Auditing Expected Credit Losses
Auditing expected credit losses is an important process for any business. It can help ensure that the organization does not suffer a financial loss due to unexpected customer defaults or other situations.
Auditing expected credit loss is a complex process that involves analyzing customer accounts and determining their level of risk. This helps companies determine how much they should set aside in reserves to cover potential losses from customer defaults or other issues. Companies must also consider factors like shifts in customer behavior, macroeconomic conditions, and changes in industry standards when auditing expected credit losses.
By understanding the ins and outs of auditing expected credit losses, organizations can get a better handle on their finances and make sure they are prepared for any eventualities. In the following sections of this article, we’ll look at why such audits are so important and what steps businesses need to take in order to properly audit their expected credit losses.
Accounting Standards
Recent accounting standards have developed new models for the measurement of expected credit losses. These include the current expected credit loss (CECL) model and the incurred loss model. CECL is a forward-looking approach that estimates expected losses over the lifetime of an asset.
The incurred loss model is more historical in nature, relying on observed losses from prior periods. Auditing firms must understand how these models are applied to ensure that financial statements accurately reflect current economic realities.
The auditor’s responsibility with regard to expected credit losses is twofold. They must assess whether the company has adopted an appropriate model and whether their computations are properly calculated and documented.
They must also ensure that management has taken appropriate steps to identify potential risks and establish controls to mitigate those risks. Finally, auditors should evaluate any unusual or unexpected results, ensuring that proper adjustments are made if necessary.
Measurement of Impairment Losses
Having discussed the accounting standards related to expected credit losses, it is time to move on to the measurement of such losses. As part of this process, an entity must first identify any potential financial assets that may be impaired. This requires them to assess risk factors and any signs that suggest impairment may have occurred.
- Identify any potential financial assets that may be impaired
- Assess risk factors associated with financial assets
- Look for signs that impairment has occurred
Once the entity has identified a financial asset as being potentially impaired, they must then estimate the credit loss allowance. This includes determining the amount of expected credit losses that should be disclosed in the statement of financial position. The entity must also consider any available objective evidence when estimating its expected credit losses.
Estimation of Credit Loss Allowance
Estimating credit loss allowance requires careful consideration of a number of variables. The most important factor to consider is the estimated range of credit losses based on historical trends and current economic conditions. Other factors such as customer-specific circumstances, borrower repayment capacity, and collateral values must also be taken into account. A table summarizing these elements is provided below:
| Factors | Description | Considerations |
|---|---|---|
| Historical Trends | Past credit loss data from similar loans or portfolios. | Frequency and severity of losses in the past may not be applicable to current loans/portfolios due to changing macroeconomic environment. |
| Current Economic Conditions | General economic outlook for the region or sector where the loan is held. | Assessments must reflect current changes in economic conditions that may affect the borrower’s repayment capacity. |
| Customer-Specific Circumstances | Unique aspects of customer that could affect their ability to repay debt obligations. | Examples include customer’s cash flow position, industry concentration, liquidity needs, etc. |
| Borrower Repayment Capacity | Capacity of borrower to meet financial obligations under an existing loan agreement or contract without defaulting on payments. | Must assess both short and long term repayment capacity across multiple scenarios (e.g., base case, stressed scenario). |
| Collateral Values | Value of collateral pledged by the borrower against a loan or debt obligation with respect to current market prices or other market indicators. | Must take into account any potential changes in collateral value resulting from depreciation, obsolescence, etc.. |
Documentation And Disclosures Requirements
When auditing expected credit losses, documentation and disclosure requirements are key. Firstly, the auditor must ensure that relevant documents exist that support the credit loss estimates. Secondly, they must also ascertain whether any changes or additions should be made to the estimate of expected credit losses in order to make it accurate and complete. Lastly, the auditor should assess whether proper disclosures have been made about any significant matters related to the audit.
- The auditor should review the current documentation related to any loans or debt instruments with potential credit losses.
- They should evaluate the adequacy of internal controls with respect to estimating expected credit losses.
- They should assess whether any additional information needs to be obtained beyond what is provided by management or other sources.
Analyzing Credit Quality Indicators
When auditing expected credit losses, the auditor must review credit quality indicators. These indicators can be used to identify any weaknesses in a borrower’s ability to repay their loan. The following table outlines some common credit quality indicators that should be analyzed when conducting an audit:
| Indicator | Description |
|---|---|
| Credit Score | A numerical score that assesses a borrower’s creditworthiness based on their payment history and other financial factors. |
| Loan-to-Value Ratio | The ratio of the loan amount to the value of the underlying collateral (e.g., home, car). A higher ratio indicates more risk for lenders. |
| Debt Service Coverage Ratio | The ratio of cash flow available to cover debt payments relative to total debt obligations for a borrower. A lower ratio indicates more risk for lenders. |
It is important for auditors to understand all relevant credit quality indicators, as they can inform decisions about allowance for loan losses and other accounting estimates related to expected credit losses. Furthermore, credit quality indicators are useful in understanding the level of risk associated with certain loans and borrowers, which can then be incorporated into the auditor’s assessment of management’s estimates.
Evaluating The Accuracy of Management’s Estimates
In auditing expected credit losses, it’s important to evaluate the accuracy of management’s estimates. This can be done by reviewing the assumptions used in making the estimates, such as the amount of risk that a customer will fail to pay back debt. The auditor should also assess if any changes have occurred since the original estimate was made.
The auditor should consider whether management’s assumptions are reasonable and consistent with their past experience in similar situations. For example, if a customer has never defaulted on payments before, it may not be realistic for management to assume they will default now. Additionally, the auditor should consider whether any new information has become available since the original estimate was made that could cause management’s assumptions to be incorrect.
Audit Risks When Auditing Expected Credit Losses
When auditing expected credit losses, auditors must be aware of the potential risks and how to address them. The first risk is misstatement due to errors or fraud. Auditors need to be aware of any potential misstatement in the financial statement due to errors, such as incorrect calculation or inputting of data, or fraud, such as intentional manipulation of information.
The second risk is inadequate disclosure. Auditors should ensure that all relevant information regarding expected credit losses is disclosed in the financial statements. This includes all available information related to the debtors’ ability to repay the loan and any other factors which may affect the amount of loss expected from a loan.
Finally, another risk when auditing expected credit losses is improper estimation. Auditors need to assess whether management has accurately estimated the amount of credit loss by applying proper methodology and assessment techniques for each loan item.
Audit Procedure To Evaluate Expected Credit Loss
The following steps should be taken during an audit of expected credit losses:
- Analyze borrower data:
- Review borrower accounts for delinquency, default status, and other risk indicators.
- Analyze current debt-to-income ratios and other related metrics.
- Examine internal controls:
- Evaluate policies and procedures in place to identify potential credit risks.
- Identify areas where additional controls may be needed.
- Assess loss estimates:
- Compare estimates with historical trends for similar loans.
- Determine if any assumptions used in estimating losses are reasonable.
Conclusion
In conclusion, auditing expected credit losses is a complex process that requires careful consideration of accounting standards, measurement of impairment losses, estimations for credit loss allowance, documentation and disclosures requirements, analyzing credit quality indicators, and evaluating the accuracy of management’s estimates and internal controls. To successfully audit these areas, audit risks must be identified and addressed. Furthermore, an appropriate audit procedure should be developed to evaluate expected credit loss.
I believe that it is important for auditors to have a deep understanding of the complexities associated with auditing expected credit losses in order to accurately assess the financial health of their clients. Auditors should also ensure that they are applying appropriate procedures to determine whether management’s estimates are reasonable and reliable.