Guide to auditing IFRS 9

expected credit loss

Contents
1. Introduction and Overview ......................................................................................................... 1
1.1. Applicable accounting principles, regulatory and audit guidance .............................. 4
1.2. Professional scepticism ...................................................................................................... 4
1.3. Information produced by the entity ................................................................................. 4
1.4. Controls over SCOTs and significant disclosure processes.......................................... 5
1.5. Updating our control testing through year end ............................................................. 5
1.6. Updating our substantive testing through year end ..................................................... 6
1.7. Using the work of a specialist ............................................................................................ 6
1.8. Risk assessment ................................................................................................................... 7
1.8.1 Fraud and significant risks .............................................................................................. 7
1.9. Understanding the process ................................................................................................ 9
1.10. Planning considerations ................................................................................................... 12
2. Accounting and other technical interpretations .................................................................. 13
2.1. Accounting and other technical interpretations – control testing considerations ..... 13
2.2 Accounting and other technical interpretations – control testing considerations ..... 14
3. Significant increase in credit risk ............................................................................................ 14
3.1. Significant increase in credit risk - Control testing considerations .......................... 15
3.2. Significant increase in credit risk - Substantive testing considerations .................. 17
4. ECL modelling ............................................................................................................................. 17
4.1. ECL modelling – Control testing considerations ........................................................... 19
4.2. ECL modelling – Substantive testing considerations ................................................... 26
5. Data accuracy and completeness ........................................................................................... 27
5.1. Data accuracy and completeness – Control testing considerations ......................... 28
5.2. Data accuracy and completeness – Substantive testing considerations ................. 30
6. Forward looking information ................................................................................................... 31
6.1. Forward looking information - Control testing considerations .................................. 33
6.2. Forward looking information - Substantive testing considerations .......................... 35
7. Contractual life ........................................................................................................................... 37
7.1. Contractual life - Control testing considerations ......................................................... 37
7.2. Contractual life - Substantive testing considerations ................................................. 39
8. Loan segmentation .................................................................................................................... 39
8.1. Loan segmentation - Control testing considerations .................................................. 39
8.2. Loan segmentation - Substantive testing considerations .......................................... 41
9. Loan risk ratings ........................................................................................................................ 41
9.1. Assigning the loan risk rating .......................................................................................... 42
 9.2. Loan risk ratings – Control testing considerations ...................................................... 42
9.3. Loan risk ratings – Sampling for substantive testing .................................................. 45
9.4. Loan risk ratings – Substantive testing considerations .............................................. 46
10. Use of appraisals .................................................................................................................... 46
10.1. Use of appraisals – Control testing considerations ...................................................... 47
10.2. Use of appraisals – Substantive testing considerations .............................................. 49
11. Loan modifications and forbearance.................................................................................. 50
11.1. Loan modifications and forbearance – Control testing considerations ................... 50
11.2. Loan modifications – Substantive testing considerations .......................................... 50
12. Write-offs and subsequent recoveries ............................................................................... 51
12.1. Write-offs and subsequent recoveries - Control testing considerations.................. 51
12.2. Write-offs and subsequent recoveries - Substantive testing considerations.......... 52
13. Off-balance sheet credit exposures .................................................................................... 52
13.1. Off-balance sheet credit exposures - Control testing considerations ...................... 53
13.2. Off-balance sheet credit exposures - Substantive testing considerations .............. 55
14. Management adjustments .................................................................................................... 55
14.1. Management adjustments – Control testing considerations ...................................... 56
14.2. Management adjustments – Substantive testing considerations .............................. 57
15. Purchased or originated credit-impaired financial assets (POCI) ................................. 58
15.1. Purchased or originated credit-impaired financial assets - Control testing
considerations ................................................................................................................................ 58
15.2. Purchased or originated credit-impaired financial assets - Substantive testing
considerations ................................................................................................................................ 59
16. Management’s final review and approval of the loss allowance .................................... 59
16.1. Management’s final review and approval of the loss allowance – Control testing
considerations ................................................................................................................................ 60
16.2. Management’s final review and approval of the loss allowance – Substantive
testing considerations................................................................................................................... 61
17. Disclosures .............................................................................................................................. 61
17.1. Disclosures - Control testing considerations ................................................................ 62
17.2. Disclosures - Substantive testing considerations ........................................................ 64
18. Other matters ......................................................................................................................... 64
18.1. Analytical procedures ....................................................................................................... 64
18.2. Executive involvement ...................................................................................................... 65
18.3. Consideration of regulatory examinations and observations .................................... 65
Appendix A - Compendium of loss allowance guidance .............................................................. 66
Appendix B - Enhanced Disclosure Task Force: Impact of ECL approaches on bank risk
disclosures .......................................................................................................................................... 66
Appendix C - Basel Committee on Banking Supervision: Guidance on credit risk and
accounting for ECL ............................................................................................................................ 67
Appendix D - Global Public Policy Committee Papers on IFRS 9 ............................................... 68
Appendix E - Basel Committee on Banking Supervision: Regulatory treatment of
accounting provisions – interim approach and transitional arrangements ............................. 69
Appendix F - European Banking Authority Guidelines on credit institutions’ credit risk
management practices and accounting for ECL .......................................................................... 71
1. Introduction and Overview

The new impairment requirements in IFRS 9 are based on an expected credit loss (‘ECL’) model and
replace the IAS 39 incurred loss model. The ECL model applies to debt instruments (such as bank
deposits, loans, debt securities, lease receivables and trade receivables) recorded at amortised cost
or at fair value through other comprehensive income. Loan commitments and financial guarantee
contracts that are not measured at fair value through profit or loss are also included in the scope of
the new ECL model.

The amount of ECLs recognised as a loss allowance or provision depends on the extent of credit
deterioration since initial recognition.

Figure A below summarises the general approach in recognising either ECLs.

Figure A - IFRS 9 General approach

This guidance is designed for the application of IFRS 9 to banks and other financial institutions with
a large lending portfolio; while some of the guidance may be applicable to other entities that
measure ECL, audit teams should use professional judgement in applying procedures.

The focus of the guidance is loans, loan commitments and financial guarantee contracts.
Throughout this guidance references to loans or financial assets generally include loan
commitments and guarantees given by the entity (also refer to 13 Off-balance sheet credit
exposures). There are other audit considerations for debt securities, lease and trade receivables,
plus intercompany balances in separate financial statements, but this guidance can be used as a
starting point for those instruments. The guidance includes considerations for scope and strategy,
controls testing and substantive testing. The substantive testing considerations included herein are
illustrative only and are not defined as Primary Substantive Procedures in EY GAM.

This guidance is written to facilitate audit teams’ determination of the audit approach after the
implementation of IFRS 9 and is a reminder that professional judgment is required in the choice and
scope of the audit work to be carried out, taking into consideration International Standard on
Auditing (ISA) 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates,
and Related Disclosures” (applicable for periods beginning after December 15, 2009 which is
currently being revised). There is no obligation to apply all its contents.

9 February 2018 1
Management’s methodologies and models

Note: Throughout this document the word “management” has been used when referring to the
client. Audit teams should use judgement when assessing the roles of those performing the
controls as certain processes and controls should be performed by those charged with governance.

Because the standard does not prescribe in exact terms how to estimate ECLs, management will
need to apply judgment to develop an approach that faithfully reflects ECL and can be applied
consistently over time to meet the objectives of the standard.

Management will need to assess what policies and models are needed to provide an estimate of ECL
that:

 Reflects credit losses over the remaining contractual life of a financial asset
 Incorporates information about past events, current conditions and reasonable and
supportable forecasts about future economic conditions
 Reflects the risk of loss, based on unbiased and probability weighted amount that is
determined by evaluating a range of possible outcomes that is representative of the loss
distribution

Developing methodologies and models to estimate ECL will likely be one of the most challenging
aspects of implementation for management. Its assessment of changes needed to the entity’s
accounting policies, processes, data requirements and the functionality of IT systems will need to
be performed with the assistance of personnel across multiple functions within the organization.

As the business and economic environment changes, management will need to ensure it has
processes and controls to monitor and evaluate, on a continuing basis, whether any modifications
are needed to the entity’s credit loss methodologies, models and underlying assumptions.

Historical loss information

The standard requires that entities consider available information (internal and external) relevant
to assessing the collectability of cash flows when developing the estimate for ECL for their loans or
receivables. The standard further clarifies that historical credit loss experience of financial assets
with similar risk characteristics provides an initial basis for an entity’s assessment of ECL.

As a result, as a starting point, entities may need to assess what historical loss data is available for
the estimation of the ECL. These data requirements may extend back several years, and some of
the data may not have been subject to the entity’s financial reporting or internal control processes.
Therefore, management will need to assess the accuracy and completeness of this data as part of
its implementation process and determine what changes are needed to its processes and IT systems
to routinely obtain the data and assess its continued relevance.

The entity’s new data requirements may be derived from several sources (e.g., databases,
spreadsheets, manual records) and will result in the identification of new information produced by
the entity (IPE) that we will need to test as part of the audit.

Reasonable and supportable forecasts

The requirement to use reasonable and supportable forecasts about future economic conditions in
the ECL model will be a significant change from current practice. Management will need to develop
new processes and controls to identify and evaluate the sources of information (internal and
external) it will need for its forecasts and to document the judgments made in concluding that its
forecasts are reasonable and supportable. For example, management will need to design new
control processes over identifying and assessing the reasonableness of economic variables used in
the forecast since these inputs may not have previously been subject to sufficiently rigorous
internal procedures.

9 February 2018 2
Judgments and estimates by management

Estimating ECL under the IFRS 9 model will require significant management judgment. For example,
management may need to make new judgments about:

 Segmentation of financial assets, including the assessment of whether a financial asset

exhibits risk characteristics similar to other financial assets
 Determining the method to estimate ECL
 Determining how expected prepayments affect the estimate of ECL
 Identifying relevant historical loss information
 Developing reasonable and supportable forecasts about future economic conditions
 Determining the time horizon of over which reasonable and supportable forecasts can be
made
 How to adjust historical loss information for current conditions and reasonable and
supportable forecasts
 Collateral values
 Different scenarios for collection of credit-impaired assets, including sales
 Determining whether financial assets have experienced a significant increase in credit risk
since origination
 Assessing whether a loan modification should be treated as a modification or de-recognition
 Addressing non-linearity in future economic estimates

This list is not all inclusive, and we may need to consider other key management judgments based
on the entity’s facts and circumstances.

In developing our audit procedures, we should consider our enablers on auditing management’s
estimates, including considering the methods and data used by the entity to make the estimate,
whether management will use a specialist, and possible sources of new or contrary information
(including the results of back-testing or model validation procedures)

In connection with these procedures, we should evaluate the sources of information underlying
management’s process, including whether there is other information that is reasonably available
that should be considered.

Disclosures

The standard will require entities to make new disclosures that may also affect our audit scope. The
most significant new disclosures are:

 Classification and measurement – disclosure of the carrying amounts of each of the

financial instruments category as specified in IFRS 9
 Impairment
o Disclosure of methods used to measure ECL, significant assumptions, and sources
of information
o Inputs, assumptions and estimation techniques used by management including any
changes to the process
o Information about changes in the factors that influenced management’s estimate of
ECL, including the reasons for those changes
o Significantly expanded disclosures about credit risk by presenting information that
disaggregates the amortised cost basis of financial assets by each credit quality
indicator and year of the asset’s origination (i.e., vintage)
o Reconciliation from the opening balance to the closing balance of the loss
allowance, by class of financial instrument showing separately the changes during

9 February 2018 3
 the period for the loss allowance measured at an amount equal to 12-month ECL
and lifetime ECL
 Hedge accounting – disclosure of risk management strategy as well as the effects of hedge
accounting on the financial position and performance of the company

These new disclosure requirements may have significant operational implications for management’s
control processes, thus affecting our audit strategy over disclosures.

1.1. Applicable accounting principles, regulatory and audit guidance

The International Accounting Standards Board (IASB) has sought to address a key concern that
arose as a result of the financial crisis that the incurred loss model in IAS 39 contributed to the
delayed recognition of credit losses. To do so, it has introduced a forward-looking ECL ('ECL') model
in IFRS 9 Financial Instruments. The ECL requirements and application guidance in the standard are
accompanied by 14 Illustrative Examples.

The IASB has set up an IFRS Transition Resource Group for Impairment of Financial Instruments
(ITG). ITG provided a public discussion forum to support stakeholders on implementation issues
arising from the new impairment requirements that could create diversity in practice. ITG also
informed the IASB about the implementation issues to help the IASB determine what action, if any,
was needed to address them.

ITG held the one introductory call in 2014 and three meetings during 2015. Staff papers and
meeting summaries are publicly available and represent educational reading on the issues
submitted. These can be found on IFRS website.

In December 2015, the Basel Committee on Banking Supervision (BCBS) issued its Guidance on
accounting for ECL, which sets out supervisory expectations regarding sound credit risk practices
associated with implementing and applying an ECL accounting framework. Refer to Appendix C -
Basel Committee on Banking Supervision: Guidance on credit risk and accounting for ECL. In June
2016, the Canadian Office of the Superintendent of Financial Institutions (OSFI) issued local
guidance in a new guideline IFRS 9 Financial Instruments and Disclosures and the European Banking
Authority has issued a paper to this effect.

On 17 June 2016, the Global Public Policy Committee of representatives of the six largest
accounting networks ('the GPPC') published The implementation of IFRS 9 impairment by banks –
Considerations for those charged with governance of systemically important banks ('the GPPC
guidance') to promote the implementation of accounting for ECLs to a high standard. It aims to help
those charged with governance to evaluate management's progress during the implementation and
transition phase. A year after, the GPPC published its second paper The Auditor’s response to the
risks of material misstatement posed by estimates of ECL under IFRS 9 which focuses on the audit
committee’s role in assessing the effectiveness of the auditor’s response to risks of material
misstatements presented by the estimate of ECL. Refer to Appendix D - Global Public Policy
Committee Papers on IFRS 9.
1.2. Professional scepticism
Professional scepticism is a fundamental principle that we are required to maintain throughout the
audit process. Professional scepticism is an attitude that includes a questioning mind, being alert to
conditions which may indicate possible misstatement due to error or fraud, and a critical
assessment of audit evidence.

Exercising professional scepticism is essential to the performance of an effective audit and is

particularly important when performing our procedures over the loss allowance.

1.3. Information produced by the entity

We encounter information produced by the entity (IPE) frequently throughout our audit of the loss
allowance. IPE can take many forms, such as a data warehouses, interfaces to and within an

9 February 2018 4
automated IFRS 9 calculator, and the various reports produced by either IFRS 9 calculators or
other specialized loan loss reporting systems. Also a spreadsheet or slide deck used in
management’s review and approval of the loss allowance, information provided by the client’s risk
function to our specialists (e.g., to FSRM Credit Analytics) or non-financial data used to support a
qualitative adjustment.

Whether used in the performance of management’s controls or within our substantive tests, we
identify each relevant piece of IPE and understand how it was created. We also evaluate whether
we have addressed the completeness and accuracy of that information (i.e., IPE risks).

In our evaluation, we consider whether any IPE is prepared from other IPE (e.g., allowance
calculation in Excel with information from other IPE) and determine whether we have addressed the
IPE risks for each piece of IPE.

We also consider the effect of information technology (IT) on IPE. Sole reliance on IT processes
(e.g., manage IT application change process) is never sufficient to address an IPE risk. Effective or
reliable IT processes can only reduce the extent of our testing to address IPE risks.

When IPE is produced from an IT application with ineffective IT processes or from an untested IT
application we determine the effect on IPE and adjust our audit procedures accordingly.

In an integrated audit, we identify, evaluate, and test controls that address the completeness and
accuracy of data and reports used by management in the performance of controls. Direct testing of
such data and reports, while providing relevant evidence for our financial statement audit, does not
provide direct evidence of the operating effectiveness of the related controls for an audit of
internal control over financial reporting.Controls over SCOTs and significant disclosure processes
Regardless of our audit strategy, we obtain a sufficient understanding of management’s process,
from initiation to reporting, for estimating the loss allowance. This includes challenging whether we
have identified and documented the method, model, significant assumptions and important data
used by the entity in developing its estimate.

As we obtain our understanding, we identify what can go wrongs (WCGWs) and link them to
relevant assertions. In an integrated audit (i.e., controls-reliance strategy), we also identify,
understand and test the design and operating effectiveness of the relevant controls over the loss
allowance that are designed to address the WCGWs.

Similar to other accounting estimates, many controls over the loss allowance are management
review controls. The importance of a particular management review control associated with the loss
allowance will depend on a variety of factors, including the complexity of the entity’s process for
estimating the loss allowance, the level of estimation uncertainty and the suite of transaction-level
and management review controls.

If we are relying on a management review control to address a risk of material misstatement, we

must thoroughly understand and have sufficient documentation retained in our workpapers to
evidence that the control is designed to address the risks identified and that the judgments made
during the review are reasonable and supportable.

To do so, we need to identify and properly define the control attributes, including the scope of the
review and the steps performed to conduct the review, the precision the control owner applies
when performing those steps and the controls over the IPE that the control owner uses in the
performance of the control (if applicable).

The processes an institution has in place to develop the relevant financial statement disclosures
regarding the loan portfolio and the loss allowance may be considered a significant disclosure
process. As such, we need to understand the critical path used by the entity to prepare these
disclosures and identify relevant WCGWs. In a controls-reliance strategy, we also need to identify
and test the design and operating effectiveness of the relevant control(s) to address the WCGWs we
identify.Updating our control testing through year end

9 February 2018 5
When we execute our tests of controls during an interim period, we perform and document
procedures to update our conclusions regarding the design and operating effectiveness of controls
through year end. Our decision to test controls over the loss allowance estimation process at an
interim date is made with the understanding that the loan portfolio is dynamic and represents an
accounting estimate that is based on changing market conditions.

We exercise professional judgment to determine the extent of our update procedures giving
consideration to various risk factors (e.g., length of the remaining period, the number of
occurrences of the control, control exceptions identified). In an integrated audit, the nature of our
update procedures and the extent of those procedures are greater due to our need to opine
separately on internal controls as of the balance sheet date.

When performing our update procedures over the loss allowance control testing, we are alert to
changes in the estimation methodology (including changes to any models or IPE) and to changes in
the composition of the portfolio, large or unusual transactions, changing conditions (e.g.,
underwriting, market changes that may lead to revised estimates of economic scenarios) that may
affect the loss allowance and changes in people, processes, technology or the related controls. If
there have been significant changes to controls from the date of our interim procedures, we obtain
an understanding of the changes and assess the effect(s) of such changes on our evaluation of the
controls tested and our planned substantive procedures. We consider performing additional tests of
controls, and additional substantive procedures where appropriate, to reduce the risk of
undetected material misstatements during the roll-forward period.

Typically, given the subjective nature of certain elements of the loss allowance estimation process,
we expect that the procedures performed to update our conclusions through year end would not be
limited to inquiry and observation, but would include some degree of inspection and re-
performance, particularly for higher risk areas.

When our procedures in the intervening period include inquiries, we direct our inquiries to the
people who execute or routinely monitor execution of the controls. Broad inquiries of senior
management (e.g., chief financial officer, controller, chief accounting officer, and chief risk officer)
are generally not sufficient unless these individuals execute or routinely monitor execution of the
controls.

Finally, we also document how we considered all evidence, including any negative evidence, that is
discovered in testing other areas within the audit (e.g., substantive testing) when making our
conclusion about the design and operation of controls over the loss allowance estimate.Updating
our substantive testing through year end
When we perform interim substantive testing, we also perform rollforward procedures that provide
a reasonable basis for extending our audit conclusions at the date of our interim testing to the
balance sheet date.

Our rollforward procedures include comparing the account balances at the balance sheet date with
the interim date and investigating any significant unexpected changes, or the lack of expected
changes, as well as designing substantive analytical procedures and / or tests of details for
transactions in the rollforward period. We design and perform more extensive rollforward
procedures as our CRA or the length of the rollforward period increases or misstatements were
found in our interim testing.

The loss allowance is often a critical and highly subjective accounting estimate, therefore we may
identify a significant risk (e.g., fraud risk) associated with the loss allowance. As a reminder, tests
of details are required to address significant risks for issuer audits. Our tests of details may be
performed at an interim date, in the rollforward period, at the balance sheet date, or some
combination thereof.Using the work of a specialist
When preparing the loss allowance estimate, management may use a specialist to provide
knowledge or expertise that management does not possess (i.e., management’s specialist). For
instance, management may engage someone from outside the entity to prepare appraisals for
collateral-dependent loans.

9 February 2018 6
We may also use a specialist to assist in auditing the estimate of the loss allowance (i.e., auditor’s
specialist). The use of internal specialists including risk modelling experts, economists and valuation
specialists is likely to be required considering the key elements of IFRS 9.

Further, when utilizing internal specialists, we may consider utilizing them to assist with procedures
over the design and/or operating effectiveness of controls, as well as substantive audit procedures.
We document in our workpapers our considerations for the use of internal specialists.

