9Credit Losses – Audit and Accounting Guide Depository and Lending Institutions, 2nd Edition

Chapter 9
Credit Losses


9.01 Financial institutions accept and manage significant amounts of credit risk. Declines in the value of underlying collateral have traditionally been the source of most credit losses incurred by financial institutions. The allowance for loan losses is an accounting estimate of credit losses inherent in an institution's loan portfolio that are incurred as of the balance sheet date. Chapter 8, “Loans,” of this guide discusses the various types of loans institutions make or purchase, the lending process and related controls, financial reporting for loans, and the audit procedures for loans.

9.02 Institutions may also have off-balance-sheet financial instruments, such as commitments to extend credit, guarantees, and standby letters of credit that are subject to credit risk. Although liabilities related to credit losses associated with such off-balance-sheet financial instruments are not part of the allowance for loan losses, institutions' processes for evaluation and estimation of credit losses may include consideration of credit risk associated with those off-balance-sheet financial instruments, especially when the counterparty to an off-balance-sheet financial instrument is also a borrower. The information and guidance in this chapter, although generally referring to loan losses, may equally be useful in evaluating and estimating credit losses for off-balance-sheet financial instruments.

9.03 Careful planning, risk assessment and execution of audit procedures related to credit losses is essential due to the significance of the allowance for loan losses and related provision to institutions’ financial statements and to the high degree of subjectivity involved in estimating these amounts, the high degree of regulatory guidance and oversight directed toward institutions' estimates of credit losses, and, consequently, the relatively high inherent audit risk associated with auditing such estimates.

Management's Methodology

9.04 Management is responsible for estimating credit losses using a methodology that results in an estimate that is in accordance with GAAP. Management has a responsibility for developing, maintaining, and documenting a comprehensive, systematic, and consistently applied process for determining the allowance for loan losses. To fulfill that responsibility, management should ensure controls are in place to consistently estimate the allowance for loan losses using a methodology that results in an estimate that is in accordance with GAAP, and that complies with the institution’s stated policies and procedures, and relevant supervisory guidance. Estimating credit losses is unavoidably subjective and involves management making careful judgments about collectibility and estimates of losses. Management's judgments often depend on micro- and macro-economic factors; current conditions existing at the balance sheet date; and realistic courses of action that management expects to take.

9.05 An institution’s methodology for estimating credit losses should be well documented, with clear explanations of the supporting analyses and rationale. An institution's methodology for estimating credit losses is influenced by many factors, including the institution's size, organizational structure, business environment and strategy, management style, loan portfolio characteristics, loan administration procedures, and management information systems. Although different institutions may use different methodologies, there are certain common elements included in any effective methodology. They include, subject to materiality considerations,

  1. a. a detailed and regular analysis of the loan portfolio and off-balance-sheet financial instruments with credit risk;
  2. b. procedures for timely identification of problem credits;
  3. c. consistent use and application;
  4. d. consideration of all known relevant internal and external factors that may affect collectibility;
  5. e. consideration of all loans (whether on an individual or pool-of-loans basis) and other relevant credit exposures;
  6. f. consideration of the particular risks inherent in the different kinds of lending;
  7. g. consideration of the current collateral fair values less cost to sell, where applicable;
  8. h. performance by competent and well-trained personnel with oversight by appropriate levels of management, and, when appropriate, board committees;
  9. i. current, relevant, and reliable data;
  10. j. good documentation with clear explanations of the supporting analyses and rationale;
  11. k. identification of all subsequent events that provide additional evidence about conditions that existed at the balance sheet date;
  12. l. segregation of loans purchased or acquired such that an appropriate allowance for loan losses is recorded for deterioration in cash flows on loans scoped into FASB ASC 310-30 (purchased credit impaired);
  13. m. segregation of troubled loans that have been modified such that an appropriate allowance for loan losses is recorded for loans scoped into FASB ASC 310-40 (troubled debt restructurings by creditors); and
  14. n. consideration of the particular risks in the organization structure, underwriting or loan administration practices, where applicable.

9.06 Allowance methodologies that rely solely on mathematical calculations, such as a percentage of total loans based on historical experience or the similar allowance percentages of peer institutions, generally fail to contain all of the essential elements of an effective methodology because they do not involve a detailed analysis of an institution's particular credit exposures or consider the current economic environment. The allowance documentation should include a conclusion as well as the basis for conclusion on the appropriateness and reasonableness of the resulting point estimate.

9.07 The components of the loan portfolio and their related allowance for loan losses might have different risks, for instance if those components relate to different credit exposures, and the components of the allowance for loan losses are determined using different methodologies, or are subject to different accounting requirements. As discussed in the following paragraph, financial institutions have traditionally identified loans that are to be evaluated for collectibility by dividing the loan portfolio into different segments. Loans with similar risk characteristics are generally grouped and evaluated together. The defining risk characteristics of each segment may include different combinations of such factors as risk classification or rating, past-due status, type of loan, collateral, vintage, geographic regions, FICO scores, loan-to-value ratios, and lines of business. Appropriate segmentation provides for a more accurate assessment of the estimated loss in the portfolio by differentiating loss rates based on common risk factors.

9.08 A key element of most methodologies for estimating credit losses related to commercial loans is a risk classification process that involves categorizing loans into risk categories or ratings. The categorization should be based on relevant information about the ability of borrowers to service the debt, such as current financial information, historical payment experience, credit documentation, public information, current trends, and the value of collateral, including its ability to generate cash flows. Many institutions classify loans using a risk rating system that incorporates as its most serious categories the supervisory classification system as follows:1

  1. substandard. Assets classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
  2. doubtful. Assets classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Doubtful is a transitional asset classification category; loans classified doubtful typically have a pending short term event that will provide evidence of the confirmed loss amount.
  3. loss. Assets classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value but, rather, that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.

9.09 Some loans are listed as special mention.2 Such loans have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or of the institution's credit position at some future date. Special-mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. However, these loans do generally represent an elevated collection risk for the institution and the method of estimating credit losses should consider the elevated collection risk accordingly.

9.10 Examples of potential weaknesses are

  • poor underwriting or loan administration practices that result in significant defects in the loan agreement, security agreement, guarantee agreement, or other documentation and the deteriorating condition of or lack of control over collateral. In other words, these are conditions that may jeopardize the institution's ability to enforce loan terms or that reduce the protection afforded by secondary repayment sources.
  • lack of information (if relevant) about the borrower or guarantors, including stale financial information or lack of current collateral valuations.
  • economic or market conditions existing at the balance sheet date that may affect the borrower's ability to meet scheduled repayments in the future. These may be evidenced by adverse profitability, liquidity, or leverage trends in the borrower's financial statements.

9.11 The supervisory ratings special mention, substandard, doubtful, and loss identify different degrees of credit weakness. Credits that are not covered by these definitions are “pass” credits, for which no formal supervisory definition exists (for example, supervisory ratings do not distinguish among loans within the pass category). However, more precise monitoring of credit risk allows for better allowance estimates and enhances early warning and portfolio management. It is difficult to manage risk prospectively without some stratification of the pass ratings. The number of pass ratings an institution will find useful depends on the complexity of the portfolio and the objectives of the risk rating system. Less complex, community banks may find that a few pass ratings are sufficient to differentiate the risk among their pass-rated credits. Larger, more complex institutions will generally require the use of a larger number of pass ratings to achieve their risk identification and portfolio management objectives.

9.12 Although the Board of Governors of the Federal Reserve System (Federal Reserve), the FDIC, and the Office of the Comptroller of the Currency (OCC) do not require institutions to adopt identical classification definitions, institutions should classify their assets using a system that can be easily reconciled with the supervisory classification system. The lack of an effective classification system may be considered to be an unsafe and unsound practice by regulators.

Loan Reviews

9.13 Loan review function. An effective loan review function should include internal controls to promptly identify loans with potential credit weaknesses and trends that affect the collectibility of the portfolio. Loan credit analyses performed by loan review focus on determining whether the loans are properly classified or rated according to their relative credit risk and were made in accordance with the institution's written lending policies and whether the borrower is likely to perform in accordance with the contractual terms and conditions of the loan. The review typically includes analysis of (a) loan performance since origination or the last renewal, (b) the current economic situation of a borrower or guarantor, (c) estimates of current fair values of collateral, and (d) other information affecting the borrower’s ability to repay. Borrower and guarantor financial statements are generally reviewed for weaknesses concerning financial resources, liquidity, future cash flows, and other financial information pertinent to the ability to repay the debt. Collateral is reviewed to determine whether it is under the institution’s control, whether security interests have been perfected (which is a legal determination), and whether the fair value less costs to sell is greater than the amount owed. Loan file contents are generally reviewed for completeness and conformity with the institution’s written policies for loan file documentation. The nature of the loan review system may vary based on an institution’s size, complexity, loan types and management practices. Some institutions outsource the loan review function to an independent third party, although the loan review function always remains a responsibility of management. Regardless of the structure, the lack of an effective loan review function may be considered to be an unsafe and unsound practice by regulators. The absence of an effective loan review function may also be an indicator of a significant deficiency or a material weakness, as defined in paragraph .07 of AU-C section 265, Communicating Internal Control Related Matters Identified in an Audit (AICPA, Professional Standards).

9.14 Foreign loans should be reviewed and require special consideration because of the transfer risk associated with cross-border lending. Transfer risk is the possibility that an asset cannot be serviced in the currency of payment because of a lack of, or restraint on the availability of, needed foreign exchange in the country of the obligor. Certain foreign loans are required by the Interagency Country Exposure Risk Committee (ICERC) pursuant to the International Supervision Act of 1983 to have allocated transfer risk reserves (ATRRs). ATRRs are minimum specific reserves related to loans in particular countries. Such reserves are minimums, and institutions may determine that a higher allowance for loan losses is necessary based on the assessment of probable losses in accordance with GAAP.

