Amendment to Statement of Policy Regarding Independent External Auditing Programs of State Nonmember Banks

FARM CREDIT ADMINISTRATION

FEDERAL DEPOSIT INSURANCE CORPORATION

Amendment to Statement of Policy Regarding Independent External

Auditing Programs of State Nonmember Banks

AGENCY: Federal Deposit Insurance Corporation (FDIC or Corporation).

ACTION: Statement of policy.

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SUMMARY: As part of the FDIC's systematic review of its regulations and

written policies under Section 303(a) of the Riegle Community

Development and Regulatory Improvement Act of 1994 (CDRI), the FDIC is

amending its policy statement regarding independent external auditing

programs of state nonmember banks (Policy Statement). These amendments

remove an inconsistency between the Policy Statement and another policy

that was later approved by the FDIC Board of Directors and eliminate a

reference to another FDIC policy which has been superseded. The

amendments also add a paragraph referencing a statutory requirement

enacted since the Policy Statement's adoption and renumber the

subsequent paragraphs of the Policy Statement.

EFFECTIVE DATE: June 24, 1996.

FOR FURTHER INFORMATION CONTACT: Doris L. Marsh, Examination

Specialist, Division of Supervision, (202) 898-8905, or Sandra

Comenetz, Counsel, Legal Division, (202) 898-3582, FDIC, 550 17th

Street NW., Washington, DC 20429.

SUPPLEMENTARY INFORMATION: The FDIC is conducting a systematic review

of its regulations and written policies. Section 303(a) of the CDRI (12

U.S.C. 4803(a)) requires each federal banking agency to streamline and

modify its regulations and written policies in order to improve

efficiency, reduce unnecessary costs, and eliminate unwarranted

constraints on credit availability. Section 303(a) also requires each

federal agency to remove inconsistencies and outmoded and duplicative

requirements from its regulations and written policies.

As part of this review, the FDIC has determined that the Policy

Statement needs several amendments to eliminate inconsistencies and

outmoded requirements.

The Policy Statement was adopted by the FDIC Board of Directors on

November 16, 1988, and published on November 28, 1988, 53 FR 47871. The

Policy Statement states that the FDIC strongly encourages each state

nonmember bank to adopt an external auditing program that includes an

annual audit of its financial statements by an independent public

accountant. However, the Federal Deposit Insurance Corporation

Improvement Act of 1991 added Section 36 to the Federal Deposit

Insurance Act. Section 36, and its implementing regulation at 12 CFR

Part 363, requires all insured depository institutions with $500

million or more in total assets at the beginning of their fiscal year

to have an annual audit performed by an independent public accountant

and to have an audit committee entirely consisting of outside directors

who are independent of management. A new paragraph 3 has been added to

the Policy Statement describing these and certain related requirements

for larger institutions and the existing paragraphs 3 through 15 have

been redesignated paragraphs 4 through 16.

In addition, the Policy Statement advises applicants for deposit

insurance that they will generally be expected to commit their bank to

obtain an audit of its financial statements by an independent public

accountant annually for at least the first three years after deposit

insurance is granted [emphasis added]. Original footnote 2 to the

Policy Statement refers to a June 24, 1987, FDIC policy statement on

deposit insurance applications by operating non-FDIC insured

institutions.

However, newly insured institutions generally present greater risks

to the deposit insurance funds than operating insured institutions

which have been subject to ongoing supervision by the applicable

federal and state regulators. In addition, a statement of policy on

Applications for Deposit Insurance was adopted by the FDIC Board of

Directors on April 7, 1992, 57 FR 12822, which superseded the

referenced 1987 policy statement. The 1992 policy statement states the

FDIC's belief that an annual audit by an independent public accountant

should be an integral part of the safe and sound management of a

depository institution. As a result, applicants for deposit insurance

coverage are expected to commit their depository institution to obtain

an audit by an independent public accountant annually for at least the

first five years after deposit insurance coverage is granted [emphasis

added]. Thus, this Policy Statement must be amended to be consistent

with the more recent statement of policy on Applications for Deposit

Insurance. A reference to the 1992 applications policy replaces a

reference to the rescinded policy statement in footnote 2.

Discussion of Amendments

A new paragraph 3 is added to the Policy Statement to explain the

audit and audit committee requirements for all insured depository

institutions with $500 million or more in total assets as a result of

the addition of Section 36 to the Federal Deposit Insurance Act in

1991. Thus, the original paragraphs 3 through 15 have been redesignated

paragraphs 4 through 16. In renumbered paragraph 11 of the Policy

Statement, the word ``three'' is replaced with the word ``five''

because newly insured

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institutions generally present greater risks to the insurance funds, a

factor recognized in the FDIC's 1992 applications policy statement.

