The First for Discussion Board Questions :In a detailed discussion board post, using formal writing, please respond the the following questions:

1. Discuss Betty’s ethical dilemma using the six-step approach.

2. The AICPA Code of Professional Conduct and the IESBA Code of Ethics for Professional Conduct both define independence as consisting of independence of mind and independence in appearance. Discuss either concept in relation to the case facts.

3. Discuss Betty’s level of professional skepticism using the six characteristics of skepticism.

4. If you were Betty or on Betty’s audit team, what questions would you have asked Toby about the large amount in the miscellaneous expense account? Do you think Betty should have investigated further? Why or why not?

5. What lessons did you learn from Betty’s experience?

What Lies Beneath: Auditing an Untruthful Client 

The Beginning

Elizabeth “Betty” Waite was an auditor and an accountant for over twenty years. She graduated from Manchester College with a degree in accounting and political science. After spending the majority of her career in public accounting – eight years being with Touche Ross (now Deloitte) – Betty developed an expertise in Housing and Urban Development (HUD) audits. She took her HUD expertise and opened her own firm, Winters Waite CPA, out of her home. The company grew to conduct hundreds of HUD audits and was home to 12 employees.

Winters Waite CPA had an extensive client list, including Groves Funding Corporation, led by founder and CEO Toby Groves. Groves Funding Corporation was based in Cincinnati, Ohio and operated as a mortgage lender, closing loans for a profit on the secondary mortgage market.  

Your Client Defrauds You

During the late 1990s, the housing and the mortgage industry underwent tremendous growth and change. Being new to the mortgage lending business, Toby and his team at Groves Funding Corporation were not prepared to be mortgage lenders. The pace of business picked up, and many of the loans they wanted to sell on the secondary market had errors, such as missing or incorrect documentation.  As a result of these errors, the loans were delayed, thereby impacting the ability to be sold on the market for a profit.  Since Toby was focused on other aspects of the business, he was unaware of the problems.  His company was losing money, and more importantly, money that belonged to clients. Funds that had been placed into client escrow accounts to cover insurance premiums and taxes were now being inappropriately used to cover ordinary business expenses.  This co-mingling of client accounts with Groves Funding Corporation business accounts eventually resulted in approximately $250,000 in losses to clients.

When Toby realized he was losing clients’ money, he panicked. He could have informed the clients of the losses, but he was afraid that he would lose his good reputation and his business.  Employees relied on Groves Funding Corporation for their livelihood; therefore, Toby felt tremendous pride and pressure to keep the business profitable. Instead of disclosing the losses to clients, he decided to apply for a no income verification loan. Popular in the late 2000s, no income verification mortgage loans provided loans to anyone with a certain credit score without income verification. Toby abused this process and misstated his income on his application by saying that his income was $350,000. In actuality, his income was nowhere close to that amount. He rationalized that falsifying his income would enable him to get the loan and get his business back on track. Unfortunately, the business losses kept mounting, and he took out new loans by repeatedly falsifying his income until he was more than $7 million dollars in debt.  At the same time, the housing market was beginning to slow down and the legitimate parts of his business began to deteriorate. 

The Cover Up

Although Betty was unaware of Toby’s scheme, many parties within the mortgage industry were aware of the problems Groves Funding Corporation was experiencing. No one wanted to see the business fail, and the company that provided his warehouse line of credit continued to trust him and issue loans. Internal employees and employees at other companies helped him to falsify documents such as tax returns, appraisal reports, pay stubs, w2s, loan applications, and supporting documentation.  The scheme continued until an anonymous person blew the whistle, which caused the scheme to collapse, and the FBI paid Toby and Groves Funding Corporation a visit.

Should Betty Have Found the Fraud?

Groves Funding Corporation was Betty’s client for 10 years. She enjoyed working with Toby, trusted him, and was proud of the prior success of Groves Funding Corporation. Since Toby was a CPA, he understood the accounting world in a way that many of Betty’s others clients did not.  During her last year of auditing Groves Funding Corporation, Betty recalled that the company experienced a large loss. This loss was an issue because the stipulations on Toby’s warehouse line of credit prohibited him from having a loss and allowing his net worth to go below $500,000 dollars. Unfortunately, both of these things happened to Toby, thereby impacting his warehouse line of credit.

Naturally, Toby was concerned about his business. After talking to a few people in the real estate industry, he was advised to form a new entity. At the time, HUD would allow Toby to continue to make HUD-insured mortgages as long as the new entity had $500,000 of net assets. Toby then formed a new company. Betty’s firm audited the beginning cash balance and some real estate accounts on the balance sheet for his new company. Betty’s team did not audit any transactions; however they discovered a miscellaneous expense account of $500,000 and were surprised.