9.15 Loan evaluations performed by management for the purpose of risk rating and measurement of impairment (and tests of such by auditors to the extent they are performed as part of the audit engagement) should avoid the following:

  • Inadequate appraisals of collateral. This is the failure to critically review appraisals to understand the methods employed, assumptions made, and limitations inherent in the appraisal process, including undue reliance on management appraisals. Appraisal methods and assumptions may be inappropriate in the current circumstances. Going concern values generally are dramatically different from liquidation values. For example, real estate appraisals made on the income approach are not usually appropriate for incomplete projects or in circumstances in which operating conditions have changed.
  • Outdated or unreliable financial information. This is the reliance on old, incomplete, or inconsistent data to assess operating performance or financial capacity. Financial information should be current and complete, particularly for borrowers or collateral sensitive to cyclical fluctuations or who demonstrate significant growth or changes in operating philosophy and markets. Collateral values and liquidity often tend to decline in periods during which they are most needed to protect against loan losses. For example, if an oversupply in the real estate market causes lower-than-projected occupancy rates (creating cash flow problems for the borrower), the value of the property will likely decline, diminishing the protection afforded by the collateral. Similar scenarios can be drawn for oil and gas reserves when energy prices decline, for specialized equipment (for example, drilling rigs, mining equipment, farm equipment, steel mills, and construction equipment) during specific industry slowdowns, for farmland during periods of depressed agricultural commodity and livestock prices, and for accounts receivable of a failing company.
  • Excessive renewals or unrealistic terms. This is the reliance on current or performing-as-agreed status if the transaction has been structured to obscure weaknesses. Excessive renewals, unrealistic terms, and interest capitalization may be indications of such a structure. The purpose of a loan and performance against the original agreement should be critically reviewed.
  • Personal bias. This is the bias of a reviewer for or against industries, companies, individuals, and products. For example, the involvement of a public personality in a venture could influence a reviewer to place more credibility than appropriate on the success of the venture.
  • Overlooking self-dealing. This concerns directors or large shareholders of the institution who improperly use their position to obtain excessive extensions of credit on an unsound basis. In this situation, management is often unduly influenced by persons in these positions because management serves at the pleasure of the board and shareholders.
  • Dependence on management representations. This is undue reliance on management and loan officer representations even though there is no supporting evidence. For example, such representations as "the guarantee is not signed but it is still good" or "the future prospects for this troubled borrower are promising" necessitate a critical review.

Loans Individually Evaluated for Impairment

9.16 After segmenting the loan portfolio into groups of loans with similar risk characteristics, loans that are not recognized as being impaired in the individual loan impairment analyses, based on the definition, normally would be evaluated and measured for impairment on a collective basis. Institutions will further identify certain loans to be assessed for individual loan impairment. Loans that are generally assessed for individual impairment include large loans, and loans with especially heightened risk profiles, for example, certain risk categories. The individual loan impairment analyses may be performed by loan officers subject to review by a loan review function or may be performed by a credit risk management function. An individual loan is deemed to be impaired when it is probable that the creditor will be unable to collect all the contractual interest and principal payments as scheduled in the loan agreement. Loans that are recognized as being impaired cannot be further evaluated and measured for impairment on a collective basis, regardless of whether such loans result in an impairment loss or not. For this reason it is important to distinguish between an assessment that concludes a loan is not impaired, and a loan that is impaired but that does not need any allowance or write down.

Loans Collectively Evaluated for Impairment

9.17 Loans not evaluated for impairment individually are included in groups (or pools) of homogeneous loans and evaluated for impairment on a collective basis. The focus of the pool approach is generally on the historical loss experience for the pool. Loss experience, which is usually determined by reviewing the historical loss (charge-off) rate for each pool over a designated time period, is adjusted for changes in current trends and conditions. The time period used for determining the historical loss rate is often referred to as the look-back period. The look-back period should be reasonable, supported, and consistently applied. However, the look-back period should not be static; rather, it should be revised (either shortened or lengthened) as changes occur in the portfolio and its credit quality. The look-back period should be the period that best reflects losses inherent in the current portfolio. The look-back period may differ by segment, as the economic cycle and current conditions may be different for different types of loans. The look-back period impacts the extent of qualitative adjustments made to the historical loss rates because the degree of comparability of the look-back period to the current period will generally vary. For example, during upswings or downswings in the credit cycle a longer look-back period may be less representative of the current environment and therefore may require higher levels of qualitative or environmental factor adjustments than may be necessary for a shorter look-back period. Generally, management should determine the historical loss rate for each group of loans with similar risk characteristics based on the institution’s own loss experience for loans in that group. Methods for calculating loss rates include average historical net charge-off rates, migration analysis (including roll rate analysis), and loss estimation models. The method used by an institution will depend on considerations such as the size of the institution and the nature, scope, and risk of its lending activities. Although historical loss experience provides a reasonable starting point for the analysis of loss rates, historical losses (or even recent trends in losses) do not by themselves form a sufficient basis to estimate the appropriate level of the allowance for loan losses. Management should also consider those qualitative or environmental factors that are likely to cause estimated credit losses associated with the institution’s existing portfolio to differ from historical loss experience. Qualitative or environmental factors can include, but are not limited to,

  • changes in the volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans;
  • changes in the nature and volume of the portfolio and in the terms of loans;
  • changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off and recovery practices not considered elsewhere in estimating credit losses;
  • changes in the experience, ability, and depth of lending management and other relevant staff;
  • changes in international, national, regional, and local economic and business conditions and developments that affect the collectibility of the portfolio, including the condition of various market segments;
  • the existence and effect of any concentrations of credit risk and changes in the level of such concentrations;
  • changes in the quality of the institution’s loan review system;
  • changes in the value of underlying collateral for collateral-dependent loans; and
  • the effect of other external factors, such as competition and legal and regulatory requirements on the level of estimated credit losses in the institution’s existing portfolio.

9.18 Qualitative adjustments may address limitations of the quantitative analysis of the allowance for loan losses based on historical loss experience and serves as a bridge for the difference between (a) conditions prevailing in the current credit environment compared to the environment in the look-back period and (b) the credit profile of the of an entity’s current loan portfolio compared to the credit profile of the portfolio in the look-back period. Identification of relevant qualitative and environmental factor adjustments depends on an understanding of the composition of the portfolio, the lending profile of the institution, market area and current economic conditions and how these elements are or are not captured in the quantitative model. When qualitative adjustments are used, they should be supported by reliable evidence. The quantitative and qualitative analyses should interact with each other to ensure that the allowance for loan losses is appropriate and reflects credit losses incurred as of the balance sheet date.

Estimating Overall Credit Losses

9.19 Careful judgment must be applied in assessing the risks as well as other relevant factors for each segment of loans to estimate the allowance amount to be recorded. Depending on the method used to measure impairment, collective or individual, institutions should follow the appropriate accounting guidance when estimating allowance levels (see paragraphs 9.38–.40). The approach for determination of the allowance should be well documented and applied consistently from period to period, as stated in FASB ASC 310-10-35-4c.

9.20 In addition to the standards outlined previously, SEC Staff Accounting Bulletin (SAB) No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, and the 2006 Federal Financial Institutions Examination Council (FFIEC) Interagency Policy Statement on the Allowance for Loan and Lease Losses provides further guidance regarding documentation requirements related to the allowance for loan losses.

9.21 Management often considers credit losses associated with certain off-balance-sheet financial instruments (such as commitments to extend credit, guarantees, and letters of credit) at the same time it considers credit losses associated with the loan portfolio. Although it is generally practical to consider credit losses on loans and other financial instruments at the same time, estimated credit losses on off-balance-sheet financial instruments should be reported separately as liabilities and not as part of the allowance for loan losses (see paragraph 9.56).

9.22 Management should consider its overall allowance for loan losses and the liability for other credit exposures to be appropriate in accordance with GAAP only if such amounts are considered appropriate to cover estimated losses inherent in the loan portfolio and the portfolio of other financial instruments, respectively. An illustration of a worksheet for an allowance and liability calculation is shown in exhibit 9-1, “Worksheet for Estimating Credit Losses.”

Exhibit 9-1 Worksheet for Estimating Credit Losses

Regulatory Matters

9.23 The Federal Reserve, the FDIC, the OCC (collectively, the federal banking agencies), and the Office of Thrift Supervision’s (prior to its transfer of powers to the federal banking agencies)3 Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions, published in the Federal Register on July 6, 2001, addresses (a) responsibilities of the board of directors and management, (b) importance of maintaining, and nature of, appropriate documentation supporting the reported amount of the allowance for loan and lease losses (ALLL), (c) written policies and procedures regarding the ALLL, and (d) appropriate ALLL methodologies, including validation of methodologies. The statement provides various examples of the areas addressed and includes six frequently asked questions along with agencies’ interpretive responses. On July 6, 2001, the SEC issued parallel guidance in SAB No. 102, which expresses certain staff views on the development, documentation, and application of a systematic methodology as required by Financial Reporting Release No. 28 for determining ALLL in accordance with GAAP. In particular, the guidance focuses on the documentation the staff normally would expect registrants to prepare and maintain in support of the ALLL.

9.24 Guidance was provided to examiners in the federal banking agencies’ December 12, 2006, joint issuance Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices,4 which clarified final guidance on concentrations in commercial real estate lending. The guidance is intended to help ensure that institutions pursuing a significant commercial real estate lending strategy remain profitable while continuing to serve the credit needs of their communities. Other matters addressed include the following:

  • Small- to medium-sized banks facing strong competition should be aware of the risk of unanticipated earnings and capital volatility due to increased real estate loan concentrations. The agencies provide supervisory criteria including the use of numerical indicators in identifying institutions with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny.
  • The guidance also serves to remind institutions that strong risk management practices and appropriate levels of capital are important elements of a sound lending program, particularly when an institution has a concentration in commercial real estate loans.

9.25 The interagency statements include the Interagency Policy Statement on the Allowance for Loan and Lease Losses, which was issued on December 13, 2006, by the federal banking agencies, along with the National Credit Union Administration (NCUA). This statement revised the 1993 policy statement on the ALLL to ensure consistency with GAAP. The revisions make the policy statement applicable to credit unions. The statement addresses (a) the nature and purpose of the allowance, (b) the related responsibilities of the board of directors and management and of the examiners, (c) loan review systems, and (d) international transfer risk matters. The federal banking agencies, along with the NCUA, also issued 16 frequently asked questions to assist institutions in complying with GAAP and ALLL supervisory guidance. (See the entry allowance for loan and lease losses, in the “Glossary” section of the FFIEC’s Instructions for Preparation of Consolidated Reports of Condition and Income, for additional information.)