If we decide to use the work of management’s specialist or plan to use an internal or external
specialist to help us audit the loss allowance estimate, we follow EY GAM topic SPECIALIST.
1.8. Risk assessment

Our approach to auditing the loss allowance for loans is based on an assessment of the risk of
material misstatement of the financial statements and, when applicable, the risk of material
weaknesses in internal control over financial reporting. We follow EY GAM topics UTB, ELC, FRAUD-
RISK, CRA and SUBSTANTIVE in planning and executing our audit procedures.As part of planning
our audit of an institution’s loss allowance, we obtain an understanding of the institution’s lending
philosophy, growth objectives, risk tolerances and strategies, and the resulting credit risks. In order
to obtain this understanding, we review the institution’s lending policies and reports prepared for
the institution’s credit committee, senior management, board of directors or others within the
institution and obtain explanations from management about any matters that are unclear. We also
obtain an understanding of the processes and procedures management performs to monitor
portfolio credit risk subsequent to loan origination or purchase, and ultimately provide for such risk
in the loss allowance.

Further, we obtain an understanding of the expectations of external parties, such as banking

regulators and investors, with respect to the institution’s lending practices and credit risk
monitoring. For example, we may read investor reports and regulatory exam findings. When
possible, we meet with the regulators to discuss matters that are significant.

As we perform our risk assessment, we recognize that different loan types may be exposed to
different risks of credit loss. For example, factors that affect credit risk on consumer loans are
likely different than the factors that affect credit risk on commercial loans. In such instances, the
institution could have a different loss allowance estimation process. As a result, we may determine
that there are multiple SCOTs that affect the overall loss allowance (i.e., a different process for
consumer loans versus commercial loans and for different geographies). Accordingly, it may be
necessary to document our understanding of the loss allowance estimation process using more
than one walkthrough.

In summary, our risk assessment and the design of our audit procedures will depend on the
particular facts and circumstances, including (1) the nature, significance and complexity of the
credit risks associated with the loan portfolio, (2) the nature and extent of management’s processes
and related controls and (3) the information available to management. Determining the nature,
timing and extent of our loss allowance audit procedures requires considerable professional
judgment and the active participation of senior audit team members to determine that our audit
procedures are commensurate with our assessment of risk.

1.8.1 Fraud and significant risks

Significant risk
A significant risk is an inherent risk with both a higher likelihood of occurrence and a higher
magnitude of effect should it occur and which requires special audit consideration. Risks of
material misstatement may be greater when accounting estimates are subject to differing
interpretations or require subjective or complex judgments or assumptions about future events,
such as the estimation of the ECL for loan losses.

9 February 2018 7
We use our professional judgment to determine the nature, timing and extent of our procedures,
recognizing that significant risks have a higher likelihood of material misstatement. In order to
determine the procedures to perform to be responsive to the significant risk, refer to EY GAM topic
SUBSTANTIVE.

The following is an illustrative example of a significant risk relating to the ECL:

Illustrative significant risk(s)

 Possible misstatement of ECLs due to inappropriate macroeconomic forecasts being

considered
 Possible misstatement of ECLs due to inappropriate lifetime being assessed

The significant risks should be specific to the components of IFRS 9 that present a higher likelihood
of occurrence and a higher magnitude of effect considering the client’s portfolio, accounting
policies and modelling approaches.
Fraud risk
As part of our risk assessment, we may identify fraud risks associated with the loss allowance. We
associate such risks to the applicable financial statement assertions and identify procedures
responsive to such risks.
A fraud risk is a condition identified that has a higher likelihood of occurrence and a higher
magnitude of potential misstatement. When identifying risks of material misstatement due to fraud,
we evaluate:
 The collective knowledge we have obtained throughout the audit
 The information obtained from our inquiries
 The type of risk (i.e., fraudulent financial reporting or misappropriation of assets)
 The magnitude of the risk
 The likelihood that the risk will result in a material misstatement in the financial statements
 The pervasiveness of the risk (i.e., whether the risk affects the financial statements as a
whole or is specifically related to a particular account, assertion or class of transaction)

When identifying risks of material misstatement due to fraud, we also consider the likelihood and
magnitude of the risk. If a condition has a higher likelihood of occurrence and a higher magnitude of
potential misstatement, we identify it as a risk of material misstatement due to fraud.

ECL related fraud risks can be identified within the most subjective aspects of the ECL estimation
process such as:
 Assessment of what is considered a significant increase in credit risk
 Definition of default
 Incorporation of macro-economic factors including the use of alternative scenarios
 Adjustments to apply macroeconomic forecasts
 Adjustments to underlying historical data
 Assumptions made where there is missing or insufficient data
 Other top sided management adjustments
 Valuation of collateral
 Determination of the life of revolving lines of credit or credit card receivables
 Estimating proceeds when expecting to sell credit-impaired loans
For each identified fraud risk we determine an appropriate response that includes heightened
professional scepticism. At a minimum and in addition to understanding and evaluating controls
designed and implemented to prevent or detect misstatements due to fraud, we respond to fraud
risks in the following ways:
 Overall response (e.g., incorporate unpredictability in the nature, timing and extent of our
procedures)
 Specific response (e.g., additional and more detailed confirmations, increasing sample
sizes, performing additional analytical review procedures)

9 February 2018 8
  Response to address the risk of management override of controls — this should include
consideration of the ways in which such override could occur
 Response to address whether the risk of fraud is associated with related party transactions
The following is an illustrative example of fraud risk relating to the ECL:
Illustrative fraud risk

Possible manipulation of adjustments in incorporating the macro-economic factors and the use of
alternative scenarios. The adjustments may include changes to the application of probability
weights, allocations for risk factors including concentration of credit, economic and business
conditions, external factors, lending management and staff experience, lending policies and
procedures, and loss and recovery trends.
1.9. Understanding the process

The methodology for estimating the loss allowance varies widely from institution to institution and,
while various methods are used, no single method is preferable. As we prepare to audit an
institution’s loss allowance, we focus on obtaining a thorough understanding of management’s
process and related controls, and designing and executing audit procedures responsive to the risks
noted above. As part of our audit, we consider whether the method used by a particular institution
is appropriate, consistently applied (with the basis for changes, if any, appropriately described and
supported), comprehensive, relevant to the institution’s particular circumstances, and documented
in writing.Our assessment of the institution’s loss allowance estimation processes, and our testing
of the related processes and controls, begins with an understanding of the institution's lending
philosophies and culture (e.g., aggressive vs. conservative, corporate policies, and code of
conduct). In addition, many other factors significantly influence the design of the institution’s
process for estimating the loss allowance, including but not limited to the following:

 The types and variety of loan products offered by the institution

 The institution’s depth of historical performance experience with those products
 The size and complexity of the institution
 The institution’s risk management practices
 The extent of the institution’s investment in personnel and systems, including credit risk
modelling and management experience
 The availability and quality of data
 The current and prospective economic environment
 The results of regulatory examinations
 The use of external versus internal data

Management’s estimation process and the related procedures and controls may take many forms
and is influenced by the nature and complexity of its loan portfolio. There is no one combination of
processes, procedures and controls that will be appropriate in every circumstance.

Because of the variation in the design of the ECL estimation process across institutions, it is
important that we document our understanding of the process and procedures, the specific points
in the process where material misstatements, including errors or fraud, could occur (i.e., the What
Can Go Wrongs) and controls, including review controls, designed to prevent and or detect those
material misstatements. We customize our audit approach to the institution’s specific process.

Management’s processes should include controls designed to prevent or detect errors in the loss
allowance. These controls influence our control risk assessments and may serve to vary the nature,
timing and extent of the substantive procedures we perform to gather evidence about the
appropriateness of the ECL.

When we determine that there are multiple SCOTs that affect the overall ECL (i.e., a different
process for consumer loans versus commercial loans or different key-sub-processes), we confirm
our understanding of each SCOT. While these SCOTs may not be documented and tested as part of
the loss allowance estimation process, given the potential for data errors to materially affect the
loss allowance estimation process, we identify and document such processes and controls within

9 February 2018 9
our audit procedures (i.e., within a routine process such as loan origination). Examples include, but
are not limited to:
 Loan origination (refer to 4 Data accuracy and completeness and 13 Off-balance sheet
credit exposures) – We obtain an understanding of and document our understanding of the
origination process as it relates to approval of the loans as well as the process and controls
in place to determine that the loans are properly set up on the system of record in a timely
manner. This process can differ from one institution to another. For example, many
institutions have a quality control function, whereby new loans that are input into the
system of record are subsequently reviewed by a second individual or group to determine
that loan and borrower information is correctly reflected on the system.
When evaluating whether loans and off-balance sheet credit exposures are input into the
system of record correctly, there are many individual financial and non-financial data points
that are important. These include, but are not limited to ensuring that the following are
input correctly in the system of record:
o Loan balance
o Loan type
o Collateral type and value
o Interest rate
o Payment date
o Risk rating
o Loan to value (LTV) ratios
o Credit scores on consumer lending (e.g., FICO)
o Prepayment features and options
o Amortisation schedule
o Contractual maturity date
IMPORTANT REMINDER: Throughout this guidance references to loans or assets generally include
any loan commitments and financial guarantee contracts (refer to 13 Off-balance sheet credit
exposures). Loan balances (refer to 4 Data accuracy and completeness) – We obtain an
understanding of and document the process and controls over how the loan balances, commitments
and guarantees used in the loss allowance estimate are reconciled back to their source. While it
may not be performed as part of the audit of the loss allowance, we obtain an understanding of the
processes and related controls over the accuracy of the loan balance information itself (i.e., within
a routine process such as loan servicing/cash receipts).

 Loan segmentation (refer to 7 Loan segmentation) - We obtain an understanding and

document the institutions’ process and controls over identifying the similar risk
characteristics that allow them to segment loans on a collective basis and how those
segments are defined.

 Loan risk ratings (refer to 8 Loan risk ratings) – We obtain an understanding of and
document the process and controls over determining and recording loan risk ratings in
accordance with the institution’s risk rating system, how frequently management updates
the ratings, how management determines that the ratings are appropriate and how
management assures that the ratings (and any changes) are recorded accurately and timely
in the system of record.

 Determining the loan’s contractual life (refer to 6 Contractual life) – We obtain an

understanding and document the institutions’ process and controls over determining the
contractual life of a financial asset, including the evaluation of extensions, and renewals.

 Loan modifications and forbearance (refer to 10 Loan modifications and forbearance) – We

obtain an understanding of and document management’s process and controls over the
timely identification of modifications to assess whether these meet the de-recognition
criteria and the controls over such process. The nature and type of the modification may
have an impact on determining the stage, effective interest rate and life of the loan.

9 February 2018 10
  Use of models (refer to 3 ECL modelling) – We obtain an understanding of and document
the institution’s use of credit loss models (including the use of spreadsheets), and the
processes and controls associated with such models.

 Significant increase in credit risk (refer to 2 Significant increase in credit risk) – We obtain
an understanding of and document the institution’s process and control over the criteria of
significant increase in credit risk established for the entity’s portfolios.

 Forward looking information (refer to 5 Forward looking information) – We obtain an

understanding of and document the institution’s process and control over the application of
entity’s forward looking information including macroeconomic scenarios and weightings
applied.

 Exposure at default (EAD), loss given default (LGD) and probability of default (PD) (refer to
3 ECL modelling) – We obtain an understanding of and document the entity’s
interpretations, criteria and models developed over EAD, LGD and PD of the financial
instrument, assuming that the entity uses a PD approach to estimating ECL.

 Historical “lookback” periods (refer to 3 ECL modelling) – We obtain an understanding of

and document the institution’s process and controls over establishing the “lookback”
periods used in the loss allowance estimate, including understanding the institution’s basis
for concluding the inputs and assumptions are reasonable.

 Adjustments to historical information: reasonable and supportable forecast (refer to 3 ECL

modelling and 4 Data accuracy and completeness) - We obtain an understanding of and
document the process and controls over management’s development of reasonable and
supportable forecasts to differ from the conditions that existed for the period during which
the historical information was evaluated. Potential variables that may be used include, but
are not limited to inflation, unemployment rates, GDP, House Price Index, and credit
spreads. We also understand the approach to incorporating multiple economic scenarios.
Approaches can included discrete scenarios, modelled solutions, or model overlays.

 Management adjustments (refer to 15 Management adjustments) – We obtain an

understanding of and document the use of qualitative factors, including the process
management uses to reflect such adjustments in the loss allowance estimate (e.g., applied
as adjustments within credit loss models, or recorded as topside adjustments once all other
allowance estimation processes have been completed) and the controls over such
processes.

 Individually evaluated loans (refer to 2 Significant increase in credit risk, 7 Loan

segmentation, and 9 Use of appraisals) – We obtain an understanding of and document the
process and controls over the identification of those loans that do not share similar risk
characteristics and are evaluated on an individual basis. An institution may use appraisals
to aid in determining the amount of ECL established for a collateral-dependent loan. Our
understanding and related documentation include management’s policies regarding the
circumstances in which appraisals are to be obtained, the source of such appraisals
(internal or external), the process and controls over obtaining an appraisal (e.g., approved
appraiser listing, including how appraisers are added or removed from the listing),
evaluating the appraisal, and the use of the appraisal in the specific reserve estimate.

 Delinquencies (refer to 4 Data accuracy and completeness) – Delinquency monitoring is

typically a key process/control as delinquencies may be analysed for a variety of reasons
within the broader loss allowance estimation process (e.g., the effect of delinquencies on
loss assumptions and loan risk ratings). We obtain an understanding of, and document the
process and controls over the accurate days past due analysis and aging of loan balances,
and the accuracy and completeness of the related aging reports (typically an application
control).

9 February 2018 11
  Management’s review (refer to 15 Management’s final review and approval of the loss
allowance) – There are typically multiple levels of review of the overall loss allowance
estimate and those levels of review cascade from being very detailed to a review that is
more general and analytical in nature. We obtain an understanding of and document each
level of the review, focusing on the competencies of those performing the review, as well as
the level of precision the review control is designed to achieve (e.g., at what level of detail
is the review performed and the nature and magnitude of misstatement the review is
designed to identify).

 Credit quality disclosures (refer to 16 Disclosures) – If not covered elsewhere (e. g., the
financial statement close process), our walkthrough documentation includes our
understanding of the process over the accumulation and sufficiency of the institution’s
credit quality disclosures, and the controls designed to prevent or detect errors or
omissions relating to such disclosures. Such process and controls should encompass how
management is appropriately identifying and accumulating the information for disclosure,
such as the year of origination (vintage).
We can use Form 201GL, Accounting estimates or the Form 202GL series (all required for audits
conducted in accordance with US standards) to confirm our understanding and to walkthrough the
loss allowance SCOT to confirm our understanding and to walk through the process:

 202GL-A, Understand and confirm our understanding of the estimation SCOT and assess
risk
 202GL-B, Design substantive procedures
 202GL-C, Execute and conclude on the estimation SCOT

In our documentation, we consider each element in the process including:

 Our understanding of the estimation process

 The relevant controls (when applicable) and our testing procedures
 Significant assumptions
 Methods and data used by management to make the estimate
 Whether management has used a specialist
 Our planned substantive procedures to test the methods, data and assumptions developed
by management, including those designed to assess management bias
 Possible sources of new or contrary evidence
 Finding and conclusion

1.10. Planning considerations

The audit team typically discusses the loss allowance and related risk(s) and audit considerations at
the Team Planning Event (TPE) during the discussion of accounting estimates. Teams may also hold
a separate meeting (e.g., Estimates Event) to discuss the loss allowance estimation process.
The TPE, or the separate Estimates Event, is designed to cover many of the procedures within both
the planning and execution phases of the audit, including the effect of these procedures on the
preliminary audit strategy, executive involvement in these meetings is important to determine that
the risks and audit considerations have been appropriately evaluated. At this time we also plan for
the continued executive involvement throughout the audit, including the degree of involvement by
the engagement quality reviewer (EQR).

During the TPE, or the separate Estimates Event, we agree on the preliminary strategy and
procedures to be performed to audit the ECL. During the discussion of accounting estimates we
discuss at a minimum:
 Management’s methods and important assumptions used to determine the ECL

9 February 2018 12
  including significant increase in credit risk and the approach to multiple economic
scenarios
 The important data used and how that data is generated
 The related internal controls, including the precision and sensitivity of review controls (e.g.,
at what level of detail is the review performed and is the review sufficient to identify errors
or fraud that could be material to the financial statements)
 The key performance indicators (KPIs) being used by management
 Roles and responsibilities of team members, including determination of the use of firm
specialists
 Other relevant significant accounting and auditing issues (e.g., planned system changes,
changes to regulatory or IFRS 9 requirements affecting the loss allowance, significant
changes from the prior year in the economy or specific industries, or in the institution’s
lending philosophies or practices)
2. Accounting and other technical interpretations

IFRS 9 requires a significant amount of management judgements as to how the requirements of

IFRS 9 may be applied. Consequently the need for well documented accounting policies is critical.
The accounting interpretations should be the basis for the modelling and data decisions used to
prepare the ECL calculation. Key interpretations include, but are not limited to:
 Definition of a significant increase in credit risk
 Definition of credit-impaired
 Incorporation of multiple economic scenarios
 Identification and treatment of revolving credit facilities
 Assumptions used when data is missing (e.g., origination data)
 Modification vs. de-recognition
 Materiality considerations
 Effective interest rate
 Use of the simplifications set out in the standard
 Whether guarantees held are considered ‘integral’ to a loan and can be included in the
measurement of the loan ECL
 ECL scope – which financial assets and off-balance sheet credit exposures should be
included in the ECL calculation (taking into account materiality considerations)

In assessing the entity’s accounting and other technical interpretations, audit teams may consider
involving the local IFRS desk.

2.1. Accounting and other technical interpretations – control testing considerations

Illustrative probing questions we may ask to understand the entity’s accounting and other technical
interpretations

Illustrative probing questions

 How was the completeness of interpretations assessed?

 Who prepared the accounting interpretations? How were they reviewed? Who approved
them?
 Are the interpretations in line with IFRS 9?
 How do the interpretations compare with peer practice?
 What is the materiality in considering alternative interpretations?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 Interpretations are not complete and therefore not all key judgements are included in
appropriate governance

9 February 2018 13
  The interpretations were not reviewed by qualified individuals
 Interpretations are not compliant with IFRS 9
 Interpretations are materially different from peers’

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative Controls

 A completeness check of all interpretations against the IFRS 9 standard is performed

 All IFRS 9 interpretations are reviewed and approved by an appropriate governance
forum
 Alternative interpretations are considered and assessed for materiality

2.2 Accounting and other technical interpretations – control testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

 Read all accounting interpretations and assess for compliance with IFRS 9 (may include
the use of the local IFRS desk )
 Assess the impact of material alternative interpretations
 Assess the completeness of interpretations
 Re-calculate a sample of materiality calls made in interpretation papers to verify they are
immaterial
 Perform peer benchmarking for key interpretations, such as significant increase in credit
risk, definition of default and application of multiple economic scenarios

3. Significant increase in credit risk

ECL measurement is based on the underlying financial instrument’s amortised cost basis.
Regardless of how an entity determines the ECL, the standard requires credit losses to reflect
expected losses of the amortised cost basis of an asset. The standard has a “staging” concept
whereby:
 12 month ECL are recognized in the first reporting period after initial recognition for all
assets in scope which have not experienced a significant increase in credit risk (stage 1)
 Lifetime ECL are recognized for all assets in scope where the credit risk has increased
significantly since origination. Interest income is recognized on the gross asset (stage 2)
 Lifetime ECL are recognized for all credit-impaired assets. Interest income is recognized on
the net asset (stage 3)

There are a limited number of exceptions to this approach:

 Simplified approach for trade receivables, contract assets and lease receivables. The
simplified approach allows for lifetime ECL to be recognized on Day 1 (there is no ‘staging’
concept). This simplification applies only to the following:
o Trade receivables or contract assets within the scope of IFRS 15 that:
 The simplification must be taken for these assets that do not contain a
significant financing component
 The simplification may be taken for these assets that do contain a
significant financing component (accounting policy choice)
o Lease receivables that are within the scope of IAS 17 and eventually in IFRS 16,
which will replace it on January 1, 2019 (accounting policy choice)

9 February 2018 14
  Purchased or originated credit impaired financial assets – changes in lifetime ECL beyond
what was originally included in the credit-adjusted effective interest rate are recognized.
Refer to 16 Purchased or originated credit-impaired financial assets (POCI) below.

The concept of staging is one of the key judgements in IFRS 9 as there is no prescribed method to
determine what factors should be used to make the assessment and assess what is considered
‘significant’. Each entity may consider different factors and the risk management practices of the
entity will be key drivers in this assessment. In addition, as it is a relative requirement which is
compared to the credit risk at origination, it requires the availability of origination data which may
be challenging. Staging is to be forward looking, therefore solely relying on ‘backward’ looking
information such as days past due is not appropriate.

Examples of significant increase in credit risk considerations include, but are not limited to:
 Change in Lifetime Probability of Default (‘PD’)
 Change in 12 month PD (the standard requires that the entity prove that the movements in
12 month PD are highly correlated to movements in lifetime PD)
 Change in internal ratings
 Change in external ratings
 Change in credit bureau scores
 Change to a watchlist classification
 Forbearance
 Days past due (the standard has a rebuttable presumption that an asset that is 30 days past
due should be classified as stage 2)

Assets in stage 3 are those assets which meet the definition of credit-impaired, the concept of
which is broadly consistent with IAS 39.

