Lincoln Savings and Loan Association Case

Table of Contents

Issues............................................................................................................................3

Facts..............................................................................................................................4

Analysis........................................................................................................................7

Conclusions/Recommendations..................................................................................14

Issues:

1.        What is the substance over form concept and exactly what does it requires? What responsibility, if any, do auditors have when a client violates this principle?

2.        How the acceptance of large, high-risk audit clients for relatively high audit fees threaten an audit firm's de facto and perceived independence? Under what circumstances should such prospective clients be avoided?

3.        How is an auditor’s examination affected when a client has engaged in significant related-party transactions? What measures should an auditor take to determine that such transactions have been properly recorded by a client?

4.        What is “control environment?” What weaknesses, if any, were evident in Lincoln’s control environment?

5.        What was the significance of Lincoln receiving nonrecourse notes rather than recourse notes as payment or partial payment on many of the properties it sold?

6(a).         What were the key assertions that Arthur Anderson should have attempted to substantiate for the Hidden Valley transactions?

6(b).        What procedures should Arthur Anderson have used for this purpose, and what type of evidence should have been collected?

7.        Was Jack Atchison’s close relationship with Lincoln and Keating prior to his leaving Arthur Young proper? After joining Lincoln’s parent company, should Atchison have “interfaced” with the Arthur Young auditors assigned to the Lincoln and ACC engagements?

8.        Does the AICPA Code of Professional Conduct discuss the collegial responsibilities of CPA firms? Were representative of either Ernst & Young or Kenneth Leventhal & Company unprofessional in this regard during their congressional testimony?

9.        What responsibility does an auditor have to uncover fraud perpetrated by client management? What factors might mitigate this responsibility and factors that compound it?

Facts:

Charles Keating Jr. started his rise to fame in the mid-1040s when he, as a scholar athlete, won an NCAA individual championship in the 200-yard butterfly swimming competition. Keating graduated with a law degree from the University of Cincinnati and spent the next 30 years establishing himself as the nation’s leading critic of the pornography industry, eventually being appointed to President Nixon’s Commission of Pornography. In the late 70s, Keating shifted his energy to business endeavors and founded the real estate firm, American Continental Corporation (ACC). In 1984, six years after its inception, ACC acquired Lincoln Savings and Loan Association (LSL). LSL was headquartered in Phoenix but its principal operations were in California. In order to acquire the company, Keating had to promise to keep the company’s management team, not to use brokered deposits to expand the size of the savings and loan and to keep residential home loans as the principal line of business. However, after gaining control, Keating disregarded the agreement and did everything he said he wouldn’t do. Due to these changes, Keating was able to triple LSL’s size in just two years.

In 1985, the CPA firm of Arthur Anderson served as LSL’s independent auditor until it resigned that year claiming that the wanted to lessen their liability exposure from savings and loan audits. Since LSL was a pretty large audit, several audit firms pursued the engagement, including Arthur Young, one of the country’s biggest firms at that time. Although the firms new that LSL was a high-risk client, they were willing to take on the engagement in exchange for large audit fees. However, before pursuing LSL, Jack Atchison, an audit partner in AY’s Phoenix office, contacted LSL’s previous engagement partner from Arthur Anderson who assured him that he had no reason to question the integrity of LSL’s management and that no major disagreement preceded the resignation of his firm as LSL’s auditor. However, the Arthur Anderson partner failed to mention that LSL was currently undergoing an intensive examination by FHLBB auditors regarding their financial statements. Shortly after acquiring LSL as a client, AY learned of the FHLBB audit. Congressional testimony later revealed that the 1986 and 1987 LSL audits were extremely complexed. William Gladstone, co-managing partner of AY’s successor, Ernst & Young, testified that the 1987 audit required 30,000 hours to complete. Despite all the difficulties, AY still issued unqualified opinions for both the 1986 and 1987 audits. Additionally, following the completion of the 1987 LSL audit in 1988, Jack Atchison resigned from AY and accepted a position with ACC. Unfortunately for LSL, the partner that replaced Atchison, Janice Vincent, was not as lenient on the audits as he was. After only a couple months of Atchison’s resignation, AY, under the recommendation of Vincent, resigned at LSL’s auditor. Following Arthur Young’s resignation in October 1988, LSL retained Touche and Ross to audit Lincoln’s 1988 financial statements, adding one more firm to the web of litigation that was about to unravel.