This case involves the valuation of loan loss estimates of First Community Bank (FCB) and the examination of relevant accounts by the CPA firm of Howard & Stacey LLP. FCB provided mostly residential loans to customers in Las Vegas, Florida, and Arizona. Beginning in about 2004, FCB expanded into high-risk types of lending that were experiencing unusual, rapid escalation in market values. This strategy made the bank particularly vulnerable to the fallout from the financial crisis, as these areas were hardest hit by the precipitous fall in real estate prices, which began in late 2006 and early 2007.
Throughout 2008, FCB was experiencing a dramatic rise in high-risk problem loans, including land and land development and residential construction. Certain of these problem loans were deemed "impaired" pursuant to Statement on Financial Accounting Standards (FAS) No. 114, meaning that it was probable the bank would not recover all amounts as contractually due. FCB reported FAS 114 impaired loan balance had increased from less than $4 million as of December 31, 2006, to nearly $186 million as of December 31, 2008.
In June 2008, Office of Community Bank Regulator (OCBR), the bank regulator, conducted a "risk-focused examination" of the bank that focused on asset quality, credit administration, management, earnings, and the adequacy of all items. As a result of that examination, OCBR downgraded the bank's credit rating from a 1 (indicating a financial institution that was "sound in every respect") to a 4 (indicating a financial institution with "serious financial or managerial deficiencies" that require close supervisory attention). OCBR provided the bank with a report that deemed the institution to be in troubled condition and board and management performance to be exceptionally poor. OCBR concluded that FCB had experienced a significant deterioration in asset quality due to eroding real estate values in Nevada and Florida, and that poor board and management oversight had exacerbated the problem. OCBR directed FCB to maintain higher minimum capital ratios. Failure to correct the problems identified by OCBR or to meet the heightened capital requirements would result in additional enforcement action by the regulator.
The bank's FAS 114 loans had a negative effect on FCB's ability to meet the heightened capital requirements mandated by the OCBR. Under GAAP, FCB was required to assess probable losses associated with its impaired loans and record those losses. The bank applied the rules in FAS 114, Accounting by Creditors for Impairment of a Loan, and decided to measure impairment using the fair value of the loans in the marketplace. As loan losses increased, the bank's capital was further eroded, directly affecting the OCBR capital requirements. In order to assess the loan losses for the bank's FAS 114 loans, FCB prepared loan-by-loan spreadsheets that contained estimates of collateral values and loan impairment determinations.
The auditors generally based the valuation on the most recent appraisal in FCB's loan files. If the appraisal was aged, as it typically was, FCB would sometimes apply a discount to the appraised value. The rationale for applying any particular discount-or for not discounting an appraisal at all-was not documented. In the limited instances where FCB did get updated appraisals or valuations on the bank's FAS 114 loans during 2008, the collateral value typically showed a significant decline from the amount used by management in the immediately preceding quarter. The auditors' review of the appraisals showed that management's estimates were inflated by twenty to almost fifty times.
With respect to the audit of FCB, Howard was the engagement partner and was responsible for the audit engagement and its performance, for proper supervision of the work of the engagement team members, and for compliance with PCAOB standards. Stacey was more of a hands-on partner and contributed significantly to the planning of the audit, the design of tests of controls, and the design and implementation of substantive procedures. In addition, Stacey was responsible for executing the audit, including directing the audit engagement team on how to conduct the audit. She reviewed the audit work papers and was responsible for on-site supervision of the audit engagement team. She also played a significant role in gathering and evaluating evidential matter to support the loan loss reserve, and specifically the valuation of collateral underlying the bank's FAS 114 loans.
Both partners were responsible for compliance with PCAOB standards with respect to the supervisory responsibilities that were assigned to Stacey. Prior to and during their 2008 audit of FCB, Howard & Stacey auditors were aware of the valuation issues with the bank's loan loss reserve. The FCB loans subject to impairment were individually material to the financial statements and presented a significant risk of material misstatement. It far exceeded the $1.9 million materiality threshold established for the 2008 audit. It was reasonably possible that even a relatively small change in the value of the bank's FAS 114 loans would cause a material error in the financial statements.
The audit planning document mentioned the significant risk, including a risk of fraud. At the completion of the audit, both Howard and Stacey signed off that "all necessary auditing procedures were completed," that "support for conclusions was obtained," and that "sufficient appropriate audit evidence was obtained." Further, Howard specifically signed off on the audit checklist's requirement that the audit engagement team had "performed and documented its work in compliance with . . . applicable auditing standards . . . and the working papers demonstrate this compliance." In the summer of 2009, when the OCBR began its annual exam, the bank was forced to get a significant number of updated appraisals and to use those appraisals in its loan loss calculations. In the fall of 2009, FCB disclosed over $130 million in additional loan loss provisions. FCB was shut down by bank regulators on June 4, 2010 and filed for bankruptcy later that month. In April 2010, Howard & Stacey LLP resigned as FCB's auditor.
Howard & Stacey withdrew its audit opinion relating to FCB's 2008 financial statements on the basis that they were materially misstated with respect to certain outof-period adjustments for loan loss reserves. The firm also withdrew its opinion relating to FCB's internal control over financial reporting as of year-end 2008 due to a material weakness in internal control over financial reporting related to the material misstatements.
In the aftermath of the FCB fraud, a forensic auditor was called in to look at the work of the auditors. A review of the audit documents showed concerns on the part of Howard & Stacey after receiving the report from OCBR indicating an inadequacy in the loan loss reserve of $5 million, a material amount. Concern also existed about the value of the collateral supporting the outstanding loans. The forensic auditor also discovered that valuation adjustments on the collateral underlying the bank's FAS 114 loans were inconsistent with independent market data. Third-party market data indicated that real estate values were declining precipitously in many of the markets where the bank's FAS 114 collateral was located, including Las Vegas, Nevada, and Phoenix, Arizona.
At year-end 2008, FCB had prepared spreadsheets analyzing more than fifty borrower relationships, totaling approximately $255 million in loans, for evaluation for impairment under FAS 114. Approximately $186 million of these loans were actually deemed impaired by the bank. The majority of the loans that the bank evaluated for impairment under FAS 114 were collateralized by property with appraisals more than a year old; over half of those stale appraisals were not discounted. Critically, when management did discount appraisals, those discounts were typically inconsistent with-and more favorable to the bank than-the declines indicated by the independent market data.
Questions
1. Explain the rules for accounting for impairment of loans under Statement of Financial Accounting Standards (FAS) No. 114, Accounting by Creditors for Impairment of a Loan. Did FCB apply these rules properly?
2. Evaluate the audit work of Howard & Stacey with respect to PCAOB audit standards discussed in the text and any other standards you choose to review. In particular comment on the auditors risk assessment in the audit of First Community Bank.
3. Evaluate the actions of the auditors using the AICPA ethics rules discussed in Chapter 4 and the GAAS discussed in this chapter.