9.26 On March 17, 2008, the FDIC issued Financial Institution Letter (FIL)-22-2008, Managing Commercial Real Estate Concentrations in a Challenging Environment, to re-emphasize the importance of strong capital and loan loss allowance levels, and robust credit risk management practices for institutions with concentrated commercial real estate exposures, consistent with the commercial real estate lending interagency guidance published on December 12, 2006, and the interagency policy statement on the ALLL issued on December 13, 2006.

9.27 On August 3, 2009, the FDIC issued FIL-43-2009, Allowance for Loan and Lease Losses: Residential Mortgages Secured by Junior Liens, which reminded financial institutions of several key points in the December 13, 2006, interagency guidance (see paragraph 9.25) and provided specific guidance for residential mortgages secured by junior liens. Institutions were reminded that, when estimating credit losses on each group of loans with similar risk characteristics under FASB ASC 450-20, they should consider their historical loss experience on the group, adjusted for changes in trends, conditions, and other relevant factors that affect repayment of the loans in the group as of the ALLL evaluation date. FDIC FIL-43-2009 stated that the need to consider all significant factors that affect the collectibility of loans is especially important for loans secured by junior liens on one-to-four family residential properties, both closed-end and open-end, in areas where there have been declines in the value of such properties. The letter notes that delaying the recognition of estimated credit losses is not appropriate and could delay appropriate loss mitigation activity, such as restructuring junior lien loans to more affordable payments or reducing principal on such loans to facilitate refinancing. The letter concluded by stating that examiners are evaluating the effectiveness of an institution's loss mitigation strategies for loans as part of their assessment of the institution's overall financial condition.

9.28 In January 2012, the federal banking agencies and the NCUA issued Interagency Supervisory Guidance on Allowance for Loan and Lease Losses Estimation Practices for Loans and Lines of Credit Secured by Junior Liens on 1-4 Family Residential Properties. This guidance reiterates key GAAP concepts and supervisory guidance related to the ALLL and loss estimation practices. For institutions that hold a significant junior lien portfolio, the guidance addresses the responsibilities of management in estimating the allowance and examiners’ review of management’s assessment. Although the discussion is specifically tailored in evaluating junior liens, the concepts and principles contained apply to estimating the ALLL for all types of loans. Readers can access the guidance from any of the federal banking agencies’ websites.

9.29 The FDIC released FIL-49-2015, Advisory on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations, in November 2015, to update information contained in the FDIC Advisory on Effective Credit Risk Management Practices for Purchased Loan Participations (initially issued September 2012 through FIL-38-2012). The update advisory addresses purchased loans and loan participations and reminds FDIC-supervised institutions of the importance of underwriting and administering loan purchases and loan participations in the same diligent manner as if the loans were directly originated by the purchasing institution. The advisory also reminds FDIC-supervised institutions that third party arrangements to facilitate the purchase of loans and participations should be managed by an effective third-party risk management process. The advisory goes on to outline recommended practices relating to (a) policy guidelines for purchased loans and participations, (b) independent credit and collateral analysis, (c) profit analysis, (d) loan purchase and participation agreements, (e) ability to transfer sell, or assign interest, (f) due diligence and monitoring of purchased loans and participations in out-of-territory or unfamiliar markets, (g) due diligence of third parties, (h) financial reporting, (i) audit, (j) board approval and reporting, (k) and Bank Secrecy Act/Anti-Money Laundering. Readers can access FIL-49-2015 from the FDIC website at www.fdic.gov.

9.30 Effective March 30, 1993, the federal banking agencies established the Interagency Policy Statement on Documentation for Loans to Small-and Medium-sized Businesses and Farms to encourage lending to small and medium-sized businesses. The policy allows certain banks and savings institutions to establish a portfolio of loans exempt from certain documentation requirements. To qualify for the exemption, each loan may not exceed the lesser of $900,000 or 3 percent of the institution’s total capital, and the aggregate value of the loans may not exceed 20 percent of an institution’s total capital. Examiners may not criticize the credit quality of an exempt loan on the basis of documentation and may not classify the loan unless it is delinquent by more than 60 days. The institution's management, however, is still required to fully evaluate the collectibility of exempt loans in determining the appropriateness in accordance with GAAP of loan loss allowances. (See paragraph 9.97.)

9.31 The OCC’s Bank Accounting Advisory Series (BAAS) is updated periodically to express the Office of the Chief Accountant’s current views on accounting topics of interest to national banks and federal savings associations. See further discussion of the BAAS in paragraph 7.82 of this guide. Topic 4, “Allowance for Loan and Lease Losses,” includes interpretations and responses related to the ALLL. Readers are encouraged to view this publication under the “Publications—Bank Management” page at www.occ.gov.

9.32 Regulatory guidance provides that loans (and other assets) should be placed on nonaccrual (a) when the loan (or asset) is maintained on a cash basis because of deterioration in the financial condition of the borrower, (b) when payment in full of principal or interest is not expected, or (c) when principal or interest has been in default for a period of 90 days or more unless the asset is both well secured and in the process of collection. (See the entry nonaccrual status in the “Glossary” section of the FFIEC’s Instructions for Preparation of Consolidated Reports of Condition and Income. See also appendix B, “Regulatory Reporting Matters—Interpretation and Reporting Related to U.S. GAAP,” of this guide for additional information. Readers can also find questions and answers related to nonaccrual loans in the OCC’s BAAS. See further discussion and a link to this publication in paragraph 9.31.)

9.33 Management should provide auditors access to regulatory examination reports, which generally disclose classified loans and certain statistics regarding those classifications. If a regulatory examination is in process, the auditor should discuss the status and preliminary findings of the examination with institution management and the examiners. Communications with regulators are discussed further in chapter 5, “Audit Considerations and Certain Financial Reporting Matters,” of this guide.

Credit Unions

9.34 Federal credit unions are required by Part 702 of the NCUA regulations to establish and maintain an allowance for loan losses. Federally insured state-chartered credit unions are usually required by their insurance agreement with the National Credit Union Share Insurance Fund (NCUSIF) to establish and maintain an allowance. The requirements for state-chartered credit unions that are not federally insured vary by state and insurer.

9.35 Credit unions should not base the justification of a lower allowance for loan losses on the maintenance of the regular reserve. Regulators have historically stated that the regular reserve has been established to cover loan losses. Although this may be true in a regulatory sense, the regular reserve constitutes an appropriation of undivided earnings and should not be considered in determining the amount of the allowance for loan losses under GAAP.

9.36 For regulatory purposes, credit unions have historically used either the experience method or the adjustment method to calculate their allowance for loan losses. The NCUA issued Interpretive Ruling and Policy Statement (IRPS) 02-3, Allowance for Loan and Lease Losses Methodologies and Documentation for Federally-Insured Credit Unions, through Letter to Credit Unions No. 02-CU-09, Allowance for Loan and Lease Losses. The IRPS provides guidance on the design and implementation of ALLL methodologies and supporting documentation practices. Furthermore, it recognizes that credit unions should adopt methodologies and documentation practices that are appropriate for their size and complexity. As a follow up to IRPS 02-3, the NCUA issued Letter to Credit Unions No. 03-CU-01, Loan Charge-Off Guidance, to provide guidance on the systematic charge off on uncollectible loans. Although the application of the NCUA's methods may or may not result in substantially the same allowance as management's estimate for the allowance, management should report an allowance in the financial statements prepared under GAAP that is appropriate in accordance with GAAP to cover all estimated losses incurred at the statement-of-financial-condition date in the loan portfolio.

9.37 The NCUA also issued Accounting Bulletin No. 06-01 to distribute an interagency advisory addressing the ALLL (see paragraph 9.25 for further discussion on the advisory). The bulletin states that the policy statement applies to all credit unions supervised by the NCUA and insured by the NCUSIF. The policy statement is designed to supplement IRPS 02-03 and the Update on Accounting for Loan Lease Losses.

Accounting and Financial Reporting

Sources of Applicable Guidance

9.38 FASB ASC 310-10 and FASB ASC 450-20 are the primary sources of guidance on accounting for the allowance for loan losses. FASB ASC 450-20 provides the basic guidance for recognition of impairment losses for all receivables (except those receivables specifically addressed in other guidance, such as debt securities). In addition, see FASB ASC 310-40 which addresses loans subject to troubled debt restructurings, and which can interact with the guidance on impaired loans.

9.39 Paragraphs 12–40 of FASB ASC 310-10-35 provide specific guidance on measurement and disclosure for loans that are identified for evaluation and that are individually deemed to be impaired (because it is probable that the creditor will be unable to collect all the contractual interest and principal payments as scheduled in the loan agreement).

9.40 The “General” subsection of FASB ASC 310-10-35 addresses both the impairment concepts applicable to all receivables, with references to the guidance in FASB ASC 450-20 where appropriate, and the impairment concepts related to loans that are identified for evaluation and that are individually deemed to be impaired, as discussed in FASB ASC 310-10-35-2 (see paragraph 9.39). Paragraphs 33–36 of FASB ASC 310-10-35 also address the interaction between FASB ASC 310-10-35 and FASB ASC 450-20.

