Banking and finance: 2020 challenges and what to do to overcome them

In auditing, the concept of professional skepticism is ubiquitous. Just as a Jedi in Star Wars is constantly trying to hone his understanding of the “force”, an auditor is constantly crafting his or her ability to apply professional skepticism. It is professional skepticism that provides the foundation for decision-making when conducting an attestation engagement.

A brief definition

The professional standards define professional skepticism as “an attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence.” Given this definition, one quickly realizes that professional skepticism can’t be easily measured. Nor is it something that is cultivated overnight. It is a skill developed over time and a skill that auditors should constantly build and refine.

Recently, the extent to which professional skepticism is being employed has gained a lot of criticism. Specifically, regulatory bodies argue that auditors are not skeptical enough in carrying out their duties. However, as noted in the white paper titled Scepticism: The Practitioners’ Take, published by the Institute of Chartered Accountants in England and Wales, simply asking for more skepticism is not a practical solution to this issue, nor is it necessarily always desirable. There is an inevitable tug of war between professional skepticism and audit efficiency. The more skeptical the auditor, typically, the more time it takes to complete the audit.

Why does it matter? Audit quality.

First and foremost, how your auditor applies professional skepticism to your audit directly impacts the quality of their service. Applying an appropriate level of professional skepticism enhances the likelihood the auditor will understand your industry, lines of business, business processes, and any nuances that make your company different from others, as it naturally causes the auditor to ask questions that may otherwise go unasked.

These questions not only help the auditor appropriately apply professional standards, but also help the auditor gain a deeper understanding of your business. This will enable the auditor to provide insights and value-added services an auditor who doesn’t apply the right degree of skepticism may never identify.

Therefore, as the white paper notes, audit committees, management, and investors should be asking “How hard do our auditors get pushed on fees, and what effect does that have on the quality of the audit?” If your auditor is overly concerned with completing the audit within a fixed time budget, professional skepticism and, ultimately, the quality of the audit, may suffer.

Applying skepticism internally

By its definition, professional skepticism is a concept that specifically applies to auditors, and is not on point when it comes to other audit stakeholders. This is because the definition implies that the individual applying professional skepticism is independent from the information he or she is analyzing. Other audit stakeholders, such as members of management or the board of directors, are naturally advocates for the organizations they manage and direct and therefore can’t be considered independent, whereas an auditor is required to remain independent.

However, rather than audit stakeholders applying professional skepticism as such, these other stakeholders should apply an impartial and diligent mindset to their work and the information they review. This allows the audit stakeholder to remain an advocate for his or her organization, while applying critical skills similar to those applied in the exercise of professional skepticism. This nuanced distinction is necessary to maintain the limited scope to which the definition of professional skepticism applies: the auditor.

Specific to the financial statement reporting function, these stakeholders should be assessing the financial statements and ask questions that can help prevent or detect flaws in the financial reporting process. For example, when considering significant estimates, management should ask: are we considering all relevant information? Are our estimates unbiased? Are there alternative accounting treatments we haven’t considered? Can we justify our selected accounting treatment? Essentially, management should start by asking itself: what questions would we expect our auditor to ask us?

It is also important to be critical of your own work, and never become complacent. This may be the most difficult type of skepticism to apply, as most of us do not like to have our work criticized. However, critically reviewing one’s own work, essentially as an informal first level of review, will allow you to take a step back and consider it from a different vantage point, which may in turn help detect errors otherwise left unnoticed. Essentially, you should both consider evidence that supports the initial conclusion and evidence that may be contradictory to that conclusion.

The discussion in auditing circles about professional skepticism and how to appropriately apply it continues. It is a challenging notion that’s difficult to adequately articulate. Although it receives a lot of attention in the audit profession, it is a concept that, slightly altered, can be of value to other audit stakeholders. Doing so will help you create a stronger relationship with your auditor and, ultimately, improve the quality of the financial reporting process—and resulting outcome.

Benchmarking doesn’t need to be time and resource consuming. Read on for four simple steps you can take to improve efficiency and maximize resources.

Stop us if you’ve heard this one before (from your Board of Trustees or Finance Committee): “I wish there was a way we could benchmark ourselves against our competitors.”

Have you ever wrestled with how to benchmark? Or struggled to identify what the Board wants to measure? Organizations can fall short on implementing effective methods to benchmark accurately. The good news? With a planned approach, you can overcome traditional obstacles and create tools to increase efficiency, improve operations and reporting, and maintain and monitor a comfortable risk level. All of this can help create a competitive advantage — and it  isn’t as hard as you might think.

