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Audit Example Case

In: Business and Management

Submitted By oriole1612
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Case Study: Lincoln Savings and Loan Association In 1978, Charles Keating, Jr. began focusing his time and energy on his business endeavours when he founded the real estate firm, American Continental Corporation (ACC). Six years later, ACC acquired Lincoln Savings and Loan Association, which was headquartered in Phoenix, although its principal operations were in California. In his application to purchase Lincoln, Keating pledged to regulatory authorities that he would retain the Lincoln management team, that he would not use brokered deposits to expand the size of the savings and loan, and that residential home loans would remain Lincoln's principal line of business. After gaining control of Lincoln, Keating replaced the management team; began accepting large deposits from money brokers, which allowed him to nearly triple the size of the savings and loan in two years; and shifted the focus of Lincoln's lending activity from residential mortgage loans to land development projects. On 14 April 1989, the Federal Home Loan Bank Board (FFILBB) seized control of Lincoln Savings and Loan, alleging that Lincoln was dissipating its assets by operating in an unsafe and unsound manner. On that date, Lincoln's balance sheet reported total assets of $5.3 billion, only 2.3 percent of which were investments in residential mortgage loans. Nearly two-thirds of Lincoln's asset portfolio was invested directly or indirectly in high-risk land ventures and other commercial development projects. At the time, federal authorities estimated that the closure of Lincoln Savings and Loan would cost U.S. taxpayers at least $2.5 billion. Congressional hearings into the collapse of Lincoln Savings and Loan initially focused on the methods Keating used to circumvent banking laws and on disclosures that five U.S. senators intervened on Keating's behalf with federal banking regulators. Eventually, the hearings centred on the failure of Lincoln's independent auditors to expose fraudulent real estate transactions that allowed the savings and loan to report millions of dollars of non-existent profits. In summarising the Lincoln debacle, U.S. Representative Jim Leach laid the blame for the costly savings and loan failure on a number of parties, including Lincoln's auditors and the accounting profession as a whole: I am stunned. As I look at these transactions, I am stunned at the conclusions of on independent auditing firm. I am stunned at the result. And let me just tell you, I think that this whole circumstance of a potential $2.5 billion cost to the United States taxpayers is a scandal for the United States Congress. It is a scandal for the Texas and California legislatures. It is a scandal for the Reagan administration regulators. And it is a scandal for the accounting profession.1

This and all subsequent quotations, unless indicated otherwise, were taken from the following source: U.S. Congress, House, Committee on Banking, Finance and Urban Affairs; Investigation of Lincoln Savings and Loan Association, Part 4 (Washington, DC: U.S. Government Printing Office, 1990).

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Creative Accounting, Influence Peddling, and Other Abuses at Lincoln Savings and Loan Representative Henry Gonzalez, chairman of the U.S. House Committee on Banking, Finance, and Urban Affairs, charged that over the five years Charles Keating owned Lincoln, he employed accounting schemes to divert the savings and loan's federally insured deposits into ACC's treasury. Keating was aware that he would be permitted to withdraw funds from Lincoln and invest them in ACC or use them for other purposes only to the extent that Lincoln reported after-tax profits. Consequently, he and his associates wove together complex real estate transactions involving Lincoln, ACC, and related third parties to manufacture paper profits for Lincoln. Kenneth Leventhal & Company, an accounting firm retained by regulatory authorities to analyze and report on Lincoln's accounting practices, used a few simple examples to explain the saving and loan's fraudulent schemes. One of the most scrutinized of Lincoln's multimillion-dollar real estate deals was the large Hidden Valley transaction that took place in the spring of 1987. On 30 March 1987, Lincoln loaned $19.6 million to E. C. Garcia & Company. On that same day, Ernie Garcia, a close friend of Keating and the owner of the land development company bearing his name, extended a $3.5 million loan to Wescon, a mortgage real estate concern owned by Garcia's friend, Fernando Acosta. The following day, Wescon purchased 1,000 acres of unimproved desert land in central Arizona from Lincoln for $14 million, nearly twice the value established for the land by an independent appraiser one week earlier. Acosta used the loan from Garcia as the down payment on the tract of land and signed a nonrecourse note for the balance. Lincoln recorded a profit of $11.1 million on the transaction—profit that was never realized, since the savings and loan never received payment on the nonrecourse note. In fact, Lincoln never expected to be paid the balance of the nonrecourse note. Lincoln executives arranged the loan simply to allow the savings and loan to book a large paper gain. Garcia later testified that he agreed to become involved in the deceptive Hidden Valley transaction only because he wanted the $19.6 million loan from Lincoln. 2 Recognising a profit on the Hidden Valley transaction would have openly violated financial accounting standards if Garcia had acquired the property directly from Lincoln and used for his down payment funds loaned to him by the savings and loan.

