One fundamental lesson of the financial crisis in 2007-2009 is that financial markets and the real economy are adversely impacted when financial institutions fail to fulfill their risk management function.
Today, the COVID-19 has shocked the banking sector in a different way. Economies around the world are still coming to terms with the widespread impacts the pandemic has unleashed in terms of lockdowns, economic slowdowns, job losses and potential bankruptcies. The COVID-19 pandemic will sorely test the enhanced risk management and capital adequacy frameworks adopted since the 2008 crisis, especially given that no scenario analysis could have imagined an event of this nature and scale.
Credit risk is a key risk for most banks, and credit loss provisioning is a key accounting measure because it reflects the changing exposure to credit risk and its potential impacts on reported profits and regulatory capital. For banks, expected credit losses (ECLs) are likely to be subject to significant uncertainty, complexity and subjectivity, and are thus at a higher risk of material misstatement.
The way in which credit losses are recognized, measured and presented in financial statements is therefore critical. Accounting for credit losses, and applying the ECL framework in particular, is a key focus area for external auditors, a bank’s audit committee and users of a bank’s financial statement.
The process of calculating ECL requires a bank to assess whether a significant increase in credit risk (SICR) has occurred for an exposure or a group of exposures. The SICR threshold is important because it determines whether an exposure is in stage 1 (12-month ECL) or stage 2 (lifetime ECL). If a management’s criteria for measuring credit risk are insufficiently comprehensive or forward-looking, or if the threshold that determines SICR is inadequately sensitive to changes in risk, there is a probability that the ECL will not accurately reflect the extent to which credit risk has changed vis-à-vis the accounting framework and result in material misstatement.
Calculating the ECL can be a complex process that involves multiple data, interrelationships and assumptions. Methods and models are often customized for individual banks. In addition, the ECL usually requires input from non-accounting experts. Otherwise, calculating the ECL involves many management judgments, some of which can be more difficult to evaluate objectively (for example, because they involve estimates of future economic conditions) or may be subject to management bias.
When auditing a bank’s financial statement, the external auditor is expected to consider and respond to the material misstatement of risk in connection with the ECL in the audit plan, risk assessment and execution of the audit. Audit committees should expect the external auditor to communicate their audit plan, the work carried out and the results.
The procedure an external auditor takes in response to a material misstatement of assessed risk includes one or more of the following approaches: (i) obtaining audit evidence from events that occurred up to the date of the auditor’s report; (ii) testing how management calculated the accounting estimate; and (iii) developing the auditor’s point estimate or range.
For audit committees to fulfill their oversight duties as regards the financial statement audit, they must have a good understanding of how ECL accounting can impact the financial statement and how external auditors obtain reasonable assurance that a financial statement is free of material misstatement.
A sound governance structure that enables board oversight of a management’s ECL processes and outputs is a key focus area for an audit committee. Governance includes the established processes for making and challenging the ultimate decisions about economic inputs, macroeconomic scenarios and weightings, model outputs, use of model adjustments and other judgments involved in determining the ECL.
As part of establishing a sound governance structure to provide oversight of the ECL processes, a bank needs an effective system of internal control to ensure that the ECL is estimated in accordance with the relevant ECL framework. Internationally accepted auditing standards require an external auditor to evaluate the effectiveness of the design and implementation of controls that, among other things, address significant risk. Where an external auditor plans to rely on the existing controls (including where substantive procedures alone cannot provide sufficient and appropriate audit evidence), they need to test the operating effectiveness of those controls.
The ECL is a complex accounting estimate that often involves interrelated processes across multiple areas of a bank as well as significant data and IT requirements, which means effective internal controls are needed to ensure the completeness, accuracy and reasonableness of the related information, from data collection and throughout the complex processes involved. In response, a bank’s external auditor performs the appropriate tests on the controls for provisioning the ECL to assess whether and to what extent they can rely on these controls.
Internal controls over the ECL are also important to the bank’s audit committee. A bank’s board of directors is responsible for approving the approach and overseeing the implementation of key policies that relate to its internal controls. Further, an audit committee’s duties include overseeing the bank’s internal auditors, who are in turn responsible for providing objective assurance to the bank board on the effectiveness of its internal controls over the ECL.
In order to assess and challenge a bank management’s ECL, external auditors may need to use the work of others with expertise in areas other than accounting and auditing, in addition to those with specialized ECL accounting knowledge.
The writer is a member of an audit committee at a state-owned bank. The views expressed are personal.