Even with a structured process, remember that benchmarking data has pitfalls, including:

• Peer data can be difficult to find. Some industries are better than others at tracking this information. Some collect too much data that isn’t relevant, making it hard to find the data that is.
   
• The data can be dated. By the time you close your books for the year and data is available, you’re at least six months into the next fiscal year. Knowing this, you can still build year-over-year trending models that you can measure consistently.
   
• The underlying data may be tainted. As much as we’d like to rely on financial data from other organization and industry surveys, there’s no guarantee that all participants have applied accounting principles consistently, or calculated inputs (e.g., full-time equivalents) in the same way, making comparisons inaccurate.

Despite these pitfalls, benchmarking is a useful tool for your organization. Benchmarking lets you take stock of your current financial condition and risk profile, identify areas for improvement and find a realistic and measurable plan to strengthen your organization.

Here are four steps to take to start a successful benchmarking program and overcome these pitfalls:

1. Benchmark against yourself. Use year-over-year and month-to-month data to identify trends, inconsistencies and unexplained changes. Once you have the information, you can see where you want to direct improvement efforts.
2. Look to industry/peer data. We’d love to tell you that all financial statements and survey inputs are created equally, but we can’t. By understanding the source of your information, and the potential strengths and weaknesses in the data (e.g., too few peers, different size organizations and markets, etc.), you will better know how to use it. Understanding the data source allows you to weigh metrics that are more susceptible to inconsistencies.

3. Identify what is important to your organization and focus on it. Remove data points that have little relevance for your organization. Trying to address too many measures is one of the primary reasons benchmarking fails. Identify key metrics you will target, and watch them over time. Remember, keeping it simple allows you to put resources where you need them most.

4. Use the data as a tool to guide decisions. Identify aspects of the organization that lie beyond your risk tolerance and then define specific steps for improvement.

Once you take these steps, you can add other measurement strategies, including stress testing, monthly reporting, and use in budgeting and forecasting. By taking the time to create and use an effective methodology, this competitive advantage can be yours. Want to learn more? Check out our resources for not-for-profit organizations here.

There’s a good chance that your organization is in the position of needing to do more with less under the strain of staffing constraints and competing initiatives. With fewer resources to work with, you’ll need to be persuasive to get the green light on new enterprise technology initiatives. To do that, you need to present decision makers with well-thought-out and targeted business cases that show your initiative will have impact and will be successful. Yet developing such a business case is no walk in the park. Perhaps because our firm has its roots in New England, we sometimes compare this process to leading a hiking trip into the woods—into the wild. 

Just as in hiking, success in developing a business case for a new initiative boils down to planning, preparation, and applying a few key concepts we’ve learned from our travels. 

Consensus is critical when planning new technology initiatives

Before you can start the hike, everyone has to agree on some fundamentals: 

Who's going? 

Where are we going? 

When do we go and for how long? 

Getting everyone to agree requires clear communication and, yes, even a little salesmanship: “Trust me. The bears aren’t bad this time of year.” The same principle applies in proposing new technology initiatives; making sure everyone has bought into the basic framework of the initiative is critical to success.

Although many hiking trips involve groups of people similar in age, ability, and whereabouts, for your business initiative you need to communicate with diverse groups of colleagues at every level of the organization. Gaining consensus among people who bring a wide variety of skills and perspectives to the project can be complex.

To gain consensus, consider the intended audiences of your message and target the content to what will work for them. It should provide enough information for executive-level stakeholders to quickly understand the initiative and the path forward. It should give people responsible for implementation or who will provide specific skills substantive information to implement the plan. And remember: one of the most common reasons projects struggle to meet their stated objectives (and why some projects never materialize to begin with), is a lack of sponsorship and buy-in. The goal of a business case is to gain buy-in before project initiation, so your sponsors will actively support the project during implementation. 

Set clear goals for your enterprise technology project 

It’s refreshing to take the first steps, to feel that initial sense of freedom as you set off down the trail. Yet few people truly enjoy wandering around aimlessly in the wilderness for an extended period of time. Hikers need goals, like reaching a mountain peak or seeing famous landmarks, or hiking a predetermined number of miles per day. And having a trail guide is key in meeting those goals. 

