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Navigating changes to the SOC 2 guide

01.05.23

Read this if you are subject to SOC examinations.

In late October 2022, the American Institute of Certified Public Accountants’ (AICPA’s) Assurance Services Executive Committee (ASEC) released an update to the System and Organization Control (SOC) 2 reporting guide. Significant updates have been made to the Description Criteria implementation guidance and the Trust Services Criteria points of focus. Overall, the changes provide clarity around several recent and emerging industry topics and continue to promote reporting quality and consistency.

Summary of changes

Available for use now, the AICPA updates for SOC 2 examinations are significant and may require additional time and attention from companies who currently have a SOC 2 report or are planning on working toward compliance. High-level updates include incorporating new attestation standards (e.g., SSAE-20 and SSAE-21):

  • Updates to the Description Criteria implementation guidance for additional clarity regarding certain disclosure requirements, guidance on disclosure of how controls meet the requirements of a process or control framework, and guidance on disclosure of information about the risk assessment process and specific risks
  • Updates to the points of focus that support the application of the Trust Services Criteria that better reflect the ever-changing technology, legal, regulatory, and cultural risks, data management requirements, particularly related to confidentiality, and differentiating between a data controller and a data processor for privacy engagements
  • Incorporating, where appropriate, updates included in the AICPA Guide Reporting on Controls at a Service Organization Relevant to User Entities’ Internal Control over Financial Reporting (SOC 1 guide)
  • Incorporating, where applicable, additional guidance included in the AICPA Guide Reporting on an Examination of Controls Relevant to Security, Availability, Processing Integrity, Confidentiality, or Privacy in a Production, Manufacturing, or Distribution System (SOC for supply chain guide), particularly related to the risk assessment guidance

Additional updates

Other updates from the AICPA include, but are not limited to, the following:

  • Making qualitative materiality assessments (from the AICPA whitepaper on materiality)
  • Considering the service organization’s use of software applications and tools (from the SOC Tools FAQ)
  • Considering the operation of periodic controls that operated prior to the period covered by the examination
  • Considering management’s use of specialists
  • Performing and reporting in a SOC 2+ engagement (including an updated illustrative service auditor’s report)
  • Addressing considerations when the service organization has identified a service commitment or system requirement related to meeting the requirements of a process or control framework (such as HIPAA, ISO, or NIST)
  • Supplements and several appendices were removed and will be replaced with links to the appropriate documents on the AICPA website

If you currently have or will be working toward a SOC 2 report, it’s essential to understand the impact to the SOC 2 reporting process. Early preparation will help your organization stay ahead of the curve when it comes to achieving compliance. It is also essential to help ensure that frameworks are aligned and controls are in place to effectively guard against cybersecurity risks and protect sensitive data. If you have questions about SOC audits, or your specific situation, please contact our SOC Audits team. We’re here to help.

Topics: SOC

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Principals

BerryDunn experts and consultants

Is your organization a service provider that hosts or supports sensitive customer data, (e.g., personal health information (PHI), personally identifiable information (PII))? If so, you need to be aware of a recent decision by the American Institute of Certified Public Accountants that may affect how your organization manages its systems and data.

In April, the AICPA’s Assurance Executive Committee decided to replace the five Trust Service Principles (TSPs) with Trust Services Criteria (TSC), requiring service organizations to completely rework their internal controls, and present SOC 2 findings in a revised format. This switch may sound frustrating or intimidating, but we can help you understand the difference between the principles and the criteria.

The SOC 2 Today
Service providers design and implement internal controls to protect customer data and comply with certain regulations. Typically, a service provider hires an independent auditor to conduct an annual Service Organization Control (SOC) 2 examination to help ensure that controls work as intended. Among other things, the resulting SOC 2 report assures stakeholders (customers and business partners) the organization is reducing data risk and exposure.

Currently, SOC 2 reports focus on five Trust Services Principles (TSP):

  • Security: Information and systems are protected against unauthorized access, unauthorized disclosure of information, and damage to systems that can compromise the availability, integrity, confidentiality, and privacy of information or systems — and affect the entity's ability to meet its objectives.

  • Availability: Information and systems are available for operation and use to meet the entity's objectives.

  • Processing Integrity: System processing is complete, valid, accurate, timely, and authorized to meet the entity's objectives.

