THOUGHTWARE Financial Services - BKD | CPA Firm ... · Financial Services THOUGHTWARE® CECL's Impact on ICFR What Could Go Wrong? July 31, 2019 THOUGHTWARE® Meagan Clark, CPA Director

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Financial Services

THOUGHTWARE®

CECL's Impact on ICFR

What Could Go Wrong?

July 31, 2019

THOUGHTWARE®

Meagan Clark, CPA

Director

Little Rock | 501.372.1040

[email protected]

Bryan Neal, CPA, CIA

Director

Oklahoma City | 405.606.2580

[email protected]

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To Receive CPE Credit

Individuals

• Participate in entire webinar

• Answer polls when they are provided

Groups

• Group leader is the person who registered & logged on to the webinar

• Answer polls when they are provided

• Complete group attendance form

• Group leader sign bottom of form

• Submit group attendance form to [email protected] within

24 hours of webinar

• If all eligibility requirements are met, each participant will be emailed their CPE certificate within 15 business

days of webinar

• Renewed understanding of common ICFR related to estimating the allowance for loan losses under the current standard

• Awareness of new control activities to be developed & documented in connection with the adoption of the new standard

• Introduction to the three lines of defense model

• Awareness of publicly available resources for use in developing & documenting new ICFR

Learning Objectives

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• Includes the current expected credit loss (CECL) model, which must be applied to financial assets carried at amortized cost as well as off‐balance‐sheet commitments

• Widely described as the most significant accounting change for financial institutions in recent memory

• One area of impact will be internal control over financial reporting (ICFR)

Financial Instruments – Credit Losses Topic 326

ASU 2016‐13

Current

PBE – SEC Filers

Interim & annual statements beginning after Dec. 15, 2019

PBE – Non‐SEC Filers


All Others


Proposed

SEC Filers, not SRCs:


All Others**


** includes all other PBEs (including SRCs), private companies, NFPs & EBPs

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• Regulatory & auditor expectations• CECL adoption will require new processes

• Significantly increased data usage

• Use of peer & economic data in new ways

• Life of loan & prepayment estimates

• Implementing control activities in tandem with new processes will improve accuracy & reduce the risk of significant methodology gaps

Why Evaluate ICFR Before Adoption?

The “What Could Go Wrong?” Approach

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Risk assessment approach used to identify and document key risks associated with a process by brainstorming on potential negative outcomes.

What Could Go Wrong?

“Risk comes from not knowing what you're doing.”

WARREN BUFFETT – BUSINESS LEADER

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Documenting the risks previously identified under the incurred loss model, which may be modified to address the CECL model, is a great first step

Maintaining a Risk Inventory

Similar Risks for Both Models

What could go wrong?

• Inappropriate loan classification at inception

• Inappropriate loan classification at modification

• Inaccurate loan interest accrual status

• Inappropriate collateral valuation at inception or during updates

• Risk grades assigned to loans are inaccurate

Control activity

• Monitoring controls over the accuracy of new loan entry

• Monitoring controls over the accuracy of modification entry

• Monitoring controls over accrual status changes

• Preventive & review controls over collateral appraisals

• Preventive & monitoring controls over grade changes

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• Troubled debt restructuring (TDR) status is not accurate

• Data elements housed in system interfaces are inaccurate or incomplete

• Data extraction from core system for use in modeling is inaccurate or incomplete

• Data importation into the model is inaccurate or incomplete

Control activity

• Preventive & monitoring controls over TDR status changes

• Preventive & periodic monitoring controls including reconciliations & data validation

• Preventive & monitoring controls including reconciliations & data validation of extraction

• Preventive & monitoring controls including reconciliations & data validation of importation



• Unauthorized or undetected changes are made to data, files or models

• Inappropriate models or spreadsheet calculations are used

• Data requested by the corporate credit team from the line of business is inaccurate or incomplete

Control activity

• Preventive & periodic monitoring controls including reconciliations & data validation

• Preventive & monitoring control activities including formula testing & recalculations

• Monitoring control activity to periodically evaluate the appropriateness of assumptions & data validation

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• The level of activity disclosed during the period is insufficient or not meaningful to understand the activity in the allowance for credit losses for the period

• The level of detail disclosed is insufficient or not meaningful to understand the extent of past‐due loans or the credit risk & interest income recognized on financial assets on nonaccrual status

Control activity

• Monitoring control activity to compare disclosures to applicable requirements & to assess the understandability of disclosures for financial statement users




• Financial statement users cannot understand the circumstances which caused changes to the allowance for credit losses & provision reported for the period

• Financial statement users cannot understand the method & information used for developing management’s estimate of expected credit losses by portfolio segment

Control activity



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• Credit quality indicators selected for use in modeling are not highly correlated to loss experience

• Historical loss period selection is not relevant or appropriate for use in modeling

Control activity

• Management should evaluate whether control activities around selecting credit quality indicators used for the incurred loss model need to be re‐evaluated due to changes in processes related to adoption of the new CECL models

• Management should evaluate whether control activities in use require updates based on models selected & implemented

The implementation of a significant new accounting standard requires the identification of risks & the key internal control activities designed to mitigate those risks related specifically to implementation activities

Risks Unique to Implementation

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Implementation Risks


• Key stakeholders not adequately involved in implementation

• Key implementation objectives are not adequately documented

Control activity

• Entitywide control establishing the formal structure of & governing principles for an implementation oversight body

• Entitywide control establishing guidelines for documenting key objectives, assignment of responsibilities, key timelines & protocols for making changes to the implementation plan



• Identification of inappropriate credit quality indicators used to segment loans for modeling

• Models selected are excessively difficult to implement due to missing or inaccurate loan data