This change in the Policy Statement will bring it into conformity with

the recommended number of years an applicant for deposit insurance must

commit to obtaining an annual audit as set forth in the applications

policy statement. The reference in footnote 2 to the FDIC's rescinded

1987 policy statement is replaced with a reference to the FDIC's

current applications policy statement.

For the reasons set forth in the preamble, the Board of Directors

of the FDIC hereby amends its Statement of Policy Regarding Independent

External Auditing Programs of State Nonmember Banks to read as follows:

Statement of Policy Regarding Independent External Auditing Programs of

State Nonmember Banks

1. In view of its interest in the financial soundness of banks and

the banking system, the FDIC believes that a strong internal auditing

function combined with a well-planned external auditing program 1

substantially lessens the risk that a bank will not detect potentially

serious problems. An external auditing program is a set of procedures

designed to test and evaluate high risk areas of a bank's business

which are performed by an independent auditor who may or may not be a

public accountant. The failure to detect and correct potentially

serious problems increases the risk a bank poses to the FDIC's

insurance funds. A strong internal auditing function establishes the

proper control environment and promotes accuracy and efficiency in a

bank's operations. An external auditing program complements this

function by providing an objective outside view of the bank's

operations.

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\1\ Terms defined in Appendix A are italicized the first time

they appear in this statement of policy.

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2. Regardless of the strength of a bank's internal auditing

procedures, the FDIC believes that an external auditing program should

be considered by a bank's board of directors as part of the cost of

operating a bank in a safe and sound manner. An external auditing

program assists the bank's board of directors in safeguarding assets

and identifying risks inherent in its operation. In addition, an

external auditing program may tend to assist directors in the event of

litigation on whether an institution's board has exercised reasonable

care in protecting the assets of the bank. Thus, the FDIC urges all

state nonmember banks to establish and maintain a sound external

auditing program.

3. In accordance with Section 36 of the Federal Deposit Insurance

Act, as implemented by 12 CFR Part 363, each insured depository

institution with $500 million or more in total assets at the beginning

of its fiscal year is required to file with the FDIC and the

appropriate federal banking agency, an annual report, including its

financial statements which have been audited by an independent public

accountant, and a management report and independent public accountant's

attestation concerning both the effectiveness of the institution's

internal controls for financial reporting and its compliance with

designated safety and soundness laws. In addition, each such

institution is required to have an audit committee consisting entirely

of outside directors who are independent of management. For state

nonmember banks subject to Section 36 and Part 363, these audit and

audit committee requirements take precedence over the provisions of

this Statement of Policy.

State Nonmember Banks Not Subject to Part 363

4. The FDIC strongly encourages the board of directors of each

state nonmember bank to establish an audit committee consisting, if

possible, entirely of outside directors. The audit committee or board

of directors of each state nonmember bank generally should analyze the

extent of the external auditing coverage needed by the bank annually.

They should determine whether the bank's needs will best be met by an

audit of its financial statements or by an acceptable alternative

(described in paragraphs 9 and 10 below). When selecting the scope of

the planned external auditing program for the year, the committee or

board should ensure that the program will provide sufficient

substantive external coverage of the bank's risk areas and any other

areas of potential concern, such as compliance with applicable laws and

regulations. If not, additional external auditing procedures conducted

by an independent auditor may be appropriate for a specific year or

several years to cover particularly high risk areas of the bank. The

decisions resulting from these deliberations should be recorded in the

committee's or board's minutes.

5. If the audit committee or board of directors of a bank, after

due consideration, determines not to engage an independent public

accountant to conduct an annual audit of the bank's financial

statements (or whose parent holding company's consolidated financial

statements are not audited), the reasons for the committee's or board's

conclusion to use one of the acceptable alternatives or to have no

external auditing program should be documented in its minutes. In the

evaluation, the committee or board generally should consider not only

the cost of an annual audit of the bank's financial statements, but

also the potential benefits.

6. A review of both a bank's internal and external auditing

programs has been and will continue to be a part of the FDIC's

examination procedures. FDIC examiners will review the nature of each

bank's external auditing program in conjunction with the risk areas

perceived in that particular bank's business and operations, and they

will exercise their judgment and discretion in evaluating the adequacy

of a bank's external auditing program. Examiners will not automatically

comment negatively to the board of directors of a bank with an

otherwise satisfactory external auditing program merely because it does

not engage an independent public accountant to perform an audit of its

financial statements.

