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 nonperforming and the availability of security and the realisable value thereof

Some 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 NPA
If 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 CLASSIFICATION
Banks 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.
ii.
iii.

Substandard Assets
ii. Doubtful Assets
iii. Loss Assets

Substandard Asset
With 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 Asset

A 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 NORMS
What 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 above
Loss 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.

ii.

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.
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)
Plus
Security Value Rs 4 Lakhs. Doubtful category for last two years. Hence
provision requirement is 40%= 40% of Rs 4 lakhs= Rs 1.6 lakhs

Total Provision to be done is Rs 6 lakhs+ Rs 1.6 lkshs= Rs 7.6 lakhs

Substandard Category
A general provision of 15 percent on total outstanding should be made
Suppose 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.