Rationale of Prudential norms on Income Recognition, Asset Classification and Provisioning

Objective of these norms:Greater consistency and transparency in the published accounts of Banks, since as such the quality of assets and the strength of the bank could not be assessed in the absence of these norms, which give transparency of the Financial Statements. The policy of income recognition should be objective and based on record of recovery rather than on any subjective considerations. Likewise, the classification of assets of banks has to be done on the basis of objective criteria which would ensure a uniform and consistent application of the norms. Also, the provisioning should be made on the basis of the classification of assets based on the period for which the asset has remained non-performing and the availability of security and the realisable value thereofSome Definitions to know before we go further:Non performing Assets An asset becomes non performing when it ceases to generate income for the bank.In general, A non performing asset (NPA) is a loan or an advance where;i. interest and/ or instalment of principal remain overdue for a period of more than 90 days.Further guidelines are given by RBI for different types of facilities, but the crux of the issue is if the interest or principal amount is not paid within 90 days of the scheduled payment date, then it is classified as a NPA.In case of interest payments, banks should, classify an account as NPA only if the interest due and charged during any quarter is not serviced fully within 90 days from the end of the quarter.Overdue Any amount due to the bank under any credit facility is overdue if it is not paid on the due date fixed by the bank.

Income Recognition:Why required? As per the accounting policy , banks may debit the loan account for interest and credit their P/L , but the investor, public or other stake holders may not know if these interest are recoverable or only book entries.The policy of income recognition has to be objective and based on the record of recovery. Internationally income from non-performing assets (NPA) is not recognised on accrual basis but is booked as income only when it is actually received. Therefore, the banks should not charge and take to income account interest on any NPAIf any advance, becomes NPA, the entire interest accrued and credited to income account in the past periods, should be reversed if the same is not realised. Subsequently if the Interest is recovered on NPAs , then may be taken to income account. But the recovery should not be done by giving another loan or advance. ( Bank cannot give another loan and credit to the old loan to show recovery of interest)ASSET CLASSIFICATIONBanks are required to classify nonperforming assets further into the following three categories based on the period for which the asset has remained nonperforming and the realisability of the dues:i. Substandard Assets ii. ii. Doubtful Assetsiii. iii. Loss Assets Substandard AssetWith effect from March 31, 2005, a substandard asset would be one, which has remained NPA for a period less than or equal to 12 months. (that means Over due for more than 90 days and up to 12 months). Such an asset will have well defined credit weaknesses that there is a distinct possibility that the banks will sustain some loss, if deficiencies are not corrected.Doubtful Assets With effect from March 31, 2005, an asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. [ After becoming Substandard 12 months]. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the added characteristic that to make collection or liquidation in full, is highly questionable and improbable.Loss AssetA loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value.PROVISIONING NORMSWhat is provisioning. Based on the recoverability of the Loan, we have classified the Loans and advances. The probability of loss to the bank should be accounted by debiting the P/L and crediting the provision account to show that there is an expected loss, hence we are debiting the P/L to that expectation. The expectation of loss is called provisioning norms.In conformity with the prudential norms, provisions should be made on the nonperforming assets on the basis of classification of assets into prescribed categories aboveLoss assets Loss assets should be written off. If loss assets are permitted to remain in the books for any reason, 100 percent of the outstanding should be provided for. This means that there is no probability that any money will be recovered from the borrower.Doubtful assets i. 100 percent of the extent to which the advance is not covered by the realisable value of the security to which the bank has a valid recourse and the realisable value is estimated on a realistic basis. ii. Further , In regard to the secured portion, provision may be made on the following basis, at the rates ranging from 25 percent to 100 percent of the secured portion depending upon the period for which the asset has remained doubtful:

For example:IF a Loan is give for 10 lakhs, and the loan was doubtful category for last two years and the security of property available for Rs 4 lakhs, the provision will be as follows:Loan amount Security= 10-4= Rs 6 lakhs-------a)PlusSecurity Value Rs 4 Lakhs. Doubtful category for last two years. Hence provision requirement is 40%= 40% of Rs 4 lakhs= Rs 1.6 lakhsTotal Provision to be done is Rs 6 lakhs+ Rs 1.6 lkshs= Rs 7.6 lakhsSubstandard CategoryA general provision of 15 percent on total outstanding should be madeSuppose the loan is Rs 10 lakhs, and security Rs 3 lakhs. Irrespective of the security Rs 10*15%= Rs 1.5 lakhs to be provided.