Allowance for Loan Losses

9.41 The following provides an overview of GAAP for loan impairments, as stated in FASB ASC 310-10-35-4:

  1. a. It is usually difficult, even with hindsight, to identify any single event that made a particular loan uncollectible. However, the concept in GAAP is that impairment of receivables should be recognized when, based on all available information, it is probable that a loss has been incurred based on past events and conditions existing at the date of the financial statements.
  2. b. Losses should not be recognized before it is probable that they have been incurred, even though it may be probable based on past experience that losses will be incurred in the future. It is inappropriate to consider possible or expected future trends that may lead to additional losses. Recognition of losses should not be deferred to periods after the period in which the losses have been incurred.
  3. c. GAAP does not permit the establishment of allowances that are not supported by appropriate analyses. The approach for determination of the allowance should be well documented and applied consistently from period to period.
  4. d. Under FASB ASC 450-20, the threshold for recognition of impairment should be the same whether the creditor has many loans or has only one loan. FASB ASC 310-10-35-9 requires that if the conditions of FASB ASC 450-20-25-2 are met, accrual should be made even though the particular receivables that are uncollectible may not be identifiable.
  5. e. The guidance in FASB ASC 310-10-35 is more specific than FASB ASC 450-20 in that it requires certain methods of measurement for loans that are individually considered impaired, but it does not fundamentally change the recognition criteria for loan losses.

9.42 The allowance for loan losses should be appropriate in accordance with GAAP to cover probable credit losses related to specifically identified loans as well as probable credit losses inherent in the remainder of the loan portfolio.

9.43 The act of lending money generally is not the event that causes asset impairment, and future losses should not be provided for at the time loans are made. Credit losses are provided for when the events have occurred that cause the losses or loan impairment (for example, loss of employment, disability, or bankruptcy). As stated in FASB ASC 942-310-25-1, generally, a loan would be impaired at origination only if a faulty credit granting decision has been made or loan credit review procedures are inadequate or overly aggressive, in which case, the loss generally should be recognized at the date of loan origination.

9.44 Loans that are identified for evaluation or that are individually considered impaired. FASB ASC 310-10-35 provides guidance on measurement and disclosure of loans that are identified for evaluation and that are individually deemed to be impaired through a three-step process of identifying loans for evaluation (paragraphs 14–15 of FASB ASC 310-10-35), assessing whether a loan is impaired (paragraphs 16–19 of FASB ASC 310-10-35), and measurement of impairment if a loan is deemed impaired (paragraphs 20–36 of FASB ASC 310-10-35). In accordance with FASB ASC 310-10-35-13, this guidance applies to all loans that are identified for evaluation, uncollateralized as well as collateralized, except for (a) large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment, (b) loans that are measured at fair value or at the lower of cost or fair value, (c) leases as defined in FASB ASC 840, Leases, and (d) debt securities as defined in FASB ASC 320, Investments—Debt and Equity Securities. This guidance does not address when a creditor should record a direct write-down of an impaired loan, nor does it address how a creditor should assess the overall adequacy of the allowance for credit losses.

9.45 Paragraphs 20–36 of FASB ASC 310-10-35 address the measurement of impairment. FASB ASC 310-10-35-21 permits a creditor to aggregate impaired loans that have risk characteristics in common with other impaired loans and use historical statistics, such as average recovery period and average amount recovered, along with a composite effective interest rate as a means of measuring those impaired loans.

9.46 FASB ASC 310-10-35-22 states that when a loan is impaired (see paragraphs 16–17 of FASB ASC 310-10-35), a creditor should measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan's observable market price or the fair value of the collateral if the loan is collateral dependent. As discussed in the FASB ASC glossary, a collateral-dependent loan is a loan for which the repayment is expected to be provided solely by the underlying collateral. Generally, repayment of an impaired loan would be expected to be provided solely by the sale or continued operation of the underlying collateral if cash flows from all other available sources (including guarantors) are expected to be no more than nominal.

9.47 FASB ASC 310-10-35-23 states that if a creditor uses the fair value of the collateral to measure impairment of a collateral-dependent loan and repayment or satisfaction of a loan is dependent on the sale of the collateral, the fair value of the collateral should be adjusted to consider estimated costs to sell. However, if repayment or satisfaction of the loan is dependent only on the operation, rather than the sale, of the collateral, the measure of impairment should not incorporate estimated costs to sell the collateral.

Loss Contingencies

9.48 Paragraphs 1 and 3 of FASB ASC 450-20-25 state that when a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset can range from remote to probable. (Probable, according to the FASB ASC glossary, means the future event or events are likely to occur.) However, the conditions for accrual are not intended to be so rigid that they require virtual certainty before a loss is accrued.

9.49 FASB ASC 450-20-25-2 requires that an estimated loss from a loss contingency should be accrued by a charge to income if both of the following conditions are met:

  1. a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
  2. b. The amount of loss can be reasonably estimated.

9.50 FASB ASC 450-20 deals with uncertainty by requiring a probability threshold for recognition of a loss contingency and that the amount of the loss be reasonably estimable. As noted in FASB ASC 450-20-30-1, when both of those recognition criteria are met, and the reasonably estimable loss is a range, the accrual should be the amount that appears to be a better estimate than any other estimate within the range or the minimum amount in the range if no amount within the range is a better estimate than any other amount.

9.51 The following are examples of loss contingencies:

  • Collectibility of receivables other than loans
  • Guarantees of indebtedness of others
  • Obligations of commercial banks under standby letters of credit
  • Agreements to repurchase receivables (or to repurchase the related property) that have been sold

Financial Statement Presentation and Disclosure of Loan Impairment and Allowance for Credit Losses

9.52 Paragraphs 41–42 of FASB ASC 310-10-35 state that credit losses for loans and trade receivables, which may be for all or part of a particular loan or trade receivable, should be deducted from the allowance. The related loan or trade receivable balance should be charged off in the period in which the loans or trade receivables are deemed uncollectible (for example, the loss is confirmed). Recoveries of loans and trade receivables previously charged off should be recorded when received. Practices differ between entities as some industries typically credit recoveries directly to earnings. Financial institutions typically credit the allowance for loan losses for recoveries, which, in combination with the practice of frequently reviewing the adequacy of the allowance for loan losses, results in the same credit to earnings, albeit in an indirect manner.

9.53 Provisions for loan and other credit losses should be charged to operating income sufficient to maintain the allowance for loan losses or liabilities related to off-balance-sheet credit exposures at a level appropriate in accordance with GAAP—that is, management should verify that the allowance is appropriate to cover incurred losses in accordance with GAAP as of the balance sheet date. Thus, the primary measurement focus is on the appropriateness of the balance of the allowance and the liabilities, rather than on the resulting provision charged to income.

9.54 Impaired loans. Paragraphs 14A–20 of FASB ASC 310-10-50 require disclosure of information about loans that meet the definition of an impaired loan in paragraphs 16–17 of FASB ASC 310-10-35. Included are various disclosures about the recorded investment in the impaired loans, the total unpaid principal balance of the impaired loans, the entity's interest income recognition policy, the activity in the allowance for loan losses, the entity’s loan impairment assessment policy, and factors considered in determining that the loan is impaired. (See FASB ASC 310-40-50 for disclosure information about an impaired loan that has been restructured in a troubled debt restructuring involving a modification of terms.)

9.55 Loans acquired with deteriorated credit quality. FASB ASC 310-30-50 provides disclosure guidance regarding loans with evidence of deterioration of credit quality since origination that are acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable, as explained in FASB ASC 310-30-05-1. Paragraphs 8.110–.122 of this guide provide additional information regarding loans and debt securities acquired with deteriorated credit quality.

9.56 Off-balance-sheet credit exposures. As stated in paragraphs 1–3 of FASB ASC 825-10-35, an accrual for credit loss on a financial instrument with off-balance-sheet risk should be recorded separately from a valuation account related to a recognized financial instrument. Credit losses for off-balance-sheet financial instruments should be deducted from the liability for credit losses in the period in which the liability is settled. Off-balance-sheet financial instruments refer to off-balance-sheet loan commitments, standby letters of credit, financial guarantees, and other similar instruments with off-balance-sheet credit risk, except for instruments within the scope of FASB ASC 815-10. See chapter 20, “Fair Value,” of this guide for a summary of FASB ASC 825, Financial Instruments.

9.57 FASB ASC 310-10-50-9 requires that in addition to disclosures required by FASB ASC 450-20, an entity should disclose a description of the accounting policies and methodology the entity used to estimate its liability for off-balance-sheet credit exposures and related charges for those credit exposures. Such a description should identify the factors that influenced management's judgment (for example, historical losses and existing economic conditions) and a discussion of risk elements relevant to particular categories of financial instruments.

9.58 Allowance for credit losses related to financing receivables. In accordance with FASB ASC 310-10-50-11B, an entity should disclose all of the following by portfolio segment:5

  1. a. A description of the entity’s accounting policies and methodology used to estimate the allowance for credit losses, including all of the following:

i.  A description of the factors that influenced management’s judgment, including both historical losses and existing economic conditions

ii.  A discussion of risk characteristics relevant to each portfolio segment

iii.  Identification of any changes to the entity’s accounting policies or methodology from the prior period and the entity’s rationale for the change

  1. b. A description of the policy for charging off uncollectible financing receivables
  2. c. The activity in the allowance for credit losses for each period, including all of the following:

i.  The balance in the allowance at the beginning and end of each period

ii.  Current period provision

iii.  Direct write-downs charged against the allowance

iv.  Recoveries of amounts previously charged off

  1. d. The quantitative effect of changes to allowance accounting policies or methodology on the current period loss provision
  2. e. The amount of any significant purchases of financing receivables during each reporting period
  3. f. The amount of any significant sales of financing receivables or reclassifications of financing receivables to held for sale during each reporting period
  4. g. The balance in the allowance for credit losses at the end of each period disaggregated on the basis of the entity’s impairment method
  5. h. The recorded investment in financing receivables at the end of each period related to each balance in the allowance for credit losses, disaggregated on the basis of the entity’s impairment methodology in the same manner as the disclosure in item g

See paragraph 8.163 for additional disclosures related to credit quality that are required pursuant to FASB ASC 310-10-50.

According to FASB ASC 310-10-50-11A, the preceding guidance does not apply to financing receivables listed in FASB ASC 310-10-50-7B or lessors’ net investments in leveraged leases.