For a new initiative, clearly define goals and objectives, as well as pain points your organization wishes to address. This is critical to ensuring that the project’s sponsors and implementation team are all on the same page. Identifying specific benefits of completing your initiative can help people keep their “eyes on the prize” when the project feels like an uphill climb.

Timelines provide additional detail and direction—and demonstrate to decision makers that you have considered multiple facets of the project, including any constraints, resource limitations, or scheduling conflicts. Identifying best practices to incorporate throughout the initiative enhances the value of a business case proposition, and positions the organization for success. By leveraging lessons learned on previous projects, and planning for and mitigating risk, the organization will begin to clear the path for a successful endeavor. 

Don’t compromise on the right equipment

Hiking can be an expensive, time-consuming hobby. While the quality of your equipment and the accuracy of your maps are crucial, you can do things with limited resources if you’re careful. Taking the time to research and purchase the right equipment, (like the right hiking boots), keeps your fun expedition from becoming a tortuous slog. 

Similarly, in developing a business case for a new initiative, you need to make sure that you identify the right resources in the right areas. We all live with resource constraints of one sort or another. The process of identifying resources, particularly for funding and staffing the project, will lead to fewer surprises down the path. As many government employees know all too well, it is better to be thorough in the budget planning process than to return to authorizing sources for additional funding while midstream in a project. 

Consider your possible outcomes

You cannot be too singularly focused in the wild; weather conditions change quickly, unexpected opportunities reveal themselves, and being able to adapt quickly is absolutely necessary in order for everyone to come home safely. Sometimes, you should take the trail less traveled, rest in the random lean-to that you and your group stumble upon, or go for a refreshing dip in a lake. By focusing on more than just one single objective, it often leads to more enjoyable, safe, and successful excursions.

This type of outlook is necessary to build a business case for a new initiative. You may need to step back during your initial planning and consider the full impact of the process, including on those outside your organization. For example, you may begin to identify ways in which the initiative could benefit both internal and external stakeholders, and plan to move forward in a slightly new direction. Let’s say you’re building a business case for a new land management and permitting software system. Take time to consider that this system may benefit citizens, contractors, and other organizations that interact with your department. This new perspective can help you strengthen your business case. 

Expect teamwork

A group that doesn’t practice teamwork won’t last long in the wild. In order to facilitate and promote teamwork, it’s important to recognize the skills and contributions of each and every person. Some have a better sense of direction, while some can more easily start campfires. And if you find yourself fortunate enough to be joined by a truly experienced hiker, make sure that you listen to what they have to say.

Doing the hard work to present a business case for a new initiative may feel like a solitary action at times, but it’s not. Most likely, there are other people in your organization who see the value in the initiative. Recognize and utilize their skills in your planning. We also suggest working with an experienced advisor who can leverage best practices and lessons learned from similar projects. Their experience will help you anticipate potential resistance and develop and articulate the mitigation strategies necessary to gain support for your initiative.

If you have thoughts, concerns, or questions, contact our team. We love to discuss the potential and pitfalls of new initiatives, and can help prepare you to head out into the wild. We’d love to hear any parallels with hiking and wilderness adventuring that you have as well. Let us know! 

BerryDunn’s local government consulting team has the experience to lead technology planning initiatives and develop actionable plans that help you think strategically and improve service delivery. We partner with you, maintaining flexibility and open lines of communication to help ensure that your team has the resources it needs.

Our team has broad and deep experience partnering with local government clients across the country to modernize technology-based business transformation projects and the decision-making and planning efforts. Our expertise includes software system assessments/planning/procurement and implementation project management; operational, management, and staffing assessments; information security; cost allocation studies; and data management.  

Do you know what would happen to your company if your CEO suddenly had to resign immediately for personal reasons? Or got seriously ill? Or worse, died? These scenarios, while rare, do happen, and many companies are not prepared. In fact, 45% of US companies do not have a contingency plan for CEO succession, according to a 2020 Harvard Business Review study.  

Do you have a plan for CEO succession? As a business owner, you may have an exit strategy in place for your company, but do you have a plan to bridge the leadership gap for you and each member of your leadership team? Does the plan include the kind of crises listed above? What would you do if your next-in-line left suddenly? 

Whether yours is a family-owned business, a company of equity partners, or a private company with a governing body, here are things to consider when you’re faced with a situation where your CEO has abruptly departed or has decided to step down.  

