Case 7-6 TierOne Bank
It took a long time but the Securities and Exchange Commission finally acted and held auditors
responsible for the fraud that occurred in banks during the financial recession. Surprisingly to
some, the TierOne bank case explained below was the nation’s first case brought by federal
securities regulators against auditors of a company that went down in the multibillion-dollar
portfolio in these high-risk loans. By September 2008, TierOne closed the LPOs, in the wake of
real estate market deterioration. By year-end 2008, TierOne had a total net loan portfolio of
approximately $2.8 billion, with a quarter of its loans concentrated in the LPO states. In October
2008, TierOne’s regulator, the Office of Thrift Supervision (OTS), issued a report following its
June 2008 examination of the bank, in which it downgraded TierOne’s bank rating; criticized
management and loan practices; and found that the bank had collateral-dependent loans either
without appraisals or with unsupported or stale appraisals. The bank was closed by OTS in 2010.
TierOne Corp. filed for bankruptcy three weeks later.
Cast of Characters
According to the agreement reached on June 27, 2014, the SEC sanctioned KPMG auditors John
J. Aesoph and Darren M. Bennett, in connection with their roles as engagement partner and
manager of the audit of the 2008 financial statements of TierOne. The SEC found that the pair
failed to identify “material weakness” in TierOne’s financial reporting. Given the findings of the
SEC, it is somewhat surprising that the only penalty was for the two auditors to be prohibited
from practicing before the SEC for one year and for six months, respectively.
According to the SEC, Aesoph and Bennett “rubber stamped” in their auditing of TierOne’s
accounts. This made it impossible to detect the deliberate understatement of the bank’s reported
losses on loans to real estate developers and construction companies. That information misled
TierOne’s stock investors, who relied on the audited data. Hence, the SEC brought action against
the auditors.
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officer of TierOne, was indicted for hiding the condition of the bank from regulators, investors,
and auditors. Allegedly, Lundstrom conspired with others to hide the bank’s problems as losses
mounted on its loan portfolio. “Lundstrom is essentially charged with having two sets of books,
with the books shown to regulators concealing tens of millions of dollars in delinquent loans,”
said Christy L. Romero, special inspector general for the U.S. Troubled Asset Relief Program,
for his role in what prosecutors called a scheme to defraud shareholders and regulators. Langford
played a major role in developing an internal estimate of losses embedded in TierOne’s loan
portfolio, but did not disclose that estimate to auditors or regulators. Langford’s initial analysis
indicated the bank needed an additional $65 million in loan loss reserves; a refined analysis,
entitled the “Best/Worst Case Scenario,” showed losses ranging from a “best case” of $36
KPMG
KPMG LLP (KPMG) audited TierOne’s 2008 financial statements. In March 2009, KPMG
issued an unqualified audit opinion on TierOne’s consolidated financial statements and
effectiveness of its internal controls over financial reporting as of year-end 2008; certified that
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resigned and withdrew its audit opinion. Citing risk of material misstatement, KPMG had also
warned the audit committee that TierOne’s financials were not to be relied upon by investors.
The two items cited in the report to the audit committee were: (1) TierOne’s year-end 2008
financial statements contained “material misstatements related to certain out-of-period
adjustments for loan loss reserves,” and (2) TierOne’s internal controls could not be relied on
As for the internal controls, the SEC said that the controls over the allowance for loans and lease
losses identified and tested by the auditing engagement team did not effectively test
management’s use of stale and inadequate appraisals to value the collateral underlying the bank’s
troubled loan portfolio. For example, the auditors identified TierOne’s Asset Classification
Committee as a key control. But there was no reference in the audit workpapers to whether or
impermissible rulemaking by enforcement, violating his due process rights by depriving him of
notice of the standards against which his professional conduct was to be judged. He stated that
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the SEC suggested in its closing argument that “fair value” measurements ought not to exclude
the impact of disorderly sales in times of economic turmoil, which he argued contravened
1. Was TierOne’s accounting for the loan loss reserve indicative of “managed
earnings?” How would you make that determination?
One way to determine whether Tier One was motivated to manage earnings by knowingly failing
to update its loan loss reserves is to first identify what earnings management is. In that regard
here are the definitions provided in the chapter.
Schipper defines it as a “purposeful intervention in the external reporting process, with the intent
of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of
the process).” Schipper says that might be the case when earnings are manipulated to get the
stock price up in advance of cashing in stock options.
Dechow and Skinner note the difficulty of operationalizing earnings management based on the
reported accounting numbers because they center on managerial intent, which is unobservable.
Dechow and Skinner offer their own view that a distinction should be made between making
choices in determining earnings that may comprise aggressive, but acceptable, accounting
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2. What role does professional judgment have in auditing the adequacy of a loan loss
reserve? Do you believe KPMG exercised a degree of care and professional
skepticism that is consistent with the level of ethical and professional judgment
expected by the accounting profession? What about the public?
According to KPMG’s Professional Judgment Framework discussed in Chapter 4, “Judgment is
the process of reaching a decision or drawing a conclusion where there are a number of possible
alternative solutions.” This certainly is true in many cases but needs to be modified in the case of
Tier One Bank. There really weren’t a number of possible solutions. Many of the outstanding
loans went bad because of the financial recession. The Bank failed to update values by
conducting current market value appraisals. It also failed to take into account that many
borrowers were having difficulty repaying interest and making principal payments on a timely
basis choosing instead to change the terms of the loans to mask problems with collectability.
This wasn’t a choice issue but one of applying professional judgment to the facts and underlying
economic realities that the very ability of a Bank (Tier One) to continue operating in the future at
least at historical levels was in doubt because of the financial recession.
3. Given the facts of the case with respect to audit work performed by Aesoph and.
Bennett, do you believe the sanctions imposed by the SEC were appropriate?
Explain.
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The SEC recognized the failure of KPMG to protect the public interest when it charged two
KPMG partners, John J. Aesoph and senior manager Darren M. Bennett, for failing to
appropriately scrutinize management’s estimates of TierOne’s allowance for loan and lease
losses. The SEC concluded that Aesoph and Bennett failed to obtain sufficient evidence
supporting management’s estimates of fair value of the collateral underlying the bank’s troubled
loans. Instead, they relied on stale information and management’s representations, and they
failed to heed numerous red flags when issuing unqualified opinions on TierOne’s 2008 financial
statements and the bank’s internal controls over its financial reporting.
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