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Audit of Non-Banking Financial Companies (NBFC)

Topics Covered:

Sr.No Particulars
1 Definition of NBFC and Criteria
2 Registration (mandatory under RBI and exempted) and Regulation
3 Types of NBFC
4 Differences between Bank and NBFC
5 Prudential Norms Capital Requirements
6 Prudential Norms Income recognition and Asset Provisioning
7 Classification of Fraud by NBFC
8 Compliance with NBFC Auditor’s Report - RBI Directions
9 Audit Procedures
9 NBFC and CARO, 2016 and CARO 2020 (Refer Company Audit Topic)
10 NBFC and IND AS (Read this from the module as it deals with FR concepts)
11 NBFC and Schedule III (Read this from the module as it deals with FR concepts)

Point-Wise discussion:

1 Definition of NBFC and Criteria

1.1 As per Section 45 I(f) of Reserve Bank of India (Amendment) Act, 1997 defines a non-banking
financial company as:
(i) A financial institution which is a company;
(ii) a non-banking institution which is a company and which has as its principal business the
receiving of deposits, under any scheme or arrangement or in any other manner, or lending in
any manner;
(iii) Such other non-banking institution or class of such institutions, as the as the Bank may,
with the previous approval of the Central Government and by notification in the Official
Gazette, specify;
1.2 In order to identify PRINCIPAL BUSINESS it will consider both assets and income pattern as
evidenced from the last audited balance sheet of the company.
1.3 The company will be treated as NBFC when……… (50-50 RULE)
a) a company's financial assets constitute more than 50 per cent of the total assets (netted
off by intangible assets)
and
b) income from financial assets constitute more than 50 per cent of the gross income.
Such company would require to be registered as NBFC by RBI.
2 Registration (mandatory under RBI and list of exempted companies) and Regulation
2.1 Under Section 45–IA of the Reserve Bank of India (Amendment) Act, 1997, no non-banking
financial company is allowed to commence or carry on the business of a non-banking financial
institution without
a) obtaining a certificate of registration issued by the Reserve Bank of India
b) having a net owned fund (NOF) of ` 25 lakhs (` 2 crore since April 1999) not exceeding `
200 lakhs, as the RBI may, by notification in the Official Gazette, specify.
2.2 The RBI (Amendment) Act (1997) provided an entry point norm of ` 25 lakh as the minimum
net owned fund which was revised upwards to ` 2 crore for new NBFCs seeking grant of
certificate of registration on or after 21 April 1999.
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2.3 A Company can apply to the Reserve Bank of India in prescribed form along with necessary
documents for registration. Registration is granted subject to satisfaction of RBI.
2.4 Companies exempted from registration under RBI:
(hint Companies that do financial business but are regulated by other regulators)
a) Housing Finance Institution (regulated by National Housing Bank)
b) Merchant banking Companies (regulated by SEBI)
c) Stock Exchanges (regulated by SEBI)
d) Stock-broking/sub-broking (regulated by SEBI)
e) Venture Capital Fund (regulated by SEBI)
f) Nidhi/Mutual benefit Companies (regulated by MCA)
g) Insurance Companies (regulated by IRDA)
h) Chit Companies (Chit Funds Act, 1982)
i) Micro Finance Companies
j) Securitisation and Reconstruction companies
k) Mortgage Guarantee Companies
l) Core-Investment Company:
(i) With Asset Size of Less than 100 crore or
(ii) With Asset Size of 100 crores and above but not accessing public funds.
m) Alternative Investment Fund (AIF) Companies
3 Types of NBFC:
Existing Classification by RBI:
1) Category 1- Liability based-in terms deposit acceptance or otherwise into Deposit (D) and
Non-Deposit (ND) accepting NBFC
2) Category 2- Asset Based- non deposit taking NBFCs by their size into systemically important
(having an asset size is of INR 500 crores or more as per last audited balance sheet) and non-
systemically important (NBFC-NDSI and NBFC-ND).
3) Category 3- Activity based- by the kind of activities, they conduct.
An overview is as follows:

Technical details about each type of NBFC is given in inter ca module of advance accounts:

Now what has changed?