1. Get a plan in place. First, assess the situation and figure out your priorities. If there is already a plan for these types of circumstances, evaluate how much of it is applicable to this particular circumstance. For example, if the plan is for the stepping down or announced retirement of your CEO, but some other catastrophic event occurs, you may need to adjust key components and focus on immediate messaging rather than future positioning. If there is no plan, assign a small team to create one immediately. 

Make sure management, team leaders, and employees are aware and informed of your progress; this will help keep you organized and streamline communications. Management needs to take the lead and select a point person to document the process. Management also needs to take the lead in demeanor. Model your actions so employees can see the situation is being handled with care. Once a strategy is identified based on your priorities, draft a plan that includes what happens now, in the immediate future, and beyond. Include timetables so people know when decisions will be made.  

2. Communicate clearly, and often. In times of uncertainty, your employees will need as much specific information as you can give them. Knowing when they will hear from you, even if it is “we have nothing new to report” builds trust and keeps them vested and involved. By letting them know what your plan is, when they’ll receive another update, what to tell clients, and even what specifics you can give them (e.g., who will take over which CEO responsibility and for how long), you make them feel that they are important stakeholders, and not just bystanders. Stakeholders are more likely to be strong supporters during and after any transition that needs to take place. 

3. Pull in professional help. Depending on your resources, we recommend bringing in a professional to help you handle the situation at hand. At the very least, call in an objective opinion. You’ll need someone who can help you make decisions when emotions are running high. Bringing someone on board that can help you decipher what you have to work with and what your legal and other obligations may be, help rally your team, deal with the media, and manage emotions can be invaluable during a challenging time. Even if it’s temporary. 

4. Develop a timeline. Figure out how much time you have for the transition. For example, if your CEO is ill and will be stepping down in six months, you have time to update any existing exit strategy or succession plan you have in place. Things to include in the timeline: 

• Who is taking over what responsibilities? 
• How and what will be communicated to your company and stakeholders? 
• How and what will be communicated to the market? 
• How will you bring in the CEO's replacement, while helping the current CEO transition out of the organization? 

If you are in a crisis situation (e.g., your CEO has been suddenly forced out or asked to leave without a public explanation), you won’t have the luxury of time.  

Find out what other arrangements have been made in the past and update them as needed. Work with your PR firm to help with your change management and do the right things for all involved to salvage the company’s reputation. When handled correctly, crises don’t have to have a lasting negative impact on your business.   

5. Manage change effectively. When you’re under the gun to quickly make significant changes at the top, you need to understand how the changes may affect various parts of your company. While instinct may tell you to focus externally, don’t neglect your employees. Be as transparent as you possibly can be, present an action plan, ask for support, and get them involved in keeping the environment positive. Whether you bring in professionals or not, make sure you allow for questions, feedback, and even discord if challenging information is being revealed.  

6. Handle the media. Crisis rule #1 is making it clear who can, and who cannot, speak to the media. Assign a point person for all external inquiries and instruct employees to refer all reporter requests for comment to that point person. You absolutely do not want employees leaking sensitive information to the media. 
 
With your employees on board with the change management action plan, you can now focus on external communications and how you will present what is happening to the media. This is not completely under your control. Technology and social media changed the game in terms of speed and access to information to the public and transparency when it comes to corporate leadership. Present a message to the media quickly that coincides with your values as a company. If you are dealing with a scandal where public trust is involved and your CEO is stepping down, handling this effectively will take tact and most likely a team of professionals to help. 

Exit strategies are planning tools. Uncontrollable events occur and we don’t always get to follow our plan as we would have liked. Your organization can still be prepared and know what to do in an emergency situation or sudden crisis.  Executives move out of their roles every day, but how companies respond to these changes is reflective of the strategy in place to handle unexpected situations. Be as prepared as possible. Own your challenges. Stay accountable. 

BerryDunn can help whether you need extra assistance in your office during peak times or interim leadership support during periods of transition. We offer the expertise of a fully staffed accounting department for short-term assignments or long-term engagements―so you can focus on your business. Meet our interim assistance experts.

Good fundraising and good accounting do not always seamlessly align. While they all feed the same mission, fundraisers work to meet revenue goals while accountants focus on recording transactions in compliance with accounting standards. We often see development department totals reported to boards that are not in line with annual financial statements, causing confusion and concern. To bridge this information gap, here are five accounting concepts every not-for-profit fundraiser should know:

Understanding the differences in how the development department and finance department track these gifts will allow for better reporting to the board throughout the year—and fewer surprises when you present financial statements at the end of the year. Stay tuned for parts two and three of our contribution series. Have questions? Please contact Emily Parker of Sarah Belliveau.