K. Kerwin and C. Yang, “Everything Was Fine Until I Met Charlie: The Rise and Stumble of Whiz Kid and Keating Crony Ernie Garcia,” Business Week, 12 March 1990, 44, 46.

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Fernando Acosta eventually admitted that his company, Wescon, which prior to the Hidden Valley transaction had total assets of $87,000 and a net worth of $30,000, was only a "straw buyer" of the Hidden Valley property. In a Los Angeles Times article, Acosta reported that Wescon "was too small to buy the property and that he signed the documents without reading them to help his friend, Ernie Garcia.” 3 In a letter a worried Acosta wrote to Garcia in 1988 regarding the Hidden Valley transaction, Acosta encouraged Garcia to assume title to the property so that he could take it off Wescon's books. Keating and his associates repeatedly used bogus real estate transactions, such as the Hidden Valley charade, to produce enormous gains for Lincoln. In 1986 and 1987 alone, Lincoln recognised more than $135 million of profits on such transactions. That amount represented more than one-half of the savings and loan's total reported profits for the two-year period. The gains recorded by Lincoln on its real estate transactions allowed ACC to withdraw huge sums of cash from the savings and loan in the form of intercompany dividend payments, funds that were actually federally insured deposits. When the "purchasers" of these tracts of land defaulted on their nonrecourse notes, Lincoln was forced to recognise losses—losses that the savings and loan offset with additional "profitable" real estate transactions. This recurring cycle of events ensured that Lincoln would eventually fail. However, since the Federal Savings and Loan Insurance Corporation (FSLIC) guaranteed Lincoln's liabilities (that is, its deposits), and since ACC had little equity capital invested in Lincoln, Keating was not overly concerned by the inevitable demise of his company's savings and loan subsidiary. Lincoln's complex and false real estate transactions appalled members of Representative Gonzalez's congressional committee. One of the Leventhal partners who testified before the congressional committee provided the following overview of his firm's report on Lincoln's accounting schemes: Seldom in our experience have we encountered a more egregious example of misapplication of generally accepted accounting principles. This association [Lincoln] was made to function as an engine, designed to funnel insured deposits to its parent in tax allocation payments and dividends. To do this, it had to generate reportable earnings. It created profits by making loans. Many of these loans were bad. Lincoln was manufacturing profits by giving money away.

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J. Garnelli, “Firm Says It Was a ‘Straw Man’ in Lincoln Deal,” Los Angeles Times, 3 January 1990, D1, D13.