9.59 FASB ASC 310-10-50-11C states to disaggregate the information required by items g and h in the preceding paragraph on the basis of the impairment methodology, an entity should separately disclose the following amounts:

  1. a. Amounts collectively evaluated for impairment (determined under FASB ASC 450-20)
  2. b. Amounts individually evaluated for impairment (determined under FASB ASC 310-10-35)
  3. c. Amounts related to loans acquired with deteriorated credit quality (determined under FASB ASC 310-30)

9.60 Risks and uncertainties. In accordance with FASB ASC 310-10-50-25, certain loan products have contractual terms that expose entities to risks and uncertainties that fall into one or more categories, as discussed in FASB ASC 275-10-50-1. See FASB ASC 275-10-50 for disclosure guidance related to those loan products.

9.61 Credit unions. A change from a method of calculating the allowance for loan losses that is not generally accepted (for example, a calculation used for regulatory purposes) to a method that is generally accepted and that results in an adjustment to the amount previously reported is considered a correction of an error and is reported as a prior-period adjustment, requiring restatement of prior-period financial statements, in accordance with FASB ASC 250-10-45-23. Such a change frequently arises when a credit union that has in the past undergone only supervisory committee audits initially undergoes an audit in accordance with generally accepted auditing standards.



9.62 The primary objectives of audit procedures for credit losses are to obtain sufficient appropriate evidence that

  1. a. the allowance for loan losses and liability for other credit exposures are appropriate in accordance with GAAP to cover the amount of probable credit losses inherent in the loan portfolio and off-balance-sheet financial instruments, respectively, at the balance sheet date;
  2. b. credit losses and other items, such as loan charge-offs and recoveries, have been included in the financial statements at appropriate amounts and in the appropriate reporting periods; and
  3. c. disclosures are adequate.

The auditor generally achieves those objectives by testing management's estimates of the allowance based on available and relevant information regarding loan collectibility. The auditor could also develop an independent estimate as more fully discussed in paragraph 9.79. The auditor is not responsible for estimating the amount of the allowance or ascertaining the collectibility of each, or any, specific loan included in an institution's loan portfolio.

Planning and Risk Assessment

9.63 In accordance with AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards), the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement (as described in chapter 5 of this guide). Because of the significance of loans to institutions' balance sheets, and because the estimation of loan losses is based on subjective judgments, auditors are likely to assess inherent risk related to the allowance for loan losses as high. Such assessment will influence engagement staffing, extent of supervision, overall scope and strategy, and degree of professional skepticism applied. Further, it is necessary for the auditor to gain familiarity with the applicable regulatory guidance, including guidance on the classification of credits, concentration of credits, foreign loans, and significant related parties.

9.64 AU-C section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures (AICPA, Professional Standards), addresses the auditor’s responsibilities relating to accounting estimates, including fair value accounting estimates and related disclosures, in an audit of financial statements. Specifically, it expands on how AU-C sections 315; 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AICPA, Professional Standards); and other relevant AU-C sections are to be applied with regard to accounting estimates. It also includes requirements and guidance related to misstatements of individual accounting estimates and indicators of possible management bias.

Considerations for Audits Performed in Accordance With PCAOB Standards

When performing an integrated audit of financial statements and internal control over financial reporting in accordance with PCAOB standards, the work that the auditor performs as part of the audit of internal control over financial reporting should necessarily inform the auditor’s decisions about the approach he or she takes to auditing an estimate because, as part of the audit of internal control over financial reporting, the auditor would be required to obtain an understanding of the process management used to develop the estimate and to test controls over all relevant assertions related to the estimate.

PCAOB Staff Audit Practice Alert No. 11, Considerations for Audits of Internal Control Over Financial Reporting (AICPA, PCAOB Standards and Related Rules, PCAOB Staff Guidance, sec. 400.11), highlights certain requirements of the auditing standards of the PCAOB in aspects of audits of internal control over financial reporting in which significant auditing deficiencies have been cited frequently in PCAOB inspection reports. Specifically, this alert discusses the following topics:

  • Risk assessment and the audit of internal control
  • Selecting controls to test
  • Testing management review controls
  • IT considerations, including system-generated data and reports
  • Roll-forward of controls tested at an interim date
  • Using the work of others
  • Evaluating identified control deficiencies

9.65 The audit procedures performed in connection with the allowance for loan losses typically are time-consuming and are most efficient if initiated early in the audit. Because of the subjective nature of the allowance for loan losses, experienced audit personnel, preferably with prior depository institution engagement experience and, if necessary, with knowledge of industries in which the institution's loans are concentrated, should closely supervise or perform the audit procedures. One example would be audit procedures over loan reviews. The assigned audit staff should also understand the lending environment, including credit strategy; credit risk; and the lending policies, procedures, and control environment of the institution, and should be familiar with known related parties and related-party transactions.

9.66 Another important consideration in obtaining an understanding of the entity and its environment is whether an institution's loan review and internal audit functions can be considered in the audit plan by the auditor, and permit the auditor to modify the nature, timing, and extent of procedures to be performed. Discussions with loan review and internal audit staff can provide the auditor with information concerning loan customers, related-party transactions, and account histories that may not be readily available elsewhere. Also, because the internal audit function is involved in evaluating accounting systems and control activities (as discussed in chapter 8 of this guide), it can provide the auditor with important control process descriptions and results of testing that are helpful in understanding internal control. Chapter 5 of this guide discusses consideration of the internal audit function.

9.67 Paragraph .A120 of AU-C section 315 states that information gathered by performing risk assessment procedures, including the audit evidence obtained in evaluating the design of controls and determining whether they have been implemented, is used as audit evidence to support the risk assessment. The risk assessment determines the nature, timing, and extent of further audit procedures to be performed. As a part of the risk assessment with respect to the allowance for loan losses, the auditor should consider factors such as

  • composition of the loan portfolio;
  • identified potential problem loans, including loans classified by regulatory agencies;
  • trends in loan volume by major categories, especially categories experiencing rapid growth, and in delinquencies and restructured loans;
  • previous loss and recovery experience, including timeliness of charge-offs;
  • concentrations of loans to individuals and their related interests, industries, and geographic regions;
  • size of individual credit exposures (few, large loans versus numerous, small loans);
  • quality of internal loan review and internal audit functions, and results of their work;
  • total amount of loans and problem loans, including delinquent loans, by officer;
  • lending, charge-off, collection, and recovery policies and procedures;
  • loan documentation and compliance exceptions reports;
  • loans with repayment terms structured (or restructured) such that collectability problems and concerns may not be evident until payments come due, such as construction loans with interest reserves included in the loan commitment amount;
  • local, national, and international economic and environmental conditions;
  • experience, competence, and depth of lending management and staff;
  • results of regulatory examinations;
  • discussions of significant lending activities included in board and loan committee minutes;
  • related-party lending;
  • organizational structure; and
  • management information systems.

Individual components of the allowance for loan losses might have different risks (for example, components that reflect different credit exposures, are determined using different methodologies, or are subject to different accounting requirements). As a result, the risk assessment process should involve challenging management’s methodology and process, including factors such as portfolio segmentation, look-back periods, loss emergence periods, qualitative factors, and other criteria and metrics used to estimate the allowance for loan losses.

Internal Control Over Financial Reporting and Possible Tests of Controls

9.68 AU-C section 315 addresses the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through understanding the entity and its environment, including the entity’s internal control. Paragraphs .13–.14 of AU-C section 315 state that the auditor should obtain an understanding of internal control relevant to the audit and, in doing so, should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel. (See chapter 5 of this guide for further discussion of the components of internal control.) To provide a basis for designing and performing further audit procedures, paragraph .26 of AU-C section 315 states that the auditor should identify and assess the risks of material misstatement at the financial statement level and the relevant assertion level for classes of transactions, account balances, and disclosures.

9.69 Effective controls related to estimating the allowance for loan losses may reduce the likelihood of material misstatement of the allowance for loan losses. The auditor should obtain an understanding of (a) how management developed the allowance for loan losses, (b) how the process has changed from prior periods, and (c) the institution's loan portfolio, lending process, loan accounting policies, market focus, trade area, and other relevant factors. Specific aspects of effective controls related to the allowance for loan losses may include the following:

  • Control environment, including management communication of the need for proper reporting of the allowance. The control environment strongly influences the effectiveness of the system of controls and affects the auditor's assessment of control risk. The control environment reflects the overall attitude, awareness, and action of the board of directors and management concerning the importance of control. The auditor might consider

—  the level of the board of directors’ and management’s integrity and ethical values;

—  the board and management’s commitment to competence;

—  the level of involvement and quality of leadership provided by the board of directors, audit committee, and senior management in evaluating the allowance;

—  management's philosophy and operating style;

—  the organizational structure;

—  the assignment of authority and responsibility; and

—  human resource policies and practices.

  • Controls over the completeness and accuracy of data used, including the accumulation of relevant, sufficient, and reliable data on which to base management's estimate of the allowance. Management reports summarizing loan activity, renewals, and delinquencies are vital to the timely identification of problem loans. The institution's procedures and controls are important for identifying when loans should be placed on nonaccrual status, provided for, or charged off. Most institutions have written policies covering nonaccrual status, the timing of charge-offs, and transfers of loans to the special asset or workout department. Most institutions have policies and procedures for the gathering and analysis of information from and about debtors. Management should have controls over the completeness and accuracy of underlying data used in formulating the allowance estimate, such as segmented portfolio balances, loan risk classifications or ratings, charge-offs, delinquencies, and exceptions to underwriting standards.
  • Controls over loan risk ratings. There may be multiple controls or elements of controls that operate over the appropriateness of loan risk ratings to mitigate the risk of using inaccurate ratings in formulating the allowance estimate. The controls should be designed such that the risk rating used for purposes of the allowance estimate is subject to review by a party other than the individual responsible for assigning the rating. The following are examples of controls that address the appropriateness of loan risk ratings; this is not intended to be an all-inclusive list:

—  Independent loan reviews. Loan reviews should be conducted by competent personnel who are independent of the underwriting, supervision, and collections functions. Alternatively, an independent loan review function may be outsourced to a competent third party. Although the specific lines of reporting for the loan review function often will depend on the complexity of the institution's organizational structure, the loan reviewers should report to a high level of management that is independent from the lending process in the institution. The loan review function is designed to test line management's identification and evaluation of existing and potential problem loans in a timely manner, including the appropriateness of individual loan risk ratings used in the allowance estimate. The loan review function should be designed to address considerations such as (a) risk assessment, including the determination of which groups of loans will be covered through credit file reviews by independent loan review in the current year; (b) selection of individual loans within those loan groups for review in the current year; (c) overall credit file review plan for the current year; (d) frequency of credit file reviews; (e) definition of loan risk rating exceptions; and (f) use of credit file review results. The sample of loans selected for review should be representative and unbiased.

