CASE 1.7
LINCOLN SAVINGS
AND LOAN ASSOCIATION
Synopsis
The collapse of Lincoln Savings and Loan Association in 1989 was one of the most expensive
and controversial savings and loan failures in U.S. history. Charles Keating, Jr., is seemingly the
perfect example of the aggressive, risk-seeking entrepreneurs who were attracted in large numbers to
the savings and loan industry when it was deregulated by the federal government in the early 1980s.
Many of these individuals, including Keating, developed innovative, if not ingenious, methods for
diverting the insured deposits of their savings and loans into high-risk commercial development
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Case 1.7 Savings and Loan Association 49
Lincoln Savings and Loan Association—Key Facts
1. Charles Keating dominated the operations of both Lincoln and its parent company, ACC, and
was largely responsible for the phenomenal growth experienced by the savings and loan during the
1980s.
3. The principal lending activities of Lincoln involved commercial development projects and other
high-risk ventures.
5. Arthur Young accepted Lincoln as an audit client during the course of an intensive marketing
effort to attract new clients.
7. Arthur Young relied upon real estate appraisals obtained by Lincoln in auditing certain of the
savings and loan’s large real estate transactions.
9. After Janice Vincent assumed control of the Lincoln audit, the Arthur Young auditors apparently
10. In October 1988, Arthur Young resigned as Lincoln’s auditor following several heated disputes
involving Vincent and Keating, disputes that focused on Lincoln’s aggressive accounting treatments.
11. Ernst & Young, Arthur Young’s successor, eventually paid $400 million to settle several
12. In 1999, Charles Keating finally admitted, in a plea bargain agreement reached with federal
Instructional Objectives
1. To illustrate the impact that excessive competition in the audit market may have on client
acceptance and retention policies of audit firms.
2. To demonstrate the legal exposure that audit firms face when they accept high-risk audit clients.
4. To stress the importance of auditors maintaining a high degree of skepticism when dealing with a
client whose management has adopted an aggressive, growth-oriented philosophy.
6. To illustrate the pressure that client executives may impose on their auditors to interpret
technical issues to the benefit of the client.
Suggestions for Use
This is another case that I often use during the first week of the semester to introduce students to
the purpose, nature, and importance of the independent audit function. This case could also be
assigned during class discussion of client acceptance and retention decisions [or, more broadly, the
discussion of quality control standards for audit firms] since both Arthur Young and Touche Ross
were criticized for agreeing to accept Lincoln as an audit client. In this same vein, the case discusses
the aggressive client development philosophy adopted by Arthur Young in the mid-1980s that may
have been at least partially responsible for the audit firm’s decision to accept the high-risk Lincoln
Case 1.7 Savings and Loan Association 51
Suggested Solutions to Case Questions
1. The “substance over form” concept dictates that the true nature, that is, economic substance, of a
transaction, rather than its legal or accounting form, should determine the manner in which it is
reflected in an entity’s accounting records. This concept is particularly pertinent for transactions
involving related parties. Quite often, such transactions will not have taken place on an arm’s length
2. The professional judgment of auditors may be compromised when their firm is overly dependent
on one or a few large clients. Auditors, even those at the lower levels of a CPA firm, are likely
cognizant of the economic impact that losing such a client would have on their firm and possibly on
their own professional careers. This awareness alone may cause auditors to be more “flexible”
during such engagements. This problem may be compounded when a large client poses a relatively
52 Case 1.7 Lincoln Savings and Loan Association
3. There are two key issues an auditor should consider when a client has engaged in material
related-party transactions: 1) whether economic substance, rather than legal form, was the
determining factor in the accounting for such transactions, and 2) whether such transactions have
been disclosed adequately in the client’s financial statements as required by U.S. GAAP. The latter
of these issues does not present any major problems for the auditor since GAAP are very explicit
a. determine whether the transaction has been approved by the board of directors
b. examine invoices, executed copies of agreements, contracts and other pertinent documents,
such as receiving reports and shipping documents
c. inspect evidence in possession of the other party or parties to the transaction
d. confirm or discuss significant information with intermediaries, such as, banks, guarantors,
4. The COSO framework describes the control environment component of an internal control
process as follows: “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. Control environment factors include the integrity, ethical values,
management’s operating style, delegation of authority systems, as well as the processes for managing
and developing people in the organization.”
