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Case 5-3: Imperial Valley Community Bank.

Choose one of the individuals in the case and identify their actions and viewpoints. Executive Summary of the case.

QUESTIONS:

1.) Brief review of the case from your auditor's point of view (one paragraph).

2.) Identify the key behaviors, attitudes, and ethical dilemmas faced by or caused by the auditor.

Case 5-3 Imperial Valley Community Bank Page 319 Bill Stanley, of Jacobs, Stanley & Company, started to review the working paper files on his client, Imperial Valley Community Bank, in preparation for the audit of the client's financial statements for the year ended December 31, 2016. The bank was owned by a parent company, Nuevo Financial Group, and it serviced a small westem Arizona community near Yuma tha reached south to the border of Mexico. The bank's preaudit statements are presented in Exhibit 1. EXHIBIT 1 Imperial Valley Community Bank Balance Sheet (preaudit) December 31, 2016 Assets Cash and cash equivalents Loans receivable Less: Reserve for loan losses Unearned discounts and fees Accrued interest receivable Drepayments Real property held for sale Property, plant, and equipment Less: Accumulated depreciation Contribution to Thrift Guaranty Corp. Deferred start-up costs Total assets $1,960,000 6,300,000 (25,000) (395,000) 105,000 12,000 514,000 390,000 (110,000) 15,000 44.000 $8,810,000 Liabilities & Equity $2,212,000 5.180,000 190,000 28.000 $7.610.000 Liabilities Regular and money market savings T-bills and CD: - Accrued interest payable Accounts payable and accruals Total liabilities Equity Capital stock Additional paid-in capital Retained earnings (deficit) Total equity Total liabilities and equity $700,000 1,120,000 (620,000) $1.200.000 $8.810,000 Statement of Operations (preaudit) for the Year Ended December 31, 2016 Revenues Page 320 Interest eamed Discount earned Investment income Fees, charges, and commissions S 820,000 210,000 82,000 78.000 $1.190.000 Total revenues Expenses Interest expense $ 815,000 Expenses $ 815,000 180,000 205,000 Interest expense Provision for loan losses Salary expense Occupancy expense including depreciation Other administrative expense Legal expense Thrift Guaranty Corp. payment Total expenses Net loss for the year 100,000 160,000 12,000 48.000 $1.520.000 $(330,000) Background Bill Stanley knew there were going to be some problems to contend with during the course of the audit, so he decided to review the planning memo that he had prepared about two months earlier. This memo is summarized in Exhibit 2. EXHIBIT 2 Planning Memo 1. The firm of Jacobs, Stanley & Co. succeeded the firm of Nelson, Thomas & Co. as auditors for Imperial Valley Community Bank. The prior auditors conducted the 2014 and 2015 audits. Jacobs, Stanley & Co. communicated in writing with Nelson, Thomas & Co. prior to accepting the engagement. In addition, authorization was given by the client for a review of the predecessor auditors' working papers. The findings of these inquiries are summarized in item 6 below and the internal office communication 2. Imperial Valley Community Bank was incorporated in Arizona on June 12, 2000. It is a wholly owned subsidiary of Nuevo Financial Group, S.A., a Mexican corporation. As a community bank with maximum asset limitations, it is restricted to certain types of business, including making real estate and consumer loans and certain types of commercial loans. 3. Imperial Valley accepts deposits in the form of interest-bearing passbook accounts and certificates of deposit. Most of the depositors are of Spanish descent. The client primarily services the Spanish-speaking community in the Imperial Valley of southern Arizona, which is a rural community located on the Mexican border. 4. The principal officers of Imperial Valley are Jose Ortega and his brother, Arturo. They serve as the CEO and the CFO, respectively. Two cousins serve as the chief operating officer (COO) and chief ethics and compliance officer (CECO). 5. Imperial Valley is subject to the regulations of the Arizona Community Bank Law and is examined by the Department of Corporations. It was last examined in December 2015 and was put on notice as “capital impaired." Additional capital was being sought from local investors. 6. Based on review of the prior auditors' working papers, the following items were noted: Page 321 a. The client's lack of profitability was due to a high volume of loan losses resulting from poor underwriting procedures and faulty documentation. b. Imperial Valley has a narrow net interest margin due to the fact that all deposits are interest bearing and it pays the highest interest rates in the area. c. Due to the small size of the client and its focus on handling day-to-day operating problems, the internal controls are marginal at best. There were material weaknesses in its loan underwriting procedures and documentation, as well as in compliance with regulatory requirements. d. There are no reports issued by management on the interal controls. e Audit evidence was frequently unavailable to the prior auditors, and they expressed their concerns about this matter in an internal memo. The next item he reviewed was an internal office communication on potential audit risks. This communication described three areas of particular concer: 1. The client charged off $420,000 in loans in 2015 and had already charged off $535,000 through July 31, 2016. Assuming that reserve requirements by law are a minimum of 1.25 percent of loans outstanding this statutory amount probably would not be large enough for the loan loss reserve. This, in combination with the prior auditors' concerns about proper loan underwriting procedures and documentation, indicates that the audit engagement team should carefully review loan quality 2. The audit report issued on the 2015 financial statements contained an unmodified opinion with an emphasis-of-matter paragraph describing the uncertainty about the client's ability to continue as a going concem. The concem was caused by the "capital impairment" declaration by the Arizona Department of Corporations. 