—  The loan review function ordinarily conducts a series of activities, including but not limited to

  • conducting a risk assessment of the segmented risk rated loan portfolios;
  • preparing a loan file review plan;
  • determining the frequency of loan reviews;
  • monitoring risk assessment considerations to determine whether the loan review plan should be updated;
  • defining loan risk rating exceptions;
  • selecting a risk-based sample of loans for review and evaluating whether the assigned loan risk rating is appropriate;
  • evaluating the appropriateness of the assigned loan risk rating for loans for which a loan review was performed;
  • concluding whether the loan review results are appropriate and representative of the entire risk rated loan population, thereby mitigating the risk of inappropriate loan risk ratings in the population of risk rating loans in the current year; and
  • communicating loan review results to management for consideration in the allowance estimate for the current year.

—  Other reviews of loan risk ratings. In addition to independent loan reviews, institutions may have one or more controls that are relevant to the accuracy of loan risk ratings. Such controls may take different forms and vary from institution to institution. For example, an institution may subject loans with risk ratings to a formal review at least annually to ensure the ratings are accurate and up to date. In that regard, the responsible loan officer may be required to conduct and document a review of each loan that includes, among other things, a formal reassessment of the accuracy of the loan’s risk rating. The loan officer’s reassessment may then be subjected to a secondary review. The secondary annual review functions as a control over risk ratings assigned to all loans with such ratings, including groups of loans that are not covered by the scope of the independent loan review function in the current year.

  • Controls over the loss estimation process. A loss estimation process for individually impaired loans and groups of other loans includes

—  assigning responsibility for identification of impaired loans;

—  assigning responsibility for measurement of impairment;

—  impaired loan tracking and impairment measurement information system;

—  historical loss tracking and loss rates measurement information system;

—  documenting current economic conditions that differ from conditions that prevailed in the prior periods used to determine historical loss rates, and justification for specific adjustments to historical loss rates; and

—  accumulating the component needs of the allowance and provision amounts.

Controls over the loss estimation process include review controls over the judgments within the allowance estimate, as well as controls over the completeness and accuracy of underlying data used in the operation of the review control. These also include controls over models used in the estimation process.

  • Adequate review and approval of the allowance estimates by the individuals specified in management's written ALLL policy (or other documents that describe the ALLL methodology). This includes

—  review of sources of relevant information;

—  review of development of assumptions and methodologies (for example, historical loss experience, including the look-back period and loss emergence period, and qualitative adjustment factors);

—  review of reasonableness of assumptions, methodologies, and resulting estimates, including metrics, thresholds, or criteria to identify outliers or exceptions;

—  consideration of the need to use the work of specialists (such as appraisers or construction specialists);

—  consideration of changes in previously established methods to arrive at the allowance; and

—  review of accuracy of data and calculations.

  • Back-testing and validation of prior estimates related to the allowance with subsequent results to assess the reliability of the process used to develop the allowance, including controls over the back-testing process.
  • Controls over the identification of subsequent events or transactions that provide additional evidence about conditions that existed or did not exist at the balance sheet date. Considerations may include the following:

—  Whether loans that have become delinquent or that have been restructured or charged off subsequent to the balance sheet date were impaired as of the balance sheet date.

—  Updated appraisal information received subsequent to the balance sheet date.

—  Independent loan review results received subsequent to the balance sheet date.

—  Regulatory examination results received subsequent to the balance sheet date.

9.70 Because compliance with a well-defined lending policy is essential to an institution's asset quality, failure to follow that policy could have a substantial impact on the reliability of financial statement assertions. For example, authority limits established in management's written underwriting policies are based in large part on (a) the knowledge and skill of the reviewing loan officer or committee and (b) the credit risk the institution is willing to assume on a particular type of loan. A loan made for an amount in excess of an officer's limit, or for an unauthorized loan type, would normally involve greater amounts of credit or other risks. Accordingly, management's financial statement assertions about impairment and valuation of the loan portfolio, for example, may be affected.

9.71 AU-C section 330 addresses the auditor’s responsibility to design and implement responses to the risks of material misstatement identified and assessed by the auditor in accordance with AU-C section 315 and to evaluate the audit evidence obtained in an audit of financial statements.

9.72 In accordance with paragraph .08 of AU-C section 330, the auditor should design and perform tests of controls to obtain sufficient appropriate audit evidence about the operating effectiveness of relevant controls if (a) the auditor’s assessment of risks of material misstatement at the relevant assertion level includes an expectation that the controls are operating effectively or (b) substantive procedures alone do not provide sufficient appropriate audit evidence at the relevant assertion level. The auditor may consider performing procedures such as the following to test the effectiveness of internal control over financial reporting in the area of credit losses:

  • Review and challenge the design of the institution’s accounting policies and procedures describing the process for determining, evaluating, and maintaining the allowance for loan losses and other credit losses in accordance with GAAP. Discuss these policies and procedures with appropriate personnel to determine whether they understand the related financial reporting objective.
  • Test the controls over identifying and reporting classified and potential problem loans (for example, a watch list) and following up on such loans, as well as delinquent loan reports and procedures for follow-up on delinquencies.
  • Examine evidence that senior management and an appropriate board committee review and monitor past due loans, watch list loans, classified loans, and assigned risk ratings.
  • Test application controls and related general IT controls, including system interfaces and account mapping, for all relevant systems.
  • Test the controls over completeness and accuracy of the underlying data used in the allowance process, including the preparation of the periodic past due, watch list, and classified loans reports.
  • Test the controls over how each report is prepared, including which loans are included and excluded.
  • Examine evidence that the delinquent loan report interfaces appropriately with the watch list or problem loan report.
  • Test the controls over the completeness and accuracy of loans between the trial balance and the applicable report.
  • Examine evidence that the institution has an independent loan review function to review and evaluate loan officer analyses of significant loans, including the accuracy of the risk ratings.
  • Examine evidence of secondary review of the loan officers’ periodic loan risk ratings.
  • Review the institution’s documentation that analyzes each component of the allowance for loan losses. For example, test the calculation of historical loss experience for one or more periods and one or more pools of loans or test the calculation of discounted expected cash flows for one or more impaired loans.
  • Read minutes of meetings of the board or loan committee for evidence of the periodic review and approval of the appropriateness in accordance with GAAP of the allowance for loan losses based on appropriate documentation.

There may be more than one control that addresses the assessed risk of material misstatement to a particular relevant assertion for the ALLL; and therefore the combination of controls would prevent, or detect, a material misstatement.

9.73 Management review controls may be higher-level or process-level controls and usually involve a member of management reviewing information contained in documents, reports, or other information produced by the entity, including variance reports, exception reports, or detailed calculations supporting financial statement balances or disclosures. Management review controls also may relate to significant management estimates or judgments incorporated into the allowance process, such as independent loan review and management review of qualitative or environmental factors and adjustments to the historical loss experience. The design of management review controls includes metrics, thresholds, or other criteria to identify outliers or exceptions and should involve the appropriate level of precision to ensure that the controls would detect a material misstatement.

9.74 Ordinarily, it is expected that a management review control is performed using information produced by the entity. When testing controls that are dependent on information produced by the entity (for example, system generated or management prepared reports), the auditor should test controls over the completeness and accuracy of that information.

Substantive Tests

9.75 Irrespective of the assessed risks of material misstatement, paragraph .18 of AU-C section 330 states that the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure, which for a financial institution would include credit losses. In accordance with paragraph .A45 of AU-C section 330, this requirement reflects the facts that (i) the auditor’s assessment of risk is judgmental and may not identify all risks of material misstatement and (ii) inherent limitations to internal control exist, including the potential for management override.

9.76 Based on the assessed risks of material misstatement, paragraph .12 of AU-C section 540 states that the auditor should determine

  1. a. whether management has appropriately applied the requirements of the applicable financial reporting framework relevant to the accounting estimate (in this instance, the allowance for loan losses) and
  2. b. whether the methods for making the accounting estimates are appropriate and have been applied consistently and whether changes from the prior period, if any, in accounting estimates or the method for making them are appropriate in the circumstances.

9.77 In responding to the assessed risks of material misstatement, as required by AU-C section 330, paragraph .13 of AU-C section 540 states that the auditor should undertake one or more of the following, taking into account the nature of the accounting estimate:

  1. a. Determine whether events occurring up to the date of the auditor’s report provide audit evidence regarding the allowance for loan losses.
  2. b. Test how management made the accounting estimate of the allowance for loan losses and the data on which it is based. In doing so, the auditor should evaluate whether

i.  the method of measurement used is appropriate in the circumstances,

ii.  the assumptions used by management are reasonable in light of the measurement objectives of the applicable financial reporting framework (see further discussion in paragraph 9.80), and

iii.  the data on which the allowance is based are sufficiently reliable for the auditor’s purposes.

  1. c. Test the operating effectiveness of the controls over how management made the accounting estimate of the allowance for loan losses, together with the appropriate substantive procedures.
  2. d. Develop a point estimate or range to evaluate management’s point estimate. For this purpose

i.  if the auditor uses assumptions or methods that differ from management’s, the auditor should obtain an understanding of management’s assumptions or methods sufficient to establish that the auditor’s point estimate or range takes into account relevant variables and to evaluate any significant differences from management’s point estimate.

ii.  if the auditor concludes that is it appropriate to use a range, the auditor should narrow the range, based on audit evidence available, until all outcomes within the range are considered reasonable.

