Final answer:
An auditor evaluates a company's loan loss reserve during the phase of auditing business processes and related accounts. This is crucial for determining if the bank has sufficiently planned for potential loan defaults and ensuring the loan loss reserve accurately reflects the loan portfolio's riskiness.
Step-by-step explanation:
An auditor's evaluation of the reasonableness of a company's loan loss reserve would typically occur during the phase of the audit that involves auditing business processes and related accounts. This aspect of the audit focuses on understanding and testing the company's internal controls related to financial reporting. It is during this phase that the auditor examines the methodologies and assumptions used by the company to estimate its loan loss reserves.
Banks must plan for the event that a portion of their borrowers will fail to repay their loans. In times of economic uncertainty, such as a recession, the risk of loan defaults increases, making the evaluation of loan loss reserves even more critical. A bank expects a certain number of loan defaults and includes this in its yearly expenses. If the actual number of defaults is higher than predicted, it can dramatically affect the bank's financial stability.
For instance, if the 'Safe and Secure Bank' anticipated loan defaults within a manageable threshold but actually faced a surge in defaults that reduced its loan values from $5 million to $3 million, this would result in a substantial reduction in assets and could push the bank into a negative net worth position. The auditor's role is to assess if the bank has adequately calculated its loan loss reserve and if it reflects the true level of riskiness of the loan portfolio. This is essential for fair and accurate financial reporting, providing reliable information to stakeholders.