Common stage 3 indicators (also known as indicators of impairment):

 There is a rebuttable presumption that assets that are 90 days past due should be in stage
3
 Significant financial difficulty of the issuer or the borrower
 A breach of contract, such as a default or past due event
 The lender(s) of the borrower, for economic or contractual reasons relating to the
borrower’s financial difficulty, having granted to the borrower a concession(s) that the
lender(s) would not otherwise consider
 It is becoming probable that the borrower will enter bankruptcy or other financial
reorganization
 The disappearance of an active market for that financial asset because of financial
difficulties
 Non-performing foreborne assets

In addition, entities must consider how an asset ‘cures’ – what triggers are required to move an
asset out of stage 3 or stage 2. While the standard does not require it, some entities may choose to
use a probation period which requires the improved conditions to be demonstrated for a period of
time before returning the asset to a better stage.

3.1. Significant increase in credit risk - Control testing considerations

We document our understanding of the entity’s credit risk management and resulting staging
assessment.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the

9 February 2018 15
following lists are not intended to be all inclusive). It is important to consider the use of IPE in the
determining significant increase in credit risk and design procedures accordingly.

Illustrative probing questions we may ask to understand the entity’s policies and implications to ECL
methodologies could include:

Illustrative probing questions

 Which approach does the institution use to measure significant increase in credit risk?
o What metrics are used?
o What quantum is considered ‘significant’?
o What is the primary driver?
o What are secondary drivers?
o What are backstops?
 How is the staging criteria forward looking?
 Are different measures used for different portfolios?
 How are loan commitments and guarantees measured for significant increases in credit
risk?
 Is there sufficient data to perform the assessment?
o Is origination data available?
o If not, what data backstops are used?
 What is the governance process to approve the measures, thresholds and results?
 What is the key management information to analyse the staging results?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 An exposure (including loans, commitments and guarantees) which meet the entity’s
criteria for significant increase in credit risk is classified as Stage 1.
 Exposures are incorrectly rated at the initiation date.
 Incorrect days past due calculation.
 Forbearance not flagged correctly.
 Staging criteria are not approved and reviewed.
 Inappropriate data proxies used.
 Staging criteria are not sufficiently forward looking.
 The staging criteria are too sensitive.
 The staging criteria are too tight.
 There is too much reliance on days past due.
 Missing data assumptions are not appropriate.
 The staging criteria are not a relative measure.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative Controls

 Staging criteria are reviewed and approved.

 Management information to assess staging contains appropriate indicators to make the
appropriate assessment.
 Management information is reviewed for completeness and accuracy. .

9 February 2018 16
  Key trends in staging are analysed and reviewed to establish reasons for movements in
staging results.
 Ratings are performed in accordance with policy and reviewed.
 System automatically calculates days past due.
 Origination data is reviewed for appropriateness.
 Data proxies are reviewed and approved.
 Review and approval of management information used at governance forums to review
the staging.

As noted above, a key control related to staging will be the management information that is
presented in order to assess the staging results. There is no ‘correct’ answer related to staging, so
management will need to use judgement to assess if the staging is appropriate. Key things to
consider in this analysis includes, but is not limited to:

 Proportion of EAD by product in stage 1, 2, 3– does the overall split appear reasonable for
the entity’s portfolio?
 Proportion of stage 2 assessed by:
o Primary Driver
o Secondary Driver
o Backstops
A large proportion being driven by backstops or secondary indicators may suggest that the
criteria are not sufficiently forward looking.
 Movements between stages – are assets moving between stages on a frequent basis which
indicates that the criteria may not be effective?
 Proportion of stage 2 that moves to stage 1 and stage 3

3.2. Significant increase in credit risk - Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

 Two way test for a sample of assets:

o Verify that those assets in stage 2 or 3 have met the criteria to be in that stage
(accuracy)
o Verify that the assets in stage 1 do not meet the criteria to be in stage 2 or 3
(completeness)
o Verify that the assets in stage 2 do not meet the criteria to be in stage 3
(completeness)
 Data testing to verify that the triggers used to calculate the staging criteria are
appropriate – this will require tracing a sample of loans back to source systems
o Historical data used for origination assessment
o Reporting date data
o Use of data proxies
 Consider the impact of multiple economic scenarios (see section 13) on staging criteria
 Review of management information and staging effectiveness information

4. ECL modelling
This section focuses on the selection and integrity of loss and staging models, while section 6 Data
accuracy and completeness considers data used in the model, including the historical data to build
the models. The forward looking information models are considered in 5 Forward Looking
Information. We encourage engagement teams to evaluate these sections together as certain
concepts are closely linked.

9 February 2018 17
For purposes of this section and the next, a model is a quantitative method, system, or approach
that applies statistical, economic, financial, or mathematical theories, techniques, and assumptions
to process input data into qualitative estimates. A model consists of three components: an
information input component, which delivers assumptions and data to the model; a processing
component, which transforms inputs into estimates; and a reporting component, which translates
the estimates into useful business information.

IFRS 9 gives institutions flexibility in selecting a method or methods to estimate ECL. For example,
institutions may use vintage based models, probability of default (PD) and loss given default (LGD)
models, or discounted cash flows models. Entities will also use models, to predict macro-economic
factors, such as unemployment, and other credit risk factors related to the financial instruments.

Some of the more common ECL models are summarized below:

 Probability of default, loss given default, exposure at default (PDxLGDxEAD) models:

Inherent in any loss model is the estimate of the probability that a loan will default
(probability of default, or PD), the estimate of the loss the institution expects to
experience upon a default, expressed as a percentage of loan amount (loss given
default, or LGD) and the drawn exposure at the time of default (EAD). We expect that
many financial institutions will move to this form of modelling for stage 1 and stage 2
under IFRS 9, even if it has not been used under previous accounting standards.

 Discounted cash flow models: A discounted cash flow (DCF) model is a method of
valuing the asset using the concept of the time value of money. All future cash flows
are estimated and discounted by using a discount rate to give their present values.
Further when a DCF method is applied, the allowance for credit losses should reflect the
difference between the amortised cost basis and the present value of the expected cash
flows. This type of modelling will be common for stage 3 individually assessed assets.

We expect that the two modelling types above will be the most common under IFRS 9.
However, the standard does not prescribe any specific modelling technique. Other
models that may be used are listed below. Audit teams need to verify that the models
are sufficiently forward looking enough to meet the requirements of IFRS 9.

 Migration or roll rate models – A migration or roll rate model seeks to predict, based on
historical delinquency or deterioration patterns, how many loans will be written off.
Under these models, the state of the portfolio is captured at several historical points
(e.g., quarterly or monthly) based on a relevant risk metric (e.g., risk ratings for
commercial loans, delinquency status for consumer loans). Based on the movement
from one stage of relevant risk metric to the next, these models project changes in the
credit quality of the portfolio prospectively from the balance sheet date to estimate the
loss allowance as the amount of write-offs that are expected to occur. Typically, a roll
rate model is used for homogenous loans with the relevant metric being stages of
delinquency, and is often based on monthly or quarterly projections. Alternatively, a
migration model may be applied to larger loans where the relevant risk metric is risk
ratings. The period analyzed in a migration model also varies in practice (e.g., monthly,
quarterly, or annually). Roll rate models built for IAS 39 will need to be amended to
include an loss allowance for exposures that are not yet delinquent, to consider forward
looking information and to allow losses to be discounted to their present value.

Entities employ credit loss models that are commensurate with the complexities of their loan
portfolios. While many institutions may have the resources necessary to model ECL in house,
others will use third parties for either part or the entire loss estimation process. We obtain an
understanding of the models employed by an institution, including the functionality of the model,
how the model is approved for use, how access to the model is administered, and how changes to
the model are authorized and made.

9 February 2018 18
4.1. ECL modelling – Control testing considerations
We document our understanding of the entity’s use of models, including the extent of reliance on
third parties for both modelling and data. This process forms the basis for our assessment of the
design of controls related to the use of models when estimating ECL.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive):

Illustrative probing questions we may ask to understand the entity’s use and review of loss
modelling could include:

Illustrative probing questions

 Do we understand model capabilities and limitations?

o Was the model approved for use? Were there model limitations that may
produces inaccurate outputs when viewed against design objectives and
intended business use? If so, how does managed address and remediate such
limits?
o How are mathematical theories applied when designing and maintaining the
model?
o How does management evaluate data input and assumptions?
 Do we understand management’s judgement when designing the model?
o Does management apply judgement when designing the model with respect
to sampling, numerical routines, shortcuts, other simplifications?
o How are different portfolios modelled? How are loan commitments and
guarantees modelled?
 Do we understand model development and implementation?
o Does management have the experience and competence to design and
implement the model?
o Does the loss modelling team have the appropriate documentation to
evidence review and approval for modelling choices, such as the overall
theoretical construction, key assumptions, data, and specific mathematical
calculations?
o Is the model performing as intended?
o Does management perform checks to test that all model components are
functioning as designed? If so, how often?
o Does management have a process in place to determine the relevance and
accuracy of the model?
o Does management have controls in place governing model access and
changes?
o How does the loss modelling team capture relevant external information and
events such as contrary evidence?
o Does the modelling team perform benchmarking steps? If so, how does that
impact other processes and controls?
o How does management ensure that the model is consistent with market
practices?
o Is the model sensitive to changes in risk factors of the portfolio?
o Are different economic conditions considered?
 Do we understand if models are used incorrectly or inappropriately?
o How does management evaluate whether the model design is appropriate for
what it is trying to predict?
o Does the institution use the same model to estimate ECL for all loan types
(e.g., commercial and consumer)? If so, how does management challenge
whether that approach is appropriate?

9 February 2018 19
 o How does management evaluate whether the model is used as intended (i.e.,
the users of the model do not have sufficient understanding of the model)?
 Do we understand how the model is integrated with other systems and processes? (For
example, when making an accounting estimate that involves large volumes of data, or
otherwise involves complex processing, management may use technology extensively or
require manual intervention in transferring data between systems.)
o Is the model automatically integrated with source data and/or those systems
for which the model output will serve as the input?
o Is the data flow occurring in a controlled environment? If not, what are the
controls in place to ensure data completeness and accuracy?
 Do we understand how management adjusts and supplements models over time?
o Does management have a process in place to evaluate models once they
have been placed in production?
o Does management evaluate results to determine if the models are providing
the expected outcome? If so, how?
o Does the modelling team evaluate root causes for differences between
expected outcomes and model outputs?
o Does the modelling team make qualitative adjustments to better align
outputs with expectations?
o Does the modelling team adjust models for known events?
o Are modelling limitations identified in the development phase? If so, how
often are they evaluated? If no, why not?
o How are modelling changes reviewed and approved?
 Do we understand the model governance structure?
o What role does model validation take?
o Is model validation sufficiently independent? (segregation of duties)
o What are the minimum acceptance criteria for a new model to be reviewed?
o What are the ongoing model monitoring procedures?
o Does management have a model governance entity level controls?
o How does management determine who has access to models?
o What is the role of senior management, internal audit, and the audit
committee?
 Do we understand how management reviews and challenges model outputs?
o Does management review discrepancies between model outputs,
expectations, external information, and benchmarking? Does management
set expectations and thresholds when performing this analysis? What is the
process to evaluate discrepancies and dispose them?
o Are model outputs overridden without proper analysis, approval and
documentation? If so, how often does this occur?
o Does management review reports or outputs for completeness and
accuracy?
o Does management have the expertise and knowledge to appropriately
challenge models that may be more complex compared to those used under
the incurred loss methodology?
 Do we understand how management effectively challenges models?
o Does segregation of duties exist between the team designing the model and
those reviewing and validating it?
o Does the validation team have the technical and necessary skills to challenge
the model during model validation?
o Does senior management challenge the process and decisions made by the
modelling team?
o Do validation procedures occur on an ongoing basis? If so, how often?
 Do we understand the use of third parties?

9 February 2018 20
 oDoes management have a process in place for selecting vendor models, or
hiring third parties to execute a portion of the process?
o How does management evaluate the model that the third party builds?
Examples include selection of inputs, assumptions, parameter values, and
mathematical theory driving the model calculations.
o If third party models can be customized, how does management review and
approve its customization choices?
o Does management have a process in place to evaluate third party vendors?
Does the client receive assurance reports on the control framework of the
third party or does internal audit perform procedures at the third party?
o Does management have controls in place governing model access and
changes?
o Does management receive validation reporting from the third party?
 Do we understand the role of internal audit?
o Does the entity have an internal audit function to serve as the third line of
defense? If so, is internal audit independent?
o Does internal audit have the right knowledge and skills to test the models?
 Do we understand loss modelling under an expected loss model?
o Does management use loss curves that cover losses over the entire life of the
loan?
o Does the model reflect reasonable and supportable forecasts in modelling
considerations?
o How does management support expectations about the future when
establishing reasonable and supportable forecasts?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

Understanding model capabilities and limitations

 The model may have fundamental errors and may produce inaccurate outputs when
viewed against design objective and intended business use.
 Mathematical theories may be misapplied when designing and maintaining the model.
 Quality of model outputs is highly dependent on the quality of the input data and
assumptions. The input data and assumptions are not vetted appropriately.

Understanding management’s judgment that is applied when designing the model

 Management does not appropriately assess and approve its judgements when designing
the model. Examples may include use of numerical routines, shortcuts, and
simplifications.

Model development and implementation

 The loss modelling team lacks the experience and competence to design and implement
the model and may produce and may produce incorrect models.
 The loss modelling team has not appropriately evidenced the overall theoretical
construction, key assumptions, data, and specific mathematical calculations resulting to
unsupported models.
 The model is not performing as intended.
 Management does not perform checks to test that all model components are functioning
as designed.

9 February 2018 21
  Management does not have a process in place to determine the relevance and accuracy
of the model.
 There are no controls or procedures in place covering access and changes to the model
resulting to unauthorised changes to the model.
 The loss modelling team ignores relevant external information and events (e.g., contrary
evidence) which may result to significant increase in credit risk not being captured.
 The loss modelling team does not consider benchmarking steps that may result to the
model not consistent with market practices.
 The underlying theory of the model is not conceptually sound and not generally accepted
for its intended purpose.
 Inappropriate data assumptions lead to inappropriate modelling decisions
 Management does not consider the legal and regulatory environment and requirements
when designing the model resulting to incompliant models.

Model may be used incorrectly or inappropriately

 The model design is not specific to what it is trying to predict.

 Entities may inappropriately use the same model to estimate ECL for all loan types (e.g.,
commercial and retail).
 The model is not being used as intended (i.e., the users of the model do not have
sufficient understanding of the model).

Adjusting and supplementing models over time

 Management does not evaluate results (e.g., via back-testing) to determine if the model is
providing the expected outcome.
 Modelling team does not evaluate root causes for differences between expected
outcomes and model outputs.
 Modelling limitations identified in the development phase are not assessed over time.
 Model changes are not reviewed and approved by the responsible parties.

Model governance

 Models are approved without going through proper model governance

 Validation findings are not addressed

Model output reviews

 Management does not assess discrepancies between model outputs, expectations,

external information, and benchmarking.
 Model outputs are overridden without proper analysis, approval and related
documentation.
 Management does not assess reports or outputs derived from the model for
completeness and accuracy.
 Management does not summarize model results in a way that is relevant and helpful to
the users of the financial statements (i.e., management does not contemplate reporting,
which translates the estimates into useful business information).
 Management does not compare model outputs to corresponding actual outcomes (e.g.,
benchmarking).
 Model validation team does not have the expertise and knowledge to appropriately
challenge models that might be more complex compared to those used under the
incurred loss methodology.

Effective challenges to models (model validation)

9 February 2018 22
  There might not be separation between teams designing the model and those reviewing
and validating it (e.g., independence).
 Those designing and reviewing the models do not have the technical knowledge and
necessary skills (e.g., competency).
 Senior management is not supportive of the process and decisions made by the modelling
team.
 Validation procedures do not occur on an ongoing or timely basis.

Use of third parties

 Management does not have a process in place for selecting vendor models, or hiring third
parties to execute a portion of the process.
 The vendor does not provide transparency into how the model is built, including,
selection of inputs, assumptions, parameter values, and mathematical theory driving the
model calculations.
 In cases where third party models can be customized, management does not
appropriately review and approve its customization choices.
 Management does not obtain sufficient information about the inputs and assumptions
and how they link to the entity’s current condition.
 The entity does not have a contingency plan in place when the vendor might no longer
support the model.
 Management does not have the knowledge and expertise to appropriately vet third party
vendors.
 Management does not have controls over model access or changes.
 Management does not receive validation reporting.
 Management does not receive reporting on the sufficiency of the control functions over
the models.

Role of internal audit

 Internal audit does not have the right knowledge and skill set to test models.
 Internal audit does not design and execute the appropriate ECL audit plan.

Interactions between models that have separate roles in the overall estimation of ECL

 Management uses models for different inputs when estimating ECL, but the models do
not interface with one another, or ignore results that impact inputs/outputs.
 Management does not update models when there are changes that impact the ECL.
 Only a sample of the models are validated by an independent group.

Models designed to estimate ECL

 Management uses loss curves that do not cover losses over the entire life of the loan.
 The model incorrectly calculates ECL as “annual loss rate” x “remaining years to
maturity” x “Unpaid Principal Balance”.
 Management does not appropriately reflect reasonable and supportable forecasts in
modelling considerations.
 Management does not appropriately support expectations about the future when
establishing reasonable and supportable forecasts.

Modelling considerations when utilizing models designed for capital stress testing in the
estimation of ECL or other purposes

 Expectations about the future in capital stress testing have not been updated to reflect
management’s current expectation about the future (e.g., stress test models assume
stressed economic environment over 1 year period).

9 February 2018 23
  Probabilities of default have not been updated to reflect lifetime probabilities of default
(e.g., stress test models assume 1 year PDs).

Selecting models based on loan types and risk drivers

 Management does not evaluate which estimation method or model is better suited to
predict ECL. For example, when estimating ECL for auto lending, a risk rating/transition
type model may provide better outputs and results over using a historical loss rate
model.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative controls

Understanding model capabilities and limitations

 Management reviews the mathematical accuracy of the loss model and follows up on
discrepancies by recalculating the ECL for a sample of parameters.
 Management validates the design objective of the model.
 The model limitations are known and assessed.
 Model type is approved.

Understanding management’s judgment that is applied when designing the model

 A second level review and approval is performed of judgements used in the model.
Examples may include use of sampling approach, numerical routines, shortcuts, and
simplifications.

Model development and implementation

 Management reviews and approves the loss model design.

 A second level review is performed by model validation team to assess that model
components are functioning as designed.
 Model approval forum assesses the experience and competency of the implementation
team.
 Management has controls in place to ensure that only authorized individuals have access
to the model and can make changes to it. For example:
o On a periodic basis, management compares the list of approved users to the
log of individuals who accessed the model
o On a periodic basis, management reviews a list of changes to validate that
they were appropriately approved.
 Management reviews and approves the model design ensuring that relevant external
information is incorporated into the loss model.
 Management stress tests the loss model on a periodic basis in order to validate that it is
sensitive to changes in individual risk factors of the portfolio.

Adjusting and supplementing models over time

 Management reviews modelling limitations and makes adjustments to models timely.

 Management reviews and approves incremental model changes.
 When the loss modelling team makes adjustments to the model for recurring and/or
non-recurring factors, management reviews such adjustments for appropriateness,
source documentation and to validate they are incorporated into the model
appropriately. Modelling team evaluates and resolves differences between expected
outcomes and model outputs.

9 February 2018 24
 Model governance

 A model governance framework has been implemented

 Model validation reviews all models before they are approved for use
 All validation findings over a certain threshold are remediated before approval
 Ongoing monitoring of all validation findings

Model input and output reviews

 The model team reviews inputs into the loss model for completeness and accuracy.
 The model team reviews and resolves discrepancies between model outputs,
expectations, external information, and benchmarking.
 The model team reviews output reports derived from the model for completeness and
accuracy.
 The model team reviews model outputs by comparing model outputs to corresponding
actual outcomes (e.g., benchmarking). For example, metrics of performance, such as
delinquency rates, prepayment speeds, and probability of defaults are monitored and
compared to modeled assumptions.
 The model team reviews and approves manual changes to the model.
 Management reviews, approves and documents the expertise and knowledge of the
validation team.
 The model validation team reviews and approves proposed model adjustments prior to
the final approval of the ECL methodology and calculations as of the balance sheet date.

Use of third parties

 Management reviews and documents whether the use of third parties in the ECL loss
estimation process is approved in accordance with the institution’s policies.
 Management reviews and approves any third party model customization. Management
reviews the customized model output and follows up in cases where the customization is
not in line with the approved specifications.
 Management has controls in place over model access and changes.

