Case 3- Adams Bank Overview Adams Bank was a regional savings and loan corporation. As a provider of community and commercial banking services, the bank financed mortgages for single family homes and also financed both residential and commercial builders. Since Adams's loan portfolio was collateralized primarily with real property in the United States, the health of the U.S housing market was an important factor in determining the collectability of its loan portfolio. As a result, a significant decline in the U.S. housing market would typically lead to an increase in the bank's allowance for loan losses and a decrease in both the bank's reported net income and its stock price. Importantly, the bank's net income had a significant and direct impact on top management's bonus compensation. In addition, the CEO and CFO each had a substantial ownership interest in Adams Bank. Thus, adverse US. housing market conditions presented a risk to the personal wealth of the bank's top management. Polish the Apple Early in 2007 the U.S. housing market entered a period of significant decline and Adams Bank, like many lenders, experienced an increase in loan delinquencies. By the third quarter, the market was showing signs of severe distress and Adams's loan delinquencies began to grow at an alarming rate. Indeed, in the 93 days from June 1 to August 31, 2007 Adams's loan delinquencies increased by more than 24%. According to Adams's delinquent loan policy, the bank was required to stop accruing interest income when a loan was past due for four straight payments. As the decline of the U.S. housing market continued, the number of delinquent loans for which interest income was not being accrued increased sharply. As a direct result, it became clear to both the CEO and CFO that the bank would likely fall short of projected earnings. Aware that analysts were closely following the bank and scrutinizing the quality of the bank's loan portfolio, the CEO and CFO decided to seek advice about their options from a group of investment bankers. The investment bankers made it clear to management that in order for the bank to fully pursue its available options (including a possible salel, the CEO and CFO needed to "polish the apple" by stabilizing the bank's non-performing assets and increasing reported net income The Loan Modification Program According to U.S. GAAP, the bank was required to test each delinquent loan for possible impairment whenever a borrower defaulted or a loan was restructured. At the end of the third quarter, the CEO and CFO recognized that the bank's deteriorating loan portfolio would soon result in a significant number of impairments under U.S. GAAP. However, since the bank needed to demonstrate "stable asset quality" in order to attract a buyer or entertain other strategic altematives, the CEO proposed a loan- modification program. Importantly, at this time of crisis in the housing market, the U.S. government encouraged the use of loan-modification programs, if done so in an appropriate manner. However, for Adams, the loan-modification program provided a mechanism for management to disguise non-performing loans as performing, which allowed the bank to accrue interest income and circumvent asset impairment. In order to execute this program, the bank asked severely delinquent borrowers to: (1) contact the bank; (2) make one payment before the third quarter earnings were released; and (3) agree that all past due payments be added to the balance of the loan at maturity. Initially, the loan-modification program appeared on track to sufficiently boost the bank's earnings and reduce external scrutiny over the bank's asset quality. Perhaps not surprisingly though, as the financial crisis continued to worsen, so did the bank's need to reclassify additional assets. Unable to keep up with the market's downward spiral, the CEO began to focus on other ways to "polish the apple. The CEO began by restructuring four troubled loans in Adams's residential builder portfolio. The loans were held by a single insolvent builder, who had already notified the bank that it would require an additional loan in order to pay the current interest charges on its outstanding loan balances. Restructuring the loans to provide such funds, however, required additional collateral that the builder did not have. Nevertheless, top management proceeded to restructure the loans to facilitate payment of the loan interest for the next 12 months and then reclassified all of the loans to performing status on the balance sheet. Despite these types of efforts, at the start of the fourth quarter, the bank's non-performing loan balance still exceeded previous estimates. Overall the loan modification and restructuring schemes executed by Adams Bank's top management caused the bank to fraudulently understate non-performing assets by 31% and non-performing loans by 61 % in its third quarter 2007 filings. At the same time, the bank fraudulently overstated earnings for the third quarter by a staggering 417% Fraud Discovery In the fourth quarter, under pressure from its external auditors, Adams Bank reclassified the four restructured loans to the al builder (described previously) as nonperforming and increased its loan loss reserve amount. The reclassification, however, merely corrected the accounting treatment for one of the fraudulent schemes used by top management. Ultimately, a tip made by an internal whistleblower in early 2008 prompted the audit committee to initiate an investigation into top management's accounting practices over the past fiscal year. As a result of the investigation, Adams had to restate its third quarter financials and was unable to file its annual report with the SEC. The bank subsequently filed for bankruptcy Case Questions Based on your understanding of fraud risk assessment and the case information, identify at least three specific fraud risk factors related to Adams Bank. 1. 