3. The client had weak internal controls according to the prior auditors. Some of the items to look out for, in addition to proper loan documentation, were whether the preaudit financial statement information provided by the client was supported by the general ledger, whether the accruals were appropriate, and whether all transactions were properly authorized and recorded on a timely basis. Audit Findings Jacobs, Stanley & Company conducted the audit of the financial statements for the year ended December 31, 2016, and the following were the areas of greatest concern to Stanley 1. Adequacy of Loan Collateral. A review of 30 loan files representing $2,100,000 of total loans outstanding (33.3 percent of the portfolio) indicated that much of the collateral for the loans was in the form of second or third mortgages on real property. This gave the client a potentially unenforceable position due to the existence of very large senior liens. For example, if foreclosure became necessary to collect Imperial Valley's loan, the client would have to pay off these large senior liens first. Other collateral often consisted of personal items such as jewelry and furniture. In the case of jewelry, often there was no effort made by the client after granting the loan to ascertain whether the collateral was still in the possession of the borrower. The jewelry could have been sold without the client's knowledge. It was difficult to obtain sufficient audit evidence about these amounts. 2. Collectibility of Loans. Many loans were structured in such a way as to require interest payments only for a small number of years (two or three years), with a balloon payment for principal due at the end of this time. This structure made it difficult to evaluate the payment history of the borrower properly. Although the annual interest payments may have been made for the first year or two, this was not necessarily a good indication that the borrower would come up with the cash needed to make the large final payment, and the financial statements provided no additional disclosures about this matter. 3. Weakness in Internal Controls. Interal control weaknesses were a pervasive concern. The auditors recomputed certain accruals and uneared discounts, confirmed loan and deposit balances, and reconciled the preaudit financial information provided by the client to the general ledger. Some adjustments had to be made as a result of this work. A material the Page 322 have the necessary cash available to repay their loans when they came due. This was of great concem to the auditors, especially in light of the inadequacy of the loan reserve, as detailed in item 5 that follows. 4. Status of Additional Capital Infusion. The audit engagement team is working under the assumption that under Arizona regulatory requirements, a community bank must maintain a 6:1 ratio of "thrift certificates" to net equity capital. Based on the financial information provided by Imperial Valley, the capital deficiency was only $32,000 below capital requirements (preaudit), as follows: Thrift certificates $7.392,000 6 $1,232,000 $1,200,000 Net equity capital required Net equity capital reported Deficiency $ 32,000 Audit adjustments explained in Exhibit 3 increased the capital deficiency to $622,000, as follows: $1,232,000 $ 610,000 Net equity capital required Net equity capital (postaudit) ($1,200,000-$590,000) Deficiency $622,000 EXHIBIT 3 Audit Adjustments AJE #1 Reserve for loan losses $ 200,000 Page 323 Loans receivable $ 200.000 To write down loans to net realizable value Reserve for loan losses AJE #2 $ 300,000 80,000 $ 380,000 Unearned discounts & fees Loans receivable To write off loans more than 180 days past due in compliance with statutes Provision for loan losses AJE #3 $ 590,000 Reserve for loan losses $ 590,000 To increase the reserve balance to 2 percent of 2 outstanding loans as follows: Reserve balance (preaudit) $ (25,000) Less adjusting entry #1 $ 200,000 #2 300,000 $ 500.000 Subtotal $ 475.000 #1 $ 200,000 #2 _300,000 $ 500,000 $475,000 Subtotal Add: Desired balance Loan balance (preaudit) Less: AJE #1 $ 6,300,000 (200,000) (380.000) #2 $ 5,720,000 2% Loan balance (postaudit) Reserve requirement Desired balance (approx.) Adjustment required 115.000 $ 590,000 There was a possibility that the parent company, Nuevo Financial Group, would contribute the additional equity capital. Also, management had been in contact with a potential outside investor about the possibility of investing $600,000. This investor, Manny Gonzalez, has strong ties to the Imperial Valley community and to the family ownership of Imperial Valley. 