ECL Models designed to estimate ECL

 Management reviews and documents whether loss curves appropriately cover the entire
life of the loan for Stage 2 assets. Refer to 15 – Management’s final review and approval
of the allowance.
 Models undergo full model governance including validations to assess that the ECL
models are fit for purpose and in line with IFRS 9 interpretations

Modelling considerations for revolving facilities

 Management reviews whether the loss allowance methodology used to estimate ECL for
revolving facilities is in line with the relevant accounting framework including:
o Accounting for unconditionally cancellable lines of credit
o Estimating the life of revolving facilities

9 February 2018 25
4.2. ECL modelling – Substantive testing considerations

Illustrative substantive model testing considerations

Below are sample substantive testing procedures for IFRS 9 models. Those denoted with a * may
be performed in conjunction with Credit Risk Specialists.

1. Testing in model documentation review*:

 Read model documentation to assess:
i. Are the models in line with stated accounting policies
ii. Are the modelling techniques appropriate
iii. Are the modelling techniques in line with industry standards
iv. Are the models sufficiently granular (i.e. Different models by product
type, location)
2. Test the PD*:
 Are regulatory models leveraged? If so, are regulatory considerations adjusted,
i.e. Floors removed, translated from through-the-cycle to point-in-time
 Assess the data used to build the PD (both internal and external)
 Read the model codes to verify that they are in line with the model
documentation
 Test and re-write model code based on model documentation and compare to
client code
 Recalculate the PD
 For lifetime PD, assess the maturity estimate
 Assess any overlays/ overrides in the model
 Consider portfolio specifics, such as patterns with interest-only mortgages

3. Test the LGD*:

 Read the model codes to verify that they are in line with the model
documentation
 Test and re-write model code based on model documentation and compare to
client code
 Assess recovery rates
 Assess collateral values
 Assess any overlays/ overrides in the model
4. Test the EAD*:
 Read the model codes to verify that they are in line with the model
documentation
 Re-write model code based on model documentation and compare to client code
 Test the data used to assess drawdown patterns
 Assess the maturities being used
 Assess the impact of prepayment/ overpayment
 Assess the prepayment/ overpayment estimates by looking at trends in
prepayment/ overpayment history at different points in economic cycles
 Assess prepayments estimated at the pool level and individually
 Review loan origination documentation and controls to verify alignment with
contractual terms
 Assess prepayment and overpayment trends
 Test amortization schedules
5. Discounting*:
 Test the accuracy of EIR calculation
 Test the accuracy of the discount factor applies

9 February 2018 26
 6. Recalculate the ECL*:
 Recalculated PDxLGDxEAD = ECL
7. Back-testing*:
 Re-perform model backtesting to determine model accuracy
8. Model validation*:
 Read validation reports
 Understand all findings
 Understand impact of findings not addressed

EY Credit Risk Specialist documentation: the audit team may work with the EY Credit Risk
Specialists and direct and review their work. Such documentation should be in EY Canvas (EY
GAM topic DOC+ARC).

Other reminder relating to substantive testing considerations include:

 Timing of testing: If we perform testing at an interim period, have we tested that there
were no model changes subsequent to our testing date? Such procedures may involve
inquiries of management and/or the appraiser, consideration of changes in market
conditions that may impact the subject collateral value, or evaluation for new or updated
sources of market data utilized in our interim testing. Refer to 1.6 Updating our
substantive testing through year-end for more information.

5. Data accuracy and completeness

The overarching principle of IFRS 9 relates to the estimation of ECL over the contractual term (or
behavioural term for revolving credit facilities) of the financial asset. In order to accomplish this
objective, institutions need to consider not only past historical experience, but all available relevant
information when assessing the collectability of cash flows. This available information may include
internal and or external information relating to past events, current conditions, and reasonable and
supportable forecasts and taking into account the effect of multiple economic scenarios.

While the previous section 3 ECL modelling focuses on selecting loss models that are in line with the
size and complexity of the institution and loan portfolio, this section covers input and assumptions
into the loss model, including considerations over data accuracy and completeness. We encourage
engagement teams to evaluate these two sections together.

Historical loss information

Institutions typically use historical loss information as a starting point when estimating ECL. This
starting point, is then adjusted for current expectations of the future to arrive at the overall ECL.
While institutions accumulate loan level data about defaults, write-offs and recoveries, this data is
then further aggregated to fit the needs of the institution. For example, individual loan level write-
off data is aggregated by segments that share similar risk characteristics.

There are many other routine processes (e.g., loan origination and loan servicing) and non-routine
processes (e.g., risk rating) that also serve as data sources for the information that is utilized in the
ECL estimation process. This guidance focuses on the audit considerations (both controls and
substantive) once the information is extracted from and is used in the ECL estimation process.

For illustrative purposes, we have summarized below examples of routine and non-routine
processes and controls that we may identify and test:

 Loan origination: During loan onboarding and set-up we typically perform audit procedures
(both controls and substantive) focusing on proper set up of new loans, including the
capture of key loan characteristics, such as: origination and maturity dates, loan type,

9 February 2018 27
 original loan balances, interest rate, renewal options, original risk rating, guarantees,
nature of and collateral value (if applicable). Refer to 2 Contractual life.
 Loan servicing: As part of ongoing servicing of the loan portfolios, either done internally or
outsourced to a third party services, we typically perform audit procedures (both controls
and substantive) covering cash receipts. For example, we identify and test controls over the
accuracy of the unpaid balance, delinquency status, accrual status, renewal or re-finance
activity, and other modifications that may be used by management as inputs in its estimate
of the loss allowance.
 Risk ratings: Similarly, while we have addressed audit considerations with respect to risk
ratings in section 7 Loan risk rating, we also perform audit procedures (both controls and
substantive) to test that changes in risk ratings are recorded timely and accurately in the
system of record. Further, to the extent that institutions use other information to assign a
new risk rating or update the current rating, we perform audit procedures to validate the
completeness and accuracy of that data. For example, an institution may periodically
update consumer borrowers’ credit scores, as well as loan-to-value ratios (“LTVs”) and/or
performance data on senior lien loans not serviced by the institution. An institution with
commercial loans typically obtains borrower financial statements or may refresh collateral
appraisals on a periodic basis.

As historical information regarding asset quality (e.g., historical delinquencies, write-offs, risk
ratings) is often transferred into and stored in a data warehouse separate from the loan origination
and loan servicing systems, we focus on the flow of information from the systems of record into the
loss allowance estimation process. Throughout this flow of data, we evaluate whether institutions
have appropriate controls and interfaces in place to reconcile the data from the systems of record
to any data warehouses and/or models (including spreadsheets) used in the loss allowance
estimation process to determine data accuracy and completeness. These warehouses need to be
reconciled to the general ledger. These controls and processes should include both on-balance
sheet and off-balance sheet exposures (loan commitments and guarantees).

In instances where clients use external data for the ECL calculation, we expect an analysis
performed by client on why that data is relevant and consistent for the portfolio and we assess any
internal data that will refute the use of the external data.
5.1. Data accuracy and completeness – Control testing considerations
We document our understanding of the entity’s process to validate data accuracy and
completeness, management uses in loss modelling. This process forms the basis for our assessment
of the design of controls related to data accuracy and completeness when estimating ECL.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive):

Illustrative probing questions we may ask to understand the entity’s process could include:

The following illustrative probing questions are applicable to the following types of data related
to loan loss provisioning that are expected to be tested:

 Historical loss experience

 Internal loss data
 External loss data
 Collateral
 Drawdown patterns
 Prepayments
 Amortisation
 Reporting date information such as balance, loan classification, days past due, interest
rate, amortization schedule and rating (both origination date and reporting date)

Illustrative probing questions

9 February 2018 28
  How is the data used by management in its estimate of the allowance and related loss
modelling?
 What systems or data warehouses store this data? Are those systems subject to IT
general control (ITGC) testing?
 Do we understand the data used to build the models?
o Is the data used internal or external?
o Does external data reflect the client’s loan portfolio?
o Is there sufficient internal loss data to be statistically relevant? If not, what
management judgement was applied
o How is historical data supplemented to be forward looking?
 How does management accumulate and aggregate data? For example,
o What are management’s controls over aggregation of data once a decision to
segment loans based on similar risk characteristics is made? If there are
subsequent changes to segmentation, how does management ensure data
accuracy and completeness?
o Does information on write-offs and delinquencies flows from different systems?
How does management ensure that the information is complete and accurate and
it appropriately flows in the loss model?
 How is data from risk systems reconciled to the financial reporting systems? This
includes on-balance sheet and off-balance sheet (loan commitments and guarantees).
 What is management’s process to validate the completeness and accuracy of the data
used in the loss estimation process? For example:
o Does management have controls in place over the input of data into the system
of record (e.g., loan origination and loan servicing systems)?
o Does management identify and test controls over the computation of
delinquencies to test that loans are appropriately placed in the correct aging
category (e.g., 30-59 days past due, 60-89 days past due)?
o Does management have controls in place that mitigate the risk that inaccurate
data may be used in the Loss allowance estimation processes?
 Are there controls to reconcile both the currency and other relevant
nonmonetary data fields from the system of record to data warehouses,
if applicable, and from data warehouses to the loss allowance estimation
models (including spreadsheets)?
 Are those controls designed with sufficient precision to detect errors that
could cause material misstatement?
o Does management have controls in place to verify that only authorized changes
are made to systems of record (e.g., ITGCs over loan systems that maintain the
critical data, including those that reside at third party service providers)?
 If key reports used in the loss allowance estimate are provided by the
third party service provider, how does management validate the
accuracy of such reports used in the Loss allowance estimation process?
Does management have other controls in place to test data accuracy and
completeness of third party service provider reports?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 Data used in the loss allowance estimation model, including other inputs and
assumptions, is not complete and accurate.

9 February 2018 29
  Source information from the system of record omits key data elements when transferred
into the allowance loss models.
 Reconciliation of data from the system of record and/or other sources is not performed
timely and at a level of precision to prevent and detect material misstatements.
 Loan segments are not appropriately identified causing aggregation of historical loss
information to be incomplete and inaccurate.
 Historical loss information is aggregated incorrectly.
 Inputs into the model are inappropriate.
 Adjustments to the historical loss experience are not reviewed by management.
 Historical loss experience only takes into account unpaid principal balances, deferred
income amounts necessary to calculate amortised cost are not included.
 External data used in the models is not reflective of the institution’s portfolio
 Data used from risk systems does not reconcile to the general ledger

Data used in the models

 There is not enough internal data to be significant and management’s judgements to

update for this are inappropriate
 The external data is not reflective of the loan portfolio.
 Incorrect data is used.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative controls

 Management reconciles inputs, including relevant non-financial data fields, into the loss
allowance model to the system of record and/or other source information. Material
differences are investigated further and disposed.
 Management reviews the historical loss information to validate that the information is
appropriately aggregated based on aggregation of loans that share similar risk
characteristics.
 Management reviews and approves changes or adjustments to the historical loss
experience used in the loss allowance calculation.
 On a periodic basis, management reviews and approves the inputs feeding into the loss
allowance model.

Data used in the models

 Management compares inputs into the model to source documents. For example,
management compares data extracted from the loan system to the general ledger and
discrepancies are investigated and resolved.
 Management approves the external data used in the model to ensure it is appropriate
 Application controls govern the automated flow of data between different systems.
In cases where model inflows and outflows require manual intervention, management
compares the data between systems and investigates and resolves differences

5.2. Data accuracy and completeness – Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

 Reconcile or otherwise test the accuracy and completeness of the data used in the loss
allowance estimate (e.g., loan balances, commitments, guarantees delinquency reports,

9 February 2018 30
 write-offs) from source system reports to the data warehouse (or similar construct) and
from the data warehouse to the loss allowance analysis/models and financial reporting
systems. Investigate and dispose of material differences.
o If application controls govern the transfer of data between systems, perform
testing of the completeness and accuracy by tracing on a sample basis
parameters such as balances, risk ratings, defaults, losses, delinquencies, write-
offs) to source data.
 If historical data from prior years is used in the analysis, test that no changes to the data
were made.
 To the extent that the loss allowance analysis is based on loan data that has been
disaggregated into subsets of loans with similar risk characteristics, trace or re-perform
the disaggregation from source systems to the loss allowance analysis.
 Perform appropriate substantive testing procedures on the details of the reports used in
the loss allowance estimate in a manner responsive to our control testing.
 Perform sufficient testing to the samples selected that is representative of the data
population.
 Perform a two-way test of samples (i.e. sample test data from source systems input into
models (1) source to model (2) model to source) to ensure completeness and accuracy of
data.
 Assess the assumption used where there was missing or insufficient data.
 If the ECL is calculated in arrears (i.e., December ECL calculated on November balances),
assess the rollfoward calculation to assess whether an adjustment is needed

6. Forward looking information

Reasonable and supportable forecasts

Paragraph 5.5.17 of IFRS 9 sets out the key principles and measurement objectives for measuring
ECL:

5.5.17 An entity shall measure ECL of a financial instrument in a way that reflects:
(a) an unbiased and probability-weighted amount that is determined by evaluating a range of
possible outcomes;
(b) the time value of money; and
(c) reasonable and supportable information that is available without undue cost or effort at
the reporting date about past events, current conditions and forecasts of future economic
conditions.

Consequently, when there is a non-linear relationship between the different forward-looking

scenarios and their associated credit losses, using a single forward-looking economic scenario
would not meet this objective of IFRS 9. Instead, more than one forward-looking scenario would
need to be incorporated into the measurement of ECL. This issue was discussed during the meeting
of the ITG on 11 December 2015.

IFRS 9 also discusses the requirement in paragraph 5.5.17(c) to reflect reasonable and supportable
information that is available without undue cost or effort. This guidance was discussed in the
context of forward-looking information at the meeting of the ITG on 16 September 2015 (Agenda
Paper 4).

Appendix A of IFRS 9 defines ECL as ‘the weighted average of credit losses with the respective risks
of a default occurring as the weights’. Credit loss is defined and is the difference between all
contractual cash flows that are due to an entity in accordance with the contract and all cash flows
that the entity expects to receive (i.e., all cash shortfalls), discounted at the original effective
interest rate over the expected life of the financial instrument.

9 February 2018 31
Further insight into the IASB’s use of the term ‘expected’ is given in paragraph BC5.263 of IFRS 9:
The term ‘expected’ as used in the terms ‘ECL’, ‘expected value’ and ‘expected cash flow’ is a
technical term that refers to the probability-weighted mean of a distribution and should not be
confused with a most likely outcome or an entity’s best estimate of the ultimate outcome.

As noted in paragraph 4, IFRS 9 requires an entity to evaluate a range of possible outcomes. This is
further elaborated in paragraphs 5.5.18, B5.5.41 and B5.5.42 of IFRS 9 as well as the Basis for
Conclusions to IFRS 9 provides further explanation in paragraphs BC5.264 and BC5.265.

Therefore incorporation of the multiple forward – looking estimates has an impact on the following
elements:
 Identification of the Significant Increase in Credit Risk (stage transfer)
 Measurement of the ECL (12-month and lifetime)

A few reminders institutions may consider in determining the reasonable and supportable forecast
periods include:
 The process for determining the reasonable and supportable period should be applied
consistently, in a systematic manner, and ensure that it is well-documented.
 The length of the forecast period is a judgmental determination based on the level to which
the institution can support its forecast of economic conditions.
 The forecast of economic conditions should reflect management’s estimate at the balance
sheet date based on all relevant data that is reasonably available.
 Because of the judgment applied in the determination of the forecast period, and the
relationship between the length of the period and the sources(s) used, the reasonable and
supportable forecast period often may differ between institutions and the products to which
it is applied.
 The economic forecast, including the period over which the reasonable and supportable
forecast is being developed, must be relevant to the portfolio. For example, a national
economic forecast might not be appropriate, or might need to be adjusted, for a portfolio of
borrowers within a narrow geographic area.
 If an entity has forecasted future economic conditions in the development of other
estimates in the financial statements (e.g., goodwill impairment tests) and those economic
conditions are relevant to the loss allowance estimate, then the base case forecast in
estimating the ECL should consider the same forecasted amounts.

Multiple scenarios and Scenarios weights:

The need to consider more than one economic outcome may require an entity to obtain multiple
forecasts from economists.

Possible approaches developed for multiple scenarios are as follows:

 Monte Carlo simulation
o Enables to determine entire credit loss distribution to better support probabilities
assigned to macro-economic scenarios
o Allows to determine where non-linear loss outcomes are possible and what factors
statistically contribute to them
 Probability weighted approach
o Considers global and political landscape
o Determines the relevant macroeconomic factors with explanatory power
o Considers which factors have a potential impact on the ECL
o Assign probabilities to each scenario using judgement, which needs to be
documented
 Overlay approach
o Assess how the portfolio reacts to different macroeconomic indicators and
scenarios
o Assess whether an adjustment to the base case is necessary
 Stage 3 individual assessment

9 February 2018 32
 o Some entities may assess stage 3 assets on an individual basis and apply multiple
scenarios on a case-by-case basis
o For example, they will consider a range of collateral values and assign probability
weights and consider a range of work-out scenarios (i.e. collateral sale, liquidation,
or debt restructuring) and assign probability weights
6.1. Forward looking information - Control testing considerations
Illustrative probing questions we may ask to understand the entity’s process could include:

Illustrative probing questions

Reasonable and supportable forecasts

 How does management support its determination of a forecast period?

o Does it document the factors considered and judgments applied, as opposed to
simply selecting a period?
 Has the forecast changed between periods? If so, why?
 When a management specialist is used, who evaluates whether the significant
components identified by the specialist are appropriate, and how is that evaluation
performed?
 Is the reasonable and supportable forecast calculated using an end user computing tool
(e.g., Excel)? If so, how does management make sure the data is correctly downloaded
(e.g., from an IT application or report writer) or manually input into Excel? How does
management make sure that any changes to, or manipulation of, the data in Excel are
complete, accurate and appropriate?
 How does management identify the significant assumptions (e.g., unemployment as a
driver to ECL) used to develop the reasonable and supportable forecast? What is the
basis for management’s determination?
 What are the sources of the significant assumptions? Are there other available sources
for such information? Would obtaining information from another source give a materially
different result?
 How does management evaluate alternative assumptions or outcomes (e.g., different
unemployment rates), and what is management’s basis for rejecting them? Are there
alternative data points that could be used? Would using these different data points give a
materially different result (i.e., contrary information)?
 Have the significant assumptions changed between periods? If so, why? If not, giving
consideration to the economic environment, the industry and other factors, should they
have?
 What is management’s process for developing reasonable and supportable forecasts
within other processes (e.g., goodwill impairment, deferred tax asset valuations)? Are
they consistent with the base case forecast used to calculate the ECL?
o Are expectations about the future similar? If not, why?
o How does management consider the institution’s history with meeting forecasts,
historical results or industry expectations?
 Does management perform a sensitivity analysis to assess the effect of the significant
assumptions? If so, what sensitivity analysis is performed?
 How does management assess whether the forecast is free from inappropriate bias?

Multiple scenarios and Scenarios weights:

 What are the main macro-economic factors driving the credit risk by portfolio?
 What is the methodology to define scenarios including their severity?
 How is the range of scenarios determined?
 How have the scenarios been defined? Mathematical (e.g., plus or minus a percentage)
or a focus on specific possible events (e.g., Brexit, China debt default, increased
protectionism in the USA)?

9 February 2018 33
  Completeness of the risks (e.g., are commodity prices included for portfolios with a
significant exposure to these markets?)
 How reasonable are the projections for key macroeconomic variables?
 What are the differences between scenarios, are these logical and of the scale that is
reasonable given the rationale behind the definition of scenarios? What is the logical
explanation for changes in key variables compared to the central estimate so that we can
form a view on the distribution of the scenarios?
 How is non-linearity included?
 How are the probability weightings developed? How have the weights been arrived at,
what is the logic and how much confidence is there in the estimates?
 How does the ECL change in each scenario? What is the process to identify the drivers
and the rationale for the relationship, i.e. how does a particular driver impact the credit
risk of a particular product?
 Is there a statistical analysis used to develop the relationships between economic
parameters and credit loss/risk? What are the data used to develop the relationship, the
statistical methods used and the strength of the relationships identified?
 How are he forecast data incorporated into credit risk and credit loss models?
 What is the methodology to assess the impact on PD, EAD and LGD?
 What is the multiple economic scenario (MES) approach for Staging?
 What is the MES approach for ECL measurement?
 What is the governance framework, MIS and Dashboards for the MES process?
 Are multiple scenarios incorporated in stage 3 individual assessments?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

Reasonable and supportable forecasts

 Significant components of the reasonable and supportable forecast are not properly
identified.
 Management’s specialists, if applicable, and/or management do not have the appropriate
qualifications or experience to develop the reasonable and supportable forecasts.
 The data used to develop the reasonable and supportable forecast is not complete and
accurate.
 The significant assumption used in the reasonable and supportable forecast are not
reasonable and/or not supportable (e.g., the assumptions are not consistent with
historical data or assumptions used in similar estimates).
 Events that occurred subsequent to the date the reasonable and supportable forecast
have been evaluated contradict the significant assumptions used to develop the
reasonable and supportable forecast and/or were not properly identified and evaluated.
 The assumptions used to develop the reasonable and supportable forecast are not
reasonable when evaluated collectively or in connection with other assumptions.
 Management allows inappropriate bias to influence the forecast.