 

Reading through the 133-page exposure draft for the Proposed Statement on Auditing Standards (SAS) Forming an Opinion and Reporting on Financial Statements of Employee Benefit Plans Subject to ERISA, issued back in April 2017, and then comparing it to the final 100+ page standard approved in September 2018, may not sound like a fun way to spend a Sunday morning sipping a coffee (or three), but I disagree.

Lucky for you, I have captured the highlights here. And it really is exciting. Our feedback was incorporated into the final standard both through written comments on the exposure draft and a voice via our firm’s Director of Quality Assurance, who holds a seat on the Auditing Standards Board.

"Limited scope" audits will no longer exist

The debate over the “limited scope” audit has been going on for years. The new standard is designed to help auditors clearly understand their responsibilities in performing an audit, and provide plan sponsors, plan participants, the Department of Labor (DOL), and other interested parties with more information about what auditors do in situations when audits are limited in scope by the plan’s management, which is permitted by DOL reporting and disclosure rules.

Once effective, Audit Committee and Board of Director meetings in which plan financial statements are presented will include more clarity into what an employee benefit plan audit entails, based on revisions to the auditor’s report. I know I would frequently kick off meetings covering the auditor’s report opinion by explaining what a “limited scope” audit was. As a “limited scope” audit will no longer exist, the revised auditor’s report language clearly articulates what the auditor is, and is not, opining on.

When is the new standard effective?

The effective date is “to be determined” as it will be aligned with the new overall auditor’s reporting standard once that is finalized, and the standard does not permit early adoption. So there is still time to educate and prepare all parties involved.

Probably the biggest conversation piece around the water cooler for the new standard is the lingo. The “limited scope” audit language will be going away and now the auditor’s report and all related language will refer to an “ERISA section 103(a)(3)(C)” audit. I know, it’s a mouthful?try and say that one three times fast!

The auditor's report will look much different

The auditor’s report under an ERISA section 103(a)(3)(C) audit will look significantly different from the old “limited scope” auditor’s report, once the standard is effective. There are several illustrative examples of reports included in the standard to refer to. One thing you will immediately notice?the auditor’s report is getting longer and not shorter. Some highlights:

The Opinion section will include two bullets that explicitly state, in basic summarized terms: (1) the certified information agrees to the financial statements, and (2)  the auditor’s opinion on everything else, which the auditor has audited.

Other Matter—Supplemental Schedules Required by ERISA section will include two bullets that explicitly state, in basic summarized terms, (1) the certified information agrees to the financial statements and (2) the auditor’s opinion on everything else, which the auditor has audited in relation to the financial statements. Sound similar to the Opinion section? Well, that’s because it is!).

Other key takeaways

• Auditors will be required to make inquiries of management to gain assurance they performed procedures to determine the certifying institution is qualified for the ERISA section 103(a)(3)(C) audit, as it is management’s responsibility to make that determination.
• Fair value disclosures included within the plan’s financial statements are also included under the certification umbrella and subject to the same audit procedures. As an auditor, if anything comes to our attention that does not meet expectations, we would further assess as necessary.
• The auditor is required to obtain and read a draft Form 5500 prior to issuance of the auditor’s report.

The final standard also removed some highly debated provisions included in the draft proposal as follows:

• There is no report on findings required, but the auditor is required to follow AU-C 250, AU-C 260 and AU-C 265. Should anything arise that warrants communication to those charged with governance, those findings must be communicated in writing. Be sure to grab another coffee and refresh yourself on AU-C 250, AU-C 260 and AU-C 265!
• The new required procedures section for an audit was scrapped and replaced with an Appendix A for recommended audit procedures based on risk assessments. There are some great tools there to look at.
• The required emphasis-of-matter section paragraph section of the auditor’s report was also scrapped.

Questions about the new employee benefit audit standard or employee benefit plan audits

At BerryDunn, we perform over 200 employee benefit plan audits each year. If you have any questions, we would love to help. And we’ll keep the acronyms to a minimum. Please reach out with any questions.

