Audit Procedure - ACUIA



|Audit Procedure |By: |Reference/Comments |

|INTRODUCTION | | |

|In December 2006, NCUA Accounting Bulletin 06-01 distributed an Interagency | | |

|Advisory on the Allowance for Loan and Lease Losses (ALLL.) The revision | | |

|replaced the 1993 Policy Statement, and also made it applicable to CUs. | | |

|AUDIT OBJECTIVES | | |

|1. To determine if management has a sound methodology, with supporting | | |

|documentation, for estimating the amount of probable existing losses in its | | |

|loan and lease portfolio. | | |

|2. To assess the overall adequacy of the ALLL. | | |

|3. To ensure management understands the purpose of the ALLL. | | |

|AUDIT PROCEDURES | | |

|Preliminary | | |

|1. Update the PAF as applicable. | | |

|2. Read and become familiar with ALLL related regulatory items, including | | |

|IRPS #02-3, NCUA R&R Part 702, EITF Topic D-80, Letters 03-CU-01 & 02-CU-09 | | |

|and NCUA Accounting Bulletin 04-01 & 06-01 (including the enclosed | | |

|Interagency Statement and Q&A.) | | |

|3. Follow up on prior internal and external audit reports (including NCUA | | |

|DORs). Ensure that any recommendations were put into place. | | |

|4. Complete ICQ & Questionnaire. Complete the ALLL ICQ on the j:\drive, so | | |

|that comments are read. | | |

|Polices and Procedures | | |

|1. From management, obtain ALLL written policies and procedures, and ensure | | |

|they address the following: | | |

|(a) Personnel and department responsibilities; | | |

|(b) Accounting policies (including charge offs); | | |

|(c) Methodology; and | | |

|Audit Procedure |By: |Reference/Comments |

|(d) Internal controls. | | |

|2. Ensure that written policies and procedures describe the methodology for:| | |

|(a) Segmenting the portfolio (i.e. by loan type, industry, risk rates, etc);| | |

|(b) Determining and measuring impairment for large balance non-homogenous | | |

|loans, including those pooled based on like risk characteristics, and | | |

|measured based on loss factors tied to relevant observable data (FAS 5) and | | |

|those individually identified as impaired (FAS 114); and | | |

|(c) Determining and measuring impairment for groups of small balance | | |

|homogenous loans pooled based on like risk characteristics and measured | | |

|based on loss factors[1] tied to relevant observable data (FAS 5.) | | |

|3. Ensure that the written policies and procedures describe the internal | | |

|control system for the ALLL estimation process including: | | |

|(a) Measures to ensure the reliability and integrity of information and | | |

|compliance with laws, regulations, and internal policies and procedures; | | |

|(b) Reasonable assurance that the credit union's financial statements | | |

|(including regulatory reports) are prepared in accordance with GAAP and ALLL| | |

|supervisory guidance; and | | |

|(c) A well-defined loan review process containing an effective loan grading | | |

|system, sufficient internal controls and clear formal communication between | | |

|the board, management and others involved in the ALLL process. | | |

|Audit Procedure |By: |Reference/Comments |

| (Note: When a loan grading system is used to segment the portfolio, it | | |

|should include the definitions of each grade, a reconciliation of the | | |

|internal grades to supervisory grades, and a delineation of responsibilities| | |

|for the grading system.) | | |

|4. Ensure that written policies and procedures: | | |

|(a) Require that the board of directors review and approve the provision | | |

|amount to be reported for loan and lease losses on an annual basis (as | | |

|recommended by the Interagency Policy Statement on the ALLL); | | |

|(b) Ensure that the CU has adequate data systems to supply the information | | |

|necessary to support & document its estimate of an appropriate ALLL; and | | |

|(c) Ensure that the CU promptly charges off loans, or portions of loans, | | |

|that available information confirms to be uncollectible. | | |

|5. Based on review of the Policy, and completion of the remaining Audit | | |

|Procedures, opine as to whether or not Policy reflects actual practice. | | |

|Methodology | | |

|1. Review the ALLL methodology and determine that it incorporates | | |

|management's current judgments about the credit quality of the loan | | |

|portfolio through a disciplined and consistently applied process. | | |

|2. Ensure also that the methodology: | | |

|(a) Includes an analysis of the loan portfolio performed on a regular basis;| | |

|(b) Considers all loan types; ensure that new and/or revised loan categories| | |

|(such as sold mortgages and participated MBLs, as well as shutting down the | | |

|Indirect Loan function) are reflected. | | |

|Audit Procedure |By: |Reference/Comments |

|(c) Identifies loans (and overdrafts, including the effect of bounce | | |

|protection) to be evaluated for impairment on an individual basis under FAS | | |

