Lincoln Savings and Loans

The high audit fee is a direct financial interest that can cause bias. The larger the amount of audit fees paid by the audit client company to the audit firm, the more likelihood that it will impair. The auditor may have to compromise their independence in many ways to ensure that they maintain that particular client, since that client provides them with relatively larger revenue. To address this, the regulators should impose a new requirement that the total fee from one single client should not exceed a certain percentage (<15%) of the total turnover of the audit firm. The regulation could decrease financial dependency and self-interest threat to independence. 4. Control environment also called “internal control environment. It is a term of financial audit, internal audit and Enterprise Risk Management. It means the overall attitude awareness and actions of directors and management regarding the internal control system and its importance to the entity. Control environment is the first of the 5 components of the COSO framework for the management of internal control.

The control environment sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Weakness: 1. Rather than admit to company’s insolvency, Charles Keating and the management team invented creative accounting strategies that turned their business that looked highly profitable. 2. Board of directors and internal control department failed to question Lincoln’s lending activity from residential mortgage loans to high-risk land ventures and commercial development projects. 5. A nonrecourse note is a note that prohibits the lender from attempting further restitution from the borrower in case of default. That means that the Lincoln may not receive further compensation for a default loan. Lincoln can only take back the item that was loaned as compensation for a default.

Their most profitable and most scrutinized deal came with the Hidden Valley Transaction that took place in 1987. This transaction allowed Lincoln to record a profit of 11.1 million on their book and similar transactions produced profits of over 135 million over the two years. 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. 6. In a financial audit, management assertions or financial statement assertions is the set of information that the preparer of financial statements is providing to another party. During the audit, Arthur Young should nest test management financial statement assertions for fixed asset transactions. Transactions (income statement):

* Occurrence – the transactions actually took place
* Completeness – all transactions that should have been recorded have been recorded * Accuracy – transactions were recorded at the appropriate amounts * Cutoff – the transactions have been recorded in the correct accounting period * Classification – transactions have been recorded in the proper accounts Keating and his associates repeatedly used bogus real estate transactions to produce enormous gains for Lincoln. Arthur Young should have attempted to substantiate Occurrence and Classification for Hidden Valley transactions. Auditor could inspect supporting documents like invoices or contracts to confirm that sales did occur and arrange for house’ owner to confirm in writing the details of the amount owing at balance date as evidence of notes payable in a liability. Auditor could also make inquiries of management about the collectability of customers’ accounts. Auditors also should examine records or documents and use own judgment according to the U.S GAAP to determine whether the Hidden Valley transactions could be classified as sales

9. An auditor has a reasonability to gather information needed to identify risks of material misstatement due to fraud and assess these risks after taking into account an evaluation of the Lincoln’s management and internal control. Auditors need to overcome some natural tendencies – such as overreliance on client representations. In this case, the auditor failed to set aside the close relationship between engagement partner and Lincoln management. Lincoln violated the substance- over –form concept by engaging in accounting-driven deals among related parties to manufacture illusory profits. At least 15 transactions in question were all very large and, collectively, accounted for one-half of Lincoln’s pretax profits during 1986 and 1987. Arthur Young also failed to include procedures to identify related-party transactions that are material to Lincoln. Incentive/Pressure: William Gladstone, the co-managing partner testified that the 1987 audit required 30,000 hours to complete, which created substantial time pressure.

The engagement audit partner, Jack Atchison built the close relationship with Keating and Atchison seemed to drop the auditor’s traditional stance of independence. Auditors from Arthur Young were reluctant to challenge their previous boss, William Gladstone, who worked for Lincoln in 1987. Rationalization: Former Lincoln engagement partner at Arthur Anderson told successor auditor 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. Current engagement team could rationalize their decision that took less effort to conduct substantial test the questionable transactions. Auditors would rationalize their audit evidence and conclude that they have fulfilled their responsibilities even though these appraisals were obtained from appraisers. Opportunity: Auditors failed to detect the fraud because they overly relied on the questionable documentary evidence provided by Lincoln employees. If Arthur Young could confirm the appraisals obtained from the third party, it reduced the opportunity for the auditors not to detect the underlying fraud.