Pursuant to the announcement of Scale Based Regulation (SBR): A Revised Regulatory
Framework for NBFCs on 22 October 2021 to be effective from 01 October 2022, RBI has
revised different facets of existing NBFC Classification and regulation like Capital
Requirements, Governance Standards, Prudential Regulations, etc. based on four layers that
are defined based on their size, activity, and perceived riskiness.
Details of NBFCs populating the various layers is mentioned below:
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3.1 Base Layer:

The Base Layer shall comprise of
(a) non-deposit taking NBFCs below the asset size of ₹1000 crore
and
(b) NBFCs undertaking the following activities-
(i) NBFC-Peer to Peer Lending Platform (NBFC-P2P),
(ii) NBFC-Account Aggregator (NBFC-AA),
(iii) Non-Operative Financial Holding Company (NOFHC) and
(iv) NBFCs not availing public funds and not having any customer interface.
3.2 Middle Layer:
The Middle Layer shall consist of:
(a) all deposit taking NBFCs (NBFC-Ds), irrespective of asset size,
(b) non-deposit taking NBFCs with asset size of ₹1000 crore and above and
(c) NBFCs undertaking the following activities:
(i) Standalone Primary Dealers (SPDs),
(ii) Infrastructure Debt Fund - Non-Banking Financial Companies (IDF-NBFCs),
(iii) Core Investment Companies (CICs),
(iv) Housing Finance Companies (HFCs) and
(v) Infrastructure Finance Companies (NBFC-IFCs).
3.3 Upper Layer:
The Upper Layer shall comprise of those NBFCs which are specifically identified by the Reserve
Bank as warranting enhanced regulatory requirement based on a set of parameters and
scoring methodology as provided in the Appendix to RBI Circular.
The top ten eligible NBFCs in terms of their asset size shall always reside in the upper layer,
irrespective of any other factor.
3.4 Top Layer:
The Top Layer will ideally remain empty. This layer can get populated if the Reserve Bank is of
the opinion that there is a substantial increase in the potential systemic risk from specific
NBFCs in the Upper Layer. Such NBFCs shall move to the Top Layer from the Upper Layer.
3.5 Important Clarification:
As the regulatory structure envisages scale based as well as activity -based regulation, the
following prescriptions shall apply in respect of the NBFCs

a) NBFC-P2P, NBFC-AA, NOFHC and NBFCs without public funds and customer interface
will always remain in the Base Layer of the regulatory structure.

b) NBFC-D, CIC, IFC and HFC will be included in Middle Layer or the Upper Layer (and not
in the Base layer), as the case may be. SPD and IDF-NBFC will always remain in the
Middle Layer.

c) The remaining NBFCs, viz., Investment and Credit Companies (NBFC-ICC), Micro Finance
Institution (NBFC-MFI), NBFC-Factors and Mortgage Guarantee Companies (NBFC-MGC)
could lie in any of the layers of the regulatory structure depending on the parameters of
the scale based regulatory framework.
Note Investment and Credit Companies (NBFC-ICC), Micro Finance Institution (NBFC-MFI), NBFC-
1 Factors and Mortgage Guarantee Companies (NBFC-MGC) could lie in any of the layers of the
regulatory structure depending on the parameters of the scale based regulatory framework.
Note Government owned NBFCs shall be placed in the Base Layer or Middle Layer, as the case
2 may be. They will not be placed in the Upper Layer till further notice.
Note All references to NBFC-ND shall mean NBFC-BL and all references to NBFC-D and NBFC-NDSI
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3 shall mean NBFC-ML or NBFC-UL, as the case may be.

It is clarified that existing NBFC-ND-SIs having asset size of ₹500 crore and above but below
₹1000 crore (except those necessarily featuring in Middle Layer) will be known as NBFC-BL.
4 Differences between banks and NBFC:- SAD Priority
4.1 Accepting Deposits NBFC cannot accept demand deposits (however some NBFCs can accept
term deposits)
4.2 Settlements NBFCS do not form part of payment and settlement systems and cannot issue
cheques drawn on itself.
4.3 DICGC deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation
(DICGC) is not available to depositors of NBFCs, unlike in case of banks.
4.4 Priority sector lendingNo Minimum Exposure to Priority Sector required by NBFCs.
5 Prudential Norms- Capital Requirements
5.1 Every ‘Applicable NBFC’ (NBFC-ND-SI and NBFC- D) as defined in RBI Master Directions, 2016
shall maintain a
-minimum capital ratio consisting of Tier I and Tier II capital
-which shall not be less than 15 % of
-its aggregate risk weighted assets on-balance sheet and of risk adjusted value of off-balance
sheet items

Note- Weights to be shown from the ICAI module.

