What to Expect When Your Auditors Are Expected

Steve Wagner

Auditors are digging deeper into the bank’s internal controls and internal control documentation relative to the allowance calculation and loan grading. They are looking design effectiveness of controls and precision of those controls.

Control precision refers to documenting to what level of detail items are being reviewed, that there is supportable evidence that the control is effective, ensuring the control is working correctly.

Auditors are increasing their focus on IT controls relative to the data used in the determination of the allowance, specifically, the controls over the data input and the accuracy and completeness of data output. Controls over the allowance should be at a level of precision to ensure data used in the model is accurate and complete.

Common key controls:

Data Integrity

  • over setup of loans, including all data entered into core system
  • over loan file maintenance charges
  • to ensure those with setup and maintenance capabilities do not have conflicting duties

Allowance (general)

  • to ensure accuracy of data included in the model is appropriate
  • to ensure the model is mathematically accurate
  • over historical loss rate
  • to ensure qualitative factors are documented, verifiable and supported
  • to document the reasonableness of the unallocated reserve

Modification of Impaired Loans

  • to ensure loans are reviewed for TDR designation at time of renewal/modification
  • over completeness of impaired loans

Allowance (impaired)

  • to ensure impaired loan worksheets are reviewed for accuracy and appropriateness
  • to ensure charge-offs are approved timely and applied to appropriate loan type code
  • to ensure valuation of collateral is appropriate for collateral dependent loans
  • to ensure projections of future cash flows are reasonable and discounted cash flows are appropriate for non-collateral dependent loans and purchased credit impaired loans

Loan Grading

  • to ensure loan relationships are periodically reviewed for accuracy
  • to ensure loan grade changes are timely entered into the system

Non-Accrual Designation

  • to ensure impaired loans are timely transferred to non-accrual status

Allowance Conclusion

  • to perform a final review of the ALLL and conclude on the reasonableness of the allowance
  • to ensure the directional consistency of the provision and allowance as compared
    to prior periods

Auditors have encouraged financial institutions to improve internal controls over the allowance due to findings that the Public Company Accounting Oversight Board (PCAOB) have reported on audits by registered independent public accountants. Example findings have included:

  • Failure to sufficiently test the reasonableness of the significant assumptions
  • Failure to evaluate whether the allowance considered relevant environmental factors
  • Failure to sufficiently test data accuracy
  • Failure to sufficiently test the process of identifying problem loans, including loan grades and impaired loans
  • Failure to properly test appraisals of collateral supporting reserves for collateral dependent impaired loans or real estate owned

Securities and Exchange Commission (SEC) hot buttons have included:

  • The effects of acquisitions on credit ratios and trends
  • Quantification of the effects of change to ALLL methodologies
  • The historical loss period used and how it interacts with the qualitative analysis
  • Clarity on how factors are identified and measured
  • Directional inconsistency in the provision for loan losses as compared to credit quality trends