|114, and segments the remainder of the portfolio into groups of loans with | | |

|similar risk characteristics for evaluation and analysis under FAS 5; | | |

|(d) Considers all known relevant internal and external factors that may | | |

|affect loan collectability; | | |

|(e) Shows consistency and, when appropriate, develops modifications for new | | |

|factors affecting collectability; | | |

|(f) Considers the particular risks inherent in different kinds of lending; | | |

|(g) Considers current collateral values (less costs to sell), where | | |

|applicable; | | |

|(h) Requires that analyses, estimates, reviews and other ALLL methodology | | |

|functions be performed by well-trained personnel; | | |

|(i) Bases methodology on current and reliable observable data; | | |

|(j) Includes clear documentation with explanations of the supporting | | |

|analyses and rationale; and | | |

|(k) Includes a systematic and logical method to consolidate the loss | | |

|estimates and ensure the ALLL balance is consolidated and recorded in | | |

|accordance with GAAP | | |

|Individual Impairment of Large-Balance, Non-Homogenous Loans | | |

|1. Document how large-balance member business or agriculture loans are | | |

|segregated in the methodology. | | |

|Audit Procedure |By: |Reference/Comments |

|(a) Review steps performed to determine which technique is most appropriate | | |

|in a given situation. | | |

|2. Ensure that the ALLL process for these types of loans complies with GAAP | | |

|(i.e. FAS 114[2]), specifically: | | |

|(a) Ensure that the large-balance member business and/or agriculture loans | | |

|are segregated between those which the CU has identified for individual | | |

|evaluation under its normal established loan grading criteria, and those | | |

|which the CU has not identified for individual evaluation; | | |

|(b) Ensure there is supporting documentation for the loan grading analysis | | |

|that resulted in a decision to individually evaluate the loan for possible | | |

|impairment. Determine if grading is reasonable; | | |

|(c) Note how loans that were identified for individual review are evaluated,| | |

|and how the impairment subsequently is measured [one of the three available | | |

|measurement methods (present value of expected future cash flows, fair value| | |

|of collateral, or observable market price) should be used.]; | | |

|(d) Review supporting documentation for the impairment measurement method | | |

|used, and note reasonableness; | | |

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|Audit Procedure |By: |Reference/Comments |

|(e) Note how the remaining large-balance member business and/or agriculture | | |

|loans not identified as impaired [in (a) above], are categorized. [They | | |

|should be pooled by like risk characteristics and an allowance component | | |

|should be developed for each pool (similar to the methodology discussed in | | |

|the next section for small-balance, homogenous loans)]; | | |

|(f) Ensure that any member business and agricultural loans that were | | |

|individually evaluated for impairment under FAS 114, and were subsequently | | |

|found not to be individually impaired under one of the three measurement | | |

|methods, were re-evaluated, when appropriate, under FAS 5. | | |

|Allowance for Small-Balance, Homogenous Pools of Loans | | |

|1. Document methodology for small-balance, homogenous pools of loans. | | |

|Ensure the ALLL process complies with GAAP (i.e. FAS 5[3]) by ensuring it: | | |

|(a) Pools small-balance, homogenous loans by like risk characteristics; | | |

|[note: according to the NCUA Examiner’s Guide, “The pools may include | | |

|individually evaluated loans (business and agricultural above) that the CU | | |

|does not consider individually impaired.”] | | |

|(b) Has a loss factor developed for each pool based on relevant observable | | |

|data for that pool; and | | |

|(c) Has an ALLL component calculated for each pool through the application | | |

|of a loss factor to each pool. | | |

|Audit Procedure |By: |Reference/Comments |

|2. Review supporting documentation, and ensure that it indicates that loans | | |

|in each component have similar attributes or characteristics. | | |

|3. Note how often management estimates the amount of ALLL needed on each | | |

|pool of loans, (this should be done on at least a quarterly basis.) | | |

|Summarizing Components and Consolidating the Amount Required in the ALLL. | | |

|1. Review financial statements, note the ALLL amount reported, and agree to | | |

|support summary documentation. | | |

|2. Ensure that the summary is reviewed and approved by the Board, and that | | |

|it includes: | | |

|(a) An estimate of the probable loss or range of loss incurred for each | | |

|category evaluated; | | |

|(b) The aggregate probable loss estimated using management’s methodology; | | |

|(c) A summary of the current ALLL balance; | | |

|(d) The amount, if any, by which the ALLL is to be adjusted; and | | |

|(e) Detailed sub-schedules of loss estimates that reconcile to the summary | | |

