to be credited to P & L A/c.

Solution

STAGE I: Ascertainment of interest and discount to be credited to Profit and Loss A/c:

 

Step 1:	Interest and Discount
	(Given in Trial Balance):	37,27,170
Step 2:	Add: Opening Balance (Balance as on 1 April 2010) of
	Bills Discounted (Given)	7,150
		37,34,320
Step 3:	Less: Closing Balance (Balance) as on 31 March 2010) of
	Bills Discounted (Given)	24,125
Step 4:	Interest and Discount to be Transferred (for the Year) to P & L A/c	37,09,195

Stage II: Journal entries

Illustration 13.5

Model: Rebate on bills discounted

As on 31 December 2010, the books of Giant Bank Ltd., include among others, the following balances:

 

Rebate on Bills Discounted (1 January 2010)	2,70,000
Discount Received	37,50,000
Bills Discounted and Purchased	3,65,00,000

Throughout the accounting year, the bank’s rate for discounting has been 15%.

On Investigation and analysis, the average due date for the bills discounted and purchased is calculated as 14 March 2011.

Show the calculation of the amount to be credited to the Bank’s P & L A/c under discount earned for the year 2010. Show also the journal entries required to adjust the above-mentioned accounts.

Solution

First, discount of the year to be transferred to P & L A/c has to be determined as follows:

 

Step 1:	Balance in Discount Received A/c (Given)	37,50,000
Step 2:	Add: Opening Balance (1 January 2010) (Given)	2,70,000
		40,20,000
Step 3:	Less: Closing Balance (as on 31 December 2010)
		10,95,000
Step 4:	Amount of Discount of the Year to be Transferred to P & L A/c	29,25,000
Step 5:

 

13.11 PROVISION FOR NON-PERFORMING ASSETS

Loans, advances, discounting of bills, purchasing of bills and the like are the main source of income for any bank. Some of such assets may not bring in any income to the banks. In accordance with International Accounting Standards, a distribution is made on the treatment of income on different advances by classifying into “performing assets” and “non-performing assets” (NPA).

13.11.1 Meaning of Non-performing Assets

An asset is said to be a non-performing asset, when it ceases to generate income for a bank. The RBI has given certain guidelines for treating an asset as NPA. Some of them are provided as follows:

1. Term loans: When interest or instalment on loans is overdue for more than 90 days, the account is to be treated as NPA.
2. Cash credits and overdrafts: When a cash credit or O/D account remains out of order for more than 90 days, it will be considered as NPA.

   An account is treated as “out of order”, if any one of the following conditions is satisfied:

   1. The outstanding balance remains continuously in excess of the sanctioned limit and or drawing power.
   2. Even if the outstanding balance is well within the sanctioned limit/drawing power, if there are no credits in the account continuously for 90 days as on the date of the balance sheet.
   3. If the credits in such accounts are not sufficient enough to meet the interest debited during the same period.
3. Bills purchased and discounted: When the bill remains overdue for a period of more than 90 days from its due date, it is to be treated as NPA.
4. Agricultural advances: Loan granted for short-duration crops is to be treated as NPA, if interest or principal remains overdue for two crop seasons. Loan granted for long-duration crops is to be treated as NPA, if the instalment of principal or interest remains overdue for one crop season.
5. Other advances: Any other credit facility is to be treated as NPA, if the amount to be received remains overdue for a period of more than 90 days.

13.11.2 Provisions for Non-performing Assets

To create provision for NPAs, the advances of a bank are classified into four categories, with variable provisions explained as follows:

Category I: Standard assets or performing assets: Dues are required to make a provision of a minimum of 0.40% on standard assets also on global loan portfolio basis and not on domestic advances alone.

Category II: Sub-standard assets:

1. A general provision of 10% on total outstanding has to be created without making any allowance for Export Credit Guarantee Corporation (ECGC).
2. However, the “unsecured exposures”, which are categorized as sub-standard assets will attract additional provision of 10%. That means 10% + 10% = 20% on the outstanding balance. (When the realizable value of the security is not more than 10% of the outstanding exposure, it is known as unsecured exposure.)
3. When loans are classified as NPAs and also as sub-standard, a provision of 20% is required.
4. W.e.f. the year ending on 31 March 2005, the banks are permitted to spread the additional provision consequent upon the reduction in the transition period from sub-standard to doubtful asset from 18 to 12 months over a 4-year period, with a minimum of 20% each year.