Audit by an Independent Public Accountant

7. The FDIC strongly encourages each state nonmember bank to adopt

an external auditing program that includes an annual audit of its

financial statements by an independent public accountant. A bank that

does so would generally be considered to have a satisfactory external

auditing program. An external audit of a bank's financial statements

benefits management by assisting in the establishment of the accounting

and operating policies, internal controls, internal auditing programs,

and management information systems necessary to ensure the fair

presentation of these statements. An audit also assists boards of

directors in fulfilling their fiduciary responsibilities and provides

them greater assurance that financial reports are accurate and provide

adequate disclosure.

8. An audit of a bank's financial statements performed by the

independent public accountant as of a quarter-end date when the Reports

of Condition and Income are prepared is preferable and would permit the

bank to use the audited financial statements in the preparation and/or

subsequent review of those reports. A bank may also find it more cost

effective to be audited during accounting firms' less busy periods. The

independent public accountant chosen should be experienced in auditing

banks and

[[Page 32440]]

knowledgeable about banking regulations in order to provide the bank

with the most effective service.

Alternatives to an Audit by a Public Accountant

9. The FDIC recognizes that a bank's audit committee or board of

directors may determine that the external auditing program that will

best meet its individual needs for that particular year will be other

than an audit of its financial statements by an independent public

accountant. The committee or board, after a full review of alternative

and/or supplemental approaches for an adequate independent external

auditing program, may decide on a well-planned directors' examination,

an independent analysis of internal controls or other areas, a report

on the balance sheet, or specified auditing procedures by an

independent auditor. If the bank has an outside auditing firm that is

simply obtaining confirmations of deposits and loans, for example, the

committee or board should normally expand the scope of the auditing

work performed to include additional procedures to test the bank's high

risk areas.

10. Nonaccounting firms with bank auditing experience and expertise

that are independent of the bank are available in some geographic

locations. They may provide acceptable directors' examinations,

analyses, or specified auditing work at a reasonable cost. In some

instances, these firms' services include nonauditing work which enables

them to provide suggestions on compliance issues and operational

efficiencies. Depending upon the expertise of the firm and the scope of

the engagement, these nonaccounting firms may be an appropriate choice

for an external auditing program.

Newly Insured Banks

11. The FDIC believes that an adequate external auditing program

performed by an independent auditor should be an integral part of the

safe and sound management of a bank. Thus, applicants for deposit

insurance coverage will generally be expected to commit their bank to

obtain an audit of its financial statements by an independent public

accountant annually for at least the first five years after deposit

insurance coverage is granted.2 The FDIC may determine on a case-

by-case basis that an independent audit of financial statements is

unnecessary where an applicant can demonstrate that the benefits

derived from such an external audit will be substantially provided by

other outside sources, or where the applicant is owned by another

company and will undergo an audit performed by an independent public

accounting firm as part of an audit of the consolidated financial

statements of its parent company.

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\2\ Refer to the April 7, 1992, Statement of Policy on

Applications for Deposit Insurance.

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Notification and Submission of Reports

12. Whether currently or newly insured, the FDIC requests each

state nonmember bank that undergoes any external auditing work,

regardless of the scope of the work, to furnish a copy of any reports

by the public accountant or other external auditor, including any

management letters, to the appropriate FDIC regional office as soon as

possible after their receipt by the bank.

13. In addition, the FDIC requests each bank to promptly notify the

appropriate FDIC regional office when any public accountant or other

external auditor is initially engaged to perform external auditing

procedures and when a change in its accountant or auditor occurs.

Holding Company Subsidiaries

14. When the audit committee or board of directors of any state

nonmember bank owned by another company (such as a bank holding

company) considers its external auditing program, it may find it

appropriate to express the scope of its program in terms of the bank's

relationship to the consolidated group. No section of this statement of

policy is intended to imply that any state nonmember bank owned by

another company is expected to obtain a separate audit of the financial

statements of the individual bank. Where the state nonmember bank is

directly or indirectly included in the audit of the consolidated

financial statements of its parent company performed by an independent

public accounting firm, the state nonmember bank may send one copy of

the comparable reports by the public accountant or notification of the

change in accountants for the consolidated company to the appropriate

regional director. If several banks supervised by the same FDIC

regional office are owned by one parent company, a single copy of each

report applicable to the consolidated company may be submitted to the

regional office on behalf of all of the affiliated banks.

