[SOLVED] It took a long time but the

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 in 2014. 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 financial crisis and real estate meltdown. Federal banking authorities had brought a handful of cases against auditors, but the SEC hadn’t brought one until TierOne.
TierOne Corporation, a holding company for TierOne Bank, had $3 billion in assets when it collapsed in 2010. The facts of the case are drawn from the initial decision reached by the SEC, In the Matter of John J. Aesoph, CPA, and Darren M. Bennett, CPA, unless otherwise noted.
TierOne was a regional bank headquartered in Lincoln, Nebraska, that originated and purchased loans, and loan participation interests, with its primary market area in Nebraska, Iowa, and Kansas. From 2002 to 2005, TierOne opened or acquired nine loan production offices (LPO) in Arizona, Colorado, Florida, Minnesota, Nevada, and North Carolina, the main purpose of which was to originate construction and land-development loans. Over time, TierOne increased its 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.
Tier One Management
The SEC alleged in the indictment that TierOne’s executives hid loan losses as OTS repeatedly requested information. On December 10, 2014, Gilbert Lundstrom, the former chief executive 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, established during the financial meltdown.
The trigger for the fraudulent activities by TierOne management was that TierOne’s core capital ratio had fallen below the 8.5 percent minimum threshold mandated by the OTS. Lundstrom and others caused the bank to issue false statements that it met or exceeded the ratio.
Lundstrom knew that the bank needed to increase its reserves to cover loan losses and didn’t report this, according to the indictment. Lundstrom in 2012 settled a lawsuit brought by the SEC claiming he understated TierOne’s loan losses and losses on real estate repossessed by the bank so that the bank would appear to meet its mandated regulatory capital requirements. Lundstrom, who didn’t admit the allegations when settling, agreed to pay $500,921 in penalties.
Another former TierOne executive, Don Langford, the bank’s chief credit officer, pleaded guilty 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 million to a “worst case” of $114 million. Langford did not share any of this analysis with the bank’s accounting staff or external auditors.
As the value of properties declined and defaults increased during 2008 and 2009, Lundstrom and others directed TierOne employees to forgo ordering new appraisals even when the old ones were stale or no longer accurate. In some cases, when appraisals were made and came in at lower values than recorded by TierOne, the new appraisals were rejected, at the direction of Lundstrom and other bank executives. They also restructured loan terms to disguise the borrowers’ inability to make timely interest and principal payments. As a result, Lundstrom and others were allegedly able to hide millions of dollars in losses from regulators and investors.
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 the audit was conducted in accordance with PCAOB standards that required KPMG to plan and perform the audit to obtain reasonable assurance whether the financial statements were free of material misstatement; and opined that the financial statements reflected in TierOne’s year-end 2008 Form 10-K presented fairly, in all material respects, the financial position of TierOne and the results of its operations and cash flows, in conformity with U.S. Generally Accepted Accounting Principles (GAAP).
Subsequently, TierOne recorded $120 million in losses relating to its loan portfolio after obtaining updated appraisals. In April 2010, when KPMG learned that TierOne had failed to disclose the document created by Langford showing an internal analysis of varying estimates of additional loan loss reserves higher than what had been disclosed during the audit, the firm 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 “due to a material weakness in internal control over financial reporting related to the material misstatements.”
Aesoph and Bennett were charged with improper professional conduct in connection with the December 31, 2008, year-end audit of TierOne’s financial statements. They failed to comply with Public Company Accounting Oversight Board (PCAOB) auditing standards because they failed to subject TierOne’s loan loss estimates—one of the highest risk areas of a bank audit—to appropriate scrutiny. The SEC also said the pair “failed to obtain sufficient competent evidential matter to support their audit conclusions, and failed to exercise due professional care and appropriate professional skepticism.”
According to the SEC’s order instituting administrative proceedings against Aesoph and Bennett, they “rubber stamped” TierOne’s accounting for loan losses. The auditors failed to comply with professional auditing standards in their substantive audit procedures over the bank’s valuation of loan losses resulting from impaired loans. They relied principally on stale appraisals and management’s uncorroborated representations of current value despite evidence that management’s estimates were biased and inconsistent with independent market data rather than make an independent analysis of loan value and collectability.
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 how the committee assessed the value of the collateral underlying individual loans evaluated for impairment, and the committee did not generate or review written documentation to support management’s assumptions. Given the complete lack of documentation, Aesoph and Bennett had insufficient evidence from which to conclude that the bank’s internal controls for valuation of collateral were effective. Robert Khuzami, director of the SEC’s Division of Enforcement, said, “Aesoph and Bennett merely rubber-stamped TierOne’s collateral value estimates and ignored the red flags surrounding the bank’s troubled real estate loans.”
In 2016, Aesoph and Bennett appealed the original decision of the Administrative Law Judge that suspended them from practicing before the SEC for a term of one year and a term of six months, respectively. The SEC cross-appealed, asking for a three- and two-year term, respectively, after which time they could apply for reinstatement. In his appeal, Bennett took issue with statements made by the SEC that, he claimed, suggested that the auditors should be responsible for “auditing” each of TierOne’s loan loss reserve estimates, whereas under PCAOB standards “[t]he auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole.” The SEC, however, contended that in order to evaluate the reasonableness of the estimates in the context of the financial statements taken as whole, they were required to evaluate those estimates on a loan-by-loan basis. In the end the SEC cross-appeal won the day based on evidence provided that the two KPMG auditors violated PCAOB auditing standards in three specific areas with respect to the loan loss reserves: (1) their audit of the effectiveness of ICFR;, (2) their substantive audit test work over the account;, and (3) their post-audit procedures following the discovery of new appraisals in 2009.
Questions:
1. Was TierOne’s accounting for the loan-loss reserve indicative of “managed earnings”? How would you make that determination?
2. What is the purpose of the auditor’s assessment of ICFR? Describe the deficiencies in KPMG’s audit work in that regard?
3. Would you conclude from the facts of this case that TierOne’s fraud caused KPMG’s auditing standards violations? Explain.
4. Which rules of conduct in the AICPA Code were violated by KPMG auditors? Be specific.

Question: It took a long time but the