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Critics chastised Charles Keating not only for employing creative accounting methods but for several other abusive practices as well. In 1979, Keating signed a consent decree with the Securities and Exchange Commission (SEC) to settle conflict of interest charges the agency had filed against him. In 1985, Keating handpicked his 24-year-old son, Charles Keating III, to serve as Lincoln's president. Along with the impressive job title came an annual salary of $1 million. At the time, the young man's only prior work experience was as a waiter in a country club restaurant. Years later, the younger Keating testified that he did not understand many of the transactions he signed off on as Lincoln's president. The elder Keating's gaudy lifestyle and grand spending habits were legendary. U.S. taxpayers absorbed many of the outrageous expenses rung up by Keating since he pawned them off as business expenses of Lincoln. The bill for a 1987 dinner Keating hosted at an upscale Washington, D.C., restaurant came to just slightly less than $2,500. One of the guests at that dinner was a former SEC commissioner. In another incident, after inadvertently scuffing a secretary's $30 shoes, Keating wrote her a check for $5,000 to replace them—and the rest of her wardrobe as well, apparently. Other Keating excesses documented by federal and state investigators included safaris, vacations in European castles, numerous trips to the south of France, and lavish parties for relatives and government officials. The most serious charges levelled at Keating involved allegations of influence peddling. Keating contributed heavily to the election campaigns of five prominent senators, including John Glenn of Ohio and John McCain of Arizona. These five senators, who became known as the Keating Five, met with federal banking regulators and lobbied for favourable treatment of Lincoln Savings and Loan. The key issue in these lobbying efforts was the so-called direct investment rule adopted by the FHLBB in 1985. This rule limited the amount that savings and loans could invest directly in subsidiaries, development projects, and other commercial ventures to 10 percent of their total assets. Because such investments were central to Lincoln's operations, the direct investment rule imposed severe restrictions on Keating—restrictions that he repeatedly ignored. In 1986, a close associate of Keating's was appointed to fill an unexpired term on the FHLBB. Following his appointment, this individual proposed an amendment to the direct investment rule that would have exempted Lincoln from its requirements. The amendment failed to be seconded and thus was never adopted. Shortly before Alan Greenspan was appointed to the powerful position of chairman of the Federal Reserve Board, Keating retained him to represent Lincoln before the FHLBB. In a legal brief submitted to the FHLBB, Greenspan reported that Lincoln's management team was "seasoned and expert" and that the savings and loan was a "financially strong" institution. Congressional testimony also disclosed that Keating loaned $250,000, with very favourable payback terms, to a former SEC commissioner, who then lobbied the SEC on Lincoln's behalf.

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The charges of influence peddling failed to concern or distract Keating. In responding to these charges, Keating made the following remarks during a press conference: "One question, among the many raised in recent weeks, has to do with whether my financial support in any way influenced several political figures to take up my cause. I want to say in the most forceful way I can: I certainly hope so.”4 Federal authorities eventually indicted Keating on various racketeering and securities fraud charges. He was also sued by the Resolution Trust Corporation, the federal agency created to manage the massive savings and loan crisis that threatened the integrity of the nation's banking system during the 1980s. That agency charged Keating with insider dealing, illegal loans, sham real estate and tax transactions, and the fraudulent sale of Lincoln securities. Audit History of Lincoln Savings and Loan Arthur Andersen served as Lincoln's independent auditor until 1985 when it resigned "to lessen its exposure to liability from savings and loan audits.” according to a New York Times article.5 That same article described the very competitive nature of the Phoenix audit market during the mid-1980s when Lincoln was seeking a replacement auditor. Because of the large size of the Lincoln audit, several audit firms pursued the engagement, including Arthur Young & Company. 6 From 1978 through 1984, Arthur Young suffered a net loss of 63 clients nationwide.7 Over the next five years, an intense marketing effort produced a net increase of more than 100 audit clients for the firm. During the 1980s, critics of the accounting profession suggested that the extremely competitive audit market induced many audit firms to accept high-risk clients, such as Lincoln, in exchange for large audit fees. The savings industry crisis has revived questions repeatedly raised in the past about the profession's independence in auditing big corporate clients: whether the accounts need more controls and whether some firms are willing to sanction questionable financial statements in exchange for high fees, a practice called "bottom fishing."8