  • Confidentiality: Information designated as confidential is protected to meet the entity's objectives.

  • Privacy: Personal information is collected, used, retained, disclosed, and disposed of to meet the entity's objectives.

New SOC 2 Format
The TSC directly relate to the 17 principles found in the Committee of Sponsoring Organization (COSO)’s 2013 Framework for evaluating internal controls, and include additional criteria related to COSO Principle 12. The new TSC are:

  • Control Environment: emphasis on ethical values, board oversight, authority and responsibilities, workforce competence, and accountability.
  • Risk Assessment: emphasis on the risk assessment process, how to identify and analyze risks, fraud-related risks, and how changes in risk impact internal controls.
  • Control Activities: Emphasis on how you develop controls to mitigate risk, how you develop technology controls, and how you deploy controls to an organization through the use of policies and procedures.
  • Information and Communication: Emphasis on how you communicate internal of the organization to internal and external parties.
  • Monitoring: Emphasis on how you evaluate internal controls and how you communicate and address any control deficiencies.

The AICPA has provided nearly 300 Points of Focus (POF), supporting controls that organizations should consider when addressing the TSC. The POF offer guidance and considerations for controls that address the specifics of the TSC, but they are not required.

Points of Focus
Organizations now have some work to do to meet the guidelines. The good news: there’s still plenty of time to make necessary changes. You can use the current TSP format before December 15, 2018. Any SOC 2 report presented after December 15, 2018, must incorporate the new TSC format. The AICPA has provided a mapping spreadsheet to help service organizations move from TSP to the TSC format.

Contact Chris Ellingwood to learn more about how we can help you gain control of your SOC 2 reporting efforts. 
 

Article
The SOC 2 update — how will it affect you?

As the technology we use for work and at home becomes increasingly intertwined, security issues that affect one also affect the other and we must address security risks at both levels.

This year’s top security risks are the first in our series that are both prevalent to us as consumers of technology and to us as business owners and security administrators. Our homes and offices connect to devices, referred to the Internet of Things (IoT), that make our lives and jobs easier and more efficient, but securing those devices from outside access is becoming paramount to IT security.

Many of this year’s risks focus on deception. Through deception, hackers can get information and access to systems, which can harm our wallets and our businesses.

In our 2017 Top 10 IT Security Risks e-book we share with you how to understand these emerging risks, the consequences and impacts these risks may have on your business, and approaches to help mitigate the risks and their impact. Some of the key ways to address these risks are:           

  1. Do your homework — change your default passwords (the one that came with your wireless router, for instance), and also make sure that your Amazon Alexa, Google Home, or other smart devices have complex passwords. In addition, turning off devices when they are not in use, or when you are gone, helps secure your home.
  1. If you work from home, or have employees who do, set up and use secure connections with dual authentication methods to help protect your networks. Remote employees should be required to use the same security measures as on-site employees.
  1. Protect your smartphone at work and at play—smartphones have become one of our most important possessions, and we use the same device for both work and personal applications, yet we don’t protect them as well we should. Password protection is step one. Consider uploading new antivirus software to corporate smartphones and using container apps for corporate emails and documents. These apps allow users to securely connect to a company’s server and reduce the possible exposure of data.
  1. Train, inform, repeat. Create a vigilant workforce—through continuous and consistent training and information sharing, you can reduce the occurrence of phishing, hacking and other attacks against your systems.
  1. Conduct IT security risk assessments annually to help you identify gaps, fix them, and prepare for any incidents that may occur.
  1. Monitor and protect your reputation through tools to identify news on your company and understand the sources of the information.

Our 2017 Top 10 IT Security Risks takes a deeper look at the IoT and other risk issues that pose a threat this year, and what you can do to minimize your own and your organization’s IT security risks.

Article
The 2017 top IT security risks: Everything is connected

During my lunch in sunny Florida while traveling for business, enjoying a nice reprieve from another cold Maine winter, I checked my social media account. I noticed several postings about people having nothing to do at work because their company’s systems were down, the result of a major outage at one of three Amazon Web Services (AWS)’ Data Centers and web hosting operations. Company sites were down directly or indirectly through a software as a service (SaaS) provider hosted at the AWS data center.