5.2 The Tier I capital in respect of ‘Applicable NBFCs’ (other than NBFC-MFI and IDF-NBFC), at any
point of time, shall not be less than 10%
5.3 ‘Applicable NBFCs’ primarily engaged in lending against gold jewellery (such loans comprising
50 percent or more of their financial assets) shall maintain a minimum Tier l capital of 12 %.
6 Prudential normsIncome Recognition and Asset Provisioning
6.1 The income recognition shall be based on recognised accounting principles
6.2 NPA-income recognition:
a) Income including interest/ discount/ hire charges/ lease rentals or any other charges on
NPA shall be recognised only when it is actually realised
b) Any such income recognised before the asset became non -performing and remaining
unrealised shall be reversed.
6.3 When is an asset classified as NPA?
a) an asset, in respect of which, interest has remained overdue for a period of
(i) 3 months or more for ‘Applicable NBFC’
(ii) 6 months or more for NBFC-NSI-ND
b) the lease rental & hire purchase instalment, which has become overdue for a period of
(i) 3 months or more for ‘Applicable NBFC’
(ii) 12 months or more for NBFC-NSI-ND
c) in respect of loans, advances and other credit facilities (including bills purchased and
discounted), the balance outstanding under the credit facilities (including accrued interest)
made available to the same borrower/beneficiary when any of the above credit facilities
becomes non-performing asset.
6.4 Asset Classification. (It does not apply to NBFC-MFIs):
Assets (loans and advances) should be classified into:
a) Standard Asset
b) Sub-Standard Asset:
(i) which has been classified as NPA for a period not exceeding
 12 months for Applicable NBFCs
 18 months for NBFC-ND-NSI
c) Doubtful Asset
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(i) Which remains in sub-standard category for a period exceeding

12 months for Applicable NBFC
 18 months for NBFC-ND-NSI
d) Loss Asset
(i) which has been identified as loss asset by mgmt, auditor, RBI inspection etc.
(ii) adversely affected due to erosion of security and there are negligible chances of recovery.
Note: The class of assets referred to above shall not be upgraded merely as a result of rescheduling,
unless it satisfies the conditions required for the upgradation.
6.5 Asset Provisioning (except NBFC-MFIs)- Refer Academic updates for your attempt.
a) Standard Asset:
‘Applicable NBFCs’ 0.4%
NBFC-ND-NSI0.25%
The provision towards standard assets need not be netted from gross advances but shall be
shown separately as ‘Contingent Provisions against Standard Assets’ in the balance sheet.
b) Sub-Standard Asset 10%
c) Doubtful Asset
a) upto one year Secured 20%, Unsecured100%
b) One to three years Secured30%, Unsecured100%
c) More than three years Secured 50%, Unsecured 100%
d) Loss Asset100%
7 Classification of Fraud by NBFC
M having FUN@CIA
In order to have uniformity in reporting, frauds have been classified by RBI (Master Direction -
Monitoring of Frauds in NBFCs (Reserve Bank) Directions, 2016) as under based mainly on the
provisions of the Indian Penal Code:
7.1 Misappropriation and criminal breach of trust.
7.2 Fraudulent encashment through forged instruments, manipulation of books of account or
through fictitious accounts and conversion of property.
7.3 Unauthorised credit facilities extended for reward or for illegal gratification.
7.4 Negligence and cash shortages***
7.5 Cheating and forgery.
7.6 Irregularities in foreign exchange transactions.
7.7 Any other type of fraud not coming under the specific heads as above
*** the following cases where fraudulent intention is not suspected/ proved, at the time of
detection, will be treated as fraud and reported accordingly:
a) cases of cash shortages more than ` 10,000/-
b) cases of cash shortages more than ` 5000/- if detected by management/ auditor/ inspecting
officer and not reported on the occurrence by the persons handling cash.
8 Compliance with NBFC Auditor’s Report - RBI Directions
8.1 This reporting requirement is in addition to the normal reporting requirements to the
shareholders under section 143 of the Companies Act, 2013.
8.2 Auditors need to submit a separate report to the board of directors of NBFC.
8.3 Matters to be included in such report:
a) In case of all NBFC 3 clauses
Summary of such clauses is produced below
i) whether the company has obtained a Certificate of Registration (CoR) from the RBI?
ii) whether that company is entitled to continue to hold such CoR?
iii) Whether the company is meeting the required net owned fund requirement?
b) In case of NBFCs accepting public deposits (PD)12 clauses
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Summary of such clauses is produced below