D. J. Jefferson,"Keating of American Continental Corp. Comes Out Fighting," The Wall Street Journal, 18 April 1989, B2 5 E. N. Berg,"The Lapses by Lincoln's Auditors:' The New York Times, 28 December 1989, D1, D6.
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Arthur Andersen and, subsequently, Arthur Young audited both ACC and Lincoln, a wholly owned subsidiary of ACC. However, the Lincoln audit was much more complex and required much more time to 7complete than the ACC audit. Reportedly, the ACC/Lincoln audit accounted for one-fifth of the annual audit revenues of Arthur Young's Phoenix office during 1986 and 1987. L. Berton, "Spotlight on ArthurYoung Is Likely to Intensify as Lincoln Hearings Resume': The Wall Street Journal, 21 November 1989,A20. N.C. Nash, "Auditors of Lincoln On the Spot' The New York Times,14 November 1989, D1, D19.

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Before pursuing Lincoln as an audit client, Jack Atchison, an Arthur Young partner in Phoenix, contacted the former Lincoln engagement partner at Arthur Andersen. The Arthur Andersen partner told Atchison that he had no reason to question the integrity of Lincoln's management and that no major disagreements preceded the resignation of his firm as Lincoln's auditor. At the time of Arthur Andersen's resignation, Lincoln was undergoing an intensive examination by FHLBB auditors, who were raising serious questions regarding Lincoln's financial records. Arthur Young was not informed of this investigation by Arthur Andersen. Years later, Arthur Andersen partners denied that they were aware of the examination when they resigned from the audit. Shortly after accepting Lincoln as an audit client, Arthur Young learned of the FHLBB audit. Among the most serious charges of the FHLBB auditors was that Lincoln had provided interest-free loans to ACC – a violation of federal banking laws – and had falsified loan documents. Three years later, officials from the Office of Thrift Supervision testified before Congress that Arthur Andersen and Lincoln employees had engaged in so-called file-stuffing. These charges resulted in formal inquiries by the Federal Bureau of Investigation and the U.S. Department of Justice.9 Arthur Andersen officials denied involvement in any illegal activities but did acknowledge that employees of their firm had worked "under the direction of client [Lincoln] personnel to assist them in organising certain [loan] files.” 10 Later, a representative of Lincoln admitted that "memorialization" had been used for certain loan files. Congressional testimony of several Arthur Young representatives revealed that the 1986 and 1987 Lincoln audits were very complex engagements. William Gladstone, the comanaging partner of Ernst & Young (the firm formed by the 1989 merger of Ernst & Whinney and Arthur Young), testified that the 1987 audit required 30,000 hours to complete. Despite concerns being raised by regulatory authorities, Arthur Young issued an unqualified opinion on Lincoln's financial statements in both 1986 and 1987. Critics contend that these clean opinions allowed Lincoln to continue engaging in illicit activities. Of particular concern to congressional investigators was that during this time Keating and his associates sold ACC's high-yield "junk" bonds in the lobbies of Lincoln's numerous branches. The sale of these bonds, which were destined to become totally worthless, raised more than $250 million for ACC. The marketing campaign for the bonds targeted retired individuals, many of whom believed that the bonds were federally insured since they were being sold on the premises of a savings and loan.

P Thomas and B. Jackson, "Regulators Cite Delays and Phone Bugs in Examination, Seizure of Lincoln S & L' The Wall Street Journal, 27 October 1989, A4; Berg, "The Lapses by Lincoln's Auditors!'
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Thomas and Jackson, "Regulators Cite Delays and Phone Bugs:'

