The Basel Committee: updated guidance on the external audit of banks

Thu 06 May 2021

Against the background of a new year still severely affected by the persistence of the pandemic throughout the world and economies facing an unprecedented global macro-economic shock, the Basel Committee has felt it necessary to address the audit of the expected credit loss (ECL) accounting estimate within the overall financial statement audit.  With IFRS 9 coming into force in 2018, the Basel Committee has published a supplemental note to its 2014 guidance (BCBS280) on external audits of banks as part of several measures to enable the banks to come through the crisis as well as possible.

Credit loss provisioning is a crucial accounting issue since the transition to IFRS 9 makes it mandatory to allocate provisions as soon as a loan is granted. For example, in anticipation of future losses under various macroeconomic scenarios.

But this is also a regulatory issue, since provisioning reflects a bank’s changing exposure to the risk of borrower default, that is to say, credit risk in the sense of the regulation. It will therefore have an impact on the regulatory capital of banks and ultimately on their solvency ratios.

Scope of the guidance

This supplemental note describes the Basel Committee’s expectations for the high-quality audit of the application of IFRS 9 and ECL estimates in particular. The practices described represent how banks can apply aspects of the accounting standards but should not be interpreted as prescriptive. The note applies to internationally active banks applying IFRS 9 and subject to a financial statement audit, including those within a banking group and holding companies whose subsidiaries are predominantly internationally active banks.

The guidance makes no claim to replace applicable accounting or auditing standards; instead, it is part of the dialogue between banking supervisors and external auditors that began with the original 2002 guidance in this area.  

The Committee’s main expectations

The guidance sets out the Committee’s expectations for the external auditor through the questions that an audit committee should ask in its oversight role and as the promoter of high-quality bank audits. It also describes the expectations for the external auditor in terms of the key aspects of ECL.

The Basel Committee sets out several relevant questions that should be asked by the audit committee relating to the creation of an audit environment conducive to exercising professional scepticism and the factors underpinning the understanding of the risks of material misstatement. In addition, there are questions relating to testing the operational effectiveness of the internal controls on which the external auditors rely, the profile of the experts used by the auditor to examine ECL and the main sources of the evidence obtained to assess the risks of material misstatement.

Gathering sufficient audit evidence

In the case of external auditors, the expectations relate to professional scepticism about the financial statements to be audited, assessment of the risk of material misstatement, key components used in estimating ECL, the internal control environment, the use of modelling experts, and the appropriate level of evidence of audit quality. Therefore, in addition to ensuring the teams’ competence, auditors need to gather sufficient audit evidence on material misstatement risk factors to demonstrate professional scepticism and understand the business model, in particular for bank lending.

By contributing to the high-quality audit of banks, the Committee recognises that ECL frameworks bring significant changes for bank management and external auditors and that ECL estimation and the related disclosures are an important aspect of financial reporting.