When last we blogged about the Financial Accounting Standards Board’s (FASB) new “current expected credit losses” (CECL) model for estimating an allowance for loan and lease losses (ALLL), we reviewed the process for developing reasonable and supportable forecasts for use in establishing the ALLL. Once you develop those forecasts, how does that information translate into amounts to set aside for loan losses?

A portion of the ALLL will continue to be based on specifically identified loans you’re concerned about. For those loans, you will continue to establish a specific component of the ALLL based on your estimate of the loss ultimately expected on the loans.

The tricky part, of course, is estimating an ALLL for the other 99% of the loan portfolio. This is where the forecasts come in. The new rules do not prescribe a particular methodology, and banking regulators have indicated community banks will likely be able to continue with their current approach, adjusted to use appropriate inputs in a manner that complies with the CECL model. One of the biggest challenges is the expectation in CECL that the ALLL will be estimated using the institution’s historical information, to the extent available and relevant.

Following is just one of many ways  you can approach it. I’ve also included a link at the end of this article to an example illustrating this approach.

Step One: Historical Loss Factors

1. First, for a given subset of the loan portfolio (e.g., the residential loan pool), you might first break down the portfolio by the number of years remaining until expected payoff (via maturity or refinancing). This is important because, on average, a loan with seven years remaining until expected payoff will have a higher level of remaining lifetime losses than a loan with one year remaining. It therefore generally wouldn’t be appropriate to use the same loss factor for both loans.
    
2. Next, decide on a set of drivers that tend to correlate with loan losses over time. FASB has indicated it doesn’t expect highly mathematical correlation models will be necessary, especially for community banks. Instead, select factors in your bank’s experience indicative of future losses. These may include:
   • External factors, such as GDP growth, unemployment rates, and housing prices
   • Internal factors such as delinquency rates, classified asset ratios, and the percentage of loans in the portfolio for which certain policy exceptions (e.g., loan-to-value ratio or minimum credit score) were granted
      
3. Once you select this set of drivers, find an historical loss period — a period of years corresponding to the estimated remaining life of the portfolio in question — where the historical drivers best approximate those you’re expecting in the future, based on your forecasts. For that historical loss period, determine the lifetime remaining loss rates of the loans outstanding at the beginning of that period, broken down by the number of years remaining until payoff. (This may require significant data mining, especially if that historical loss period was quite a few years ago.
    
4. Apply those loss rates to the breakdown derived in (a) above, by years remaining until maturity.

   Step Two: Adjustments to Historical Loss Rates

   The CECL model requires we adjust historical loss factors for conditions that may not be adequately captured by the historical loss period analysis we’ve just described. Let’s say a particular geographical subset of your market area is significantly affected by the economic fortunes of a large employer in that area.  Based on economic trends or recent developments, you might expect that employer to have a particularly bright – or dim – future over the forecast period; accordingly, you forecast loans to borrowers in that area will have losses that differ significantly from the rest of the portfolio.

   The approach for these loans is the same as in the previous step. However:

   These loans would be segregated from the remainder of the portfolio, which would be subject to the general approach in step one. As you think through this approach, there are myriad variations and many decisions to make, such as:

   Our intent in describing this methodology is to help your CECL implementation team start the dialogue in terms of converting theoretical concepts in the CECL model to actual loans and historical experience.

   To facilitate that discussion, we’ve included a very simple example here that illustrates the steps described above. Analyzing an entire loan portfolio under the CECL model is an exponentially more complex process, but the concepts are the same — forecasting future conditions, and establishing an ALLL based on the bank’s (or, when necessary, peers’) lifetime loan loss experience under similar historical conditions.

   Given the amount of number crunching and analysis necessary, and the potentially significant increase in the ALLL that may result from a lifetime-of-loan loss model, it’s safe to say the time to start is now! If you have any questions about CECL implementation, please contact Tracy Harding or Rob Smalley.

   Other resources
   For more information on CECL, check out our other blogs:

   CECL: Where to Start
   CECL: Bank and Branch Acquisitions
   CECL: Reasonable and Supportable

   To sign up to receive notification of our next CECL update, click here.

   • In substep (c), you would focus on forecasted conditions (such as unemployment rate and changes in real estate values) in the geographical area in which the significant employer is located.
   • You would then select an historical loss period that had actual conditions for that area that best correspond to those you’ve just forecasted.
   • In substep (d), you would determine the lifetime remaining loss rates of loans outstanding at the beginning of that period.
   • In substep (e), you would apply those rates to loans in that geographic area.
   • How to break down the portfolio
   • Which conditions to analyze
   • How to analyze the conditions for correlation with historical loss periods
   • Which resulting loss factors to apply to which loans

Recently, federal banking regulators released an interagency financial institution letter on CECL, in the form of a Q&A. Read it here. While there weren’t a lot of new insights into expectations examiners may have upon adoption, here is what we gleaned, and what you need to know, from the letter.