i) Whether PDs accepted + Public Unsecured NCDs + Borrowings from shareholders +
Borrowings not excluded from the definition of PD as per RBI directions  is within
the admissible limit as per RBI norms.
ii) Whether excess public deposits (above permissible limits) have been regularised as
per RBI norms.
iii) Is NBFC accepting PD without obtaining minimum investment grade credit rating?
iv) Whether CRAR in case of NBFC- D is correctly determined?
v) For NBFC referred in Clause iii-
a) Whether credit rating is in force & b) Whether PD accepted has exceeded the
amount approved by credit rating agencies?
vi) Whether there is any violation of any restriction placed on acceptance of PD as per
RBI directions.
vii) Whether the company has defaulted in paying to its depositors?
viii) Whether the company has complied with the prudential norms?
ix) Whether the company has
a) complied with the liquid assets requirement as prescribed by the RBI and
b) communicated the details of the bank where designated securities are held?
x) Filed Regulatory Return on deposits with RBI?
xi) Filed Quarterly return on prudential norms with RBI?
xii) Opening/closing of new branches accepting PDs- RBI norms complied?
c) In case of NBFCs not accepting public deposits5 clauses
Summary of such clauses is produced below
i) Whether BOD has passed a resolution for non-acceptance of any public deposits?
ii) Whether the company has accepted any public deposits during the relevant year?
iii) Whether the company has complied with the prudential norms?
iv) For NBFC-ND-SI and NBFC- ND
a) Whether CRAR has been correctly maintained?
b) Annual statement of capital funds and risk exposures submitted to RBI?
v) Whether NBFC has been correctly classified as NBFC-MFI
d) NBFCs not required to hold CoR (Certificate of Registration) from the RBI based upon
certain conditions auditor should report whether those conditions are being complied.
8.4 Where, in the auditor’s report, the statement regarding any of the items referred above is
unfavourable or qualified:
a) auditor should provide the reasons for the same.
b) make a report of such qualified remarks/non-compliance to the concerned RO (Regional
Office) of the Department of Non-Banking Supervision of the RBI.
The duty of the Auditor for reporting to RBI shall be to report only the contraventions of the
provisions of RBI Act, 1934, and Directions, Guidelines etc.. and such report shall not contain
any statement with respect to compliance of any of those provisions.
9 Audit procedures:
9.1 Verifying Registration compliance by NBFC
Refer Point number 2
9.2 Verifying compliance with prudential norms.
 Check compliance with prudential norms covering
a) income recognition,
b) income from investments
c) accounting standards,
d) accounting for investments
e) asset classification
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f) capital adequacy norms etc.

 NBFC should frame an internal policy for granting loans
 advances and other credit facilities have been properly classified as
standard/substandard/doubtful/loss and that proper provision has been made in accordance with the
Directions.
whether the unrealised income in respect of such assets has not been taken to the Profit & Loss
Account on an accrual basis. Income from NPAs should be accounted for on realisation basis only.
whether all accounts which have been classified as NPAs in the previous year also continue to be
shown as such in the current year also. In case of changes, ascertain the reasons.
9.3 Verifying Compliance with Acceptance of Public Deposit Directions, 2016
a) Credit ratingObtain a copy of the credit rating assigned to NBFC and check whether the public
deposits accepted/held by it are in accordance with the level of credit rating assigned to it
b) In the event of downgrading of credit rating below the minimum specified investment grade, NBFC
shall:
a) with immediate effect, stop accepting fresh public deposits and renewing existing deposits
b) all existing deposits shall run off to maturity
c) report the position within 15 working days, to the concerned Regional Office of the RBI where the
NBFC is registered.
c) Renewal no matured public deposit shall be renewed without the express and voluntary consent
of the depositor.
d) Accuracy of interest Test check the interest calculations in respect of public deposits
e) Consent of depositor whether the NBFC has accepted or renewed any public deposit only after a
written application form the depositor in the form to be supplied by the company
f) Return filing whether the NBFC has filed its prescribed returns in a timely manne
g) Board ResolutionNBFCs not accepting/holding public deposits, check whether a board resolution
has been passed by the NBFC to the effect that it has neither accepted any public deposits nor would
it accept any public deposits during the year
9.4 General points for Auditing NBFC (e.g. audit of Investment and Credit Company NBFC-ICC)
a) Physically verify all the shares and securities held by a NBFC. Where any security is lodged with an
institution or a bank, a certificate from the bank/institution to that effect must be verified.
b) that dividend income wherever declared by a company, has been duly received by an NBFC and
interest wherever due [except in case of NPAs] has been duly accounted for.
c) that dividend income wherever declared by a company, has been duly received by an NBFC and
interest wherever due [except in case of NPAs] has been duly accounted for.
d) whether the investments have been valued in accordance with the NBFC Prudential Norms
e) In respect of shares/securities held through a depository, obtain a confirmation from the
depository regarding the shares/securities held by it on behalf of the NBFC.
f) Compliance with securities lending and borrowing scheme Verify charges received or paid in
respect of securities lend/borrowed.
g) Whether loans and advances have been made as per the internal policy, authorization and after
assessment of credit worthiness of the borrower.

Note- Compliance with CARO 2020- Refer Company Audit- Discussions on CARO 2020.
FR paper reference- Applicability of IND AS for NBFC and Difference between DIVISION II
and DIVISION III of SCHEDULE III to be done thoroughly.