Case 1.

5
Lincoln Savings and Loan Association

Prepared by:
Alexa Rodriguez

for
Professor C.E. Reese
in partial fulfillment of the requirements for
ACC502-- Advanced Auditing
College of Business/Graduate Studies
St. Thomas University
Miami Gardens, Fla

Term SP2/Spring, 2020

March 31, 2020

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 Table of Content
Issues 3
Facts 5
Analysis/Authority 7
Conclusions/Recommendations 14
References 17

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Issues:
1.
What is the substance over from concept and what does it require? Is the firm’s independent
auditors or the financial accountants responsible for making sure it is complied with? What can
auditors do when the substance over form rule has been violated?
2.
Why would the acceptance of a large, high risk audit client for high fees potentially threaten the
audit firm’s independence? When should those clients be avoided?
3.
What extra measures must be taken by the audit firm when the company has significant related
party transactions? How can they determine that the transactions are recorded correctly?
4.
What is a control environment and what weaknesses were present in Lincoln’s control
environment?
5.
Why is it important that Lincoln received nonrecourse notes instead id recourse notes as form
of payment for many properties sold?
6.
According to SAS No. 31 “Evidential Matter” what are the five key management assertions
related to financial statements? Which of these assertions should Arthur Young have
substantiated for the Hidden Lake Valley transaction? What procedures should have been
performed and what evidence should have been gathered?
7.
Is it acceptable that a former independent auditor join a client’s company? And if they do,
should they be involved in the next audit for the company?
8.
Does the AICPA mention the professional conduct to be maintained by CPA firms? Were there
any instances where either Ernst & Young or Kenneth Leventhal & Company acted
unprofessionally in regards to these standards?
9.

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IS an auditor responsible for uncovering fraud committed by the client’s management? What
factors in this case alleviate that responsibility and which compound it in relation to this Lincoln
case?

4
Facts:
In 1978, Charles Keating, Jr. founded American Continental Corporation (ACC) and a few

years later acquired Lincoln Savings and Loan Association; in 1989 the Federal Home Loan Bank

Board seized control of the company for operating unsafely. Keating was involved in multiple

schemes like the Hidden Valley transaction in which Lincoln loaned $19.6 million to Garcia,

Garcia loaned $3.5 million to Wescon who purchased land from Lincoln at $14 million, even

though it was worth much less, allowing Lincoln to record a profit of $11.1 million. There were

several other false real estate transactions resulting in over $135 million of false profits.

Keating also was frivolous in his spending and would expense those extravagant costs through

the company; he was also accused of influence peddling, where he would financially contribute

to campaigns for senators who would help pass the direct investment rule. He also loaned a

former SEC commissioner $250,000, whom ended up lobbying on his behalf with the SEC.

Eventually, Keating was charged for insider dealings, illegal loans, sham real estate and tax

transactions and fraudulent sales of Lincoln securities.

Arthur Anderson was in charge of Lincoln’s audits for years until 1985; Arthur Young

became the next audit firm for Lincoln even though it was being investigated by the FHLBB

because it was not informed. It is believed that due to a competitive audit market, audit firms

may have been willing to take on high risk clients in exchange for larger audit fees; some firms

even engaged in bottom fishing, which means sanctioning questionable financial statements for

higher fees. Arthur Young issued unqualified opinions for Lincoln perpetuating its illegal

activities of selling junk bonds, especially to retired individuals. In 1987, one of the auditors

from Arthur Young resigned and began working at ACC, and worse yet was actively involved in

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the following audits. Arthur Young failed to perform sufficient tests, readily accepted evidence

presented directly by Lincoln, and when under investigation was reluctant to submit

documents.

After Arthur Young resigned, Touche Ross became Lincoln’s auditor. Once the SEC

began examining Lincoln’s financial situation, Kenneth Leventhal & Co was hired to perform a

detailed investigation; they discovered that Lincoln violated the substance over from concept.

They looked at 15 major real estate transactions and found that none were accounted for

correctly. Unfortunately, many people suffered the effects of this corrupt scheme, and there

was an estimated loss of $3.4 billion. Arthur Anderson paid $85 million, Arthur Young paid

$400 million, and Touche Ross paid $8 million in settlements regarding the Lincoln case.

Charles Keating was sentenced to a 10-year sentence and an additional 12 years, of which he

only served 4 and a half as he agreed to admit his guilt in exchange for a lesser sentence and so

the charges against his son would be dropped.

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Analysis:
1.