9.78 Generally, the most effective audit strategy for the allowance for loan losses is to test management’s methodology and process. This strategy may include

  • testing the extent to which data used in formulating the accounting estimate of the allowance for loan losses is accurate, complete, and relevant and whether the estimate has been properly determined using such data and management assumptions;
  • considering the source, relevance, and reliability of external data or information, including that received from external experts engaged by management to assist in making the accounting estimate;
  • determining how management has taken into account the effect of events, transactions, and changes in circumstances occurring between the date that the accounting estimate or inputs to the estimate were determined and the reporting date (for example, a valuation by an independent appraiser made prior to the reporting date);
  • recalculating the accounting estimate and reviewing information about the estimate for internal consistency;
  • considering management’s review and approval processes for the accounting estimate; and
  • determining consistency of the resulting estimate with applicable GAAP.

9.79 In accordance with paragraph .A81 of AU-C section 540, the assumptions on which accounting estimates, such as the allowance for loan losses, are based may reflect what management expects will be the outcome of specific objectives and strategies. In such cases, the auditor may perform audit procedures to evaluate the reasonableness of such assumptions by considering, for example, whether the assumptions are consistent with

  • the general economic environment and the entity’s economic circumstances.
  • the plans of the entity.
  • assumptions made in prior periods, if relevant.
  • the experience of, or previous conditions experienced by, the entity to the extent this historical information may be considered representative of future conditions or events. For example, compare current year charge-offs with prior period estimated losses to determine the historical reliability of prior period estimates.
  • other assumptions used by management relating to the financial statements.

9.80 The auditor may test key factors and assumptions such as those that are

  • significant to the estimate of the amount of the allowance for loan losses, such as

—  the effectiveness of the institution's internal control related to loans and the allowance for loan losses (the design and operating effectiveness of controls may impact the nature, timing, and extent of substantive procedures);

—  portfolio segmentation based on similar credit risk characteristics;

—  look-back period used to calculate the historical loss component of the allowance;

—  loss emergence period used to calculate the historical loss component of the allowance (this period is typically defined as the period of time from the event that triggers a loss to the charge-off or confirmation of the loss);

—  current local, national, and international economic conditions and trends, particularly as they have affected collateral values;

—  the amount of recoveries of loans previously charged off;

—  composition of the loan portfolio and trends in volume and terms of loans, as well as trends in delinquent and nonaccrual loans that could indicate historical loss averages do not reflect current conditions;

—  identified potential problem loans and large groups of problem loans, including delinquent and nonaccrual loans and loans classified according to regulatory guidelines;

—  concentrations of loans to individuals or entities and their related interests, to industries, and in geographic regions;

—  size of specific credit exposures (a few large loans versus numerous small loans);

—  quality of the loan review and internal audit functions;

—  the effects of changes in lending policies and procedures, including those for underwriting, credit monitoring, collection, and charge-offs that could indicate historical loss averages do not reflect current conditions;

—  results of regulatory examinations; and

—  nature and extent of related-party lending.

  • sensitive to variations. Assumptions based on historical trends, such as the amount of late or partial payments in a particular period and the amount of charge-offs, can have a significant effect on estimates of the allowance.
  • subjective and susceptible to misstatement and bias, such as

—  the risk classification and allowance allocation given to problem loans;

—  estimates of collateral values, and the related assumptions that drive the determination of such values, such as cash flow estimates, discount rates, and projected occupancy rates;

—  current economic or market conditions that in the future may affect a borrower's ability to meet scheduled repayments; and

—  contingencies, such as a commitment for funding from a third party.

9.81 For accounting estimates (such as the allowance for loan losses) that give rise to significant risks, in addition to other substantive procedures performed to meet the requirements of AU-C section 330, the auditor should evaluate the following:7

  1. a. How management has considered alternative assumptions or outcomes and why it has rejected them or how management has otherwise addressed estimation uncertainty in making the accounting estimate
  2. b. Whether the significant assumptions used by management are reasonable
  3. c. When relevant to the reasonableness of the significant assumptions used by management or the appropriate application of the applicable financial reporting framework, management’s intent to carry out specific courses of action and its ability to do so

If, in the auditor’s professional judgment, management has not addressed adequately the effects of estimation uncertainty on the accounting estimates that give rise to significant risks, the auditor should, if considered necessary, develop a range with which to evaluate the reasonableness of the accounting estimate.

9.82 Further, the auditor should consider the total credit exposure of particular borrowers, including that related to standby letters of credit, guarantees, commitments to lend, and other off-balance-sheet exposures in addition to the institution’s recorded liability for such other credit exposures.

9.83 When information included in reports prepared by management is used in the performance of substantive tests, the accuracy and completeness of such information should be evaluated by, for example, testing loan subsidiary ledgers and tracing delinquencies to the past-due reports.

9.84 In determining the matters identified in paragraph .12 of AU-C section 540 (see paragraph 9.76) or in responding to the assessed risks of material misstatement in accordance with paragraph .13 of AU-C section 540 (see paragraph 9.77), paragraph .14 of AU-C section 540 states that the auditor should consider whether specialized skills or knowledge with regard to one or more aspects of the allowance for loan losses is required in order to obtain sufficient appropriate audit evidence.

9.85 AU-C section 620, Using the Work of an Auditor’s Specialist (AICPA, Professional Standards), addresses the auditor’s responsibilities relating to the work of an individual or organization possessing expertise in a field other than accounting or auditing when that work is used to assist the auditor in obtaining sufficient appropriate audit evidence. To properly evaluate the collectibility of certain loans, the auditor may need information outside of his or her usual experience. For example, the auditor might encounter valuation risks that require special knowledge and expertise of the types of collateral supporting the loan.

9.86 The knowledge of a specialist could be useful for loans based on oil and gas reserves. The specialist might review engineering reports on current reserves and production reports if the wells are in production. If fluctuating market conditions exist, a specialist could answer additional inquiries concerning the current status of oil and gas properties. For example, a loan secured by drilling equipment might have only marginal collateral value in a period of declining petroleum prices, even though the loan was highly secured when it was made.

9.87 Loans to developing countries are another example of instances in which the auditor may obtain the assistance of a specialist to become familiar with the economic, political, and social factors affecting the country's debt repayment. Other sources of such information include International Monetary Fund publications, international economists, and reports provided to institutions by the ICERC.

9.88 For impaired collateral-dependent loans, the specific allowance is generally based on the fair value of collateral less estimated selling costs. In this situation, auditors generally use an appraisal obtained by management as evidence of the fair value of the collateral, which is an example of using a management specialist as contemplated by paragraph .08 of AU-C section 500, Audit Evidence (AICPA, Professional Standards). Refer to chapter 11, “Real Estate Investments, Real Estate Owned, and Other Foreclosed Assets,” of this guide for audit procedures over appraisals.

9.89 In accordance with paragraphs .09–.10 and .12 of AU-C section 620, the auditor should evaluate whether the auditor’s specialist has the necessary competence, capabilities, and objectivity for the auditor’s purposes. In the case of an auditor’s external specialist, the evaluation of objectivity should include inquiry regarding interests and relationships that may create a threat to the objectivity of the auditor’s specialist. Furthermore, the auditor should obtain a sufficient understanding of the field of expertise of the auditor’s specialist to enable the auditor to

  1. a. determine the nature, scope, and objectives of the work of the auditor’s specialist for the auditor’s purposes and
  2. b. evaluate the adequacy of that work for the auditor’s purposes.

Further application and explanatory material regarding the competence, capabilities, and objectivity, as well as understanding the field of expertise, of the auditor’s specialist can be found in paragraphs .A15–.A24 of AU-C section 620.

9.90 The auditor should evaluate the adequacy of the work of the auditor’s specialist for the auditor’s purposes, including

  1. a. the relevance and reasonableness of the findings and conclusions of the auditor’s specialist and their consistency with other audit evidence.
  2. b. if the work of the auditor’s specialist involves the use of significant assumptions and methods,

i.  obtaining an understanding of those assumptions and methods and

ii.  evaluating the relevance and reasonableness of those assumptions and methods in the circumstances, giving consideration to the rationale and support provided by the specialist, and in relation to the auditor’s other findings and conclusions.

  1. c. if the work of the auditor’s specialist involves the use of source data that is significant to the work of the auditor’s specialist, the relevance, completeness, and accuracy of that source data.

9.91 If the auditor determines that the work of the auditor’s specialist is not adequate for the auditor’s purposes, paragraph .13 of AU-C section 620 states that the auditor should

  1. a. agree with the auditor’s specialist on the nature and extent of further work to be performed by the auditor’s specialist or
  2. b. perform additional audit procedures appropriate to the circumstances (such as selecting and hiring another specialist).

9.92 Large groups of loans. For loans that are pooled for purposes of measuring the allowance for loan losses, the focus of testing is not on individual loan files, and the collectibility of individual loans is not tested directly. Rather, the auditor generally reviews and tests for compliance with the institution's charge-off and nonaccrual policies and tests the completeness and accuracy of historical data and reports, such as delinquency reports, that are relied upon in estimating the allowance for such loans.

9.93 For example, loan categories represented by large volumes of relatively small loans with similar characteristics, such as residential real estate mortgages, consumer loans, and credit-card loans, are generally evaluated on an aggregate, or pool, basis. The auditor is generally more concerned with the effectiveness of and adherence to procedures related to assessing the collectibility of such loans as a group rather than the collectibility of each individual loan. The testing or procedures and the review of delinquency status reports may permit the auditor to draw a conclusion about the appropriateness in accordance with GAAP of the allowance necessary for those loan categories. In evaluating the appropriateness in accordance with GAAP of the portion of the allowance attributable to those loans, use of unadjusted historical annual charge off experience may not be sufficient in itself but could be considered in light of consistent application of loan policies, and current economic conditions at the balance sheet date.

9.94 Individually evaluated loans. In contrast to large groups of smaller balance homogeneous loans, an evaluation of larger balance loans (for example, commercial loans) generally requires a more detailed review because of the loan size and the fact that the type of borrower, the purpose of the loan, and the timing of cash flows may be dissimilar from loan to loan. More important, a relatively small number of credit losses on larger balance loans can significantly affect the appropriateness of the allowance in accordance with GAAP. In these circumstances, the auditor will generally select and review in detail a number of those loans. The auditor’s review of loans may be performed as a dual purpose test (test of controls and substantive attribute test).