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Following the completion of the 1987 Lincoln audit, the engagement audit partner, Jack Atchison, resigned from Arthur Young and accepted a position with ACC. Gladstone later testified that Atchison earned approximately $225,000 annually as an Arthur Young partner before his resignation. ACC records revealed that Atchison's new position came with an annual salary of approximately $930,000. The close relationship that Atchison developed with Keating before resigning from Arthur Young alarmed congressional investigators. Testimony before the congressional committee disclosed that Atchison, while he was serving as the engagement partner on the Lincoln audit, wrote several letters to banking regulators and U.S. senators vigorously supporting the activities of Keating and Lincoln. “Atchison seemed to drop the auditor's traditional stance of independence by repeatedly defending the practices of Lincoln and its corporate parent to Congress and federal regulators.... Since when does the outside accountant – the public watchdog – become a proponent of the client's affairs?"11 During the summer of 1988, the relationship between Lincoln's executives and the Arthur Young audit team gradually soured. Janice Vincent, who became the Lincoln engagement partner following Atchison's resignation, testified that disagreements arose with client management that summer over the accounting treatment applied to several large real estate transactions. The most serious disagreement involved a proposed exchange of assets between Lincoln and another corporation – a transaction for which Lincoln intended to record a $50 million profit. Lincoln management insisted that the exchange involved dissimilar assets. Vincent, on the other hand, stubbornly maintained that the transaction involved the exchange of similar assets and, consequently, that the gain on the transaction could not be recognised. During the congressional hearings, Vincent described how this dispute and related disputes eventually led to the resignation of Arthur Young as Lincoln's auditor. These disagreements created an adversarial relationship between members of Arthur Young's audit team and American Continental officials, which resulted in Mr. Keating requesting a meeting with Bill Gladstone. . . . While in New York at that meeting, Mr. Keating turned to me at one point and said, "Lady, you have just lost a job." That did not happen. Rather, he had lost an accounting firm. Following Arthur Young's resignation in October 1988, Keating retained Touche Ross to audit Lincoln's 1988 financial statements. Touche Ross became entangled, along with Arthur Andersen and Arthur Young, in the web of litigation following Lincoln's collapse. Purchasers of the ACC bonds sold in Lincoln's branches named Touche Ross as a defendant in a large class-action lawsuit. The suit alleged that had Touche Ross not accepted Lincoln as an audit client, ACC's ability to sell the bonds would have been diminished significantly.

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Berg,"The Lapses by Lincoln's Auditors."

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Criticism of Arthur Young Following Lincoln's Collapse Both Arthur Young and its successor, Ernst & Young, were criticised for the former's role in the Lincoln Savings and Loan debacle. One of the most common criticisms was that Arthur Young readily accepted questionable documentary evidence provided by Lincoln employees to corroborate the savings and loan's real estate transactions. During the congressional hearings into the collapse of Lincoln, William Gladstone commented on the appraisals that Arthur Young obtained to support those transactions. All appraisals of land [owned by Lincoln] were done by appraisers hired by the company, and we had to rely on them.” Certainly, these appraisals were relevant evidence to be used in auditing Lincoln's real estate transactions. However, appraisals obtained by Arthur Young from independent third parties would have been just as relevant and less subject to bias.12 The most stinging criticism of Arthur Young during the congressional hearings was triggered by the report prepared by Kenneth Leventhal & Company on Lincoln's accounting decisions for its major real estate transactions. Although the Leventhal report served as the basis for much of the criticism directed at Arthur Young, the report did not mention Arthur Young or, in any way, explicitly criticise its Lincoln audits. Nevertheless, since Arthur Young had issued unqualified opinions on Lincoln's financial statements, many parties, including Ernst &Young officials, regarded the Leventhal report as an indictment of the quality of Arthur Young's audits. The key finding of the Leventhal report was that Lincoln had repeatedly violated the substance-over-form concept by engaging in "accounting-driven" deals among related parties to manufacture illusory profits. Ernst &Young representatives contested this conclusion by pointing out that Leventhal reviewed only 15 of the hundreds of real estate transactions that Lincoln engaged in during Arthur Young's tenure. The Ernst & Young representatives were particularly upset that, based upon a review of those 15 transactions; Leventhal implied that none of Lincoln's major real estate transactions were accounted for properly. In Leventhal's defence, a congressman noted that the 15 transactions in question were all very large and, collectively, accounted for one-half of Lincoln's pre-tax profits during 1986 and 1987.

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Quite possibly, Arthur Young did obtain independent appraisals in certain cases, although Gladstone's testimony suggests otherwise.