The crash lasted for four hours and affected hundreds of thousands sites, including Airbnb, Expedia, Netflix, Quora, Slack, and others. The impact of such crashes can be devastating to organizations that rely on their website for revenue, such as online retailers and users of SaaS providers that may rely on a hosted system to conduct day-to-day business.

We advise our clients who consider hosting services in the cloud to weigh the option seriously and understand potential challenges in doing so. Here are some steps you can take to prevent future outages and loss of valuable uptime:

  1. Know the risks and weigh them against the benefits.  Ask questions about the system you are thinking of having hosted. Is the system critical to business? Without the system, do you lose revenue and productivity? Is the company providing the SaaS service hosting their own systems, or are they hosted at a data center like AWS? Does the SaaS provider have failover sites at other, separate data centers that are geographically distant from another?
  2. Have a backup plan. If your business conducts e-commerce or needs SaaS service to function, consider hosting your web servers and other data at two different providers. Though costly, the downtime impact is highly reduced.
  3. Consider hosting yourself. In some cases, we advise against relying on a third-party hosted data center. We do this when the criticality of the function is so high that having your own full-time dedicated support personnel, with multiple internet service providers available, allows you to address outages in-house and reduce the risk of outages.
  4. Have a service level agreement. Having a service level agreement with the hosted third party establishes expectations for uptime and downtime. In many instances where uptime is critical, you may consider incorporating liquidated damage clauses (fines and penalties) for downtime. Often when revenue is involved, the hosted party will take deeper measures to ensure uptime.

These types of outages are rare, but significant and while most organizations should not be scrambling to host their own systems and cancel all hosted agreements, it’s a good idea to take a hard look at your cyber security and IT risk management plan. Then, like me, when the clouds clear and you are in warm and sunny Florida, you can take a long lunch and enjoy the day.

Article
When the skies clear: Web-hosting outage hits Amazon data centers

Read this if your CFO has recently departed, or if you're looking for a replacement.

With the post-Covid labor shortage, “the Great Resignation,” an aging workforce, and ongoing staffing concerns, almost every industry is facing challenges in hiring talented staff. To address these challenges, many organizations are hiring temporary or interim help—even for C-suite positions such as Chief Financial Officers (CFOs).

You may be thinking, “The CFO is a key business partner in advising and collaborating with the CEO and developing a long-term strategy for the organization; why would I hire a contractor to fill this most-important role?” Hiring an interim CFO may be a good option to consider in certain circumstances. Here are three situations where temporary help might be the best solution for your organization.

Your organization has grown

If your company has grown since you created your finance department, or your controller isn’t ready or suited for a promotion, bringing on an interim CFO can be a natural next step in your company’s evolution, without having to make a long-term commitment. It can allow you to take the time and fully understand what you need from the role — and what kind of person is the best fit for your company’s future.

BerryDunn's Kathy Parker, leader of the Boston-based Outsourced Accounting group, has worked with many companies to help them through periods of transition. "As companies grow, many need team members at various skill levels, which requires more money to pay for multiple full-time roles," she shared. "Obtaining interim CFO services allows a company to access different skill levels while paying a fraction of the cost. As the company grows, they can always scale its resources; the beauty of this model is the flexibility."

If your company is looking for greater financial skill or advice to expand into a new market, or turn around an underperforming division, you may want to bring on an outsourced CFO with a specific set of objectives and timeline in mind. You can bring someone on board to develop growth strategies, make course corrections, bring in new financing, and update operational processes, without necessarily needing to keep those skills in the organization once they finish their assignment. Your company benefits from this very specific skill set without the expense of having a talented but expensive resource on your permanent payroll.

Your CFO has resigned

The best-laid succession plans often go astray. If that’s the case when your CFO departs, your organization may need to outsource the CFO function to fill the gap. When your company loses the leader of company-wide financial functions, you may need to find someone who can come in with those skills and get right to work. While they may need guidance and support on specifics to your company, they should be able to adapt quickly and keep financial operations running smoothly. Articulating short-term goals and setting deadlines for naming a new CFO can help lay the foundation for a successful engagement.

You don’t have the budget for a full-time CFO

If your company is the right size to have a part-time CFO, outsourcing CFO functions can be less expensive than bringing on a full-time in-house CFO. Depending on your operational and financial rhythms, you may need the CFO role full-time in parts of the year, and not in others. Initially, an interim CFO can bring a new perspective from a professional who is coming in with fresh eyes and experience outside of your company.