9.95 In addition to identified problem loans, the auditor may select other commercial loans to include in the detailed loan file review. The selection of these additional loans generally may include large loan balances above specified limits, loans from other sources (such as related parties and industry concentrations), and some loans selected without regard to size or other specific criteria. The auditor generally will be concerned with the total credit exposure of the borrower, including standby letters of credit and other commitments to lend, rather than with individual loan balances. Based on the auditor's evaluations and tests, the number of loans reviewed might be limited when the internal loan review function is deemed effective in identifying and classifying problem credits.

9.96 The extent of an individual loan review varies from loan to loan. For example, a loan that has been subjected to a recent management review, an effective internal review, or a recent regulatory review may be reviewed in less detail than a loan that has not had some or all of those reviews.

9.97 The exemption of certain loans from examiner review and criticism pursuant to the March 30, 1993, regulatory policy (see paragraph 9.30) does not extend to management's financial reporting responsibilities or to the auditor's responsibility in financial statement audits or other engagements involving management assertions about the exempt loans. An institution's exempt portfolio could be material to its financial statements. An auditor's assessment of management assertions about the allowance for loan losses may depend on the availability of certain documentation, including adequate collateral appraisals or current and complete financial information about borrowers or guarantors. The March 1993 policy may affect the availability of such documentation. Auditors are cautioned against undue reliance on management representations when no supporting evidence exists.

9.98 For each loan selected for review, the auditor may prepare a loan review worksheet or other memoranda documenting the procedures performed and summarizing the conclusions reached. Exhibit 9-2, “Sample Loan Review Form,” is an example of a loan review form that could be used for a commercial loan. It can also be adapted to other types of loans. For loans reviewed previously, the auditor typically updates prior reviews for new information concerning the loan. In addition, the auditor usually reviews correspondence updating classified loans, working papers prepared by the institution's internal loan review personnel, and any regulatory examination reports (including those with information on shared national credits). Such data often provide additional information concerning the loan and how management considered the loan in determining the allowance for loan losses.

Exhibit 9-2 Sample Loan Review Form

9.99 For many loans, the auditor should discuss the status and background of the loans reviewed with the responsible loan officer and the loan review officer. In addition to providing information about the loans, such discussions may provide the auditor with information about the loan officer's and loan review officer's attitudes and degree of awareness of the status of loans and controls.

9.100 In reviewing individual loans, the auditor could review the institution's analysis of the borrower's financial resources, liquidity and future cash flows, and other financial forecasts, particularly for unsecured loans for which repayment is dependent on the borrower's ability to generate funds from profitable operations. The auditor might consider measuring such financial data against the trends and norms, both historical and forecasted, for both the borrower being reviewed and the industry in which the borrower operates. It is preferable that the institution's analysis be supported by current audited financial statements, although financial statements that have been reviewed or compiled by the borrower's accountant or prepared internally by the borrower may be useful.

9.101 Collateral review. Assessment of collateral is important to the classification or grading of the loan portfolio as well as the measurement of credit losses when the loan, individually evaluated for impairment, is deemed collateral dependent. For loans secured by collateral, a careful evaluation and valuation of that collateral is often necessary. In such circumstances, the auditor may evaluate the security interest in the collateral to determine how the institution knows that it has been perfected by execution and recording of the appropriate legal documents. The auditor could also consider the reasonableness of the institution's collateral valuation by referring to quoted market prices or other pertinent sources, such as a specialist's appraisal.

9.102 The auditor may test the existence of the collateral by physical observation, independent confirmation, or other appropriate procedures, especially when the institution is involved in loans secured by marketable securities or in asset-based lending, which may include loans secured by inventories, equipment, or receivables. For collateral in the form of marketable securities, the auditor may evaluate whether such securities are under the institution's control, either in its own vault or in a safekeeping account in the institution's name maintained with an independent, third-party custodian. In the latter case, the auditor may wish to evaluate the independent custodian's ability to perform under its obligation. For other types of collateral, there should be documentation that the institution has verified the existence of the collateral. In the absence of such documentation, the auditor should perform these or other collateral verification procedures, especially for significant loans for which collectibility is otherwise questionable. The auditor should also consider the potential accounting consequences of collateral arrangements under FASB ASC 860, Transfers and Servicing.

9.103 Personal guarantees. For loans supported by personal guarantees, the auditor may perform a review solely of the borrower's ability to pay. However, if the review indicates the guarantor may be a source of repayment, the auditor might review the financial statements and other pertinent information about the guarantor as if the guarantor were the borrower. It is also important to consider the extent of, as well as the institution's policies and practices for, pursuing guarantees and to evaluate, perhaps in consultation with an attorney, the enforceability and scope of the guarantee.

9.104 The substance of a personal guarantee depends on (a) the ability and willingness of the guarantor to perform under the guarantee, including a determination of whether the guarantor has other guarantees outstanding that might be pursued, (b) the practicality of enforcing the guarantee in the applicable jurisdiction, (c) the scope of the guarantee (that is, whether it covers all principal and interest or has a limit), and (d) a demonstrated intent by the institution to enforce the guarantee. Even if the guarantee is legally enforceable, the auditor should consider making a determination concerning whether there are business reasons that might preclude the institution from enforcing the guarantee. Those business reasons could include the length of time necessary to enforce a guarantee, whether it is normal business practice to enforce guarantees on similar transactions, or whether it is necessary for the institution to choose between pursuing the guarantee or the underlying collateral, instead of pursuing both. See paragraphs 21–25 of FASB ASC 310-10-25 for additional information.

9.105 Participation. Management should have the information necessary to authorize, monitor, and review participation loans and to estimate any related allowance for loan losses. The collectibility of participation loans (whether at the lead institution or at a participating institution) is normally evaluated in light of the entire amount of the loan, not just of the share held by the institution. Accordingly, the participating institution should supplement documentation by the lead institution with its own investigation and credit analysis. The participating institution should not rely solely on the lead institution to monitor the credit. Certain large participation arrangements are reviewed by regulators, who issue a shared national credit report detailing their classification and rationale to the lead and all participating institutions. The auditor's objectives in testing loans for a participating institution are the same as for other loans. For example, the repayment status, borrowers' financial statements, and appraisals should be considered.

9.106 The auditor usually confirms the existence and terms of significant participations (both purchased and sold) with the debtor and lead institution. In addition, the auditor normally reviews the related loan file documentation. For participations, the loan files should contain the same information as other loan files.

9.107 Charge-offs and recoveries. The auditor should test the propriety of charge-offs and recoveries. Substantive detail testing in this area may be minimized if tests of controls and analytical procedures on charge-offs and recoveries are performed.

9.108 Analytical procedures. AU-C section 520, Analytical Procedures (AICPA, Professional Standards), addresses the auditor’s use of analytical procedures as substantive procedures (substantive analytical procedures). The auditor should consider analytical procedures as a supplement to the detailed tests of the reasonableness of the allowance. These analytical tests may use statistics relating to the allowance as compared to related income statement accounts, net charge-off rates, nonperforming loan levels and other loan categories, historical experience, and peer results. Various analytical techniques can be utilized to assist the auditor in determining the appropriateness in accordance with GAAP of the allowance. See chapter 5 of this guide for additional guidance regarding analytical procedures.

9.109 Conclusions. In accordance with paragraph .18 of AU-C section 540, the auditor should evaluate, based on the audit evidence, whether the allowance for loan losses in the financial statements is either reasonable in the context of the applicable financial reporting framework or is misstated. Based on the audit evidence obtained, paragraph .A122 of AU-C section 540 goes on to state that the auditor may conclude that the evidence points to an accounting estimate of the allowance that differs from management’s point estimate. When the audit evidence supports a point estimate, the difference between the auditor’s point estimate and management’s point estimate constitutes a misstatement. When the auditor has concluded that using the auditor’s range provides sufficient appropriate audit evidence, a management point estimate that lies outside the auditor’s range would not be supported by audit evidence. In such cases, the misstatement is no less than the difference between management’s point estimate and the nearest point of the auditor’s range. (Note that this only applies to situations in which the auditor has chosen to test the reasonableness of the institution’s allowance for loan losses by independently developing a point estimate or range, as opposed to testing how management made the accounting estimate, in accordance with paragraph .13 of AU-C section 540. AU-C section 450, Evaluation of Misstatements Identified During the Audit (AICPA, Professional Standards), provides guidance on distinguishing misstatements for purposes of the auditor’s evaluation of the effect of uncorrected misstatements on the financial statements. With regard to accounting estimates, a misstatement, whether caused by fraud or error, may arise as a result of

  • misstatements about which no doubt exists (factual misstatements).
  • differences arising from management’s judgments concerning accounting estimates that the auditor considers unreasonable or the selection or application of accounting policies that the auditor considers inappropriate (judgmental misstatements).
  • the auditor’s best estimate of misstatements in populations involving the projection of misstatements identified in audit samples to the entire population from which the samples were drawn (projected misstatements).

In some cases involving accounting estimates, a misstatement could arise as a result of a combination of these circumstances, making separate identification difficult or impossible.

9.110 If the auditor deems the financial information inadequate, the auditor may discuss the situation with an appropriate member of management. In accordance with paragraph .A38 of AU-C section 260, The Auditor’s Communication With Those Charged With Governance (AICPA, Professional Standards), this discussion may clarify facts and issues and give management an opportunity to provide further information and explanations. For example, the discussion may include missing information that may be evidence of an internal control deficiency as well. The results of such discussion or the inability of the institution to obtain financial information that is appropriate in accordance with GAAP should be considered in evaluating the collectibility of the loan. In accordance with paragraph .12 of AU-C section 260, the auditor should communicate with those charged with governance8 significant difficulties, if any, encountered during the audit (for example, appropriate financial information in accordance with GAAP that is not available for significant loans). In some circumstances, paragraph .A26 of AU-C section 260 explains that such difficulties may constitute a scope limitation that leads to a modification of the auditor’s opinion.

9.111 Furthermore, during their examinations of depository institutions, regulators focus a great deal of attention on the allowance for loan losses. Failure to maintain an adequate allowance is considered an unsafe or unsound practice.