Category III: Doubtful assets:

1. If the debt is not covered by realizable value of the security, 100% provision should be created.
2. If the debt is secured, then provision is to be made as follows: Provisions Percentage

    

   Provisions	Percentage
   Up to 1 Year	20
   1–3 Years	30
   More than 3 Years	100

Category IV: Loss assets: This category has been identified as assets, which have lost value but not written off. The entire assets are to be written off completely. However, if the assets are to be retained in the books of accounts for any specific reason, then 10% provision is required to be created.

Illustration 13.6

Model: NPA—Provisions to be created

On 31 March 2011, Indian Inland Bank Ltd. finds its advances classified as follows:

 

Standard Assets	20,60,500
Sub-standard Assets	1,10,000
Doubtful Assets : (Secured)
: Doubtful for 1 Year	40,000
: Doubtful for 1−3 Years	25,000
: Doubtful for More Than 3 Years	10,500
Doubtful Assets: (Unsecured)	22,000
Loss of Assets	15,500

Calculate the amount of provision to be made by the Bank against the above-mentioned advances.

Solution

Illustration 13.7

Model: Provisions to be created

From the following information, find out the amount of provisions required to be made in the profit and loss A/c of a commercial bank for the year ended on 31 March 2011:

1. Packing credit outstanding from food processors is 80,00,000 against which the bank holds securities worth 20,00,000. Forty per cent of the above advance is covered by ECGC. The above advances have remained doubtful for more than 3 years.
2. Other Advances:

Assets Classification:	( in Lakhs)
Standard	5,000
Sub-standard	4,200
Doubtful:
For 1 Year	1,200
For 2 Years	800
For 3 Years	600
For More Than 3 Years	400
Loss Assets	800

Solution

1. Calculation of required provision (packing credit):
   
2. Calculation of required provision for other advances:

Solution

Illustration 13.8

Model: Provision to be created

Best Bank Ltd. had extended the following credit lines to a small-scale industry, which had paid any interest since March 2009:

Particulars	Term Loan	Export Credit
Balance Outstanding on 31 March 2011	90,00,000	70,00,000
DICGC/ECGC Cover	50%	40%
Securities Held	40,00,000	30,00,000
Realizable Value of Securities	30,00,000	20,00,000

Compute the necessary provisions to be made for the year ended on 31 March 2011.

Solution

13.12 INCOME RECOGNITION

For the purpose of income recognition, the banks are required to classify their assets into two main categories: performing and non-performing assets (NPAs). The banks should ensure that interest on non-performing assets should not be recognized as income. Such income should not be taken to P & L A/c.

Banks should strictly adhere to the guidelines issued by RBI. Accordingly, banks should recognize their income on “accrual basis” with respect to income on performing assets and on “cash basis” with respect to income on non-performing assets.

Interest on non-performing assets is not recognized unless it is actually realized in cash. But, interest on advances against term deposits is treated as income on due date (even though not actually received in cash) provided if the value of deposit is more than the balance outstanding.

Fees and commission earned by the banks due to re-negotiation or rescheduling of outstanding debts are to be recognized on an accrual basis.

Similarly, the interest on government-guaranteed advances are not to be taken to income account until the same has been realized in cash.

The guidelines of RBI relating to income recovered from NPAs are as follows:

1. Interest realized on NPAs is to be credited to P & L A/c only if the credits in the accounts to interest are not out of fresh or additional credit facilities sanctioned to the borrower.
2. The banks should appropriate recoveries in NPAs property.
3. Although the banks do not recognize income until it is realized, banks are permitted to debit interest to NPA account if it is credited to interest suspense account.

The banks are required to classify the assets of NPA into the following categories:

1. (a) Sub-standard assets, (b) doubtful assets and (c) loss assets for the purpose of ascertaining provisions to be made for each category. The RBI, in its Master Circular issued on 1 July 2008, has mentioned the following clarifications in respect of assets classification inter alia.
2. Assets are to be classified on the basis of borrower and not facility wise.
3. Advances on consortium should be based on the record of recovery of individual member banks.
4. Exemption from classification of government-guaranteed advances as non-performing assets is not intended to income recognition.
5. When arrears of interest and principle are paid by the borrower in loan accounts classified as NPAs, such accounts should no longer be treated as NPAs but are to be upgraded as “standard accounts”.
6. The asset classification of borrowal accounts must be done objectively. When the account reflects any unreliability, it is to be considered as non-performing asset only.

Illustration 13.9

Model: Income recognition

Following are the information provided by ABZ Ltd. regarding the interest on advance along with the measure of assets.