|schedule, if necessary. | | |

|3. Ensure that there is a periodic (preferably monthly) adjustment of the | | |

|ALLL, in compliance with NCUA R&R 702.402, namely that, “Full and fair | | |

|disclosure demands that a credit union properly address charges for loan | | |

|losses as follows: | | |

|a. Charges for loan losses shall be made in accordance with generally | | |

|accepted accounting principles (GAAP); | | |

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|Audit Procedure |By: |Reference/Comments |

|b. The allowance for loan and lease losses (ALLL) established for loans must| | |

|fairly present the probable losses for all categories of loans and the | | |

|proper valuation of loans. The valuation allowance must encompass | | |

|specifically identified loans, as well as estimated losses inherent in the | | |

|loan portfolio, such as loans and pools of loans for which losses have been | | |

|incurred but are not identifiable on a specific loan-by-loan basis; | | |

|c. Adjustments to the valuation ALLL will be recorded in the expense account| | |

|“Provision for Loan and Lease Losses”; | | |

|d. The maintenance of an ALLL shall not affect the requirement to transfer | | |

|earnings to a credit union's regular reserve when required under subparts B | | |

|or C of this part; and | | |

|e. At a minimum, adjustments to the ALLL shall be made prior to the | | |

|distribution or posting of any dividend to the accounts of members.” | | |

|4. Review the Commercial Loan Watch List as of the same date as the ALLL | | |

|calculation. | | |

|a. Ensure that all MBL relationships classified special mention or worse are| | |

|properly categorized in the “Allowance for Commercial Loan” section of the | | |

|calculation. | | |

|b. Ensure there is sufficient, documented support for the percentage | | |

|reserved for Watch List loans. | | |

|Validating the ALLL Methodology | | |

|1. Review board minutes to determine that the board of directors | | |

|periodically validate and revise, as needed, the ALLL methodology and/or | | |

|Policies & Procedures. | | |

|Audit Procedure |By: |Reference/Comments |

|2. Ensure that there is a documented review of the ALLL methodology[4] | | |

|(consisting of policies, procedures and processes) performed by a party who | | |

|is independent of the ALLL estimation process. | | |

|Note: Remember, as long as the methodology is reasonable, defensible, and | | |

|documented, it can be considered acceptable | | |

|Charged off Loans | | |

|1. Ensure that there is a charge off policy which is: | | |

|(a) Realistic; | | |

|(b) Timely; and | | |

|(c) Applied consistently from period to period. | | |

|2. From management, obtain the list of non-performing loans, and note if | | |

|policy is being followed. | | |

|3. If applicable, prepare a schedule of loans and recommend that they be | | |

|charged off. | | |

|Analytical Procedures | | |

|1. Review the quarterly ALLL calculations and relevant financial | | |

|information, and: | | |

|a. Perform a documented analysis to determine if the growth in the ALLL is | | |

|comparable with the percentage growth in total loans over the same period; | | |

|b. Perform a documented analysis to determine if non-performing or problem | | |

|loans as a percentage of total loans are not increasing at a rate materially| | |

|greater than the ALLL; and | | |

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|Audit Procedure |By: |Reference/Comments |

| c. Ensure that there has been appropriate adjustment of loss estimation | | |

|processes if there has been significant easing of credit underwriting | | |

|standards, coupled with huge growth. | | |

|3rd Party Due Diligence | | |

|1. Document due diligence performed on any 3rd party vendors used in the | | |

|ALLL process. | | |

|2. Complete the “3rd Party DD ICQ.” | | |

|3. Opine on adequacy of 3rd party due diligence. | | |

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[1] A loss factor is external and/or internal information that provides a reasonable basis for estimating loan impairment on a pool basis, consistently applied. Examples include charge off data for the particular loan pool, publicly available bankruptcy data, or historical experience-based impairment adjusted upward or downward for published economic data.

[2] As noted in FAS 114, some individually impaired loans have risk characteristics that are unique to an individual borrower and the institution will apply the measurement methods on a loan-by-loan basis. However, some impaired loans may have risk characteristics in common with other impaired loans. An institution may aggregate those loans and may use historical statistics, such as average recovery period and average amount recovered, along with a composite effective interest rate as a means of measuring impairment of those loans. (Source: December 2006 Interagency Statement.)

[3] FAS#5 Loss Recognition states that there is a “loss contingency” if (1) it is probable a loss has been incurred this period, and (2) the loss can be reasonably estimated.

[4] According to the IRPS 02-03, “A CU’s ALLL methodology is considered valid when it accurately estimates the amount of loss contained in the portfolio. Thus, the CU’s methodology should include procedures that adjust loss estimation methods to reduce differences between estimated losses and actual subsequent charge-offs, as necessary.”

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