• Key terms & concepts adopted with the new standard are not adequately or consistently defined

Control activity

• Policy document which defines successful selection criteria & analysis necessary to evaluate correlation to losses

• Detective control activity which defines activities necessary to analyze the data available for use in modeling

• Policy document which defines new terms and concepts which is periodically reviewed & approved by the governance body

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• Data collection & warehousing protocols may be inadequate to support models selected for implementation

• Identification of data fields necessary to support models selected for implementation may be inaccurate or incomplete

Control activity

• Completion of a data gap analysis to evaluate data gathering & storage requirements to support the models selected

• Completion of a data gap analysis to evaluate data input requirements to support the models selected

“I can't change the direction of the wind, but I can adjust my sails to always reach my destination”

JIMMY DEAN – SINGER & ACTOR

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While some of the risks associated with estimating losses under the CECL model are similar to those present under the incurred loss model, new concepts in the CECL model will require the identification of new risks unique to the CECL model

Risks Unique to the CECL Model

• Use of historical lifetime loss experience

• Estimating the remaining life of loan receivables, including the impact of prepayment

• More than just loans (HTM debt securities & unfunded commitments)

Concepts Unique to the CECL Model

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• Identifying & selecting reliable data necessary to support forecast adjustments

• Determining the length of the reasonable & supportable forecast

• Reversion method from forecast back to historical loss experience

• New accounting methods for both existing & new purchased loans upon adoption

Concepts Unique to the CECL Model



• Inappropriate periods are used to develop the CECL calculation determining lifetime loss experience resulting in errors in estimates

• Inappropriate assumptions used to estimate overall life of loans & prepayment rates across diverse loan pools

• Economic variable assumptions are not appropriate for use in the forecasting estimates

Control activity

• Monitoring control activity to periodically evaluate the appropriateness of assumptions

• Monitoring control activity performed periodically to evaluate the accuracy of assumptions

• Monitoring control activity to periodically evaluate the appropriateness of assumptions

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• Economic variable assumptions obtained from an external source are inaccurate

• Inappropriate periods are used to develop the expected credit loss calculation, e.g., reasonable & supportable forecast period, reversion to historical loss information period, & post‐reversion period

Control activity

• Monitoring control activity to periodically evaluate the accuracy of source data used in the model

• Monitoring control activity to periodically evaluate & challenge the appropriateness of the period selected for use in the model & the level & quality of documentation supporting the rationale used for selections



• Accounting treatment for purchased credit impaired (PCI) loans did not change to comply with the new standard

• Inappropriate identification of purchased credit deteriorated loans (PCD) under new definition in existing portfolio at adoption

• Accounting treatment for new PCD loans may not comply with requirements in the new standard

Control activity

• Monitoring control activity to evaluate the appropriateness of transitional accounting at adoption of the new standard

• Monitoring control activity to evaluate the appropriateness of transitional accounting at adoption of the new standard

• Monitoring control activity to evaluate the appropriateness of business combination accounting

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• Inappropriate or missing management adjustments for changes in trends, condition or other relevant factors

• Models do not reflect the best estimate of expected credit losses considering available internal & external data not captured by the model

Control activity

• Monitoring control activity to evaluate the appropriateness of assumptions used in the model & forecasting

• Monitoring control activity to evaluate the results of the model calculations for reasonableness, directional consistency, inclusion of relevant data

• “The Three Lines of Defense in Effective Risk Management and Control”

• Operational management

• Internal monitoring & oversight functions

• Internal audit

Institute of Internal Auditor’s (IIA) position paper January 2013

“Three Lines of Defense” Model

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A best practice for documenting the oversight provided for adopting significant standards is to formalize key decisions & milestones into a general narrative which can be used to tell your institution’s story for external auditors & regulators

CECL Narrative

• Internal governance practices• Key player involvement

• Roles & responsibilities

Management Oversight – Implementation

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• Unit of account• Estimating remaining life, including prepayments

• Estimating historical loss experience

• Adjustments for changes in current conditions

• Reasonable & supportable forecasts

New Estimation Processes

• Financial assets measured at amortized cost

• AFS debt securities

Methodology Development & Validation

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• Defining key terms & new concepts

• Documenting implementation decisions

Accounting Policies & Procedures

• Management interaction with governance

• Independent periodic review of methodology

• Controls over• Data inputs

• Reasonableness of assumptions

• Reversion period methods

• Reporting & disclosure process

Internal Control Framework

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• The Committee of Sponsoring Organizations of the Treadway Commission’s (COSO) “Internal Control – Integrated Framework”

• The Institute of Internal Auditors’ (IIA) “The Three Lines of Defense in Effective Risk Management and Control”

• The Committee on Corporate Reporting of Financial Executives International (FEI)’s “A Guide to Implementing Internal Control over Financial Reporting for the Current Expected Credit Loss (CECL) Standard”

Publicly Available Resources

In Closing …

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Continuing Professional Education (CPE) Credit

BKD, LLP is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: www.nasbaregistry.org

The information contained in these slides is presented by professionals for your information only & is not to be considered as legal advice. Applying specific information to your situation requires careful consideration of facts & circumstances. Consult your BKD advisor or legal counsel before acting on any matters covered

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To Receive CPE Credit

• CPE credit may be awarded upon verification of participant attendance

• For questions, concerns or comments regarding CPE credit, please email the BKD Learning & Development Department at [email protected]

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Documents

THOUGHTWARE Financial Services - BKD | CPA Firm ... · Financial Services THOUGHTWARE® CECL's Impact on ICFR What Could Go Wrong? July 31, 2019 THOUGHTWARE® Meagan Clark, CPA Director