ALLL Documentation: More is better

Your management will be required to develop reasonable and supportable forecasts to determine an appropriate estimate for their allowance for loan and lease losses (ALLL). Institutions have always worked under the rule that accounting estimates need to be supported by evidence. Everyone knows both examiners and auditors LOVE documentation, but how much is necessary to prove whether the new CECL estimate is reasonable and supportable? The best answer I can give you is “more”.

And regardless of the exact model institutions develop, there will be significantly more decision points required with CECL than with the incurred loss model. At each point, both your management and your auditors will need to ask, “Why this path vs. another?” Defining those decision points and developing a process for documenting the path taken while also exploring alternatives is essential to build a model that estimates losses under both the letter and the spirit of the new rules. This is especially true when developing forecasts. We know you are not fortune tellers. Neither are we.

The challenge will be to document the sources used for forecasts, making the connections between that information and its effect on your loss data as clear as possible, so the model bases the loss estimate on your institution’s historical experience under conditions similar to those you’re forecasting, to the extent possible.

Software may make this easier… or harder.               

The leading allowance software applications allow for virtually instantaneous switching between different models, permitting users to test various assumptions in a painless environment. These applications feature collection points that enable users to document the basis for their decisions that become part of the final ALLL package. Take care to try and ensure that the support collected matches the decisions made and assumptions used.

Whether you use software or not there is a common set of essential controls to help ensure your ALLL calculation is supported. They are:

• Documented review and recalculation of the ALLL estimate by a qualified individual(s) independent of the preparation of the calculation
• Control over reports and spreadsheets that include data that feed into the overall calculation
• Documentation supporting qualitative factors, including reasonableness of the resulting reserve amounts
• Controls over loan ratings if they are a factor in your model
• Controls over the timeliness of charge-offs

In the process of implementing the new CECL guidance it can be easy to focus all of your effort on the details of creating models, collecting data and getting to a reasonable number. Based on the regulators’ new Q&A document, you’ll also want to spend some time making sure the ALLL number is supportable.  

Next time, we’ll look at a lesser known section of the CECL guidance that could have a significantly negative impact on the size of the ALLL and capital as a result: off-balance-sheet credit exposures.

By now, pretty much everyone in the banking industry has heard plenty of talk about CECL – the forthcoming “Current Expected Credit Loss” model of accounting for an institution’s allowance for loan losses (ALL). While the previous “Incurred Loss” model has been problematic to implement conceptually, and most of us thought CECL would improve ALL accounting and make it more comparable to how banks account for other debt instruments, it’s beginning to feel a bit like the dog who caught the car – now that we have this model, how the heck do we implement it?

The good news: We have a number of years before CECL’s effective date, and thus have some time to better understand the new rules and how to adapt an institution’s ALL model to reflect them. The bad news – the banking regulators recently announced they want banks to get cracking on this, and will expect to see some progress when they visit during upcoming exams – maybe not immediately, but likely at some point during the 2017 exam cycle.

This is the third in a series of articles addressing various aspects of this complex pronouncement. We hope that they provide you with practical advice that can help you get started on the nuts and bolts of CECL implementation.

Our previous article offered pointers on building the CECL team, brainstorming the process, and starting the data gathering conversation. In this article, we look at how to implement CECL when acquiring another bank, one or more branches of another bank, or simply a loan portfolio, such as a group of auto or credit card loans.

First, let’s remember the basics

The basic premise of CECL is that lifetime expected losses are to be booked at origination (or, in the case of an acquisition, at the acquisition date). You’ve likely heard some gnashing of teeth over the fact that this means losses are recorded “on Day One”, which many of us have some degree of conceptual difficulty with: For example, a higher risk loan will likely carry a higher yield at origination, so booking a higher level of expected losses on Day One (through the ALL) and the offsetting higher yield over the loan term (through interest income) feels like a mismatch between income and expense.