Multiple scenarios and Scenarios weights

 The scenarios and probability weights do not adequately reflect the underlying loss
distribution
 Significant macro-economic factors driving the credit risk by portfolio have not been
identified
 The assumptions used to develop the reasonable and supportable MES are not
reasonable when evaluated collectively or in connection with other assumptions.
 The methodology to define scenarios is based on a sole management judgement
 The methodology to assign probability-weights is affected by inappropriate bias

9 February 2018 34
  The data used to assess the impact on PD, EAD and LGD is not complete and accurate
and correlation has not been identified
 MES is not considered for Staging
 MES is not considered for ECL measurement
 There is no Governance framework for MES and scenario weights

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:
Reasonable and supportable forecasts

 Management reviews the method used to develop the reasonable and supportable
forecast to make sure it is appropriate.
 Management tests that the data used to develop the reasonable and supportable forecast
is complete and accurate.
 Management reviews an analysis of the significant assumptions used to develop the
reasonable and supportable forecast to determine whether they are reasonable and free
from inappropriate bias.
 Management reviews and approves its specialist’s report, if applicable.
 Management evaluates its specialist’s qualifications and reputations, if applicable.
 Management reviews a sensitivity analysis performed on the significant assumptions to
evaluate the changes in reasonable and supportable forecasts resulting from changes in
assumptions.
 Management evaluates the impact of events after the balance sheet date based on
reliable information available.

Multiple scenarios and scenarios weights:

 Management analyses and challenges the completeness and suitability of the macro-
economic factors driving the credit risk by portfolio.
 Methodology / model to define scenarios and weights has been validated by an
independent validation unit.
 Methodology to define scenarios and weights has been approved by the Management.
 Management reviews and approves definition of the scenarios and key macroeconomic
variables for MES.
 Management reviews and challenges MES developed by specialists – whether the
differences between scenarios are logical and what is the scale that is reasonable given
the rationale behind the definition of scenarios.
 Management reviews and challenges any impact of non-linear events to be included.
 Management reviews and challenges the outcome of the probability weighting
assignment model.
 The statistical model to identify relationship between economic parameters from MES
and credit risk impact has been validated by an independent validation unit.
 The model to incorporate the forecast data into credit risk and credit loss models has
been validated by an independent validation unit.
 Management has reviewed an analysis to assess the impact on PD, EAD and LGD.
 Management has reviewed an analysis to assess the impact of MES on Staging.
 The overall impact of the MES and scenario weights on ECL has been challenged and
approved by the management. Any overlays have been documented and approved.
 If multiple scenarios are considered for stage 3 individually assessed assets, the review
process includes the scenarios and the probability weights

6.2. Forward looking information - Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

9 February 2018 35
 Illustrative substantive testing considerations

Below are sample substantive testing procedures for IFRS 9 forward looking information.
Those denoted with a * may be performed in conjunction with EY economists.

Reasonable and supportable forecast

 Determine whether the method used to develop the reasonable and supportable
forecast is appropriate for the item subject to measurement.
o Consider engaging EY specialists.
 Test that the components of the reasonable and supportable forecast are appropriate
based on the valuation method selected.*
 If management uses a specialist, perform sufficient procedures to:
o Evaluate the competence, capabilities and objectivity of management’s
specialists*
o Obtain an understanding of the work performed by management’s specialists*
o Evaluate the appropriateness of the methods and assumptions used by
management’s specialists*
o Evaluate the information provided by management and used by its specialists
for accuracy and completeness*
 For significant assumptions, evaluate and document sources of available contrary
evidence.
 Evaluate whether the assumptions appear reasonable when considered collectively or
in connection with other assumptions.
 Identify the significant assumptions and perform sensitivity testing or analysis to
evaluate the change in the reasonable and supportable forecast from changes in
assumptions.*
o Document our basis for determining why an assumption is significant,
including whether management has also identified it as significant.
o Reconcile the base case forecast developed for purposes of the ECL
estimation process to other reasonable and supportable forecasts used in
other parts of the organisation (e.g., goodwill impairment, DTA valuation,
board of director presentations) and understand the reason for the
difference.

Multiple scenarios and Scenarios weights:*

 Assess completeness and suitability of the macro-economic factors driving the credit
risk by portfolio.
 Review methodology / model to define scenarios and weights.
 Evaluate the geographic coverage for all significant countries and whether those were
included in a consistent manner.
 Assess definition of the scenarios and key macroeconomic variables for MES.
 Challenge MES developed by specialists – whether the differences between scenarios
are logical and determine the scale that is reasonable given the rationale behind the
definition of scenarios. Challenge severity of negative scenarios and assessed any
bias.
 Test the statistical model to identify relationship between economic parameters from
MES and credit risk impact.
 Test the model to incorporate the forecast data into credit risk and credit loss
models.
 Test the calculation of MES on PD, EAD and LGD.
 Test the impact of MES on Staging to determine if the probability-weighted PD was
used in the staging assessment.

9 February 2018 36
  Test the overall impact of the MES and scenario weights on ECL. Identify any
overlays. Test calculation and documentation underlying overlays.

If multiple scenarios are considered for stage 3 individually assessed assets, test the different
scenarios applied and assess the rationale for the probability weights applied

7. Contractual life

IFRS 9 requires that credit losses should reflect losses expected over the contractual life of an
asset.

 The life of an asset generally should not include extensions, renewals and modifications that
would extend the expected remaining life beyond the contractual term when these are at the
option of the lender. They should be included when at the option of the borrower,

These clarifications are intended to result in an estimate of ECL that reflects losses expected over
the remaining period of time that the lender is expected to be exposed to losses on outstanding
borrowings.

However, some financial instruments include both a loan and an undrawn commitment component
and the entity's contractual ability to demand repayment and cancel the undrawn commitment does
not limit the entity's exposure to credit losses to the contractual notice period. For such financial
instruments, and only those financial instruments, the entity shall measure ECL over the period
that the entity is exposed to credit risk and ECL would not be mitigated by credit risk management
actions, even if that period extends beyond the maximum contractual period. (For more detail,
refer to IFRS 9.5.5.20)

When using an approach that discounts expected cash flows, prepayments can be reflected in the
timing and amount of future cash flows as inputs into the EAD calculation.

The standard provides that the contractual term over which credit losses are established shouldn’t
include expected extensions, renewals and modifications unless they are only at the option of the
borrower.

7.1. Contractual life - Control testing considerations

We document our understanding of the entity’s policies around estimating contractual life. This
process forms the basis for our assessment of the design of controls.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive).

Illustrative probing questions we may ask to understand the entity’s policies and implications to ECL
methodologies could include:

Illustrative probing questions

 How does the institution record the contractual maturity date (for applicable products) in
the system of record?
 How does the institution define “contractual life” for purposes of its credit loss
methodology? Is this definition in line with the accounting framework?
 How does the institution reflect modifications, extensions, or renewals, in estimating the
contractual life of the financial asset and the overall loss allowance methodology?
o How does the institution evaluate loans with contractual amounts due at the end
of contractual life (e.g., bullet loans or balloon payment loans)? Does

9 February 2018 37
 management typically roll-over these loans (i.e., extend the loan’s life)? If so,
does the loan go through an underwriting process?
o Do borrowers initiate renewals prior to when the loan is due? If so, how does
management evaluate the request? Does the loan go through an underwriting
process? If the lender has the option to reject the renewal, it is not to be
incorporated in the estimate.
 How does management estimate the life of those instruments that have revolving
features (e.g., credit cards) and thus do not have a contractual maturity date? What are
some considerations management evaluates to estimate the life? For example:
o How does management allocate payments and/or future draws on these products
for purposes of determining the life and the related ECL?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 The contractual maturity date is inaccurately recorded in the system of record, thereby
resulting in an inaccurate and incomplete estimation of contractual life and ECL.
 The contractual life is improperly reflected in the credit loss models/calculations.
 The entity inappropriately assumes extensions, modifications, or renewals, in its
determination of contractual life, such that the expected life is extended beyond the
contractual life.
 For loans where a discounted cash flow methodology is not utilized, management does
not consider its evaluation of prepayments as part of historical loss statistics, or does not
justify a separate prepayments assumption.
 The expected life of revolving loans (e.g., credit cards) is not properly estimated.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative controls

 At loan origination, management reviews that the contractual maturity date is properly
reflected in the system of record.
 Management reviews subsequent changes to loan terms and whether warranted changes
are made to the system of record.
 System queries or reports are reviewed for completeness and accuracy with respect to
the contractual maturity date or other fields that supports the contractual life of loan
input to the ECL estimate.
 Management periodically reviews, on a sample, basis how the contractual life is
calculated for certain loan types.
 Management reviews policies on extensions, modifications, or renewals, to ensure they
are in line with the accounting framework.
 Management reviews the methodology to calculate the life of revolving loans (e.g., credit
cards) to ensure it is in line with the accounting framework.
 Management reviews the completeness and accuracy of revolving loans identified, as
well as the assumption of estimate life.

9 February 2018 38
7.2. Contractual life - Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

 Substantively test the contractual maturity date of loans. For example:

o Include the loan’s maturity date in the customer loan confirmations.
o During origination, test a sample of loan agreements by agreeing maturity date
to the system of record.
 Substantively test the completeness and accuracy of loan information included in the
ECL calculation. For example:
o Test that the maturity dates in the system of record are the same as the ones
used in the credit loss methodology.
o Test the accuracy of the contractual live calculation in the system of record for
different loan types.
 For revolving loans (e.g., credit cards), include in our testing considerations about
management’s assumptions regarding future payments and advances past the balance
sheet date. Confirm if these assumptions in line with the accounting framework.
 For non-revolving loans (e.g., those that have a stated contractual maturities), test
management’s assumptions about extensions, renewals, and modifications, and their
impact to the contractual life. Test whether changes to stated contractual life or lack
thereof is appropriate.
 In our substantive testing of management’s ECL estimates, conclude as to whether any
assumptions extended the contractual life of loans.

8. Loan segmentation

The standard allows an entity to measure ECL of exposures on a collective basis if they share
similar risk characteristics. Further, the standard provides flexibility as to how entities should make
this segmentation, Examples of shared risk characteristics include:

 Internal or external (third-party) credit score or credit ratings

 Risk ratings or classification
 Financial asset type
 Collateral type
 Size
 Loan to value ratios
 Effective interest rate
 Term
 Geographical location
 Industry of the borrower
 Vintage
 Historical or ECL patterns

If an entity determines that a loan does not share risk characteristics, the entity would evaluate the
financial asset for ECL on an individual basis. If this is the case, the standard is clear in that the
financial asset cannot be included in both collective assessments and individual assessments.

8.1. Loan segmentation - Control testing considerations

9 February 2018 39
We document our understanding of the entity’s policies and procedures around loan segmentation
for both acquired loans and originated loans. This process forms the basis for our assessment of
the design of controls.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive).

Illustrative probing questions we may ask to understand the entity’s policies and implications to ECL
methodologies could include:

Illustrative probing questions

 How did management consider the characteristics for purposes of segmenting the loan
portfolios? Are there other characteristics that the institution has considered?
 How has the entity determined that the criteria utilized represent similar risk
characteristics?
 Are there characteristics utilized in segmenting a particular group that may not be
similar? If so, how did management evaluate and document the appropriateness of the
segment?
 How does the entity maintain data attributes to ensure that segments are aggregated
based on the selected criteria? For example:
o Does the entity have controls at the initiation/modification points in its process
to ensure that data attributes recorded in the loan system are accurate?
o To the extent that subsequent changes are made (e.g., updates to credit scores),
how does management determine whether the loan should stay in the same
segment, moved to another segment, or evaluated for individually? If changes
are made,
 How are changes evaluated and documented?
 Are there controls in place over the completeness and accuracy of data
updates?
 To the extent that management moves loans to another segment or determines that
individual evaluation is warranted, what is management’s process to evaluate whether
other relevant information should move to the new segment? For example, credit loss
indicators and statistics, unemployment trends, and other factors considered when
estimating ECL.
 Does management use the same loan segments for purposes of measuring ECL as it does
for disclosure purposes?
o If yes, what are the controls in place to ensure consistency?
o If not, why are loans segmented differently for purposes of disclosures and
measurement?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 Characteristics used to segment loans result in segments of loans that do not share
similar risk characteristics.
 Inaccurate data is used to aggregate and segment loans.
 Internal data (e.g., credit loss indicators and statistics) and external data (e.g.,
unemployment trends impacting a loan segment) is not tracked/maintained in
accordance with the defined loan segments.
 Subsequent changes in loans (e.g., updates to credit scores) that impact loan
segmentation are not tracked appropriately resulting in inaccurate loan segments.
 Loans are incorrectly evaluated for credit impairment both on a collective and individual
basis, resulting in the measurement of ECL being “double counted”.

9 February 2018 40
  Loans are inconsistently segmented for purposes of measuring credit losses and
disclosure purposes.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative controls

 Periodically, management confirms its conclusions related to segmentation, including

reviewing characteristics used to segment loans.
 Management reviews and approves the rationale for transferring loans from one segment
to another.
 Management reviews and approves the accuracy of the data attributes used to segment
loans based on similar risk characteristics.
 Management reviews and approves criteria used to generate queries/data reports to
aggregate loan data into the defined loan pools to ensure that such segments are
complete and accurate.
 Periodically, management reviews the collection of internal and external data utilized to
estimate credit losses or generate forecasts, to determine that such data is consistent
with the risk characteristics defined for the loan segments.
 Periodically, management reviews segmenting for purposes of measuring credit losses
and disclosure purposes to verify the segmentation remains appropriate.

8.2. Loan segmentation - Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

 Test management’s criteria for purposes of aggregating loans into segments.

 Assess whether the criteria for each segment is indicative of similar risk characteristics.
 Test the aggregation of loans to determine that loans in each loan segment are in
accordance with management’s defined segment criteria.
 Test the accuracy of the data used for purposes of segmenting to be complete and
accurate. (e.g., confirmation procedures, tracing data to documentation in the loan file).
 Evaluate whether disclosure of loan segments are consistent with the segments used for
measuring ECL.

9. Loan risk ratings

Loan risk ratings directly affect the loss allowance estimate as different PDs (or, in some cases, loss
rates) are applied to loans with different risk ratings. We test a sample of loans to address the risk
of material misstatement in the loss allowance stemming from an incorrect risk rating.

Management often assigns credit risk ratings or simply risk ratings to the loans they originate and
service. Risk ratings represent the institution’s assessment of credit risk associated with the loan.

Most institutions use a loan risk rating scale that including characteristics of loans that fall in these
categories. A typical system may include the following ratings but often with intermediate
gradings.Pass: Loans that are not covered by the definitions below (special mention, substandard,
doubtful, and loss) are “pass” credits for which no formal regulatory definition exists.
 Special Mention: A special mention loan has potential weaknesses that deserve
management’s close attention. If left uncorrected, these potential weaknesses may result in
deterioration of the repayment prospects for the asset or in the institution’s credit position

9 February 2018 41
 at some future date. Special mention assets are not adversely classified and do not expose
an institution to sufficient risk to warrant adverse classification. (Note: some institutions
refer to special mention loans as “watch” loans.)
 Substandard: A substandard loan is inadequately protected by the current sound worth and
paying capacity of the obligor, or by the collateral pledged, if any. Assets so classified must
have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.
They are characterized by the distinct possibility that the institution will sustain some loss if
the deficiencies are not corrected.
 Doubtful: A loan classified Doubtful has all the weaknesses inherent in one classified
Substandard with the added characteristic that the weaknesses make collection or
liquidation in full, on the basis of currently existing facts, conditions, and values, highly
questionable and improbable.
 Loss: Loans classified loss are considered uncollectible, and of such little value that their
continuance on the books is not warranted. This classification does not mean that the loan
has absolutely no recovery or salvage value; but rather, it is not practical or desirable to
defer writing off an essentially worthless asset (or portion thereof), even though partial
recovery may occur in the future.
Risk ratings are initially established at loan origination by the loan officer and then reviewed and
approved by the officer’s supervisor. Once assigned, the loan’s risk rating is then monitored and
maintained throughout the life of the loan.
Management periodically revisits the initially assigned risk rating in order to determine if any events
have occurred which warrant a change in the risk rating. Some institutions typically require that
this be done annually or sooner if circumstances suggest a change in credit quality since
origination. While others may also have thresholds that require a re-evaluation of the risk rating for
such loans more often, such as annually. For instance, loans that are individually or part of an
aggregate exposure (e.g., multiple loans with the same borrower or guarantor) above a certain
threshold may be evaluated on a monthly or quarterly basis. Similarly, institutions often have
policies to revisit the risk ratings on loans that are “watch” or “special mention” on a monthly or
quarterly basis.
9.1. Assigning the loan risk rating
A loan’s risk rating is assigned, based on an information such as an analysis of the borrower’s
financial statements for corporate lending, or credit bureau scores or payment history for retail
customers, and is designed to focus on the borrower’s capacity to repay its debts. This generally
entails analysis of present financial condition and operating results as a basis for projections about
borrower’s future financial condition and performance.Once management reviews the factors
impacting the loan, as described above, it compares the analysis to the risk rating definitions as
developed and approved by the institution. Often this is a management pre-approved matrix which
indicates the various factors considered in the evaluation and the risk rating that those factors
correlate too.

As loan risk ratings are generally derived from historical information of the borrower, when the PD
is established by considering the rating, the modelling may also need to incorporate forward
looking information.Loan risk ratings – Control testing considerations
We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive):

Illustrative probing questions we may ask to understand the entity’s process and controls over loan
risk ratings could include:

Illustrative probing questions

 What is management’s process, including controls, to risk rate loans?

o Does management’s process and controls include both consumer and commercial
loans?

9 February 2018 42
 o Do all loans fall under the same process? Or, does management have different
processes and controls that cover the risk rating for loans that fall below a
certain monetary threshold? Similarly, does management have different
processes and controls that cover the risk rating for loans that are in the
different risk rating categories such as pass, special mention, substandard,
doubtful, and loss?
o Are there differences between newly originated loans and those that
management updates periodically (e.g., an annual review)?
 How does management ensure that updated and accurate financial information about the
borrower and guarantor, including updated appraisals if applicable, is used in the loan
risk rating evaluation?
o What are management’s controls over data accuracy and completeness of such
information?
 How does management ensure that controls over loan risk ratings focus not only on the
accuracy but also the timeliness of risk rating updates? For example, what are
management’s controls to ensure that risk rating changes are made to the system of
record timely?
 How does the institution rate loans that are part of a participation or syndication
Does the institution use a currency threshold for refreshing risk ratings, following up on
issues, or the timing of risk rating updates?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 Loans are inadvertently excluded from the risk rating process.

 Loans are inadvertently grouped and evaluated for credit risk using an inappropriate
process (e.g., large loans are inadvertently grouped with loans that fall below a certain
currency threshold and are omitted from the risk rating process.)
 Loans are not risk rated at origination.
 Loans are not evaluated for risk rating changes either periodically or when changes to
credit risk occur.
 Loans are improperly risk rated.
 Management does not identify timely loans that should be evaluated by the “special
asset” group.
 Management improperly analyses the loans (e.g., does not determine and document the
primary source of repayment) which results in an improper risk rating for the loan.
 There are no controls or processes in place to ensure that updated and accurate financial
information about the borrower is used in the loan risk rating evaluation.
o Management doesn’t challenge the data accuracy and completeness of the
information used in the loan risk rating.
 Risk rating changes are not accurately and timely reflected in the system of record.
 When management uses delinquency reports to assist in monitoring credit risk ratings,
the report used is not complete and accurate, resulting in values that may be over or
understated.
 Evaluation of loans are improperly assigned to the business units, resulting in improper
evaluation and risk rating of loans.
 Similar loans have inconsistent risk ratings.

When evaluating illustrative internal controls, or attributes of internal controls, we may identify and
test could include:

Illustrative controls

9 February 2018 43
  Risk ratings assigned to new loans are reviewed by a loan officer, other than the officer
assigning the risk rating, and/or the credit risk committee.
 Management reviews risk ratings for all loans annually or more often if significant
deterioration in credit has occurred in a portfolio or sector of the business. Alternatively,
management uses a monetary threshold for loan reviews on a periodic basis. As an
illustration, management reviews risk ratings for loans above a certain threshold (e.g.,
€500,000) annually or more often if significant deterioration in credit has occurred in a
portfolio or sector of the business.
 Management has controls in place to ensure that loans are appropriately grouped and
assigned to the appropriate business unit, including “special asset group”, for review
 A second level review is performed to ensure that the risk rating is appropriately
assigned, including a review of:
o The source data used in the evaluation of the risk rating,
o Documentation over the basis for the risk rating,
o Updates to the system of record to reflect the changes, if any.
 On a periodic basis, management compares the listing of risk rating changes to the
system of record and certifies that all risk rating changes been made in the system of
record.
 On a sample basis management reviews similar controls to ensure that risk ratings are
consistently applied.
 Management performs a periodic review of loan classifications to assess loan grade
accuracy.

Because credit risk management is an integral part of the loss allowance process, listed below are
additional considerations and reminders with respect to our testing of this process and related
controls. The considerations may include any one or a combination of the following items (the items
on the following lists are not intended to be all inclusive):

 Did we identify and test controls over risk ratings?

