In this short case, you will evaluate the adequacy of internal controls in the audit of the allowance for loan losses for XYZ bank, a privately-held entity.

Because of the critical nature of this account for every financial institution, the external auditors desire a high level of control reliance. Instead of following a formal audit program, you are instructed to evaluate the evidence presented and determine whether a material weakness or significant deficiency[1] exists within the allowance for loan loss valuation process.

A condensed balance sheet and income statement for XYZ bank as of December 31, 2017 (and comparative data for December 31, 2016) are as follows:

 XYZ Bank

Unaudited Statements of Financial Condition

             (in millions of dollars)

        ASSETS 

12/31/2017

12/31/2016

Cash

142

253

Investments

867

1,308

Loans

2,833

2,947

Less: Allowance for loan loss

86[2]

88

   Net loan valuation

2,647

2,759

Property and equipment

332

337

        Total assets

4,088

4,757

       

             

LIABILITIES AND EQUITY

LIABILITIES:

Checking and savings accounts

3,136

3,821

Borrowed funds

299

325

Accounts payable

31

30

    Total liabilities

3,466

4,176

EQUITY:

Retained earnings

622

581

    Total equity

622

581

         Total liabilities & equity

4,088

4,757

   XYZ Bank

Unaudited Consolidated Statements of Income

             (in millions of dollars)

12/31/2017

12/31/2016

Interest Income

413

473

Interest Expense

219

287

    Net interest income

194

186

Less: Provision for loan losses

86

88

    Net interest income after

    provision for loan losses

108

98

Non-interest income

207

324

315

422

Non-interest expense

264

380

          NI before tax (NIBT)

51

42

          Accrued taxes

10

9

          Net income after tax

41

33

Note 3: Loans

Loans outstanding:                                       12/31/2017                       12/31/2016

     Real estate                                                       1,190                                1,238

     Vehicle                                                            1,048                                1,031

     Business                                                             595                                   678

                                                                              2,833                                2,947

The consolidated schedule of outstanding loans was used to select a sample (n=32) of 'individually material' real estate, vehicle and business loans and the related supporting loan documentation was pulled and analyzed against current approved policies and procedures by the external auditors[3].  To comply with GAAP, the allowance for loan loss reserve should be adequate to provide for probable, but yet unconfirmed loan losses that have been incurred in a bank's loan portfolio as the of financial statement date.  

Real estate and vehicle loan packages appeared to consistently (with only a few relatively minor exceptions) be in compliance with established bank policies and procedures and applicable laws and regulations.  For instance, each real estate and vehicle loan included evidence of the following:

• Loans were originated and periodically reviewed by qualified loan officers and approved by the chief loan officer.

• Supporting documentation for each loan included current financial statements[4], credit reports[5] and FICO credit scores[6].

• Appropriate 'risk grades' (discussed 'below') that matched applicable reserve percentages.

• Board approved policies and procedures related risk grades to reserve percentages as follows:

 

 

 

 

 

 

 

 

Risk Grade                   Reserve Percentage                                                                                                                                                                                                                  

1                                       0

2                                      2.5

3                                      5

4                                    10

5 (marginal)                  20

6 (substandard)             60

7                                    90

8                                  100

The higher the risk grade the great