The Financial Accounting Standards Board (FASB) was sympathetic to this point, and spent a lot of time pondering it. Its international equivalent, the International Accounting Standards Board (IASB), which establishes – you guessed it – international accounting standards, actually tackled this issue by precluding Day One losses, unless they were expected to materialize within one year of origination (Day 365 losses?).

This approach, however, has led to a fairly convoluted – and challenging – model, which is already drawing a fair amount of criticism in the international community. In the end, although they had hoped to have a “converged” standard that would result in the same approach for U.S. and international institutions, FASB and the IASB decided to part company and use different models.

The short answer? We have to accept the notion of Day One losses as the price to pay for a less convoluted (but still complex to implement) model. This becomes important to remember as we look at accounting for acquisitions.

Accounting for acquisitions

Whether you’re acquiring a pool of loans, a branch, or an entire institution, the basic accounting under CECL is the same, and it’s the same (with a twist) as the accounting for originated loans: an ALL should be established for the purchase price allocated to the loans, and that ALL should reflect management’s estimate of the lifetime losses in the acquired portfolio.

Before we get into the details of how to do this, let’s take a moment to celebrate. Prior to CECL, it was not permissible to establish an initial ALL for acquired loans. Many bankers – and investors – complained that this made it difficult to compare one bank to another on metrics such as ALL coverage ratios. If one bank had a strategy that included acquisitions, and another didn’t, their ALLs would likely be quite different even if their loan portfolios and estimated incurred losses were similar. Now, with the CECL model, these two banks’ financial statements are much easier to compare.

As noted above, an ALL should be established for these loans under CECL, using the same methodology you would use for originated loans. The twist relates to what to do with the other side of the entry. The solution:

• For loans with a more-than-insignificant amount of credit deterioration since origination, the offset is to add this amount to the amount originally recorded for the purchase price allocated to the loans.

• For the rest of the acquired portfolio, the offset is to loan loss expense. That’s right, your provision is increased by the amount of ALL recorded in the transaction, except as noted in the previous bullet.

Why is this so? FASB is apparently assuming that:

• Buyers adjust the purchase price for the first item above. These loans, which we used to call “purchased – credit impaired (PCI)”, and now will call “purchased – credit deteriorated (PCD)” under CECL, are the loans with hair on them. They probably got some extra scrutiny during due diligence, thus theoretically depressing the purchase price a bit. Therefore, the amount of the purchase price allocated to loans is a lower number, and offsetting the establishment of the ALL by adding that amount to the purchase price assigned to the loans properly “grosses up” the recorded loan balance.

• Buyers don’t adjust the purchase price for other loans. This is probably true, as the lifetime losses on loans that aren’t PCD are just the cost of doing business for financial institutions. Therefore, as it is with originated loans, a big Day One provision is booked at closing.

It should be noted that the extent to which the definition of PCD loans differs from the previous definition of PCI loans depends on your interpretation of the old PCI definition. It appears clear that the new definition of PCD loans refers to loans that have specific indicators of significant credit deterioration since origination.

Let’s look at an example:

A bank buys three branches from another bank, which have total loans with a principal balance of $20 million and a fair value of $20,100,000. The portfolio includes loans with a principal balance of $1 million, and a fair value of $910,000, that are PCD.

The buyer bank determines the ALL under CECL would be $100,000 for the PCD loans and $475,000 for the rest of the acquired portfolio. Thus, the buyer bank records an ALL of $575,000. What’s the offset? As noted above:

• For the PCD loans, the offsetting $100,000 will be added to the $910,000 of purchase price allocated to those loans. As a result, these loans will have a gross amount allocated of $910,000 plus $100,000, or $1,010,000, which will then be reduced by an ALL of $100,000 on the balance sheet, for a net reported amount of $910,000 (their fair value). The difference between the gross amount assigned ($1,010,000) and the principal balance ($1 million), or $10,000, represents an implied adjustment to reflect current market interest rates, and is therefore amortized over the expected loan term through interest income.

• For the rest, the offsetting $475,000 will be an increase to the provision for loan losses, and will thus reduce income.

The last number could be a big one for institutions that do large or frequent acquisitions; thus, their balance sheets may be more comparable to other banks, but their income statements in the year of acquisition won’t be! The good news – like other acquisition costs such as legal fees and conversion expenses, this amount will be separately disclosed, so a reader can adjust for it if they believe it’s appropriate to do so.

Next time, we’ll look at the nuts and bolts of CECL’s concept of “reasonable and supportable” by considering proper documentation and controls over the ALL.