After the immediate need or initial crisis passes, you can review your options. Once the temporary CFO’s agreement expires, you can bring someone new in depending on your needs, or keep the contract CFO in place by extending their assignment.

Considerations for hiring an interim CFO

Making the decision between hiring someone full-time or bringing in temporary contract help can be difficult. Although it oversimplifies the decision a bit, a good rule of thumb is: the more strategic the role will be, the more important it is that you have a long-term person in the job. CFOs can have a wide range of duties, including, but not limited to:

  • Financial risk management, including planning and record-keeping
  • Management of compliance and regulatory requirements
  • Creating and monitoring reliable control systems
  • Debt and equity financing
  • Financial reporting to the Board of Directors

If the focus is primarily overseeing the financial functions of the organization and/or developing a skilled finance department, you can rely — at least initially — on a CFO for hire.

Regardless of what you choose to do, your decision will have an impact on the financial health of your organization — from avoiding finance department dissatisfaction or turnover to capitalizing on new market opportunities. Getting outside advice or a more objective view may be an important part of making the right choice for your company.

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.

Article
Three reasons to consider hiring an interim CFO

It’s one thing for coaching staff to see the need for a new quarterback or pitcher. Selecting and onboarding this talent is a whole new ballgame. Various questions have to be answered before moving forward: How much can we afford? Are they a right fit for the team and its playing style? Do the owners approve?

Management has to answer similar questions when selecting and implementing a cybersecurity maturity model, and form the basis of this blog – chapter 2 in BerryDunn’s Cybersecurity Playbook for Management.

What are the main factors a manager should consider when selecting a maturity model?
RG: All stakeholders, including managment, should be able to easily understand the model. It should be affordable for your organization to implement, and its outcomes achievable. It has to be flexible. And it has to match your industry. It doesn’t make a lot of sense to have an IT-centric maturity model if you’re not an extremely high-tech organization. What are you and your organization trying to accomplish by implementing maturity modeling? If you are trying to improve the confidentiality of data in your organization’s systems, then the maturity model you select should have a data confidentiality domain or subject area.

Managers should reach out to their peer groups to see which maturity models industry partners and associates use successfully. For example, Municipality A might look at what Municipality B is doing, and think: “How is Municipality B effectively managing cybersecurity for less money than we are?” Hint: there’s a good chance they’re using an effective maturity model. Therefore, Municipality A should probably select and implement that model. But you also have to be realistic, and know certain other factors—such as location and the ability to acquire talent—play a role in effective and affordable cybersecurity. If you’re a small town, you can’t compare yourself to a state capital.

There’s also the option of simply using the Cybersecurity Capability Maturity Model (C2M2), correct?
RG: Right. C2M2, developed by the U.S. Department of Energy, is easily scalable and can be tailored to meet specific needs. It also has a Risk Management domain to help ensure that an organization’s cybersecurity strategy supports its enterprise risk management strategy.

Once a manager has identified a maturity model that best fits their business or organization, how do they implement it?
RG: STEP ONE: get executive-level buy-in. It’s critical that executive management understands why maturity modeling is crucial to an organization's security. Explain to them how maturity modeling will help ensure the organization is spending money correctly and appropriately on cybersecurity. By sponsoring the effort, providing adequate resources, and accepting the final results, executive management plays a critical role in the process. In turn, you need to listen to executive management to know their priorities, issues, and resource constraints. When facilitating maturity modeling, don’t drive toward a predefined outcome. Understand what executive management is comfortable implementing—and what the business or organization can afford.

STEP TWO: Identify leads who are responsible for each domain or subject area of the maturity model. Explain to these leads why the organization is implementing maturity modeling, expected outcomes, and how their input is invaluable to the effort’s success. Generally speaking, the leads responsible for subject areas are very receptive to maturity modeling, because—unlike an audit—a maturity model is a resource that allows staff to advocate their needs and to say: “These are the resources I need to achieve effective cybersecurity.”

Third, have either management or these subject area leads communicate the project details to the lower levels of the organization, and solicit feedback, because staff at these levels often have unique insight on how best to manage the details.