Troubled Banks

15. An annual independent external auditing program complements

both the FDIC's supervisory process and bank internal auditing programs

by further identifying or clarifying issues of potential concern or

exposure. It can also greatly aid management in taking corrective

action, particularly when weaknesses are detected in internal control

or management information systems. For these reasons, an annual audit

of bank financial statements performed by an independent public

accounting firm or, if more appropriate, specified auditing procedures

will be a condition of future enforcement actions, when deemed

necessary, or if it appears that any of the following conditions may

exist:

(a) Internal controls and internal auditing procedures are inadequate;

(b) The directorate is generally uninformed in the area of internal

controls;

(c) There is evidence of insider abuse;

(d) There are known or suspected defalcations;

(e) There is known or suspected criminal activity;

(f) It is probable that director liability for losses exists;

(g) Direct verification is warranted; and/or

(h) Questionable transactions with affiliates have occurred.

16. Such an enforcement action may also require that (a) The bank

provide to the appropriate FDIC regional office a copy of the auditor's

report and any management letter received from the auditor promptly

after the completion of any auditing work and that (b) the bank notify

the regional office in advance of the time and date of any meeting

between management and the auditor at which any auditing findings are

to be presented so that a representative of the FDIC may be present if

the FDIC so chooses.

Appendix A--Definitions

Audit. An examination of the financial statements, accounting

records, and other supporting evidence of a bank performed by an

independent certified or licensed public accountant in accordance with

generally accepted auditing standards and of sufficient scope to enable

the auditor to express an opinion on the bank's financial statements as

to their presentation in accordance with generally accepted accounting

principles (GAAP).

Audit Committee. A committee of the board of directors, consisting,

if possible, entirely of outside directors. To the extent possible,

members of the committee should be knowledgeable about accounting and

auditing. They should be responsible for reviewing and approving the

bank's internal and external auditing programs or

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recommending adoption of these programs to the full board. Both the

internal auditor and the external auditor should have unrestricted

access to the audit committee without the need for any prior management

knowledge or approval. Other duties of the audit committee should

include reviewing the independence of the external auditor annually,

being consulted by management when it seeks a second opinion on an

accounting issue, overseeing the quarterly regulatory reporting

process, and reporting its findings periodically to the full board of

directors.

Directors' Examination. A review by an independent third party that

has been authorized by the bank's board of directors and is performed

in accordance with the board's analysis of potential risk areas.

Certain procedures may also be required as a result of state law. A

directors' examination consisting solely of such procedures as cash

counts and confirmations of loans and deposits would not normally be

considered a well-planned directors' examination. (Sometimes directors'

examinations are similar to so-called ``engagement audits'' or

``operational audits.'' Nevertheless, no widely accepted national

standards exist for the specific procedures that must be performed in

directors' examinations or these ``audits.'')

External Auditing Program. The performance of procedures to test

and evaluate high risk areas of a bank's business by an independent

auditor, who may or may not be a public accountant, sufficient for the

auditor to be able to express an opinion on the financial statements or

to report on the results of the procedures performed.

Financial Statements. The statements of financial position, income,

cash flows, and changes in shareholders equity together with related

notes.

Independent. No certified public accountant, public accountant, or

other auditor will be recognized as independent who is not in fact

independent. (Reference is made to Sec. 335.604 of the FDIC rules and

regulations for the complete definition of the term ``independent.'')

Outside Directors. Members of a bank's board of directors who are

not officers, employees, or principal stockholders of the bank, its

subsidiaries, or its affiliates, and do not have any material business

dealings with the bank, its subsidiaries, or its affiliates.

Public Accountant. A certified public accountant or licensed public

accountant who is duly registered and in good standing as such under

the laws of the place of his/her residence or principal office, who is

licensed by the accounting regulatory authority of his/her state, and

who possesses a permit to practice public accountancy.

Report on the Balance Sheet. An examination of the balance sheet,

accounting records, and other supporting evidence performed by an

independent certified or licensed public accountant in accordance with

generally accepted auditing standards.

Risk Areas. The risk areas are those particular activities of a

specific bank that expose the bank to potential losses if problems were

to exist and go undetected. The highest risk areas in banks generally

include, but are not necessarily limited to, the valuation of

collectibility of loans (including the reasonableness of the allowance

for loan losses), investments, and repossessed and foreclosed

collateral; internal controls; and insider transactions.

By order of the Board of Directors.

Dated at Washington, D.C. this 17th day of June, 1996.

Federal Deposit Insurance Corporation.

Robert E. Feldman,

Deputy Executive Secretary.

[FR Doc. 96-16047 Filed 6-21-96; 8:45 am]

BILLING CODE 6714-01-P