According to Bragg, the substance over form concept means that financial statements should

reflect the underlying reality of the accounting records (Bragg, 2018). Information in the

accounting system should not just comply with legal form, but rather the true intent of the

transaction should be considered; transactions should not be entered to hide facts or mislead

readers (Bragg, 2018). Because the substance over form concept is vital for the accurate

preparation of fair and true financial statements, it becomes the responsibility of financial

accountants to ensure that the client is complying with the concept (Substance Over Form).

Accountants need to measure and present the economic impact of a transaction instead of just

representing its legal form; this is key in the financial statement analysis (Substance Over Form).

If the auditors determine that the substance over form concept has been violated by the client,

they need to perform sufficient test to decide whether or not the violation results in a material

misstatement; if it does, they can issue a qualified opinion.

2.

Accepting high risk audit clients for high audit fees can be considered a breach of the auditor

independence agreement because it can create an incentive to issue an unqualified opinion in a

situation where the client does not merit it. Any kind of relationship that could call into

question the auditor’s independence should be either avoided or brough to the audit

committee of the company for approval or the relationship should eb disclosed in the audit

report (Audit Committees and Auditor Independence). These high-risk types of clients should

be avoided altogether if they are willing to pay contingent fees, which is a prohibited

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relationship according to the SEC (Audit Committees and Auditor Independence). When a client

offers contingent fees, they are willing to pay the firm more money if they sanction

questionable financial statements, which means the audit report is unreliable and could cost

people for investing in a company that is worse off than admitted (Audit Committees and

Auditor Independence).

3.

When an auditor determines that the client has significant related party transactions extensive

testing and evidence should be gathered to make sure that the client is recording these

transactions correctly. Auditors must obtain a detailed understanding of the company’s

processes in recording such transactions, they must make inquiries, and communicate with

other auditors (Auditing Standard No. 18). In understanding how the client handles related

party transactions, auditors must decipher how they identify these related parties, how the

transactions are authorized and approved, and how they are accounted for (Auditing Standard

No. 18). When performing inquiries, the auditors should look to management to get certain

information, but they should also speak with others in the company about their knowledge on

these transactions (Auditing Standard No. 18). Also, the auditors should ask the audit

committee about its understanding of these relationships and see if they have any concerns

(Auditing Standard No. 18). Lastly, communicating any party related transactions to other

auditors or team members is important to help with identifying any potential risk of material

misstatement (Auditing Standard No. 18).

4.

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A company’s control environment is the foundation on which effective systems of internal

controls are creates; the goal of the control environment is to achieve the company’s

objectives, provide reliable financial reporting, operate efficiently and effectively, comply with

the laws and regulations, and safeguard assets (Clarke, 2020). The control environment can be

made up of many different aspects like the organizational structure, the company’s processes,

policies and standards, and the company’s culture and attitude (Clarke, 2020). There are

several elements to maintaining a good control environment like demonstrating a commitment

to uphold ethical values like integrity, maintaining independence of the board of directors and

management, establishing organizational structure, maintaining competent employees, and

creating accounting procedures that help enforce the internal control responsibilities (Clarke,

2020). Control environment is one of the five components of maintaining good internal control

along with risk assessment, control activities, information and communication, and monitoring

activities (Clarke, 2020).

Lincoln’s control environment was weak to start because of Keating’s frivolous spending and

lobbying schemes; if upper level management does not care about setting a good tone and

emphasizing the importance of internal controls, it is difficult to get the rest of the company to

adhere to such policies. With a leader that clearly had no regard to uphold ethical values,

Lincoln also lacked the direction needed to create organizational structure and policies; this was

evident as it was able to enter multiple bogus real estate transactions.

5.

According to the IRS a recourse debt means the borrower is personally liable, whereas a

nonrecourse debt means the borrower is not personally liable (Recourse vs. Nonrecourse Debt).

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If a borrower on a recourse debt fails to pay the lender can collect whatever debt is owed even

after they have taken collateral; however, if the borrower had a nonrecourse debt, then the

lender cannot pursue anything else other than collateral (Recourse vs. Nonrecourse Debt).

Nonrecourse loans therefore put more financial responsibility on the lender and pose a greater

risk, which is why they can charge higher interest rates (Kagan, 2020). While Lincoln may have

made more money on these high-risk loans due to the interest rate charges, they were also

setting themselves up for failure by having so many of these loans because if borrowers

defaulted, they lost a lot of their money since they could not recover it from the borrower.

6.

The five major management assertions according to SAS No. 31 “Evidential Matter” includes:

existence or occurrence, completeness, right and obligations, valuation or allocation, and

presentation and disclosure (AU 326 Evidential Matter). The Hidden Valley transaction in which

Lincoln inappropriately recorded a profit of $11.1 million on a fake and complex real estate

transactions should have been investigated further by Arthur Young auditors. The auditors

should have attempted to prove that the existence, rights, and valuation assertions were

present for this transaction. Clearly, the Hidden Valley transaction lacked existence as it was

not really a valid sale, which goes hand in hand with the rights assertion. They had no right to

record that sale and recognize revenue, and finally the valuation on the sale was incorrect.