 Did we identify and test controls that determine that updated and accurate financial
information about the borrower and guarantor, including updated appraisals if
applicable, is being used in the loan risk rating evaluation?
 Does our testing of controls over the accuracy of the loan risk rating process consider
loans from the complete population, including whether there are separate controls for
loans that fall below a certain monetary threshold?
 For those loans that fall below the established monetary threshold have we evaluated the
significance of that population and tested controls as necessary.
 Is our testing of controls over loan risk ratings focused not only on the accuracy but also
the timeliness of risk rating updates? Specifically, have we tested controls with respect
to how risk rating changes are made to the system of record and how management
ensures that those changes are made in a timely manner?
 Were the nature, timing and extent of our testing of controls over the accuracy of the
loan risk rating process at the business unit level appropriate?
o Did our procedures, and related documentation, include detailed discussions with
individuals performing the control to ascertain the precision and sensitivity of the
review control?
o Did our testing include testing beyond inquiry?
o Did we consider re-performing at least some of the steps performed by the
reviewer?
 Does the institution use a monetary threshold for refreshing risk ratings, following up on
issues, or the timing of risk rating updates? If so, did we evidence how we identified and
tested controls over the loans that fall below the identified threshold and how those

9 February 2018 44
 controls directly link to risk rating (e.g., review of a delinquency report may trigger
follow up on the associated risk rating for loans noted as delinquent)?
 Did we identify and test controls for loans that are part of a participation or syndication
 Did we identify and test controls regarding management’s process to evaluate
subsequent events and their impact on the loan risk rating?
 How is forward looking information incorporated in the risk rating process?

9.3. Loan risk ratings – Sampling for substantive testing

We follow our sampling methodology in EY GAM topic SAMPLE for purposes substantive testing
related to loan risk ratings (including off balance sheet exposures). When we design tests of details,
we determine the most appropriate strategy for obtaining sufficient appropriate audit evidence,
which includes determining the extent of work to be performed and how we plan to select items
from the population for testing to achieve the objective of the test effectively and efficiently. When
we select items from the relevant population for testing, we start by selecting key items. However,
if there are insufficient key items from which to draw our conclusions, we perform additional
procedures. This may include extending our testing to a representative sample from the remaining
population. Whether to use judgmental or statistical sampling techniques to determine a
representative sample is a matter of professional judgment.

To facilitate our substantive testing, we typically stratify the loan portfolio into the following three
groups:

1. Key items based on higher risk of loss or a significant increase in credit risk – Our key items
selection of non-homogenous loans focuses primarily on those loans that have the highest
credit risk, such as loans that are identified as “special mention” or “substandard” but have
yet to be identified as individually impaired. The threshold set for key items in this
population is matter of auditor judgment and considers the inherent risks and account
characteristics of the population. In establishing our key items threshold for our high-risk
sample, we establish a threshold that considers the qualitative factors discussed further
below.

2. Key items based on other risks – Our key items selection also considers the institution’s risk
exposures outside of those loan populations with a higher risk of loss. This might include
the following:
a. Large exposures that do not have a higher risk of loss: We consider selecting a sample
of the institution’s largest exposures, even when those loans have been identified as
lower risk (i.e., large “pass” loans).
b. Geography, industry or product risk: Specific increase in risk in a particular geography
or industry that has yet to affect the loan risk ratings, or an increase in risk due to a
new loan product or an aggressive growth strategy for an existing product.
c. Loans close to being classified as stage 2. If a loan is a small number of ratings from
being moved to stage 2, a sample of these loans should be selected.

3. Non-key items – If we determine that we cannot obtain sufficient appropriate audit evidence
from the key item testing described above, together with other substantive testing, we may
decide to extend our testing to a representative sample from the remaining population to
obtain sufficient appropriate audit evidence. Determining whether key items will provide
appropriate audit evidence alone is a matter of professional judgment. If we determine that
we have obtained sufficient audit evidence from the key item testing and therefore do not
select any non-key items for testing, we document our rationale for that conclusion in our
workpapers.
The extent of our sampling, that is, the thresholds we use to determine our key items, reflects our
overall assessment of credit risk in the non-homogenous loan portfolio. We document in our
workpapers the factors we considered in establishing these thresholds. We consider the following
factors, among other things (the list is not intended to be inclusive):
 Our combined risk assessment for the allowance for credit losses.

9 February 2018 45
  How the institution evaluates aggregate relationships, such as those loans that have the
same debtor or guarantor (sometimes referred to as “counterparty exposure”).
 Loans on “watch lists”, criticized assets lists and loans discussed in risk committee
meetings.
 Loans that are delinquent.
 The currency effect on the loss allowance that would result from an incremental change in
the loan risk rating (e.g., consider the difference between the loss allowance that would
result from a loan being identified on the “watch” list versus one determined to be “special
mention”).
 The proportion of loans that are purchased participations or syndicated loans where the
institution is not the lead syndicator.

9.4. Loan risk ratings – Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:
Illustrative substantive testing considerations

 Substantively test a sample of loans to assess the appropriateness of the assigned loan
risk rating.
 If the institution establishes a currency threshold for individual evaluation of loans,
perform substantive testing on loans that fall below the threshold.
 Evaluate and document the institution’s determination that certain loans were not
impaired when contrary evidence exists concerning borrower's ability to service the debt.
 Perform roll forward procedures beyond inquiry through year end for loan risk ratings
tested at interim dates. This might include obtaining and evaluating the borrower’s most
recent financial statements, or assessing the valuation of collateral. At some institutions,
we might consider attending special assets committee meetings to obtain detailed,
updated information regarding the status of problem loans and potential problem loans.
 Consider how forward looking information is included in the PD once the loan rating is
established.

10. Use of appraisals

Appraisals may be utilized to support valuations of collateral, such as real estate, equipment,
business assets, and other assets as part of an entity’s estimation of the Allowance for Loan Losses
(the Allowance or ECL). We may determine it is necessary to perform procedures over appraisals
when the entity:

 Determines foreclosure is a possible work-out scenario, thus requiring ECL to be measured

based on the fair value of collateral in that scenario.

During our planning procedures, we obtain an understanding of the institution’s procedures for
obtaining and reviewing appraisals, including management controls. Depending on the size and
complexity of the entity, management may task an internal group of professionals to review
external appraisals, while at other entities may outsource this function to a third parties.

Regardless of size, it is management’s responsibility to design and implement controls that ensure:
 The appraiser has the appropriate competence, capabilities, and objectivity to perform the
work
 The approach to value (discussed further herein) is consistent with the nature of the
collateral
 Key assumptions are reasonable and supportable
 The determination of final value is reasonable and supportable

9 February 2018 46
There are three basic methods for computing collateral value:

 Sales or market data approach – this approach uses information on recent sales of similar
(comparable) property. It uses the concept of substitution, as a willing buyer will not pay
more for a property when a comparable property is available at a lower price. This
approach entails locating and comparing comparable properties with the subject property in
order to determine property value.
 Income approach – this approach capitalizes or discounts the property’s net cash flow to
present value. Application is practical only when there is an income stream attributable to
the property that can be reasonably estimated. This approach entails determining the
collateral’s effective gross income, determining its net operating income, and applying
capitalization and discount rates and methods as appropriate in the circumstances.
 Cost approach – This approach applies the concept of reproducing (considering a
depreciation factor) or replacing. This approach entails estimating the value of the existing
improvements in terms of either reproduction or replacement cost (new), reducing that
value by accrued depreciation, then adding an estimate of the value of land as if vacant and
unimproved.

For certain, more specialized collateral, different valuation methodologies may be utilized. In these
instances, we understand and evaluate the appropriateness of the methodologies and
assumptions.In many instances, an appraiser will estimate value using multiple approaches, and
then “reconciles” the values to determine a final estimated value. In these instances, we
understand and evaluate the appropriateness of that reconciliation of value.Use of appraisals –
Control testing considerations
We document our understanding of the entity’s use of appraisals, including the extent of reliance on
appraisal values when measuring the Loss allowance. This process forms the basis for our
assessment of the design of controls related to the use of appraisals.
We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive):Illustrative probing questions we may ask to
understand the entity’s use and review of appraisals could include:

Illustrative probing questions

 How does management obtain and review appraisals utilized for collateral valuation?
 Is there an internal group tasked with appraisal review, or does management utilize a
third party? Are these individuals appropriately qualified to perform such reviews?
 How does management evaluate the competency, capabilities, and objectivity of
appraisers?
 Does management maintain an “approved appraiser” listing? If so, what is management’s
process for adding or removing appraisers from this listing, including the frequency of
such updates?
 Does management’s process ensure that the appraisal was ordered by the entity, and not
by the borrower/customer?
 Does management commonly apply adjustments to appraised values (e.g., liquidation
discounts)? If so, what is management’s basis for such adjustments, and how is the
measurement of such adjustments reviewed?
 How does management evaluate the timeliness of appraisals? If formal policies are
maintained, does management still evaluate the timeliness of individual appraisals,
although they may be in compliance with general policy timelines?
 How does management evaluate the valuation of more specialized collateral that may
involve more complex or unique valuation methodologies?

9 February 2018 47
  Where relevant, are expectations, assumptions, and conclusions related to the review of
appraisal sand collateral valuation consistent with applicable expectations, assumptions,
and conclusions in other areas of the Loss allowance methodology?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 The appraiser, either internal or third party, does not maintain the appropriate level of
competence, capabilities, and objectivity, resulting in inappropriate appraisal
assumptions, methodologies, and conclusions.
 The timing of the appraisal is not appropriate relative to the financial statement date at
which ECL are being measured, resulting in an unsupportable appraised amount.
 The appraisal methodology, key assumptions, and overall value conclusions are not
reasonable and supportable.
 The appraisal methodology, key assumptions, and overall value conclusions, including
any adjustments to value completed by management, do not represent fair value.
 Appropriate security interest in the collateral (i.e., perfection of collateral) does not
exist.
 Adjustments to appraised amounts (e.g., liquidation discounts), where applicable, are not
supportable, resulting in an adjusted appraisal value that is not reflective of fair value of
the collateral.
 Adjustments for selling costs, where applicable, are not supportable.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative controls

 Management reviews and approves an approved appraiser listing, including review and
approval of changes to the listing. Such reviews include attributes to assess the
competency, capabilities, and objectivity of appraisers.
 Management reviews and approves the competency, capabilities, and objectivity of
individuals, either internal or external, tasked with review of appraisals.
 Management reviews and approves the evaluation of the appropriateness of the timing of
the appraisal relative to the Loss allowance measurement date.
 Management reviews and approves the evaluation of the appropriateness of the
appraisal valuation methodology(s) utilized, including the reconciliation of overall value,
if applicable.
 Management reviews the key assumptions utilized in the appraisal report. Key
assumptions may relate to the condition of the collateral, the intended use, as well as
valuation-related assumptions (e.g., identification of a comparable sale group, income
capitalization rates, market rental and vacancy rates, and net operating income
assumptions).
 Management validates that the appropriate security interest exists in collateral.
 When management makes adjustments to appraisal values, a reviewer ensures that the
adjustments are appropriate. For example, entities may apply adjustments to appraised
values when measuring credit loss. Such adjustments may be due to changes to the
collateral subsequent to an appraisal date, or other facts and circumstances identified by
management that were not contemplated in the appraisal.
 Where selling costs are estimated, management reviews estimation of such selling costs.
Examples of costs may include standard legal, real estate commission, or auction fees for

9 February 2018 48
 collateral. Management’s controls may consider market reports, actual experience in
liquidating collateral, or industry accepted costs (e.g., real estate commission rates,
standard equipment auction fees).

10.2. Use of appraisals – Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

Below are sample substantive testing procedures for the use of appraisals. Those denoted with a
* may be performed in conjunction with Valuation specialists.

 Evaluate and document the competency, capabilities, and objectivity of the appraiser.
For example:
o Assess that the appraisal was ordered by the entity, and not the
borrower/customer.
o Evaluate that the appraiser was appropriately licensed in the jurisdiction in which
the collateral was located. Did we perform procedures to corroborate the license
(e.g., inspect online state appraisal board rosters).
o Assess that the appraiser’s experience was appropriate, given the nature and
location of the collateral. For example, review resumes or experience profiles
included in the appraisal report.
 Document our understanding of the scope of work completed by the appraiser. For
example:
o Assess whether the collateral subject to valuation in the appraisal was the same
collateral for which the entity held its security interest. Include evidence of our
testing of the perfection of collateral in our documentation.
o Assess that the appraisal approach was appropriate relative to the intended use
of the appraisal (e.g., “as is” value in bank liquidation scenario).
 Evaluate the appropriateness of the timing of the appraisal relative to the Loss allowance
measurement date.*
 Evaluate the appropriateness of the appraisal methodology, given the nature of
collateral, relative to the fair value accounting framework.*
 Document our understanding and testing of key appraisal assumptions. For example:*
o Under a sales comparison approach, evaluate the appropriateness of the
comparable sale group, and address the existence of such sales transactions.
o Under an income capitalization approach:
 Evaluate that the income capitalization or discount rate utilized was
supported by market data (e.g., broker surveys, inquiries of appraisers in
market where collateral is located).
 Evaluate assumptions regarding net operating income, including (where
applicable) rental and vacancy rates.
 Where multiple valuation approaches were utilized, evaluate the “reconciliation” of those
results of the results of each approach in estimating final value.*
 Test the mathematical accuracy of computations within the appraisal, where necessary.*
 Document our evaluation of the methodology, assumptions, and valuation conclusions
for consistency with fair value accounting guidance.
 Evaluate the appropriateness of any adjustments to value made by management (e.g.,
liquidation discounts). For example, our procedures may include comparing the final
adjusted value to potential contrary information (e.g., market real estate valuation
reports, equipment auction history).
 Evaluate the appropriateness of selling cost adjustments, including that they were
applied only when the source of repayment was dependent on sale of collateral.*

9 February 2018 49
  Document our consideration of potential contrary information. For example, consider
evaluating market real estate value reports, broker surveys, equipment auction history.
 Assess that the valuation conclusions from the appraisal were completely and accurately
reflected in management’s documentation supporting the measurement of the Loss
allowance or related assumptions.
 Retain sufficient appropriate audit evidence to support our testing of appraisals. For
example, retain evidence of key sections of appraisal documents, and evidence
supporting our evaluation of applicable market data.

11. Loan modifications and forbearance

When a loan is modified, the entity needs to assess whether it meets the criteria to be de-
recognised, or whether it should be recognised as a modified loan. A de-recognised loan will either
be in stage 1 with a 12 month ECL or will be classified as originated credit impaired. A modified
loan will continue to be classified in the stage it was in pre-modification, unless it meets the criteria
for another stage. A modification gain or loss will be calculated based on the modified terms,
discounted at the loan’s original EIR. As such, entities need to determine a modification/ de-
recognition policy and apply it consistently across their portfolios.
11.1. Loan modifications and forbearance – Control testing considerations
Our testing of controls over modifications may consider the following:

Illustrative probing questions

 What are the criteria for modification vs. derecognition?
 How is the modification gain or loss calculated?
 Who approves the modification?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs
 A modification if misclassified as a derecognition and therefore the asset is
inappropriately moved back to stage 1
 A derecognition is misclassified as a modification and therefore purchased or originated
credit impaired (‘POCI’) is not identified (see 14 – Purchased or originated credit-
impaired financial assets)
 The modification gain or loss is miscalculated
 Management does not have sufficient processes or controls in place to identify the
existence of a modification

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:
Illustrative controls
 A modification policy is put in place to lay out criteria for assessing modification vs.
derecognition
 All modified loans are assessed against the policy to assess the classification
 The modification gain/ loss calculation is reviewed
 The assessment of derecognized assets as POCI is performed
 ITAC for system-generated reports to assess modifications
11.2. Loan modifications – Substantive testing considerations
Our substantive testing of loan modifications may consider the following:

Illustrative substantive testing considerations

 Test a sample of renegotiated assets and apply the institution’s modification policy to
assess if it is appropriately classified as a modification or derecognition.

9 February 2018 50
  Recalculate a sample of modification gains and losses
 Assess the staging of modified assets to verify the origination date for modified assets is
the original initiation date and the modification date for derecognised assets

12. Write-offs and subsequent recoveries Write-off

Entities have policies whereby they determine when an asset is written-off. Write-offs are defined
as when an entity has no reasonable expectations of recovering the contractual cash flows on a
financial asset in its entirety or a portion thereof. A write-off constitutes a derecognition event.
(IFRS 9.5.4.4)

Write-offs are removed from the ECL calculation as the gross asset and related ECL are
derecognised.

Recoveries
When an entity collects payment related to financial asset amounts previously written-off, the
payment is considered a recovery. Recoveries should be recorded when received.
12.1. Write-offs and subsequent recoveries - Control testing considerations
We document our understanding of the entity’s policies over recording write-off and recovery
activity.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive):

Illustrative probing questions we may ask to understand the entity’s policies and processes around
recoveries, and how recoveries impact the overall Loss allowance methodology, could include:
Illustrative probing questions

 How does management record write-offs?

 Is there a policy for partial write-offs?
 Is the same definition of write-off applied to all assets?
 How does management record recoveries?
 How are recoveries reflected in the system of record and the general ledger? Is it easily
identifiable?
 Does management consider write-offs and recoveries in the Loss allowance methodology
when measuring ECL?
 Does the institution adjust historical loss experience (e.g., write-offs) for recoveries? If
so, what is management’s process?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 Assets are not written-off in accordance with policy

 Written-off assets are still included in the ECL calculation
 Cash collections are not appropriately recorded as recoveries in the system of record.
 Recoveries in the system of record are not properly recorded on the general ledger.
 Recovery data extracted from the system of record is incomplete or inaccurate.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include (given that most controls may be at the application level, we need to consider involvement
of FAIT):
Illustrative controls

 The system automatically writes-off assets when the criteria is met

9 February 2018 51
  Written-off assets are excluded from the ECL calculation
 Application controls govern the proper coding of recoveries in the system of record, so
that the data attributes are complete and accurate when extracted for use in the ECL
estimation process
 Application controls govern the proper posting of recoveries in the system of record and
interface to the general ledger (e.g., we may consider testing controls related to the
interface of data or the manual recording of recovery transactions to the appropriate
general ledger accounts)

12.2. Write-offs and subsequent recoveries - Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:
Illustrative substantive testing considerations

 Test a sample of assets written-off to verify they met the write-off criteria (accuracy).
 Test a sample of assets not written-off to verify they do not meet the write-off criteria
(completeness).
 Test the completeness of the recovery transactions reflected in the rollforward of the
Loss allowance.
 Vouch a sample of recovery transactions to ensure that recoveries were appropriately
supported by cash payments.
 Test a sample of cash payments to validate they related to previously charged-off loan
amounts.

13. Off-balance sheet credit exposures

IFRS 9 requires institutions to measure ECL on off-balance sheet exposures related to lending
arrangements using the ECL model. Said differently, the standard requires institutions to estimate
ECL over the contractual period in which they are exposed to credit risk. While institutions will
measure ECL on the funded portion of the financial asset (i.e., loan) as described under their overall
methodology for the loss allowance for loan (ECL or the Allowance), entities must measure ECL
related to the unfunded portion (i.e., off-balance sheet credit exposures) using a similar approach.
Similar to practices under an incurred loss model, institutions will recognize the estimate of ECL for
off-balance-sheet credit commitments as a liability (i.e., a reserve for credit losses).

Institutions may consider the following when estimating credit losses for off-balance-sheet
commitments and financial guarantees:
 The contractual period in which the entity is exposed to credit risk because of a present
contractual obligation to extend credit, unless that obligation is unconditionally cancelable
by the entity
 The probability that funding will occur, which may be affected by a material adverse
change clause, among other things
 An estimate of ECL on commitments expected to be funded over the instrument’s
estimated life

When the obligation is unconditionally cancelable, the standard does not require institutions to
measure and recognize a reserve for credit losses. Example 10 in the standard illustrates this
scenario. In certain cases, detailed analyses may be necessary to appropriately conclude whether
the contract is unconditionally cancelable

The most common types of arrangements that would give rise to off-balance sheet credit exposures
and that institutions may enter into include:

 Loan commitments: Loan commitments represent a contractual agreement by an

institution to fund amounts under a lending arrangement in the future.
 Lines of credit: Line of credit arrangements provide the borrower with a maximum
borrowing limit for a specified period. Lines of credit may be structured in a variety of
ways.

9 February 2018 52
  Letters of credit: Letters of credit are commonly used as credit enhancements for other
forms of borrowing such as commercial paper, performance guarantees, or trade financing,
are agreements to lend a specified amount for a specified period, usually less than one
year.
 Revolving credit agreements: Revolving credit arrangements are agreements to lend up to a
specified maximum amount for a specified period, usually more than one year, and provide
that repayment of amounts previously borrowed under the agreement are available to the
borrower for subsequent borrowing. Repayment schedules may be on an instalment basis,
demand, time, or term basis.
 Financial guarantees: Only financial guarantees not accounted for as insurance and other
similar instruments would be evaluated for under ECL for purposes of measuring ECL.
13.1. Off-balance sheet credit exposures - Control testing considerations

We document our understanding of the entity’s policies and accounting for unfunded loan
commitments, including assessing whether or not such commitments are unconditionally
cancellable. This process forms the basis for our assessment of the design of controls.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive).