The fourth step is to just get to work. This work will look a little different from one organization to another, because every organization has its own processes, but overall you need to run the maturity model—that is, use the model to assess the organization and discover where it measures up for each subject area or domain. Afterwards, conduct work sessions, collect suggestions and recommendations for reaching specific maturity levels, determine what it’s going to cost to increase maturity, get approval from executive management to spend the money to make the necessary changes, and create a Plan of Action and Milestones (POA&M). Then move forward and tick off each milestone.

Do you suggest selecting an executive sponsor or an executive steering committee to oversee the implementation?
RG: Absolutely. You just want to make sure the executive sponsors or steering committee members have both the ability and the authority to implement changes necessary for the modeling effort.

Should management consider hiring vendors to help implement their cybersecurity maturity models?
RG: Sure. Most organizations can implement a maturity model on their own, but the good thing about hiring a vendor is that a vendor brings objectivity to the process. Within your organization, you’re probably going to find erroneous assumptions, differing opinions about what needs to be improved, and bias regarding who is responsible for the improvements. An objective third party can help navigate these assumptions, opinions, and biases. Just be aware some vendors will push their own maturity models, because their models require or suggest organizations buy the vendors’ software. While most vendor software is excellent for improving maturity, you want to make sure the model you’re using fits your business objectives and is affordable. Don’t lose sight of that.

How long does it normally take to implement a maturity model?

RG: It depends on a variety of factors and is different for every organization. Keep in mind some maturity levels are fairly easy to reach, while others are harder and more expensive. It goes without saying that well-managed organizations implement maturity models more rapidly than poorly managed organizations.

What should management do after implementation?
RG: Run the maturity model again, and see where the organization currently measures up for each subject area or domain. Do you need to conduct a maturity model assessment every year? No, but you want to make sure you’re tracking the results year over year in order to make sure improvements are occurring. My suggestion is to conduct a maturity model assessment every three years.

One final note: make sure to maintain the effort. If you’re going to spend time and money implementing a maturity model, then make the changes, and continue to reassess maturity levels. Make sure the process becomes part of your organizations’ overall strategic plan. Document and institutionalize maturity modeling. Otherwise, the organization is in danger of losing this knowledge when the people who spearheaded the effort retire or pursue new opportunities elsewhere.

What’s next?
RG: Over the next couple of blogs, we’ll move away from talking about maturity modeling and begin talking about the role capacity plays in cybersecurity. Blog #3 will instruct managers on how to conduct an internal assessment to determine if their organizations have the people, processes, and technologies they need for effective cybersecurity.

Read our next cybersecurity playbook article, Tapping your internal capacity for better results: Cybersecurity playbook for management #3, here.

Article
Selecting and implementing a maturity model: Cybersecurity playbook for management #2

For professional baseball players who get paid millions to swing a bat, going through a slump is daunting. The mere thought of a slump conjures up frustration, anxiety and humiliation, and in extreme cases, the possibility of job loss.

The concept of a slump transcends sports. Just glance at the recent headlines about Yahoo, Equifax, Deloitte, and the Democratic National Committee. Data breaches occur on a regular basis. Like a baseball team experiencing a downswing, these organizations need to make adjustments, tough decisions, and major changes. Most importantly, they need to realize that cybersecurity is no longer the exclusive domain of Chief Information Security Officers and IT departments. Cybersecurity is the responsibility of all employees and managers: it takes a team.

When a cybersecurity breach occurs, people tend to focus on what goes wrong at the technical level. They often fail to see that cybersecurity begins at the strategic level. With this in mind, I am writing a blog series to outline the activities managers need to take to properly oversee cybersecurity, and remind readers that good cybersecurity takes a top-down approach. Consider the series a cybersecurity playbook for management. This Q&A blog — chapter 1 — highlights a basic concept of maturity modeling.

Let’s start with the basics. What exactly is a maturity model?
RG
: A maturity model is a framework that assesses certain elements in an organization, and provides direction to improve these elements. There are project management, quality management, and cybersecurity maturity models.

Cybersecurity maturity modeling is used to set a cybersecurity target for management. It’s like creating and following an individual development program. It provides definitive steps to take to reach a maturity level that you’re comfortable with — both from a staffing perspective, and from a financial perspective. It’s a logical road map to make a business or organization more secure.