2. If you were responsible for planning the audit of Adams Bank, how would the fraud risk factors identified in question #1 have influenced the nature, timing, and extent of your audit work? 3. Please consider the five steps of the KPMG Judgment Framework. For each step, think carefully about what the auditors could have done to help detect the fraudulent activity related to the understatement of non-performing assets at Adams Bank. Please use the following questions to guide your critical thinking about this case a) Clarify the issue and the objectives related to auditing whether non-performing assets were understated at Adams Bank. To do so, please ask yourself what specific problem needs to be solved by the auditor? What assumptions would have the biggest impact on the overall judgment to be made? How does this judgment relate to the overal audit process? b) Consider the various alternatives that should be thought about when auditing whether non-performing assets were understated at Adams Bank. To do so, please ask yourself about all of the alternatives that are reasonably possible, even when they might contradict the client's point of view. Are there any external factors that should be considered? c) Consider the type of information and evidence that should be gathered when completing the audit of the internal control activities related to non-performing assets at Adams Bank. To do so, please ask yourself about the type of information that would be helpful to determine whether the internal control activities were operating effectively. How can you be sure that the information is reliable? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence could be gathered that might reveal that the internal controls were NOT operating effectively? d) Consider the type of information and evidence that should be gathered when completing the substantive testing procedures related to non-performing assets at Adams Bank. To do so, please ask yourself about the type of information that would be helpful to determine whether non-performing assets were fairly stated. How can you be sure that the information is reliable? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence could be gathered that might disconfirm your belief that non-performing assets were fairly stated? e) Consider the factors that would have to be thought about when reaching a final conclusion about non-performing assets at Adams Bank. Although you do not have access to the actual evidence, what "big picture" issues would Case 3 Adams Bank have to be considered at Adams Bank before reaching a final conclusion? Finally, what could possibly go wrong in this situation? f Consider the importance of documenting the rationale for your final conclusion. Why do you think it is important to document your rationale when finalizing your judgment? In addition, describe what is expected to be 4. Describe the availability tendency in your own words, and give an example of how the tendency could result in a lacl 5. Describe the confirmation tendency in your own words, and give an example of how the tendency could result in a 6. Describe the overconfidence bias in your own words, and give an example of how the bias could result in a lack of 7. Describe the anchoring bias in your own words, and give an example of how the bias could result in a lack of audit 8. What tendency or bias is most likely to have manifested in the Adams Bank case example? Please provide support documented to support an auditor's professional judgment. of audit effectiveness. How can the tendency be mitigated? lack of audit effectiveness. How can the tendency be mitigated? audit effectiveness. How can the bias be mitigated? effectiveness. How can the bias be mitigated? your answer Case 3- Adams Bank Overview Adams Bank was a regional savings and loan corporation. As a provider of community and commercial banking services, the bank financed mortgages for single family homes and also financed both residential and commercial builders. Since Adams's loan portfolio was collateralized primarily with real property in the United States, the health of the U.S housing market was an important factor in determining the collectability of its loan portfolio. As a result, a significant decline in the U.S. housing market would typically lead to an increase in the bank's allowance for loan losses and a decrease in both the bank's reported net income and its stock price. Importantly, the bank's net income had a significant and direct impact on top management's bonus compensation. In addition, the CEO and CFO each had a substantial ownership interest in Adams Bank. Thus, adverse US. housing market conditions presented a risk to the personal wealth of the bank's top management. Polish the Apple Early in 2007 the U.S. housing market entered a period of significant decline and Adams Bank, like many lenders, experienced an increase in loan delinquencies. By the third quarter, the market was showing signs of severe distress and Adams's loan delinquencies began to grow at an alarming rate. Indeed, in the 93 days from June 1 to August 31, 2007 Adams's loan delinquencies increased by more than 24%. According to Adams's delinquent loan policy, the bank was required to stop accruing interest income when a loan was past due for four straight payments. As the decline of the U.S. housing market continued, the number of delinquent loans for which interest income was not being accrued increased sharply. As a direct result, it became clear to both the CEO and CFO that the bank would likely fall short of projected earnings. Aware that analysts were closely following the bank and scrutinizing the quality of the bank's loan portfolio, the CEO and CFO decided to seek advice about their options from a group of investment bankers. The investment bankers made it clear to management that in order for the bank to fully pursue its available options (including a possible salel, the CEO and CFO needed to "polish the apple" by stabilizing the bank's non-performing assets and increasing reported net income The Loan Modification Program According to U.S. GAAP, the bank was required to test each delinquent loan for possible impairment whenever a borrower defaulted or a loan was restructured. At the end of the third quarter, the CEO and CFO recognized that the bank's deteriorating loan portfolio would soon result in a significant number of impairments under U.S. GAAP. However, since the bank needed to demonstrate "stable asset quality" in order to attract a buyer or entertain other strategic altematives, the CEO proposed a loan- modification program. Importantly, at this time of crisis in the housing market, the U.S. government encouraged the use of loan-modification programs, if done so in an appropriate manner. However, for Adams, the loan-modification program provided a mechanism for management to disguise non-performing loans as performing, which allowed the bank to accrue interest income and