Considering all the false transactions created by Lincoln, the auditors should have been able to

pick up on them if they were performing sufficient audit tests. Some of the additional audit

procedures to test for accurate sales recorded can include testing the internal controls (Mohr,

2019). Auditors can review whether the sales invoices are sequentially ordered, if proper

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purchase order authorization has occurred, and if authorization for receivable write offs is

occurring as well (Mohr, 2019). While Lincoln forged most of these documents, the auditors

should have been able to recognize the forgery based on the signatures of the packing slips,

which both belonged to Lincoln employees. The auditors can also test the accounts receivable

balances by sending letters of confirmation to customers (Mohr, 2019). Another method of

determining whether sales reported are correct is looking at the general ledger and comparing

it to the accounts receivable ledger; auditors should be looking for any discrepancies amongst

the two ledgers, which in the case of Lincoln were found (Mohr, 2019). Tests seemed to have

been done properly, but once the evidence was found there was no follow through and

resolution for the problems; the audit firm just issued an unqualified opinion regardless.

7.

Audit clients can have close relationships with clients, but the lines can get a bit blurred and it

can call into questions the audit firm independence and therefore the accuracy of their report.

According to the SEC if the auditor is placed in a position where they might become an

advocate of the audit client, then the independence is impaired (Audit Committees and Auditor

Independence). While there is no way to know for sure whether Atchison was close enough to

Keating that he would advocate for him, the fact that he then went to work for him, definitely

raises a red flag about the former audit reports reliability. The audit committee should have

investigated further to decide whether the audit firm’s independence was impaired (Audit

Committees and Auditor Independence).

After Atchison joined ACC, he should not have been involved in the audits of Lincoln and ACC as

it calls into questions the independence of the audit per the PCAOB standards (ET Section 101-

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Independence). According to the PCAOB, if an individual who was formerly employed by the

audit firm and participates in the audit procedures is impairing the forms independence (ET

Section 101- Independence). The former employee knows how the audit firm works and could

manipulate or hide suspicious activity better having that knowledge.

8.

In accordance with the AICPA Code of Professional Conduct, CPA’s are required to act with

integrity, objectivity, due care, competence, fully disclose any conflicts of interest, maintain

client confidentiality, disclose to the client any commission or referral fees, and serve the public

interest (Professional Responsibilities). During the congressional hearings, Arthur Young was

described as “very unhelpful, very unforthcoming, and very resistant to cooperate in any way”.

Arthur Young also acted unprofessionally and unethically by attacking the Leventhal firm stating

that their report was general and unprofessional. Arthur Young failed to comply with the Code

of Professional Conduct by trying to hide documents, slander another company and put the

blame on their reports; those are all acts lacking integrity and do not serve the public interest

(Professional Responsibilities).

9.

Typically, an annual financial audit is not performed to detect fraud, but rather to provide

assurance that the financial statements are free from material misstatement (Pully, 2016). The

primary responsibility for preventing and detecting fraudulent activity falls on those governing

the company and management (Pully, 2016). Unfortunately, more often than not management

is involved in the fraudulent schemes, so auditors should have some responsibility in looking for

fraud (Pully, 2016). One method of testing for fraud is to determine whether or not the

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company has strong internal controls (Pully, 2016). In the case of Lincoln, it would have been

beneficial for Arthur Young’s auditors to examine the company’s internal control structure.

While it may not have been to detect fraud, it certainly would have been useful in evaluating

the financial statements, and it may have led them to discover Keating’s schemes.

Furthermore, considering that the company was already under investigation by the FHLBB, the

auditors should have recognized that management may have been compromised in their ability

to detect fraud and therefore the auditors should have been more vigilant and extensive in

testing procedures and gathering evidence.

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Conclusions:
1.

While independent auditors are not primarily responsible for determining if a company is in

compliance with the substance over form concept, they should still be conscious of it while

performing their audit report. Once they have recognized that there is a violation of the

concept, they need to decide whether it will cause a material misstatement of the financial

statements, and if it does then they can communicate concerns tot eh audit committee and

write a qualified opinion disclosing this finding.

2.

Overall, audit firms should not be tempted to accept high risk clients in hopes of making more

money. If they have to take in a high-risk client, they need to do everything in their power to

maintain their independence. They must also ensure that any potential relationships that could

cause their independence to come into question be disclosed to the audit committee.