What are some well-known maturity models that agencies and companies use?
RG
: One of the first, and most popular is the Program Review for Information Security Management Assistance (PRISMA), still in use today. Another is the Capability Maturity Model Integration (CMMI) model, which focuses on technology. Then there are some commercial maturity models, such as the Gartner Maturity Model, that organizations can pay to use.

The model I prefer is the Cybersecurity Capability Maturity Model (C2M2), developed by the U.S. Department of Energy. I like C2M2 because it directly maps to the U.S. Department of Commerce’s National Institute of Standards and Technology (NIST) compliance, which is a prominent industry standard. C2M2 is easily understandable and digestible, it scales to the size of the organization, and it is constantly updated to reflect the most recent U.S. government standards. So, it’s relevant to today’s operational environment.

Communication is one of C2M2’s strengths. Because there is a mechanism in the model requiring management to engage and support the technical staff, it facilitates communication and feedback at not just the operational level, but at the tactical level, and more significantly, the management level, where well-designed security programs start.

What’s the difference between processed-based and capability-based models?
RG
: Processed-based models focus on performance or technical aspects — for example, how mature are processes for access controls? Capability-based models focus on management aspects — is management adequately training people to manage access controls?

C2M2 combines the two approaches. It provides practical steps your organization can take, both operationally and strategically. Not only does it provide the technical team with direction on what to do on a daily basis to help ensure cybersecurity, it also provides management with direction to help ensure that strategic goals are achieved.

Looking at the bigger picture, what does an organization look like from a managerial point of view?
RG
: First, a mature organization communicates effectively. Management knows what is going on in their environment.

Most of them have very competent staff. However, staff members don’t always coordinate with others. I once did some security work for a company that had an insider threat. The insider threat was detected and dismissed from the company, but management didn’t know the details of why or how the situation occurred. Had there been an incident response plan in place (one of the dimensions C2M2 measures) — or even some degree of cybersecurity maturity in the company, they would’ve had clearly defined steps to take to handle the insider threat, and management would have been aware from an early stage. When management did find out about the insider threat, it became a much bigger issue than it had to be, and wasted time and resources. At the same time, the insider threat exposed the company to a high degree of risk. Because upper management was unaware, they were unable to make a strategic decision on how to act or react to the threat.

That’s the beauty of C2M2. It takes into account the responsibilities of both technical staff and management, and has a built-in communication plan that enables the team to work proactively instead of reactively, and shares cybersecurity initiatives between both management and technical staff.

Second, management in a mature organization knows they can’t protect everything in the environment — but they have a keen awareness of what is really important. Maturity modeling forces management to look at operations and identify what is critical and what really needs to be protected. Once management knows what is important, they can better align resources to meet particular challenges.

Third, in a mature organization, management knows they have a vital role to play in supporting the staff who address the day-to-day operational and technical tasks that ultimately support the organization’s cybersecurity strategy.

What types of businesses, not-for-profits, and government agencies should practice maturity modeling?
RG
: All of them. I’ve been in this industry a long time, and I always hear people say: “We’re too small; no one would take any interest in us.”

I conducted some work for a four-person firm that had been hired by the U.S. military. My company discovered that the firm had a breach and the four of them couldn’t believe it because they thought they were too small to be breached. It doesn’t matter what the size of your company is: if you have something someone finds very valuable, they’re going to try to steal it. Even very small companies should use cybersecurity models to reduce risk and help focus their limited resources on what is truly important. That’s maturity modeling: reducing risk by using approaches that make the most sense for your organization.

What’s management’s big takeaway?
RG
: Cybersecurity maturity modeling aligns your assets with your funding and resources. One of the most difficult challenges for every organization is finding and retaining experienced security talent. Because maturity modeling outlines what expertise is needed where, it can help match the right talent to roles that meet the established goals.

So what’s next?
RG
: In our next installment, we’ll analyze what a successful maturity modeling effort looks like. We’ll discuss the approach, what the outcome should be, and who should be involved in the process. We’ll discuss internal and external cybersecurity assessments, and incident response and recovery.

You can read our next chapter, Selecting and implementing a maturity model: Cybersecurity playbook for management #2here.

Article
Maturity modeling: Cybersecurity playbook for management #1

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
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CECL implementation: So, you've developed reasonable and supportable forecasts — now what?

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.

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CECL: Reasonable and supportable? Be ready to be ALLL in