5. Adequacy of General Reserve Requirement. The general reserve requirement of 1.25 percent had not been met. Based on the client's reported outstanding loan balance of 56,300,000, a reserve of $78,750 would be necessary. However, audit adjustments for the charge-off of uncollectible loan amounts significantly affected the amount actually required. In addition, th: auditors felt that a larger percentage would be necessary because of the client's history of problems with loan collections; initially, a 5 percent rate was proposed. Management felt this was much too high, arguing that the company had improved its lending procedures in the last few months and that it expected to have a smaller percentage of charge-offs in the future... current delinquent report showed only two loans from 2016 still on the past due list. The auditors agreed to a 2 percent reserve, and an adjusting entry (AJE 3, shown in Exhibit 3) was made. Regulatory Environment Imperial Valley Community Bank was approaching certain regulatory filing deadlines during the course of the audit. Stanley had a meeting with the regulators at which representatives of management were present. Gonzalez also attended the meeting because he had expressed some interest in possibly making a capital contribution. There was a lot of discussion about the ability of Imperial Valley to keep its doors open if the loan losses were recorded as proposed by the auditors. This was a concem because the proposed adjustments would place the client in a position of having net equity capital significantly below minimum requirements. The regulators were concerned about the adequacy of the 2 percent general reserve because of the prior collection problems experienced by Imperial Valley. The institution's solvency was a primary concem. At the time of the meeting the regulators were quite busy trying to straighten out problems caused by the failure of two other community banks in Arizona. Many deposit is bad lost man en het verlede of the banke of the related to the li ha res nulators vere e as a cushion to protect depositors. The regulators Page 324 viewed this as in light of the other bank failures and the fact that the insurance ction mechanism for thrift and loan depositors was less substantial than depository insurance available through the Federal Deposit Insurance Corporation (FDIC) in commercial banks and in savings and loans (S&L). Summary of the Client's Position The management of Imperial Valley Community Bank placed a great deal of pressure on the auditors to reduce the amount of the loan write-offs. It maintained that the customers were good for the money" Managers pointed out the payments to date on most of the loans had been made on a timely basis. The client felt that the auditors did not fully understand the nature of it: business Managers contended that a certain amount of risk had to be accepted in their business because they primarily made loans that commercial banks did not want to make. "We are the bank of last resort for many of our customers," commented bank president Eddie Salazar. Salazar then commented that the auditors' inability to understand and appreciate this element of th: thrift and loan business was the main reason why the auditors were having trouble evaluating the collectibility of the outstanding loans. Management informed the auditors that they vouched for the collectibility of the outstanding loans. Outstanding Loans The auditors' contended that the payments to date, which were mostly annual interest amounts, were not necessarily a good indication that timely balloon principal payments would be made. They felt it was very difficult to evaluate the collectibility of the balloon payments adequately, primarily because the borrowers' source of cash for loan repayment had not been identified They could not objectively audit or support borrowers' good intentions to pay or undocumented resources as represented by client management. To ensure that they were not being naive about the community bank, the auditors checked with colleagues in another office of the firm who knew more about this type of business. One professional in this office explained that the real secret of this business was to follow up ruthlessly with any nonpayer. The auditors certainly did not believe that this was being done by Imperia Valley management. The auditors knew that Manny Gonzalez was a potential source of investment capital for Imperial Valley. They believed it was very important to give Gonzalez an accurate picture because if a rosier picture were painted than actually existed, and Gonzalez made an investment, then the audit firm would be a potential target for a lawsuit. Board of Trustees The auditors approached the nine-member board of trustees that oversaw the operations of Imperial Valley, three of whom also served on the audit committee. Of the nine board members, four were officers with the banks and five were "outsiders." All members of the audit committee were outsiders. The auditors had hoped to solicit the support of the audit committee in dealing with management over the audit opinion issue, as detailed in the next section. However, the auditors were concerned about the fact that all five outsiders had loans outstanding from Imperial Valley that carried 2 percent interest payments until the due date in two years. Perhaps not coincidentally, all five had supported management with