Illustrative probing questions we may ask to understand the entity’s policies and implications to ECL
methodologies could include:

Illustrative probing questions

 What are the institution’s policies over the origination of lending arrangements which
may result in off-balance sheet credit exposures?
 How does the entity record critical data in its systems of record, including the funded and
unfunded portions of the financial instrument?
o How are changes to amounts updated in the system of record?
 How does the entity estimate the probability of funding the unfunded amounts?
o Do these estimates differ by product/borrower type?
o How often are the assumptions updated?
o If the institution uses a historical funding period to estimate probability, does
management make qualitative adjustments to the period?
 How does the entity assess its lending arrangements as to whether they are
unconditionally cancellable? How are such conclusions reflected in the systems of record
and captured in the ECL models/calculations?
 What discount rating is used for off-balance sheet exposures?
 How are risk premiums incorporated in the discount rate?
 How does the entity distinguish between funded and unfunded portions of commitments
in its Loss allowance methodology? For example:
o For the funded portion, how does the entity ensure that such amounts are
subjected to the Loss allowance methodology?
o For the unfunded portion, what methodology does management use to estimate
the reserve for credit losses? Is the methodology consistent with ECL’s core
principles?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

9 February 2018 53
  The entity does not appropriately record off-balance sheet credit exposures in the
system of record, resulting in incomplete or inaccurate unfunded commitment amounts.
 Loan agreements related to products with commitment features are not appropriately
assessed as to whether the commitments are unconditionally cancellable by the
institution.
 The entity records a loss allowance for loan commitments that are unconditionally
cancellable.
 Funded loan amounts and unfunded amounts that are not unconditionally cancellable,
are inappropriately excluded from the entity’s process to estimate the Loss allowance.
 Assumptions regarding the probability of funding for unfunded amounts are not
supported.
 An inappropriate discount rate is used
 A risk premium is added to the risk free rate used for discounting (as opposed to
subtracting it)

9 February 2018 54
Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative controls

 Management reviews key attributes of the loan, including total off-balance sheet
exposure amounts and duration of exposures at the time a new loan is set up on the
system of record.
 Management reviews loan agreements to determine whether commitments to fund loan
amounts at a future date are unconditionally cancellable.
 Management reviews inputs into the overall Loss allowance methodology to validate that
off-balance sheet credit exposures are appropriately identified as conditionally or
unconditionally cancellable.
 Management reviews assumptions into the overall Loss allowance methodology to
validate that they are in line with their nature and management’s expectations about the
future.
 Periodically, management reviews and approves assumptions related to the probability of
funding for unfunded amounts.
 Management calculates an appropriate discount rate for off-balance sheet exposures.

13.2. Off-balance sheet credit exposures - Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

• Substantively test the key provisions of the loan agreement to determine if off-balance
sheet credit exposures are included, including the amount and duration of the exposure.
• Perform substantive procedures to determine whether such provisions were accurately
recorded in the system of record. For example, we may consider confirming maximum
commitment amounts in addition to confirming the outstanding funded amount.
• Test the institution’s conclusions as to whether off-balance sheet credit exposures are
unconditionally cancellable. Include sufficient consideration as to differences between
product types (e.g., consumer lines of credit versus commercial lines of credit).
• Test management’s assumption around the utilization of commitments/probability of
unfunded amounts being funded.
o Consider differences in funding expectations based on product and borrower
types (e.g., consumer versus commercial), and seasonal considerations (e.g.,
agricultural commitments versus commercial construction commitments).
o Consider how current economic/credit conditions may impact assumptions
around the utilization of commitments.
• Test the completeness and accuracy of the loan information included in the estimate of
the Loss allowance. Ensure that funded amounts were included in the Loss allowance
model/calculations, and that unfunded amounts were appropriately considered and
evaluated.
• Test the appropriateness of the discount rate used

14. Management adjustments

Management may make adjustments (sometimes referred to as overlays) in order to estimate ECL.
We should give consideration to the extent of use of management adjustments such as in the
following circumstances:

 Missing data to determine origination PDs, LGD or EAD for a proportion of portfolios
 Recent events not yet modelled for purposes of determining multiple economic scenarios
 Non-modelled portfolios
 Address model shortcomings

9 February 2018 55
  Insufficient loss information available to create a statistically sound ECL calculation

When evaluating the appropriateness of such adjustments used in estimating ECL, we consider
guidance in the standard as well as regulatory guidance (e.g., Basel Committee on Banking
Supervision: Guidance on credit risk and accounting for ECL Basel guidance).

Management adjustments are often subjective in nature but should be supported by documented
quantitative analysis and management should have a process and controls over their development,
incorporation into the estimate of expected losses, and review and approval thereof. Since these
amounts are subjective, we frequently involve our senior executives in auditing these adjustments,
including the controls over the associated process.

When the estimate of ECL is adjusted for such management adjustments our procedures include
testing and documentation of the controls that assure that an institution maintains sufficient,
objective evidence to support both the inclusion and exclusion of considerations or information and
the amount of the management adjustments, and to explain why the adjustments are reasonable
and supportable.

When management adjustments are material, we use professional scepticism and challenge and
document not only the directional consistency of the amounts provided by the institution, but also
how management derived those amounts. The sections below address our considerations with
respect to control and substantive testing.
14.1. Management adjustments – Control testing considerations
We document our understanding of the institution’s policies and procedures around evaluating and
assessing management adjustments. This process forms the basis for our assessment of the design
of controls.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive):

Illustrative probing questions we may ask to understand the entity’s process and controls over
management adjustments:

Illustrative probing questions

 Does management apply adjustments to the loss allowance estimate outside of those
already incorporated in the ECL model? If so,
o What is management’s process, including controls, to determine their
appropriateness?
o What information does management utilize in order to determine whether or not
an additional adjustment factor is warranted?
o Does management consider borrower-specific and macro-economic factors?
o How does management consider and evaluate contrary or disconfirming
evidence?”
o Who reviews and approves the adjustments? Can members of management
overwrite them?
o Does management make adjustments without appropriate support (e.g.,
unallocated loss allowance)?
o How does management back-test or evaluate the appropriateness of adjustments
with the passage of time?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

9 February 2018 56
  Factors that are already considered in other aspects of the loss allowance, are
incorporated again in the adjustments to the loss allowance (i.e., double counting).
 Adjustments are misapplied or applied inconsistently in the loss allowance calculation.
 Adjustments are calculated based on inaccurate information.
 Borrower-specific factors are not appropriately considered when determining amounts.
 Macro-economic factors are not appropriately considered when determining amounts
 Adjustments are over- or under- stated.
 Adjustments are not reviewed and approved
 Adjustments are not properly supported.
 Management does not consider and evaluate disconfirming or contrary evidence.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative controls

 Management tests for completeness and accuracy information on which adjustments are
based.
 Management reviews the loss allowance calculation to ensure that adjustments are
appropriately factored in to the estimate ECL.
 Management reviews and approves inputs and documentation of any adjustments. For
example, management reviews:
o Quantitative analysis of portfolio specific factors, when applicable, that serve as
the basis for making adjustments.
o Macro-economic factors, when applicable, that serve as the basis for making
adjustments.
 When applicable, a loss allowance committee meets to discuss and review the
adjustments.
 Management reviews the computation of the adjustments for accuracy.
 Senior management reviews the adjustments for reasonableness.
 Management reviews and documents changes or updates to adjustments.
 Changes in adjustments that are deemed to be significant are reviewed by senior
management, in both finance and credit risk management.

14.2. Management adjustments – Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

 Test the qualitative portion of the loss allowance beyond inquiry. For example:
o Test the qualitative the considerations applied.
o Test the completeness and accuracy of the quantitative information utilized to
compute the qualitative factors.
o Understand and document the buildup or establishment of the adjustments and
then understand significant changes between periods.
o Review each adjustment for both confirming and disconfirming evidence.
o Evaluate the appropriateness over economic and other factors used (or not used)
in the measurement of the adjustments.
 Illustrate how we exercised professional skepticism in auditing the adjustments, including
whether there are indications of management bias as well as how negative or
contradictory evidence was considered (e.g., could other assumptions have been used in
the analysis, and evaluate those assumptions as compared to those used by
management).
 Consider adjustments for other off-balance sheet commitments.
 Consider any adjustments that are not supported (e.g., unallocated loss allowance).

9 February 2018 57
15. Purchased or originated credit-impaired financial assets (POCI)
Entities often acquire individual assets or groups of assets in the course of business. If an asset is
credit-impaired when purchased or originated, it is referred to as Purchased or originated credit-
impaired (‘POCI’).

Accounting for POCI assets requires entities to make significant judgments. An entity must first
determine, as of the date of acquisition, which of those acquired assets are credit-impaired on
origination or purchase. A listing of credit-impaired indicators was provided above in Section 2.

Accounting for POCI assets differs from other assets in the following ways:

 Presented separately from other assets

 There is no staging and their designation as POCI remains with them as long as they exist
 Lifetime ECL are included in the effective interest rate at origination of these assets
 Any changes to lifetime expected losses originally contained with the credit-adjusted
effective interest rate are adjusted through profit or loss as an impairment gain or loss.

15.1. Purchased or originated credit-impaired financial assets - Control testing considerations

We document our understanding of the entity’s policies and procedures around measuring ECL for
POCI assets. This process forms the basis for our assessment of the design of controls.

We have summarized below illustrative probing questions, WCGWs, internal controls and substantive
audit procedures to help identify and address any new or revised risks of material misstatement under
the standard. The illustrations which may include any one or a combination of the following items are
not intended to be all inclusive but should be considered on all audits as we design our audit programs
to address the standard’s requirements.

Illustrative probing questions we may ask could include:

Illustrative probing questions

 Has the entity acquired/ originated assets or groups of assets during the reporting
period?
 How does management evaluate acquired assets to determine whether they qualify for
POCI accounting treatment on origination?
 What factors does management consider when assessing credit-impairment?
 How are POCI assets tracked?
 Are loans that are modified and subsequently derecognised inappropriately classified as
POCI?
 How does management evaluate whether restructured assets that did qualify for
derecognition meet the requirements for originated credit-impaired assets?
 How are POCI assets disclosed?
 How is the credit-adjusted EIR measured?
 How are lifetime ECL measured?
Illustrative WCGWs we may identify could include:

Illustrative WCGWs

9 February 2018 58
  Management does not have processes and controls in place to determine whether
originated or acquired/ originated assets meet the POCI definition.
 The credit adjusted EIR is miscalculated
 POCI assets are not presented separately and are included with other assets
Illustrative internal controls, or attributes of internal controls, we may identify and test could include:

Illustrative controls
 Periodically, management reviews and approves the accounting for acquired loans,
including identification and scoping of POCI assets. When performing testing to assess
whether loans are credit-impaired, the date of recognition should be considered to
determine if they were credit-impaired on origination
 At acquisition, management reviews the application of the accounting policy to validate
that only those assets that are credit-impaired are classified as POCI.
 Management reviews and approves the ECL calculation of POCI
 POCI assets are flagged in the system in order to track them
 Management reviews and approves the journal entries for POCI assets prior to posting to
the general ledger.
 Management reviews and approves the disclosures for POCI assets
 The calculation of the credit-adjusted EIR is reviewed and approved

15.2. Purchased or originated credit-impaired financial assets - Substantive testing

considerations

Illustrative considerations related to our substantive procedures could include:

Illustrative substantive testing considerations

 Test a sample of assets with higher risk ratings on origination to assess if they were
correctly assessed as POCI (completeness).
 Test a sample of assets flagged as POCI to assess if they meet the POCI definition.
 Recalculate a sample of credit-impaired EIR.
 Test a sample of lifetime ECL calculations.
 Test the disclosure of POCI assets.
16. Management’s final review and approval of the loss allowance
Management’s final review and approval of the loss allowance should be documented in accordance
with its internal process. Management’s review typically consists of several layers including
business unit level management, credit risk management, executive management and board or
audit committee review. At each layer of review, the control is often based on an analysis of key
ratios and trends over time. As the review cascades up the chain of management, the level of
precision and sensitivity may decrease. It is important that we evaluate the precision at which
management’s review functions at each level of review. For instance, we might gather evidence for
each level of review:

 What circumstances might cause management to change the ultimate level of the loss
allowance?
 How does management consider (and document its consideration) of
negative/contradictory evidence in establishing the final loss allowance amount?

When we evaluate management’s review and approval of the loss allowance, we also consider the
following:
 What key loss allowance ratios and credit quality indicators does management analyze in
evaluating the appropriateness of the loss allowance? How is that data compiled
(completeness and accuracy), reconciled for consistency across periods, and presented at
each level of review?

9 February 2018 59
 o How were the key assumptions reviewed and approved (such as forward looking
information, staging criteria, etc.)?
o Were any separate governance committees established under IFRS 9 to assess the ECL
 How does management document its review at each level?
 Is there is a reconciliation of the data presented for review back to the respective data
sources?
 Are those executing the review functions competent and have appropriate experience?
 How is the design of the control consistent with the control’s intended precision? How does
the design and associated precision change with each subsequent layer of review?
 How does management use the results of that evaluation to inform their evaluation of the
continuing appropriateness of the institution’s loss allowance estimation policy, changes to
credit acceptance and credit monitoring policies?

When we test the review controls functioning at a senior management-level or at a committee-level,

we do not conclude on effectiveness merely through inference (e.g., that no errors are noted
through our substantive testing) or inquiry but rather through obtaining direct evidence that the
control is operating as designed such as that obtained by attending meetings, review of minutes
and direct discussions with meeting participants. Such evidence includes examples of the precision
and sensitivity of the review control, including if applicable instances wherein adjustments were
made as a result of the review.

We also do not infer from a conclusion that management review controls are operating effectively
that other controls in the loss allowance estimation process are operating effectively. Further, we
expect the final management review will complement other controls in the loss allowance
estimation process and would not of themselves be sufficient to reach an overall effective/rely
conclusion on loss allowance related controls.

16.1. Management’s final review and approval of the loss allowance – Control testing
considerations
Our testing of controls over management review and approval of the loss allowance and
preparation of associated disclosures may consider the following:

Illustrative control testing considerations

 If the review of the loss allowance includes multiple levels of review, did we document the
competency and authority of the individuals at each of those levels performing the
review? Did we document and test the precision of each level of review in order to
determine if the review was precise enough to detect a material misstatement? Did we
directly observe any of these reviews occurring (e.g., loan or loss allowance meetings)?
Did we examine evidence of follow up that may have been necessary as a result of these
reviews?
o Did we assess how management validated key IFRS 9 assumptions, such as
forward looking information and staging?
o Did the committees have the appropriate representation from those in Finance,
Risk, Economics, Modelling, etc.?
 Did we identify and test controls over the accumulation of data and the preparation and
review of management’s loss allowance summary documentation, including the
completeness and accuracy of the underlying data, used by any credit, special assets and
other committees in their review of the appropriateness of the loss allowance?
 Did we include the information relevant to the proper functioning of the review controls
in our testing of IPE? In an integrated audit, did we test the institution’s controls that
assure the accuracy and completeness of the IPE Relevant information includes data
generated or processed through an IT application, spreadsheet, and/or end user
computing solution, be it in electronic or printed form, which is used to support audit
procedures?

9 February 2018 60
  Does management have a review control to identify errors in the loss allowance through
review of key loss allowance ratios and credit risk indicators, comparing them to
forecasted levels and prior periods? Did we gain an understanding of its level of precision
and test its operating effectiveness?

16.2. Management’s final review and approval of the loss allowance – Substantive testing
considerations
Our substantive testing of management review and approval of the loss allowance may consider the
following:
Illustrative substantive testing considerations

 Demonstrate how we considered all evidence, including any contrary evidence, identified
during our testing of other areas within the audit.
 Test the accuracy of the loss allowance management reporting, including historical loss
and default rates, ratio analyses, etc. used by management in its review.
o Test the staging analysis performed by management to support the staging
criteria.
o Assess the competency and authority of those approving the provision.
 If the institution prepares a "look-back" analysis to assess the historic write-offs versus
management's loss allowance estimate, consider how management's current estimate of
incurred losses compares to the analysis. Perform an analysis at a sufficient level of
disaggregation.
 Compare write-offs and ECLs as percentages of total loans and as percentages of each
other. Evaluate trends in these metrics in light of current economic conditions. Perform
these evaluations at the portfolio segment and/or class level, rather than on the entire
loan portfolio in the aggregate.
 When evaluating the appropriateness of the loss allowance, consider the guidance in
Basel’s GRAECL (Appendix C) ISA 540 (Appendix G), and EBA’s guidelines (Appendix H).
o Assess and document whether and how the institution considered the effect of
current environmental factors in developing its loss allowance estimate.
o For any adjustment of loss measurements for environmental factors, assess
whether the institution maintained sufficient, objective evidence to support the
amount of the adjustment and to explain why the adjustment is necessary to
reflect current information, events, circumstances, and conditions in loss
measurements.

To the extent that we perform our substantive testing at an interim date, we perform a rollforward
or otherwise update our substantive testing through year end, considering our combined risk
assessment.

17. Disclosures
Financial statement disclosures are an important component of IFRS 9.

IFRS 9 does not introduce new disclosure requirements, although the IASB made a number of
amendments to other standards when it finalised IFRS 9, including amendments to IFRS 7 Financial
Instruments: Disclosures (IFRS 7), which introduce new disclosure requirements in connection with
the introduction of IFRS 9. These amendments, which are described in Appendix C of IFRS 9, have
been incorporated into the text of the relevant Standards (e.g., IFRS 7).

To promote high quality implementation of IFRS 9, the Basel Committee on Banking Supervision
(BCBS) issued in December 2015, Guidance on credit risk and accounting for ECL (G-CRAECL or the
Basel Guidance), applicable exclusively to lending exposures. The Basel Committee has significantly
heightened the supervisory expectations that “internationally active banks” will deliver high-quality
implementation of the ECL (ECL) accounting framework, including the related guidance on
disclosures.

9 February 2018 61
Additionally, the Financial Stability Board (FSB) requested the Enhanced Disclosure Task Force1
(EDTF) to consider the disclosures that may be useful to help the market understand the upcoming
changes resulting from the use of ECL approaches (whether under US Generally Accepted
Accounting Principles (US GAAP) or IFRS) and to promote consistency and comparability. Following
such request, in December 2015, the EDTF issued a report on the Impact of ECL Approaches on
Bank Risk Disclosures (the EDTF ECL Guidance).

The EDTF has developed its recommendations with large international banks in mind. However, the
recommendations and considerations should be equally applicable to other banks that actively
access the major public equity or debt markets. Some of the recommendations, therefore, are likely
not to be applicable, or to be less relevant, to smaller banks and some subsidiaries of listed banks.
As such, the EDTF would expect such entities to adopt only those aspects of the recommendations
that are relevant to them. The EDTF also states that, although its recommendations have not
specifically been developed for other types of financial services organisations, such as insurance
companies, the considerations contained therein may provide some appropriate guidance.

It should be noted that, although EDTF is not a standard setter and its recommendations are not
mandatory, regulators (including those in the UK, Switzerland, Italy, Spain and the Netherlands)
have strongly encouraged the implementation of some or all of the recommendations. Ultimately,
entities will have to exercise judgement to establish, based on specific facts and circumstances, the
extent to which each recommendation is relevant and applicable to them.

EY has a checklist designed to assist you in the preparation of disclosures in accordance with IFRS 7
(as amended in accordance with the introduction of IFRS 9), the EDTF recommendations and the
Basel Guidance. Refer to this link for the IFRS 9 Disclosure Tool. In addition, refer to Good Bank
(International) Limited (November 2017), Illustrative IFRS Disclosures for Impairment and
Classification and Measurement.

The required disclosures include the following categories:

 Credit risk management practices
 Inputs, assumptions and estimation techniques – including any changes to the process
 Credit risk concentration
 What assets were included in a collective assessment
 Modified assets
 Default definition
 Credit-impaired
 Write-offs
 ECL for trade receivables
 Reconciliation of the loss allowance
 Collateral disclosures

17.1. Disclosures - Control testing considerations

We document our understanding of the entity’s policies and procedures around preparing required
disclosures. This process forms the basis for our assessment of the design of controls.

We have summarized below illustrative probing questions, what could go wrongs (WCGWs), and
controls which may include any one or a combination of the following items (the items on the
following lists are not intended to be all inclusive). (Note: Illustrative disclosures for IFRS 9
including transition and IAS 8 requirements can be found in Good Bank (International) Limited
(November 2017).

