Why Do Audits Fail? Evidence from Lincoln Savings and Loan

Abstract

This study describes and critiques the audit procedures applied to a set of material transactions from the Lincoln Savings and Loan (LSL) audit failure. Auditor deposition testimony and audit working papers produced in the civil litigation against the auditors of LSL provide the basis for this analysis. The public availability of the deposition testimony and audit working papers creates a unique opportunity to study and evaluate audit procedures and decisions from an audit failure. To date, evaluating actual audit procedures from an audit failure has proven nearly impossible for accounting researchers because audit workpapers are owned by the defendant audit firm and are usually sealed in the litigation and/or destroyed when a case is settled. In spite of objections from the audit firms' legal counsel, U.S. District Judge Richard Bilby released to the public deposition transcripts and associated audit working papers from the civil litigation against the former auditors of LSL. We use these documents as the basis for our analysis. To our knowledge, this is the first study to examine audit procedures documented in depositions and working papers from litigation over the adequacy of an auditor's performance.

Our access to LSL's auditor's depositions and work papers enables us to evaluate the audit procedures that were applied by LSL's auditors and the information they used. More importantly, we are able to identify the information that was not used and procedures that were not performed. Other researchers have been unable to study audit procedures associated with audit failures, in spite of the compelling importance of such an inquiry, using traditional research methods. Our ability to study these issues highlights the potential value of a detailed analysis of legal documents from a single case. Moreover, the current approach enables us to generate alternative procedures that may have averted the failure. Our ability to draw such inferences is a unique characteristic of this type of research. This study is one of the first to identify procedures or omissions associated with an audit failure. For this reason, the analyses in this study, although imperfect, provide an important basis upon which future research can build.

The main conclusion of our analysis is that the most significant shortcoming in the LSL audit was the auditor's failure to obtain and use knowledge of LSL's business, the industry in which it operated, and the economic forces that influenced this industry/business. It is our view that had the auditors obtained this understanding and applied it to an evaluation of the substance of LSL's main source of profits during this period, sales of undeveloped Arizona land, the auditors would have reached different revenue recognition conclusions. More specifically, if the auditors had compared LSL's wholesale sales of undeveloped land to trends in Arizona's retail residential real estate market; it would have been apparent that the reported profit margins were "too good to be true." Furthermore, analysis of the substance of these transactions, including consideration of the motivations of LSL and its transacting parties, would have provided additional evidence that immediate revenue recognition on these transactions was inappropriate. Instead, the auditors evaluated the compliance of each material real estate transaction's form with the mechanical aspects of SFAS No. 66 "Accounting for Sales of Real Estate" (e.g. the down payments appeared to meet the requirements of SFAS No. 66). Our evaluation suggests that understanding a client's business is an effective audit procedure that provides reliable audit evidence both in the absence and presence of management fraud.

JEL Classification: M49, K42