respect to the validity of collateral and loan collectibility issues with customers. Auditor Responsibilities The management of Imperial Valley was pressuring the auditors to give an unmodified opinion. If the auditors decided to modify the opinion, then, in the client's view, this would present a picture to their customers and the regulators that their financial statements were not accurate. The client maintained that this would be a blow to its integrity and would shake depositors confidence in the institution. On one hand, the auditors were very cognizant of their responsibility to the regulatory authority, and they were also concerned about providing accurate picture of Imperial Valley's financial health to Manny Gonzalez or other potential investors. On the other hand, they wondered whether they were holding the client to standards that were too strict. After all, the audit repor issued in the preceding year was unmodified with an emphasis-of-matter paragraph on the capital impairment issue. They also wondered whether the doors of the institution would be closed by the regulators if they gave a qualified or adverse opinion. What impact could this action have on the depositors and the economic health of the community? Bill Stanley wondered whose interests thev were really representina depositors, shareholders. management the local community or regulators, or all of these. Page 325 Auditor Responsibilities The management of Imperial Valley was pressuring the auditors to give an unmodified opinion. If the auditors decided to modify the opinion, then, in the client's view, this would present a picture to their customers and the regulators that their financial statements were not accurate. The client maintained that this would be a blow to its integrity and would shake depositors confidence in the institution On one hand, the auditors were very cognizant of their responsibility to the regulatory authority, and they were also concerned about providing an accurate picture of Imperial Valley's financial health to Manny Gonzalez or other potential investors. On the other hand, they wondered whether they were holding the client to standards that were too strict. After all, the audit repor issued in the preceding year was unmodified with an emphasis-of-matter paragraph on the capital impairment issue. They also wondered whether the doors of the institution would be closed by the regulators if they gave a qualified or adverse opinion. What impact could this action have on the depositors and the economic health of the community? Bill Stanley wondered whose interests they were really representing depositors, shareholders, management, the local community, or regulators, or all of these. Page 325 Stanley knew that he would soon have to make a recommendation about the type of audit opinion to be issued on the 2016 financial statements. Before approaching the engagement review partner on the engagement, Stanley drafted the following memo to file. Memo: Going-Concern Question The question of the going-concern status of Imperial Valley Community Bank is being raised because of the client's continuing operating losses and high level of loan losses that has resulted in a "capital impairment" designation by the Arizona Department of Corporations. The client lost $920,000 after audit adjustments in 2016. This is in addition to a loss of $780,000 in 2015. Imperial Valley has also reported a loss of $45,000 for the first two months of 2017. Imperial Valley is also out of compliance with regulatory capital requirements. After audit adjustments, the client has net equity capital of 5610,000 as of December 31, 2016. The Arizona Department of Corporations requires a 6:1 ratio of thrift certificates to capital. As of December 31, 2016, these regulations would require net equity capital of $1,232,000. Imperial Valley was therefore undercapitalized by $622,000 at that date, and no additional capital contributions have been made subsequent to December 31. It is possible, however, that either the parent company, Nuevo Financial Group, or a private investor, Manny Gonzalez, will contribute additional equity capital. We have been unable to obtain enough support for the value of much of the collateral backing outstanding loans. We also have concluded that there is a substantial doubt about the bank's ability to continue in business. The reasons for this conclusion include the following · The magnitude of losses, particularly loan losses, implies that Imperial Valley is not well managed. The losses are continuing in 2017. Annualized losses to date, without any provision for loan losses, are $270,000. Additional equity capital has not been contributed to date, although Gonzalez has $600,000 available. · Our review of client loan files and lending policies raises an additional concem that loan losses may continue. If this happens, it would only exacerbate the conditions mentioned herein. We also believe that it is not possible to test the liquidation value of the assets at this time should Imperial Valley cease to operate. The majority of client assets are loans receivable. These would presumably have to be discounted in order to be sold. In addition, there is some risk that the borrowers will simply stop making payments. In conclusion, it is our opinion that a going-concem question exists for Imperial Valley Thrift & Loan at December 31, 2016.