ALLL Audit Program
2/28/10
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-CU01 & 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
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(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
factors1 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.
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.
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(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.
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(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, NonHomogenous Loans
1. Document how large-balance member business
or agriculture loans are segregated in the
methodology.
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(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 1142),
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;
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.)
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(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 reevaluated, 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 53) 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.
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.
3
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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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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.
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2. Ensure that there is a documented review of the
ALLL methodology4 (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 nonperforming 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
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.”
4
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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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