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, \ , V"' r CASE 1.7 Lincoln Savings and Loan Association Charles Keating, Jr., was a scholar-athlete at the University of Cincinnati during the...

#6 SAS No. 31, "Evidential matter," identifies five key management assertions that underlie a set of financial statements . What five key assertions that Arthur Young should have attempted to substantiate for the hidden valley Transaction? What other procedures should Arthur Young have used for this purpose, and what other types of evidence should have been collected?

Case study is attached.

\ , , V"' r CASE 1.7 Lincoln Savings and Loan Association Charles Keating, Jr.,was a scholar-athlete at the University of Cincinnati during the mid- 19405.In 1946, Keating won an NCAA individual championship in the 200-yard butterfly a swimming event, and two years later graduated from the University of Cincinnati Law School. Over the next thirty years, Keating established himself as the nation's leading critic of the pornography industry. In 1960,he founded the Citizens for Decency through Law;an organization dedicated to "stamping out smut:' A decade later, Keating was ap- pointed to President Nixon's Commission on Pornography. Keating became best known nationally for his successful effort to help law enforcement authorities prosecute maga- zine publisher Larry Flynt, another native of Cincinnati, on obscenity charges. In 1978, Keating began focusing his time and energy on his business endeavors when he founded the real estate firm, American Continental Corporation (ACe). 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 pur- chase Lincoln, Keating pledged to regulatory authorities he would retain the Lincoln management team, 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 accept- ing 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 April 14,1989, the Federal Home Loan Bank Board (FHLBB) seized control of Lincoln Savings and Loan, alleging that Lincoln was dissipating its assets by operat- ing 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 centered on the failure of Lincoln's independent auditors to ex- pose fraudulent real estate transactions that allowed the savings and loan to report mil- lions of dollars of nonexistent profits. In summarizing the Lincoln debacle, U.S.Repre- sentative 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. J am stunned. As I look at these transactions, J am stunned at the conclusions of an independent auditing tirm.I am stunned at the result. And let me just tell you,! think that this whole circumstance of a potential $2.5 billion CDS! to tile United States taxpayers is a scandal for the United States Congress. It is a scandal for the Texas and 85
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,.86 ! " SECTION ONE COMPREHENSIVE CASES California legislatures, It is a scandal for the Reagan administration regulators, And it is a scandal for the accounting profession, I Creative Accounting, Influence Peddling, and other Abuses at lincoln Savings and Loan Representative Henry Gonzalez, chairman of the US, 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 pur- poses 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. Exhibit 1 contains a portion of the Leventhal EXHIBIT 1 CONGRESSIONAL TESTIMONY OF KENNETH LEVENTHAL & COMPANY REGARDING LINCOLN'S REAL EsTATE TRANSACTIONS To illustrate the accounting concepts Lincoln used, let me give you a few simple, hypothetical examples. Suppose you own a house that you paid $100,000 for, and against which you still owe $60,000. Now, suppose you could not find a buyer for your house. Therefore, you go out and find an individual who agrees to pay you the $200,000 you want for your house, but is only willing to give you one dollar in cash and a non-recourse note for the balance of $199,999. A non-recourse note means that you cannot get at him personally. If he defaults on the note, your only recourse is to take the house back. So now you have one dollar in your pocket, and a note for the rest. You very likely have not parted company with your house in this situation, because your so-called buyer may be unable to pay you, or he may simply decide that he does not want to pay you. Economically, he has an option to stick to the deal if the price of the house appreciates, or he can walk away from it if it does not. That is not a sale. Now, suppose you have the same house again. Your next-door neighbor has a different house, but it is worth the same as yours, and has the same outstanding mortgage balance. You then swap houses and mortgages with your neighbor. You now have a house which is different, but very similar to the one that you did have. I think that you will agree, there is no profit realized on this exchange. By the accounting theory that Lincoln appears to have followed, you would be able to record a $100,000 profit the difference between what you originally paid for your house and what you think your neighbors house is worth. Really, it could have been more, if you could have found an appraiser to tell you that your neighbors house was worth $300,000. And it could have been still more if you and your neighbor had simply chosen to agree upon a stated price which was even in excess of these amounts. As you can see, all sales of real estate are not created equal. Over the years, accountants have had to wrestle with what is economically a sale and what is not. The economic substance of a transaction should of course be the controlling consideration. L This and all subsequent quotations, unless indicated otherwise, were taken from the following source: US. Congress, House, Committee on Banking, Finance and Urban Affairs; Investigation of Lincoln Savings and Loan Association, Part 4 (Washington, D.C; US Government Printing Office, 1990).
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