Illustrative probing questions we may ask to understand the entity’s policies and implications to ECL
methodologies could include:

9 February 2018 62
 Illustrative probing questions

 What is management’s process to validate that it has accumulated the necessary

information to prepare the disclosures required by the standard? For example:
o How does management evaluate whether it has appropriately segmented the
information by portfolio segment or class of financing receivable? Does
management segment the portfolio differently for measurement and disclosure
purposes? If so, does management document why that is the case?
o How does management evaluate which credit quality indicators to disclose? How
does it define a “new loan” for purposes of determining the initial date of
issuance to determine the year of origination?
o How does management perform the reconciliation of the loss allowance?
 What are the credit quality indicators management has identified in its overall credit
monitoring and measurement process? Are those consistent with what management has
disclosed?
 How does management determine which inputs and assumptions to disclose in the
financial statements? Does it disclose all those inputs and assumptions used to measure
ECL, or only those that have a material impact? If so, how does management determine
what is material?
 What is management’s process for identifying, documenting and disclosing, if applicable,
which practical expedients have been adopted by the entity?
 What controls does management have in place to ensure completeness and accuracy of
data used for disclosure process? For example, how does it ensure that the reports used
to compile information on staging and on the reconciliation of the loss allowance
schedules and other disclosures are complete and accurate? Do data warehouses or
separate reporting systems exist?
 What is management’s process to evaluate disclosure requirements related to off-
balance sheet credit exposures?

Illustrative WCGWs we may identify could include:

Illustrative WCGWs

 Disclosures are incomplete and/or inaccurate.

 Renewals/modifications/restructurings are not appropriately evaluated under the
definition of a new loan, resulting in inaccurate vintage disclosures.
 Disclosures do not appropriately reflect the credit loss estimation methodology, and key
assumptions made during that process.
 The reconciliation disclosure for the Loss allowance is incomplete and/or inaccurate.
 Write offs and recoveries are not consistent with management’s policies and procedures.
 All components of amortized cost are not included in the required disclosures.
 Disclosures over POCI loans are incomplete or inaccurate.
 Disclosures related to off-balance sheet credit exposures are not consistent with
management’s methodology and process.

Illustrative internal controls, or attributes of internal controls, we may identify and test could
include:

Illustrative controls

 Management reviews and approves financial statement disclosures to ensure they are in
line with the disclosure requirements in the standard (e.g., review of the disclosure
checklist).
 Management reviews the disclosures to ensure they are consistent with the entity’s
policies and procedures, including inputs and assumptions used in measuring ECL.

9 February 2018 63
  Data aggregated for required disclosures is reconciled to source systems: (Data
aggregated for required disclosures is reconciled to source systems): this may be
performed using IT systems or manually.
 All data attributes of loan records that are key to the aggregation of data for disclosure
purposes are periodically reconciled to the design existing controls over the
completeness and accuracy of that data.

17.2. Disclosures - Substantive testing considerations

Illustrative considerations related to our substantive procedures may include:

Illustrative substantive testing considerations

 Read management’s disclosures, and compare them to required disclosures (e.g.,

disclosure checklist).
 Compare the disclosed methodologies, policies, processes, and procedures to the
documentation and evidence obtained through our audit of the Loss allowance. Evaluate
them for consistency.
 Appropriately test whether renewals/modifications/restructurings were appropriately
assessed as to whether the change resulted in a new loan, and were those conclusions
appropriately captured in the disclosures.
 Substantively test the transfer of data from source systems to disclosures, including the
completeness and accuracy of the aggregation of data.
 Test key data attributes that drive the aggregation of data (e.g., credit quality indicators,
industry codes).

18. Other matters

18.1. Analytical procedures
As part of substantive testing, audit teams may apply analytical procedures to the allowance for
credit losses. As a reminder, when we use analytical procedures, we refer to EY GAM topic
SUBSTANTIVE SAP, which provide guidance on performing data analysis and substantive analytical
procedures in connection with an audit.

 Data analytics – Generally for the loss allowance, we use data analytics designed to help us
identify items with a higher likelihood of material misstatement or anomalies within the
population that may require additional follow up; that is, such data analysis is used to
inform the nature, timing and extent of our audit approach. However, it is important to
point out that those procedures do not constitute substantive procedures in and of
themselves. As noted in DA_1.1 Substantive analytical procedures versus data analysis,
“Data analytics enhances our understanding of the business and the process by which we
identify risks of material misstatement, including the risk of fraud, and can support us in
obtaining audit evidence through substantive analytical procedures and tests of details.”

Additional data analytics tools are being developed for IFRS 9 and will be communicated
when available.

 Substantive analytical procedures – We may also design analytical procedures to provide

evidence that is important to our overall conclusions for a specific financial statement
assertion. The audit evidence we gain from analytics is a function of our variance threshold
and precision of our expectation of the amount (or trend, ratio, data pattern, etc.).
Therefore, the greater the amount of evidence (assurance) we desire from an analytic (e.g.,
when we seek evidence to support a specific financial statement assertion), the higher the
precision of our expectation needs to be and the narrower our variance threshold needs to

9 February 2018 64
 be. EY GAM topic SUBSTANTIVE SAP provides additional guidance on developing
expectations, executing analytical procedures and evaluating results.
In order to be considered substantive procedures, analytical procedures must include setting
expectations with sufficient precision to identify errors that could be material to the financial
statements. Therefore, analytical procedures over the loss allowance generally are considered only
as a supplement to the detailed tests of the client’s methodology and controls, tests of details, and
other substantive procedures.

Substantive analytical procedures over the loss allowance are typically limited to those cases where
(a) there is a direct, predictable relationship between an objective loan portfolio measure (e.g.,
delinquency) and realised losses and (b) the loan collateral, if any, is relatively liquid, objectively
verifiable and does not rely heavily on asset-specific characteristics (e.g., the use of published
wholesale values to estimate the value of automobiles). Use of substantive analytical procedures is
generally not appropriate for areas of the allowance where losses are triggered by less objective
measures (e.g., loan risk ratings on non-homogenous commercial loans, qualitative reserves) or for
loans backed by relatively less liquid collateral such as real estate.Whether we use analytics for
data analysis or for substantive analytical procedures as described above, the analytics over the
loss allowance typically include those ratios and trends that management evaluates as part of its
overall review of the loan portfolio’s credit risk and the appropriateness of the associated loss
allowance. These analytics include statistics relating the allowance to net write-off rates,
nonperforming loan levels and other loan categories, historical experience, and peer results.

18.2. Executive involvement

Senior members of our audit teams must be involved in the planning, execution, and conclusions
related to our audit procedures surrounding the loss allowance for financial statement. Our audit
procedures focus on understanding, documenting, and evaluating the sufficiency of the institution’s
procedures for estimating the allowance, evaluating and testing the design and operation of the
associated internal controls, performing substantive procedures to assess the reasonableness and
appropriateness of assumptions used by management, and concluding on the appropriateness of
the amount recorded at the balance sheet date. Given the highly judgmental nature of the loss
allowance, substantial executive involvement, including in the development of our combined risk
assessment and audit strategy, is warranted.The engagement quality reviewer (EQR) discusses with
the audit team the risk assessments and planned control testing procedures (where applicable) and
substantive audit procedures for sensitive accounting, auditing and financial reporting areas where
we expect to make significant judgments. For audits of banks, the allowance for credit losses is
generally a sensitive accounting, auditing and financial reporting area where we expect to make
significant judgments. Further, on all financial statement audits, in order to evaluate the significant
judgments made and related conclusions reached by the audit team, the EQR reviews key audit
documentation, as necessary, for sensitive accounting, auditing (including those related to internal
control over financial reporting) and financial reporting areas. The EQR uses his or her professional
judgment to determine the workpapers to review.Consideration of regulatory examinations and
observations

If a regulatory examination is in process, we conduct a meeting with the regulatory team, prior to
the issuance of our report, and determine that our audit procedures have adequately considered
issues or areas of regulatory concern.

We document our determination that our audit procedures have appropriately considered issue or
areas of regulatory concern in the workpapers. Further, we handle confidential supervisory
information (CSI) in line with our engagement agreement(s), and discuss with Professional Practice
on CSI-related matters as appropriate.

9 February 2018 65
Appendix A - Compendium of loss allowance guidance

Selected IFRS 9 and bank regulatory guidance relevant to the allowance for reference:

November 2015 Enhanced Disclosure Task Force (EDTF): Impact of ECL approaches on bank
risk disclosures

December 2015 Basel Committee on Banking Supervision (BCBS): Guidance on credit risk
and accounting for ECL

June 2016 and Global Public Policy Committee Papers (GPPC) on IFRS 9
July 2017

November 2016 European Securities and Markets Authority (ESMA): Public statement on
implementing IFRS 9

March 2017 Basel Committee on Banking Supervision: Regulatory treatment of

accounting provisions – interim approach and transitional arrangements

April 2017 Proposed ISA 540 (Revised): Auditing accounting estimates and related
disclosures

May 2017 European Banking Authority (EBA) Guidelines on credit institutions’ credit
risk management practices and accounting for ECL

Appendix B - Enhanced Disclosure Task Force: Impact of ECL approaches on bank risk
disclosures

The Enhanced Disclosure Task Force ('EDTF') is a private sector group comprising representatives
from financial institutions, investors and analysts, credit rating agencies and external auditors. It
was formed by the Financial Stability Forum in May 2012 and its objectives include the
development of principles for enhanced disclosures about market conditions and risks, including
ways to enhance the comparability of those disclosures and identifying those disclosures seen as
leading practice.

In November 2015, the EDTF noted that a user group of investors and analysts found that
significant opportunity remains for banks to improve credit risk disclosures. This aims to enhance
their disclosures, help the market understand the upcoming change in provisioning based on ECL
(whether under IFRS or US GAAP) and promote consistency and comparability of disclosures across
internationally-active banks. Please refer to the attached file below for a copy of the publication.

The guidance builds on the existing fundamental principles and recommendations noted above and
addresses the following key areas of focus:

• Concepts, interpretations and policies developed to implement the new ECL approaches,
including the significant credit deterioration assessment required by IFRS 9
• The specific methodologies and estimation techniques developed;
• The impact of moving from an incurred to an ECL approach
• Understanding the dynamics of changes in impairment allowances and their sensitivity to
significant assumptions, including those as a result of the application of macro-economic
assumptions
• Any changes made to the governance over financial reporting, and how they link with
existing governance over other areas including credit risk management and regulatory
reporting

9 February 2018 66
 • Understanding the differences between the ECL applied in the financial statements and
those used in determining regulatory capital

An IFRS 9 Disclosure tool has been developed to ensure completeness of the EDTF requirements
and other disclosure requirements in one single checklist.

Appendix C - Basel Committee on Banking Supervision: Guidance on credit risk and accounting
for ECL

The Basel Committee published the final version of its Guidance on Credit Risk and Accounting for
ECL in December 2015. It updates the Basel Committee's previous guidance on Sound Credit Risk
Assessment and Valuation of Loans. The new guidance deals with lending exposures, and not debt
securities, and does not address the consequent capital requirements.

The main section of the Basel Committee's guidance is intended to be applicable in all jurisdictions
(i.e. for banks reporting under US GAAP as well as for banks reporting under IFRS) and contains 11
supervisory principles. The guidance is supplemented by an appendix that outlines additional
supervisory requirements specific to jurisdictions applying the IFRS 9 ECL model.

It is important to stress that the guidance is not intended to conflict with IFRS 9, but it goes further
than IFRS 9 and, in particular, removes some of the simplifications that are available in the
standard. It also insists that any approximation to what would be regarded as an 'ideal'
implementation of ECL accounting should be designed and implemented so as to avoid 'bias'. The
term 'avoidance of bias' is used several times in the guidance and we understand it to have its
normal accounting meaning of neutrality.

Perhaps one of the most significant pieces of guidance provided by the Basel Committee relates to
the important requirement in IFRS 9 that ECLs should be measured using 'reasonable and
supportable information'. The Committee accepts that in certain circumstances, information
relevant to the assessment and measurement of credit risk may not be reasonable and supportable
and should therefore be excluded from the ECL assessment and measurement process. But, given
that credit risk management is a core competence of banks, 'these circumstances would be
exceptional in nature'. This attitude pervades the guidance. It also states that management is
expected 'to apply its credit judgement to consider future scenarios' and '[t]he Committee does not
view the unbiased consideration of forward looking information as speculative'. The guidance,
therefore, establishes a high hurdle for when it is not possible for an internationally active bank to
estimate the effects of forward looking information. It is possible that banking regulators would
expect banks to make an estimate of the effects of events with an uncertain binary outcome that is
highly significant, such as the result of a referendum.

Please refer here for a copy of the Basel Committee’s Guidance.

9 February 2018 67
Appendix D - Global Public Policy Committee Papers on IFRS 9

On 17 June 2016, the GPPC published The implementation of IFRS 9 impairment by banks
Considerations for those charged with governance of systemically important banks. The GPPC is the
Global Public Policy Committee of representatives of the six largest accounting networks. This
publication was issued to promote high-quality implementation of the accounting for ECLs in
accordance with IFRS and to help those charged with governance to identify the elements of a high-
quality implementation. It was designed to complement other guidance such as that issued by the
Basel Committee and the EDTF. It does not purport to amend or interpret the requirements of IFRS
9 in any way. The first half of the GPCC guidance sets out key areas of focus for those charged with
governance. This includes governance and controls, transition issues and ten questions that those
charged with governance might wish to discuss. The second half of the guidance sets out a
sophisticated approach to implementing each aspect of the requirements of IFRS 9, along with
considerations for a simpler approach and what is not compliant.

The GPPC guidance regards determination of the level of sophistication of the approach to be used
as one of the key areas of focus for those charged with governance. Consequently, it provides
guidance on how to make this determination for particular portfolios. It sets out factors to consider
at the level of the entity, such as the extent of systemic risk that the bank poses, whether it is listed
or a public interest entity, the size of its balance sheet and off balance sheet credit exposures, and
the level and volatility of historical credit losses. Portfolio-level factors include its size relative to
that of the total balance sheet and its complexity, the sophistication of other lending-related
modelling methodologies, the extent of available data, the level of historical losses and the level
and volatility of losses expected in the future. The document stresses that a simpler approach is not
necessarily a lower quality approach if it is applied to an appropriate portfolio.

In July 2017, the GPPC issued its second paper titled The Auditor’s Response to the Risks of
Material Misstatement Posed by Estimates of Expected Credit Loss under IFRS 9. This second paper
was written in an effort to assist audit committees in their oversight of the bank’s auditors with
regard to the ECL. It is addressed primarily to the audit committees of systemically-important banks
(“SIBs”) because of the relative importance of SIBs to capital markets and global financial stability
but it relevant for other banks as well.

The second paper focuses on the audit committee’s role in assessing the effectiveness of the
auditor’s response to risks of material misstatements presented by the estimate of ECL. In
assessing the effectiveness of the auditor’s response to the risk of material misstatement
presented by IFRS 9, the audit committee should:

 Consider the appropriateness of the planned audit approach and any deviations from the
proposed approach during the course of the audit
 Evaluate the findings of the auditor in the context of their understanding of the bank’s
processes, systems and controls

The paper emphasises that the bank’s ability to support reasonable estimates of ECL will be
dependent upon a robust system of internal control over the critical sources of information,
processes and models upon which the bank’s estimate of ECL is based and must be supported with
appropriate documentation. Also in evaluating the auditor’s planned audit approach and the
auditor’s findings, audit committees should consider whether the auditor has the appropriate skills,
knowledge and resources to address the risks presented by the ECL estimate.

The paper includes the following nine questions that audit committees may wish to discuss with the
auditors: The sections referred to below provide further detail on the topic and provide some
implications for the bank and implications for the auditor:

9 February 2018 68
 1. How has the auditor identified the key sources of complexity, judgment and uncertainty in
the bank’s estimate of ECL under IFRS 9? (Section 1)
2. How do the skills, knowledge and resources of the audit team align with the key sources of
complexity, judgment and uncertainty that contribute to the risk of material misstatement in
the bank’s estimate of ECL under IFRS 9? (Section 1)
3. What is the auditor’s assessment of the bank’s controls over the key sources of complexity,
judgment and uncertainty in the bank’s estimate of ECL under IFRS 9 and how has that
assessment informed the auditor’s approach? (Section 3)
4. How has the auditor evaluated the relevance and reliability of data sourced from different
functions of the bank (i.e. outside of the financial reporting function) and external
sources? (Section 4)
5. Where the bank has made use of proxies[1], how has the auditor evaluated and challenged
the appropriateness of these proxies and the bank’s plan (or lack thereof) to eliminate their
use? (Section 2)
6. In its testing of models, what limitations did the auditor identify, and how did the auditor
satisfy themselves that such limitations were appropriately addressed by
management? (Section 5)
7. How has the auditor exercised professional scepticism in testing the bank’s key judgements
and assumptions (such as the selection of multiple, probability-weighted forward-looking
economic scenarios and the determination of significant increases in credit risk) in the
estimation of ECLs? (Section 6)
8. What are the auditor’s views regarding the neutrality, clarity and comprehensibility of the
disclosures regarding the bank’s estimate of ECLs? (Section 7)
9. What process was undertaken by the auditor to ‘stand back’ and consider, in the context of
the financial statements as a whole, the presence of bias in the bank’s estimate of, and
disclosures regarding, ECLs? (Section 6)

Appendix E - Basel Committee on Banking Supervision: Regulatory treatment of accounting

provisions – interim approach and transitional arrangements

On 29 March 2017, the Basel Committee on Banking Supervision (BCBS) issued the final Standard
for the Regulatory treatment of accounting provisions – interim approach and transitional
arrangements. BCBS seek to address the complexities that the change in accounting of an ECL
model is anticipated to bring, under both IFRS 9 and CECL. A summary of the key points within the
Standard is contained below covering (i) the regulatory treatment of accounting provisions, (ii) the
proposed transitional arrangements, and (iii) the long term view.

(i) Retaining the current regulatory treatment of accounting provisions for an interim period
The current treatment of provisions under both the standardised approach (SA) and the internal
ratings-based (IRB) approach will be retained for an interim period, with jurisdictions extending
their existing approaches to categorising accounting provisions as either General Provisions (GP) or
Specific Provisions (SP). Following the transition period, the distinction of accounting provisions as
either GP or SP will remain the remit of regulatory authorities, with BCBS recommending they
provide guidance on this categorisation as appropriate.

For EU based firms, the European Banking Authority (EBA) recently published an opinion on
transitional arrangements and credit risk adjustments due to the introduction of IFRS 9. This
confirmed that the EBA perceive no general provision is created under ECL accounting and the
existing treatment under IAS 39 is anticipated to continue.

9 February 2018 69
(ii) Transitional arrangements
In October 2016, the BCBS CD proposed three possible transitional approaches that could be
introduced upon implementation date for the impact of ECL accounting on regulatory capital.
Interestingly, the BCBS final Standard does not adopt any of these three approaches. Instead the
global body provides jurisdictions with the option to choose whether to apply a transitional
arrangement and, if elected, the design of the approach is the jurisdiction’s responsibility - subject
to a number of rules laid out by BCBS.

Within these rules, the Standard clearly notes that the approach must only apply to “new”
provisions arising as a result of moving to ECL accounting, and must consider consequential
adjustments to other areas of the regulatory framework. However, the BCBS principles allow some
flexibility - for example it does not prescribe a static or dynamic approach, despite having espoused
a preference for the former within the earlier CD. Additionally, while the proposal in October clearly
showed that BCBS preferred a three year transition period, the final Standard provides jurisdictions
with the flexibility to choose a period of up to five years. For certain elements, BCBS does express a
preference, such as regarding straight line amortisation, but it does not exclude alternative
approaches.

The Standard also consider disclosures, noting that Pillar 3 reports must publically communicate
both whether a transitional arrangement has been applied and also compare the regulatory and
leverage ratios to a “fully loaded” position.

For EU based firms, the lack of a prescriptive approach will ensure that the proposals within the
CRR update contained in Article 473a do not diverge from any global requirements. Yet, these
remain proposals and there is no definitive transitional approach determined and approved for
European firms.

(iii) The long term view from BCBS

The Standard does not address the long term regulatory treatment of provisions - the subject of the
DP issued in October 2016. BCBS note that further analysis is required for this viewpoint to be
formed and that the impact of ECL accounting on regulatory capital may be significantly more
material than expected. This serves to underline the lack of available data for evidence-based
analysis of the impact of IFRS 9.

9 February 2018 70
Appendix F - European Banking Authority Guidelines on credit institutions’ credit risk
management practices and accounting for ECL

In May 2017, the European Banking Authority (EBA) published its final report on the Guidelines on
credit institutions’ credit risk management practices. These guidelines aim at ensuring sound credit
risk management practices for credit institutions, associated with the implementation and ongoing
application of ECL accounting models. The existence of supervisory guidance emphasises the
importance of high-quality and consistent application of IFRS 9 and could help to promote
consistent interpretations and practices. The objective of the EBA guidelines is to be in line with the
BCBS guidance (Refer to Appendix C).

The EBA guidelines include four main sections as follows:

•
proportionality and materiality, and the use of information by credit institutions.
•
the provisions for the main elements of credit risk management and accounting for ECL,
and provide detailed guidance for the application of each principle.
•
limited to providing guidance on certain aspects of the ECL requirements in the impairment
section of IFRS 9 that may not be common to other ECL accounting frameworks.
•
the supervisory evaluation of credit risk management practices, accounting for ECL and the
overall capital adequacy.

9 February 2018 71