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What happen afterwards? The estimated losses linked to the demise of Lincoln Savings and Loan eventually rose to $3.4 billion, making it the most costly savings and loan failure in U.S. history. In March 1991, after posting huge losses – approximately $1 billion in 1989 alone – most of Lincoln's remaining assets were sold to another financial institution by the Resolution Trust Corporation, which had been operating the savings and loan for more than one year. One month later, Lincoln's parent company ACC, filed for protection from its creditors under the federal bankruptcy laws. In late 1992, Ernst & Young paid $400 million to settle four lawsuits filed against it by the federal government. These lawsuits charged Ernst & Young with substandard audits of four savings and loans, including Lincoln Savings and Loan. In a similar settlement reported in 1993, Arthur Andersen paid $85 million to the federal government to settle lawsuits that charged the firm with shoddy audits of five savings and loans, including Lincoln. Finally, although Touche Ross served as Lincoln's auditor for only five months, that firm's successor, Deloitte & Touche, paid nearly $8 million to the federal government to settle charges filed against it for its role in the Lincoln debacle. In April 1991, Ernst &Young agreed to pay the California State Board of Accountancy $1.5 million to settle negligence complaints that the state agency filed against the firm for Arthur Young's audits of Lincoln. An Ernst & Young spokesman noted that the accounting firm agreed to the settlement to "avoid protracted and costly litigation" and insisted that the settlement did not involve the "admission of any fault by the firm or any partner.”13 In August 1994, Arthur Andersen agreed to pay $1.7 million to the California State Board of Accountancy for its alleged negligence in auditing Lincoln. Andersen personnel were also required to perform 10,000 hours of community service. Like Ernst & Young, Andersen denied any wrongdoing when its settlement with the California State Board was announced. In October 1990, Ernie Garcia pleaded guilty to fraud for his involvement in the Hidden Valley real estate transaction. His plea bargain agreement with federal prosecutors required him to assist them in their investigation of Charles Keating, Jr. In March 1991, the Lincoln executive who oversaw the sale of ACC's junk bonds through Lincoln's branches pleaded guilty to eight state and federal fraud charges that he had misled the investors who purchased those bonds. Two years later, Charles Keating III was sentenced to eight years in prison after being convicted of fraud and conspiracy charges.

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"E &Y Pays $1.5M in Lincoln Failure:' Accounting Today,13 May 1991,1,25

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In a California jury trial presided over by Judge Lance Ito, Charles Keating, Jr., was convicted in 1991 on 17 counts of securities fraud for his role in marketing ACC's junk bonds. While serving a 10-year prison term for that conviction, Keating was convicted of similar fraud charges in a federal court and sentenced to an additional 12 years in prison. In April 1996, a federal appeals court overturned Keating's 1991 conviction. The appellate court ruled that Judge Lance Ito had given improper instructions to the jurors who found Keating guilty of securities fraud. Several months later, a U.S. District judge overturned Keating's federal conviction on fraud charges. The judge ruled that several jurors in the federal trial had been aware of Keating's 1991 conviction. According to the judge, that knowledge had likely prejudiced the federal jury in favor of convicting Keating. For the same reason, the judge overturned the 1993 conviction of Charles Keating III. With both of his convictions overturned, Charles Keating was released from federal prison in December 1996 after serving four and one-half years. In January 1999, federal prosecutors announced that they would retry the 75year-old Keating on various fraud charges. Three months later, the federal prosecutors and Keating reached an agreement, an agreement that gave both parties what they wanted most. In federal court, Keating admitted for the first time that he had committed various fraudulent acts while serving as ACC's chief executive. In return, Keating was sentenced to the time he had already served in prison. Even more important to Keating, his plea bargain arrangement required federal prosecutors to drop all charges still outstanding against his son, Charles Keating III.14

(Adapted from Knapp, Michael C. (2009) Auditing Cases, 7th Edition. South Western: Canada)

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In November 2000, California state prosecutors announced that they would not retry Charles Keating

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