3.

When a client engages in significant related party transactions the audit firm must do additional

testing to ensure that the such transactions are recorded accurately.

4.

A company’s control environment is an important aspect of the company’s culture and can help

company’s develop good internal controls to detect and prevent fraudulent activity. Lincoln

had a poor control environment with a leader lacking in integrity and not enforcing any

controls. When a company has a weak control environment like this one, the auditors need to

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be very cautious and perform additional tests and gather evidence to make sure their confident

in the opinion they release for the company.

5.

Lincoln was acting irresponsibility in accepting so many nonrecourse loans as that meant that if

the borrowers were unable to pay, they were not personally liable and Lincoln would only be

able to recover the collateral and nothing more, which meant major potential losses. They

should have offered recourse loans instead as a safer option, even if it meant less interest

charged.

6.

When evaluating a company, it is vital to take the five assertions into consideration to help

guide auditors. It can aid them in determining what areas need special attention and where to

perform more test or gather more evidence. In the case of Lincoln, the auditors performed

some of the additional audit procedures needed to detect false real estate transactions like that

of Hidden Valley; however, they failed to come up with a resolution to the problem. Ignoring

assertions and issues found and writing an unqualified opinion regardless is reckless of the

audit firm.

7.

Whenever an audit firm is put in a position where their independence is called into question,

they should either discuss with the audit committee and allow them to make a decision or drop

the client. Not being deemed as independent in an audit can have severe consequences

because it calls into question the accuracy of the financial statements. Audit firms should limit

their relationships with clients and stay away from anything that impairs their independence.

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8.

CPA’s have many standards to comply with, amongst those includes the Code of Professional

Conduct. Unfortunately, in the Lincoln case, Arthur Young did not act professionally, especially

in regards to the congressional hearings, where they were reluctant to disclose documents and

information related to the case. By acting without integrity and not serving the public by hiding

information for a corrupt company, Arthur Young failed to adhere to the professional standards

outlined by the AICPA.

9.

Although it may not be the primary responsibility of the auditor to uncover fraud, they have an

obligation to observe the company’s internal controls procedures. Typically, once a company’s

internal controls are evaluated, the firm can decide whether more testing is necessary and that

can lead to fraud detection. In the Lincoln case the auditors seemed very unconcerned with

regards to the company’s internal controls and is perhaps one of many reasons why they either

did not detect the fraud or failed to write a qualified opinion.

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References:
AU 326 Evidential Matter. (n.d.). Retrieved March 31, 2020, from
https://pcaobus.org/Standards/Archived/Pages/AU326.aspx
Audit Committees and Auditor Independence. (2017, May 12). Retrieved March 31, 2020, from
https://www.sec.gov/info/accountants/audit042707.htm
Auditing Standard No. 18. (n.d.). Retrieved March 31, 2020, from
https://pcaobus.org/Standards/Archived/PreReorgStandards/Pages/Auditing_Standard_
18.aspx
Bragg, S. (2018, March 18). Substance over form. Retrieved March 31, 2020, from
https://www.accountingtools.com/articles/what-is-substance-over-form.html
Clarke, I. (2020, March 25). Effective Internal Control Environment & Risk Assessment.
Retrieved March
31, 2020, from https://linfordco.com/blog/internal-control-environment/
ET Section 101 - Independence. (n.d.). Retrieved March 31, 2020, from
https://pcaobus.org/Standards/EI/Pages/ET101.aspx
Kagan, J. (2020, January 29). What You Should Know About Non-Recourse Debt. Retrieved
March 31,
2020, from https://www.investopedia.com/terms/n/nonrecoursedebt.asp
Mohr, A. (2019, January 28). What Are the Audit Procedures for the Sales & Collection Cycle?
Retrieved March 31, 2020, from https://smallbusiness.chron.com/audit-procedures-
sales-collection-cycle-49846.html
Professional Responsibilities. (n.d.). Retrieved March 31, 2020, from
https://www.aicpa.org/interestareas/personalfinancialplanning/resources/practicecent
er/professionalresponsibilities.html
Pulley, A. (2016, April 19). Are Financial Auditors Responsible for Detecting Internal Fraud?
Retrieved
March 31, 2020, from https://www.claconnect.com/resources/articles/are-financial-
auditors-responsible-for-detecting-internal-fraud
Recourse vs. Nonrecourse Debt. (n.d.). Retrieved March 31, 2020, from
https://apps.irs.gov/app/vita/content/36/36_02_020.jsp
Substance Over Form. (n.d.). Retrieved March 31, 2020, from
https://xplaind.com/534006/substance- over-form

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