Bank Branch Audit and the Revised LFAR: The Threshold, Annexure III, and a Week That Works

Branch audit is the one assignment where the report that takes the longest is not the audit report. The LFAR is a questionnaire, it is not an annexure to the audit report, and it is addressed to somebody else entirely.

What the LFAR is, and who it is for

RBI advised public sector banks to obtain a long form audit report from their auditors in 1985. The main audit report is made under the Banking Regulation Act, 1949; the LFAR is a separate report to the bank's management in the format RBI prescribes. Management has to ensure compliance, place it before the Board of Directors, and submit it to RBI.

The formats in force were revised by RBI's circular of 5 September 2020, applicable from the audits of financial year 2020-21 onwards. ICAI's Technical Guide records the objective RBI set for it: to identify and assess the gaps and vulnerable areas in business operations, risk management, compliance and the efficacy of internal audit, and to give an independent opinion on those to the Board.

Two consequences follow, and both change how the work is planned:

• It is not an annexure to the auditor's report. A qualification in one does not automatically appear in the other.
• It is about systemic issues, not only about balances. The Technical Guide is explicit that auditors should state what they verified, how they verified it and to what extent — a sentence that decides the shape of every answer.

The branch format, in order

Section B of the revised LFAR, for branch auditors, runs in four chapters and an appendix:

• I — Assets. I-1 Cash. I-2 Balances with RBI, State Bank of India and other banks. I-3 Money at call and short notice. I-4 Investments (for branches outside India). I-5 Advances. I-6 Other assets.
• II — Liabilities. II-1 Deposits. II-2 Other liabilities: bills payable, sundry deposits and the like. II-3 Contingent liabilities.
• III — Profit and Loss Account.
• IV — General. IV-1 Gold, bullion and security items. IV-2 Books and records. IV-3 Inter-branch accounts. IV-4 Frauds. IV-5 Implementation of KYC and AML guidelines. IV-6 Management information system. IV-7 Miscellaneous.
• Appendix — additional questionnaire, for specialised branches: branches dealing in foreign exchange, branches dealing in clearing house operations (service branches), and branches dealing in recovery of non-performing assets such as asset recovery branches.
• Annexure III — a separate LFAR for large, irregular or critical advance accounts.

Advances occupy more of the format than everything else put together, which is the correct weighting and also the planning problem.

The threshold that changed, and the table that came with it

The revised format's General Instructions define which advances must be examined account by account:

Large advances are those in respect of which the outstanding amount is in excess of 10% of the outstanding aggregate balance of fund based and non-fund based advances of the branch, or Rs. 10 crores, whichever is less.

Two things about this are routinely got wrong.

It is "whichever is less", not more. For a branch with ₹200 crore of advances, 10% is ₹20 crore and the cap is ₹10 crore, so the threshold is ₹10 crore — every account above ₹10 crore is examined individually. The Technical Guide works exactly this example.

It replaced a lower threshold, not a higher one. Under the old format large advances were those above 5% of aggregate advances or ₹2 crore, whichever is less. So for most branches the revised format examines fewer accounts individually — and in exchange asks for something the old format never did: the list of accounts examined, with funded and non-funded balances and the percentage of the branch's total that the examined accounts cover.

Below the threshold, the instruction is different in kind: the process is checked and commented upon, rather than the transactions. And regardless of size, comments on advances with significant adverse features that need the attention of management or the Statutory Central Auditors are appended to the LFAR.

One more item sits at the top of the advances section: comment on the adverse features considered significant in the top 5 standard large advances which need management's attention.

Annexure III: what the branch has to prepare

Annexure III is obtained by the branch auditor from the branch for large, irregular or critical advance accounts, and it is a schedule of twenty-six items. Among them: total exposure split fund based and non-fund based; asset classification by the branch and separately by the branch auditor, each at the current audit date and at the previous balance sheet date; the date the asset was first classified as NPA; facilities sanctioned with prime and collateral security, margin and balances for both years; consortium or multiple banking details; verification and valuation of primary and collateral security with evidence; guarantees with date, validity and value; compliance with the terms of sanction item by item, including registration of charges and insurance validity; key financial indicators of the borrower for two audited years and the current year's projections; and observations on operations, including the number of occasions the balance exceeded the drawing power or sanctioned limit, whether the excess was reported and approved, and the summations in the account.

The Technical Guide's practical note is worth repeating: the branch prepares it, the auditor reviews the keyed data on a test check basis — and the auditor's own observations must rest on the loan files, not on the branch's answers.

The other reports nobody schedules time for

ICAI's Guidance Note on Audit of Banks lists what a branch auditor issues besides the main report and the LFAR: a certificate on income recognition, asset classification and provisioning as per RBI's guidelines; a report on compliance with the Ghosh and Jilani Committee recommendations; a certificate of cash and bank balances; a certificate that the previous year's memorandum of changes were accounted for; a certificate on the credit-deposit ratio; and certification of advances to infrastructure projects and the income from them.

The memorandum of changes certificate catches people out. Because the previous year's changes are passed in the branch's books during the following year, this year's auditor is certifying that last year's recommendations were actually effected.

A week, in the order the format wants

Branch audit is short and the sequence is the whole game. A workable order:

• Day 1 — get the population. Facility-wise, security-wise, sanction-date-wise list of advances at the year end; compute the large advance threshold; issue the Annexure III request to the branch for every account above it; ask for the previous year's LFAR, the memorandum of changes and the concurrent, internal, credit and stock audit reports.
• Day 2 — cash, balances and books. Cash retention limits and verification, balances with RBI and other banks and their reconciliations, books and records, inter-branch accounts.
• Days 3 to 5 — advances. The accounts above the threshold end to end: appraisal, sanction, disbursement, documentation, security and its valuation, monitoring, review and renewal, and classification. Read the Annexure III returns against the loan files, not instead of them.
• Day 6 — the rest of the format. Deposits, other liabilities, contingent liabilities, profit and loss, frauds, KYC and AML, management information system, and the specialised branch appendix if it applies.
• Day 7 — certificates and consolidation. IRAC certificate, cash and bank balances, memorandum of changes, credit-deposit ratio; then the LFAR answers, each stating what was verified, how, and to what extent.

One planning note

The IRAC certificate and the LFAR advances section draw on the same work, and the memorandum of changes ties the two reports together. Sequencing advances before the certificates — rather than treating the certificates as a last-day formality — is what keeps the classification in the certificate, the LFAR comments and the memorandum of changes saying the same thing.