Types of (Classification of) Assets	Interest Earned ( in Lakhs)	Interest Received ( in Lakhs)
(A) Performing Assets:
Term Loans	250	150
Cash Credits & Overdrafts	900	550
Bills Purchased & Discounted	400	260
(B) Non-performing Assets:
Terms Loans	150	40
Cash Credits & Overdrafts	560	55
Bills Purchased & Discounted	200	20

You are required to calculate the income to be recognized for the year ending on 31 March 2011.

Solution

 

In compliance with the guidelines of the RBI,

1. Interest on performing assets should be recognized on “accrual basis”.
2. Interest on non-performing assets (NPAs) should be recognized on “cash basis”.

Illustration 13.10

Model: Preparation of profit and loss A/c

From the following particulars, prepare a profits and loss A/c of Fancy Bank Ltd. for the year ended on 31 December 2010:

Solution

Note: Even though the proper procedure is to provide all the schedules only after showing P & L A/c, here in one or more illustrations, schedules with workings are shown first so as to make the students to understand at ease.

 

Step 1:	Schedule 13 is to be prepared as follows:
	In this schedule, interest earned is to be shown in detail as interest on loans. Discount on bills discounted, interest on cash credits and O/DS have to be shown and added.

 

	(in Lakhs)
Interest on Loans	130
Discount on Bills Discounted	100
Interest on Cash Credits	112.5
Interest on Overdrafts	28
Total	370.5

 

Step 2:

Schedule 14 is to be prepared. Under this head, i.e., “Other Income”, only one item is to be shown in this problem, i.e., commission charged to customers.

 

	(in Lakhs)
Commission Charged to Customers	4.5
	4.5

Step 3:

Schedule 15 is to be prepared under the head “Interest Expended”. Interests on fixed deposits, current accounts and SB accounts have to be shown and get aggregated value.

 

	(in Lakhs)
Interest on Fixed Deposits	140
Interest on Current Account	22.5
Interest on SB A/c	35
Total	197.5

Step 4:

Schedule 16—“Operating expenses” is prepared as follows:

 

	(in Lakhs)
Establishment Expenses	28
Printing & Advertisement Expenses	1.5
Rents and Taxes	10
Director’s Auditor’s Fees	2
Postage & Email	1
Sundry Charges	1
Total	43.5

Hence, no need to show under separate head in this question.

 

Step 5:

Preparation of P & L A/c:

 

Illustration 13.11

Model: Preparation of P & L A/c

From the following information, prepare the profit and loss A/c of Merchant Bank Ltd. for the year ended on 31 March 2011 in the prescribed form:

 

Interest on Loan	5,18,000
Interest on Fixed Deposits	5,50,000
Rebate on Bills Discounted Required	98,000
Commission	16,400
Establishment	1,08,000
Discount on Bills Discounted	3,90,000
Interest on Cash Credit	4,46,000
Interest on Current Account	84,000
Rent and Taxes	36,000
Interest on Overdraft	3,08,000
Director’s Fees	6,000
Auditor’s Fees	2,400
Interest on Savings Bank Deposits	1,36,000
Postage, Phone, Internet Expenses	2,800
Printing and Stationery	5,800
Sundry Charges	3,400

Bad debts to be written off amounted to 80,000. Provision for taxation may be made @ 50%.

Balance of profit from last year was 2,40,000. The Directors have recommended a dividend of 40,000 for the shareholders.

[CA (Inter) and ICWA (Final)—Modified]

Solution

First, required schedules are prepared as follows:

 

Step 1:           Schedule 13—Interest Earned

 

Year Ended on 31 March 2011

Interest on Loan	5,18,000
Discount on Bills Discounted	3,90,000
Interest on Cash Credits	4,46,000
Interest on Overdrafts	3,08,000
	16,62,000
Less: Rebate on Bills Discounted Required	98,000
	15,64,000

Step 2:           Schedule 14—Other Income

Commission	16,400
	16,400

Step 3:           Schedule 15—Interest Expended

Interest on Fixed Deposits	5,50,000
Interest on Current Accounts	84,000
Interest on Savings Bank Deposits	1,36,000
	7,70,000

Step 4:           Schedule 16—Operating Expenses

Establishment	1,08,000
Rent and Taxes	36,000
Directors Fees	6,000
Auditor’s Fees	2,400
Postage, Phone & Interest	2,800
Printing and Stationery	5,800
Sundry Charges	3,400
	1,64,4000

Step 5:           Provision and Contingencies

Bad Debts Written off	80,000
Provision for Taxation:
( 15,64,000 + 16,400) − ( 7,70,000 + 1,64,400 + 80,000) = 5,66,000
50% of 5,66,000 = 2,83,000	2,83,000
	3,63,000

Step 6: