Internal Audit for NBFC: Guidelines, Scope & Types Explained

Internal audit for NBFCs in India can be a difficult to understand because of the complexity of regulatory requirements 

This guide breaks it down in simple terms what exactly needs to follow internal audit rules, what RBI expects, and how your NBFC can stay compliant in 2025.

Key Objectives of Internal Audit for NBFCs

Internal Audit is a critical regulatory requirement and governance pillar for NBFCs in India. 

It acts as the third line of defense (after Business/Operations – 1st line, and Risk/Compliance – 2nd line). 

Here are its key objectives:

1. Ensure Compliance with RBI Regulations

NBFCs are regulated by the Reserve Bank of India (RBI).

Internal audits helps to make sure that the company is following all RBI circulars and directions, meeting the Scale-Based Regulation (SBR) framework and keeping up with KYC, AML, and fair lending practices

2. Risk Management

NBFCs deal with credit risk, operational risk, liquidity risk, and even cyber risks.

Internal audit helps in identifying high-risk areas, reviewing control systems, recommending preventive steps

This helps to prevent fraud, NPA spikes, and poor lending decisions.

3. Fraud Detection and Prevention

Internal auditors check for unauthorized transactions, fake documents and misreporting of loans or NPAs.  Early detection means less damage and faster resolution.

Internal audits also proactively identify vulnerabilities in processes and systems that could be exploited for fraud and recommend preventive/detective measures.

Support fraud investigations when required.

4. Evaluate Internal Controls

An NBFC needs solid internal controls for performing its functions including loan disbursal, customer data protection, employee roles and accounting processes.

Internal audits assess the adequacy, effectiveness, and reliability of the internal control framework across all operations (credit, treasury, operations, IT, compliance, etc.).

5. Improve Operational Efficiency

Internal audit finds gaps like delays in loan processing, inefficient use of staff or tools and duplication of tasks.

They thus help identify opportunities for improving operational efficiency, cost reduction, and process optimization without compromising control.

6. Financial Accuracy

Audits ensure proper bookkeeping, reliable financial statements, accurate asset valuation

They also review the reliability of management information systems (MIS) used for decision-making and reporting. This builds trust with investors, lenders, and regulators.

7. Support Decision-Making by Management

They offer timely, accurate, and objective information to the Audit Committee of the Board and senior management on the state of controls, risks, and compliance.

They provide advisory insights to improve processes and controls based on audit findings and industry best practices.

Types of Internal Audit for NBFC

• Financial & Accounting Audits: It focuses on accuracy of financial records , compliance with accounting standards (Ind AS), revenue recognition, expense controls, asset verification.
• Compliance Audits: Checks adherence to RBI regulations, company policies, laws (KYC/AML, FEMA, Companies Act), and internal procedures.
• Credit or Loan Portfolio Audit): Reviews the entire loan lifecycle – from sourcing & appraisal to disbursement, monitoring, collection and recovery. 
• Information Technology Audits: Assesses IT systems security, data privacy, system reliability, IT controls, cybersecurity, IT governance, disaster recovery. 
• Operational Audits: Focuses on efficiency and effectiveness of key business processes – loan processing, treasury operations, collections, customer service, branch operations, etc.
• Treasury & Investment Audits: Looks into management of funds (borrowing & lending), investments, liquidity risk, interest rate risk, foreign exchange risk, compliance with investment policies.
• Fraud  / Forensic Audits: Proactively detects fraud risks or investigates suspected/alleged fraud (by employees, customers, vendors).
• Concurrent Audit: Real-time or frequent review of high-risk transactions as they happen (especially large loans, treasury deals, cash transactions). Mandatory for larger NBFCs per RBI.
• Thematic or Risk-Based Audits: Deep dive into a specific high-risk area identified by management or the audit plan (e.g., Digital Lending practices, Data Quality, New Product Launch).
• Management Audit: Checks the effectiveness of management processes – decision-making, planning, organizational structure, performance measurement.

Applicability of Internal Audit for NBFCs in India

The Reserve Bank of India (RBI) has made it mandatory for certain NBFCs to implement a Risk-Based Internal Audit (RBIA) framework.

This rule applies to specific categories of NBFCs, based on their size and type.

Applicability Criteria

• Deposit-taking NBFCs (NBFC-D): Internal audit function is mandatory for all deposit-taking NBFCs, regardless of asset size.
• Non-deposit-taking NBFCs (NBFC-ND): Applies to NBFC-NDs (including Core Investment Companies) with asset size ≥ ₹5,000 crore.
• Housing Finance Companies (HFCs): Mandatory irrespective of asset size. For non-deposit-taking HFCs, it is applicable if asset size ≥ ₹5,000 crore.

Tiered Audit Approach Based on Size/Complexity:

RBI mandates a tiered internal audit approach for NBFCs based on their size and complexity. 

Larger NBFCs need advanced, specialized audits; mid-sized ones require robust audit functions; and smaller NBFCs can have simpler setups but must still meet core audit standards like independence and risk-based coverage.

Risk-Based Internal Audit (RBIA) Framework for NBFC

RBIA is an audit approach mandated by RBI for NBFCs and some other financial institutions.

Instead of checking everything equally, it focuses on identifying and auditing the riskiest areas of an NBFC.

Core Principles of RBIA for NBFCs

• Risk-Centric Focus: Prioritize audits based on impact & likelihood of risks.
• Proportionality: Scale of RBIA aligns with the NBFC’s size, complexity, and risk profile (Base/Middle/Upper/Top Layer).
• Dynamic & Continuous: Regular refresh of risk assessments to reflect changing business/regulatory landscapes.
• Integration: Aligns with the NBFC’s Enterprise Risk Management (ERM) framework and business strategy.

Key Features

Risk Assessment and Audit Planning

• NBFCs must create a risk profile of their business each year.
• Then they develop an Annual Audit Plan (AAP) focused on those risks.
• A Risk Audit Matrix is needed to map risks by magnitude and frequency.

Policy Review

Internal audit policies must be reviewed every 3 years to align with evolving risks.

 Audit Frequency

All activities/ locations must undergo risk assessment annually, with audits conducted at least once yearly

Independence of Auditors

RBIA must be independent.

So, the Chief Audit Executive (CAE) reports directly to the Audit Committee of the Board, not to management.

Governance Requirements

Head of Internal Audit (HIA) must be appointed for a minimum 3-year tenure and report directly to the Board/Audit Committee.

Compliance Focus

Audits ensure adherence to RBI regulations, fraud detection, and mitigation of penalties.

Internal Audit Reports must include:

• Assessment of risk maturity levels.
• Opinions on control adequacy and residual risk vs. risk tolerance.
• Pending high/medium-risk issues reported to the Board

Audit Committee Oversight

The Audit Committee of the Board (ACB) must approve the audit plan, monitor progress and ensure audit issues are fixed.

Exemptions

NBFC-NDs with asset size < ₹5,000 crore and non-deposit-taking HFCs below the threshold are exempt

Scope of Internal Audit in NBFCs

The scope of internal audit for NBFCs in India is comprehensive and critical. It covers all areas that can affect risk, compliance, performance, and governance.

Here’s an overview of the same: 

1. Regulatory & Statutory Compliance

• Auditing adherence to RBI Master Directions (e.g., Prudential Norms, KYC/AML, Fair Practices Code, IT Framework).
• RBI reporting timelines and accuracy
• Compliance with Companies Act, FEMA, SARFAESI, Prevention of Money Laundering Act (PMLA), Consumer Protection Rules, etc.
• Validation of regulatory returns 
• Scale-Based Regulation (SBR) compliance
• Risk-Based Internal Audit (RBIA) framework checks

2. Corporate Governance & Ethics

• Board effectiveness, committee structures (Audit, Risk, Nomination & Remuneration)
• Conflict of interest policies, whistleblower mechanisms, and code of conduct
• Related-party transactions and transparency in disclosures

3. Risk Management Framework

• Credit Risk: Loan appraisal, sanctioning, monitoring, NPA management, collateral valuation, and restructuring
• Market Risk: ALM, liquidity risk, investment portfolio volatility
• Operational Risk: Process failures, IT outages, fraud, outsourcing risks
• Integrated Risk: Effectiveness of th e ERM  framework and ICAAP

4. Financial Controls & Reporting

• Accuracy of financial statements -income recognition, asset classification, provisioning
• Treasury operations (funding, investments, derivatives).
• Tax compliance – GST, TDS, Income Tax
• Prevention of window-dressing or misreporting

5. Information Systems & Cybersecurity

• IT strategy alignment, data integrity, system access controls.
• RBI’s Cyber Security Framework compliance, incident response, vulnerability management.
• Digital Lending – Auditing apps/platforms, data privacy, third-party agreements 

6. Fraud Prevention & Management

• Implementation of Fraud Risk Management policies (RBI Master Direction)
• Early warning signal detection and reporting (FMR-1/FMR-2 returns).
• Investigation of suspected frauds and root-cause analysis.

7. Operational Processes

• Loan lifecycle management from sourcing, underwriting, disbursement to recovery
• Treasury/dealing operations, investment safeguards.
• Outsourcing/co-lending arrangements 
• Business continuity planning (BCP) and disaster recovery

8. Customer Protection & Fair Practices

• Adherence to Fair Practices Code 
• Prevention of mis-selling, unfair recovery practices
• Data privacy

9. Strategic & Emerging Risks

• Business model viability, new product risks 
• Climate risk, ESG compliance
• Geopolitical/economic impact assessments

Internal Audit Checklist for NBFCs

Download a free sample Internal Audit Checklist for NBFCs here:

Reasons to Choose PKC for NBFC Internal Audits

✅ Specialized RBI compliance auditing for regulated NBFCs

✅ Proven track record with major financial institutions

✅ Risk-based audit methodology identifies operational vulnerabilities early

✅ Experienced team understands complex NBFC operational challenges

✅ Strategic recommendations beyond mere compliance checking requirements

✅ Digital transformation expertise enhances audit efficiency significantly

✅ Multi-vertical consulting approach addresses holistic business needs

✅ Advanced internal controls testing for NBFC-specific vulnerabilities

✅ NBFC-focused reporting addresses RBI filing requirement gaps

Common Issues Found in NBFC Internal Audits

Some of the most common issues that come to light in NBFC audits are: 

KYC/AML Shortcuts:

Not properly verifying customer identity (address, photo ID) or missing red flags for suspicious money transactions.

 High risk of fraud, money laundering, and heavy RBI penalties.

Late or Wrong RBI Reporting:

Submitting required reports to RBI late, with errors, or missing data (like loan details, capital levels, NPAs).

 RBI relies on this info, mistakes hide risks and invite fines.

Poor NPA Management:

Not identifying bad loans quickly, not setting aside enough money to cover losses, or having weak processes to recover dues.

 Hides true financial health, hurts profits, and risks stability.

Lax IT & Cybersecurity:

Weak passwords, no data encryption, outdated software, missing backups, no proper access controls.

 High risk of data breaches, system crashes, fraud, and operational disruption.

Messy Reconciliation:

Loan system data doesn’t match accounting books; branch cash/bank balances don’t match head office records.

 Hides errors, fraud, and means financial reports are unreliable.

Ignoring Internal Rules:

Employees not following the NBFC’s own approved policies and procedures (e.g., loan approval limits, collection methods).

 Creates inconsistency, operational risks, and control failures.

Weak Branch Controls:

Poor cash handling, missing security documents, lack of supervision at branches/offices.

Opens doors for theft, fraud, and customer complaints.

Ineffective Internal Checks:

Key processes  like loan disbursement, repayments, treasury deals lack proper review or approval steps.

Allows mistakes and fraud to go unnoticed.

Fraud Vulnerabilities:

Lack of systems to detect fake documents, fake borrowers, or employee collusion, especially in loan sourcing/disbursal.

Direct financial loss and legal trouble.

Poor Vendor Management:

Not properly checking third-party service providers like IT vendors, collection agencies or monitoring their performance.

Exposes NBFC to operational, compliance, and reputational risks through the vendor’s actions.

Frequently Asked Questions

1. Are internal audits mandatory for NBFCs in India?

Yes, internal audits are mandatory for certain NBFCs as per RBI guidelines. Smaller NBFCs are not mandated but are encouraged to follow internal audit practices for better risk management.

2. What is the frequency of internal audits for NBFCs?

The frequency depends on the risk profile, but audits are typically conducted quarterly or half-yearly for key areas like loans, compliance, and IT systems. NBFCs must define audit cycles in their Annual Audit Plan based on risk.

3. Can internal audit for NBFCs be outsourced?

Yes, NBFCs can outsource internal audits, but they must ensure the auditors are independent, skilled, and follow RBI norms. The NBFC remains responsible for any lapses, even if the function is outsourced.

4. What are the main types of internal audits conducted by NBFCs?

NBFCs conduct risk-based audits, operational audits, compliance audits, financial audits, and IT audits. These audits cover areas like loans, asset quality, customer service, regulatory compliance, and cybersecurity.