circumvent asset impairment. In order to execute this program, the bank asked severely delinquent borrowers to: (1) contact the bank; (2) make one payment before the third quarter earnings were released; and (3) agree that all past due payments be added to the balance of the loan at maturity. Initially, the loan-modification program appeared on track to sufficiently boost the bank's earnings and reduce external scrutiny over the bank's asset quality. Perhaps not surprisingly though, as the financial crisis continued to worsen, so did the bank's need to reclassify additional assets. Unable to keep up with the market's downward spiral, the CEO began to focus on other ways to "polish the apple. The CEO began by restructuring four troubled loans in Adams's residential builder portfolio. The loans were held by a single insolvent builder, who had already notified the bank that it would require an additional loan in order to pay the current interest charges on its outstanding loan balances. Restructuring the loans to provide such funds, however, required additional collateral that the builder did not have. Nevertheless, top management proceeded to restructure the loans to facilitate payment of the loan interest for the next 12 months and then reclassified all of the loans to performing status on the balance sheet. Despite these types of efforts, at the start of the fourth quarter, the bank's non-performing loan balance still exceeded previous estimates. Overall the loan modification and restructuring schemes executed by Adams Bank's top management caused the bank to fraudulently understate non-performing assets by 31% and non-performing loans by 61 % in its third quarter 2007 filings. At the same time, the bank fraudulently overstated earnings for the third quarter by a staggering 417% Fraud Discovery In the fourth quarter, under pressure from its external auditors, Adams Bank reclassified the four restructured loans to the al builder (described previously) as nonperforming and increased its loan loss reserve amount. The reclassification, however, merely corrected the accounting treatment for one of the fraudulent schemes used by top management. Ultimately, a tip made by an internal whistleblower in early 2008 prompted the audit committee to initiate an investigation into top management's accounting practices over the past fiscal year. As a result of the investigation, Adams had to restate its third quarter financials and was unable to file its annual report with the SEC. The bank subsequently filed for bankruptcy Case Questions Based on your understanding of fraud risk assessment and the case information, identify at least three specific fraud risk factors related to Adams Bank. 1. 2. If you were responsible for planning the audit of Adams Bank, how would the fraud risk factors identified in question #1 have influenced the nature, timing, and extent of your audit work? 3. Please consider the five steps of the KPMG Judgment Framework. For each step, think carefully about what the auditors could have done to help detect the fraudulent activity related to the understatement of non-performing assets at Adams Bank. Please use the following questions to guide your critical thinking about this case a) Clarify the issue and the objectives related to auditing whether non-performing assets were understated at Adams Bank. To do so, please ask yourself what specific problem needs to be solved by the auditor? What assumptions would have the biggest impact on the overall judgment to be made? How does this judgment relate to the overal audit process? b) Consider the various alternatives that should be thought about when auditing whether non-performing assets were understated at Adams Bank. To do so, please ask yourself about all of the alternatives that are reasonably possible, even when they might contradict the client's point of view. Are there any external factors that should be considered? c) Consider the type of information and evidence that should be gathered when completing the audit of the internal control activities related to non-performing assets at Adams Bank. To do so, please ask yourself about the type of information that would be helpful to determine whether the internal control activities were operating effectively. How can you be sure that the information is reliable? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence could be gathered that might reveal that the internal controls were NOT operating effectively? d) Consider the type of information and evidence that should be gathered when completing the substantive testing procedures related to non-performing assets at Adams Bank. To do so, please ask yourself about the type of information that would be helpful to determine whether non-performing assets were fairly stated. How can you be sure that the information is reliable? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence could be gathered that might disconfirm your belief that non-performing assets were fairly stated? e) Consider the factors that would have to be thought about when reaching a final conclusion about non-performing assets at Adams Bank. Although you do not have access to the actual evidence, what "big picture" issues would Case 3 Adams Bank have to be considered at Adams Bank before reaching a final conclusion? Finally, what could possibly go wrong in this situation? f Consider the importance of documenting the rationale for your final conclusion. Why do you think it is important to document your rationale when finalizing your judgment? In addition, describe what is expected to be 4. Describe the availability tendency in your own words, and give an example of how the tendency could result in a lacl 5. Describe the confirmation tendency in your own words, and give an example of how the tendency could result in a 6. Describe the overconfidence bias in your own words, and give an example of how the bias could result in a lack of 7. Describe the anchoring bias in your own words, and give an example of how the bias could result in a lack of audit 8. What tendency or bias is most likely to have manifested in the Adams Bank case example? Please provide support documented to support an auditor's professional judgment. of audit effectiveness. How can the tendency be mitigated? lack of audit effectiveness. How can the tendency be mitigated? audit effectiveness. How can the bias be mitigated? effectiveness. How can the bias be mitigated? your