Listed next are weaknesses that were evident in Lincoln’s control environment.
a. The prior problems of Charles Keating, Jr., with the SEC suggest that the he may not have
had the proper degree of control consciousness (this an important observation since
5. The party holding a nonrecourse note resulting from a sales transaction has no legal recourse
other than to retake possession of the previously sold asset if the maker of the note defaults.
Consequently, an auditor examining sales transactions involving such notes must attempt to
Case 1.7 Savings and Loan Association 53
6. PCAOB Auditing Standard No. 15, paragraph 11, identifies the following five management
assertions that auditors should consider in developing an audit plan: occurrence, completeness,
accuracy, cutoff, and classification. (Note: The AICPA Professional Standards identify thirteen
management assertions that are closely related to the five management assertions included in AS No.
15. See AU-C 315.A114 for a list of those thirteen assertions.) Of these five assertions “accuracy”
seems to have been the most relevant to the Hidden Valley transaction. “Accuracy. Amounts and
appropriately recorded.”
To corroborate the “accuracy” assertion for the Hidden Valley transaction, Lincoln’s auditors
should have first attempted to determine whether the transaction was, in terms of economic
substance, a valid sales transaction. A cursory investigation of the transaction would likely have
revealed that it qualified as a related party transaction. At this point, it would have been incumbent
on the auditors to apply the appropriate audit procedures for related party transactions (see suggested
answer to Question 3). For example, given the size of the transaction and its unusual characteristics
(such as a sales price greatly in excess of the property’s appraised value), the auditors, at a minimum,
should have confirmed or discussed the transaction with intermediaries and other parties to the
transaction.
NOTE: The actual procedures that Arthur Young used vis-a-vis the Hidden Valley transaction were
not discussed at length in the congressional transcripts. The suggested solution to this question is
not intended to imply that Arthur Young did not use the most appropriate procedures to audit this
particular transaction. Nevertheless, William Gladstone’s comment that his firm had to rely upon
real estate appraisals provided by Lincoln was somewhat curious. Almost certainly, Arthur Young
54 Case 1.7 Lincoln Savings and Loan Association
had the option of retaining independent appraisals of Lincoln’s properties.
7. At the time that Atchison served as Lincoln’s audit engagement partner, there were no explicit
rules that forbid auditors from lobbying on behalf of a client’s interest. Whether such behavior on
the part of auditors is “professional” and/or appropriate is a question that has been widely debated
both within and outside the profession. Apparently, Atchison did not believe that his lobbying
efforts on behalf of Lincoln were inappropriate. In fact, in most ethical dilemmas that arise in an
audit context, the audit professional must use his/her own ethical yardstick to determine how to
8. The predecessor of the Code of Professional Conduct contained a series of rules entitled
“Responsibilities to Colleagues.” Presently, there are no such rules in the Code of Professional
Conduct. Nevertheless, implicit in the Principles of the Code of Professional Conduct is the
9. AU Section 110.02 (as well as AU Section 316.01) of the PCAOB Interim Standards succinctly
summarizes an auditor’s responsibility for fraud detection. “The auditor has a responsibility to plan
1. Discuss [among members of the audit engagement team] the risks of material misstatement
due to fraud that are posed by a client
2. Obtain the information needed to identify the risks of material misstatement due to fraud.
Case 1.7 Savings and Loan Association 55
3. Identify the risks that may result in a material misstatement due to fraud
4. Assess the identified risks after taking into account an evaluation of the entity’s programs
Because fraud is often well concealed, auditors do not have an absolute responsibility to discover
fraud-related misstatements in a client’s financial statements, as explicitly noted in AU 316.12:
“However, absolute assurance is not attainable and thus even a properly planned and performed audit
may not detect a material misstatement resulting from fraud.” For instance, in cases in which
forgery and/or collusion among client personnel has occurred, the likelihood that the auditor will