The audit team questioned Toby numerous times about the large miscellaneous expense balance. Toby and his employees gave Betty and her team an explanation that would explain a piece of the story. The audit team would then go back and pour over calculations, attempting to get comfortable with Toby’s explanations. Every time the audit team had a question, Toby was able to come up with a reasonable explanation to satisfy a part of the mystery. Betty and her team’s questions remained but their questions were not material, so they suggested that Toby complete a reconciliation. A reconciliation supports a specific amount and is normally expected to tie the amount recorded in the client’s records to another source of information. A reconciliation was beyond Betty and her team’s scope of work, therefore they did not complete it. After Toby completed the reconciliation, the team discovered Toby was involved in some derivative transactions which were not illegal but were concerning. After going back to Toby with additional questions and analyzing Toby’s answers, the audit team felt confident in Toby’s explanation and did not investigate further.

The questions Betty’s team raised were just the “tip of the iceberg” of the mortgage fraud scheme Groves Funding Corporation was involved in. Ultimately, Toby Groves was sentenced to two years in federal prison for a $7 million dollar bank fraud which caused several companies to go out of business and hundreds of people to lose their jobs.

{From movie: Betty explains how she missed red flags in the fraud scheme.

[Betty Waite] Well you see there wasn’t- you have to understand that the massive part of the fraud did not happen in 2004. It was just the tip. It was just the very beginning of it happened in 2004. The massive part of the fraud happened in 2005 and in 2006. So you know how – you know how – you ladies are probably too young but your hair goes gray. Your hair goes and you know there’s a few, you see a few gray hairs and you think ‘oh it’s no big deal’ But then time goes on and you see a few more gray hairs and you wonder what it looks like for people that are standing above you. They can see all the gray hairs, so you starting coloring your hair. Well there were really just a few gray at that point. There- in retrospect, in retrospect which is you know 20/20. I can see where the two loans in particular we looked at they were related party transactions. They were- he had overstated his income in order to get the warehouse to release the funds from the line of the credit so that he could-he had this sinking ship and he was trying to bail water as quickly as he could. If we had- there were tests we probably could have done to discover that, but it was way beyond the scope of what our- what the procedures were that HUD specifies we have to do under those circumstances. So even in retrospect, I doubt that we would have caught it. I mean there was collusion. Everybody in that organization was working together by the time- even at that point everybody in the organization was working together. I sat in a room with Toby and Kevin Moore trying to understand what this $500000 in miscellaneous expense was and they were both lying to us. They both knew what the issue was, and they both lied to us. And I’m not sure- I’m not sure if there was anything that we could have done, short of going through every single loan file to find those loans. Cause they didn’t- your question earlier we were talking about whether any of the fraudulent loans showed up in our random testing and there were, I mean, he had I don’t know 2000 loan files a year and there weren’t- there was just this tiny little tip that were fraudulent at that point, and none of them showed up in our sample. And we did do – because there were so many loans we did do random testing for the- but HUD specifies how many loans we test. We tested 45 loans and that is considered- if you don’t have any problems then you can stop there. And we didn’t have any problems. We did- there were two loans that were not- and those two loans actually were supported by real properties. The error on those two loans was that he overstated his income and it was himself and an employee. But he was self-employed, so how were we gonna know if he overstated his income? Because all you have to do is look on the personnel records and they’re really easy to manipulate when you’re self-employed. You make them say whatever you want to.

How did you feel when you heard what happened to Toby’s business?

Well, it was scary. I was- whenever you, I was concerned my work would become part of the lawsuit. That was scary. Not that I really worried about it, it’s scary. It’s like getting a call from the IRS that they’re gonna audit your tax return. You know that you’ve done everything the way that it should be, it’s still scary. So there was some fear that they would look at my stuff and I mean, I wasn’t really- we – every year, because Toby was the largest mortgage broker that we audited, every time we had a period review, his audit were looked at the period reviewers, and they never found anything… anything inappropriate with the way we were doing his audits. So I wasn’t really concerned about that, but just the exposure and I mean, you audit someone for ten years and you feel compassion, you get to know them, you… you know, develop some affection for them, and I didn’t want anything bad to happen to Toby. I was sad that his life was going to be dramatically changing.

Reflection

Betty and her team raised questions about some potential red flags, however, the level of collusion among the employees prevented her team from discovering the fraud. Although they were asking the right questions, they were getting inaccurate information because the clients were lying. Maintaining a high level of professional skepticism is key, especially when working with long-term clients whom you’ve developed a close relationship. Perhaps if Betty and her team continued to question Toby and his employees, they would have discovered the red flags that would have uncovered the fraud.

Toby was motivated by a fear of falling; that is, he was afraid that because of some mistakes on his part, he faced the prospect of losing his business.  To avoid the demise of his business and a subsequent fall in his standard of living, he decided to cover up his losses by fraudulently securing a loan.  He hoped that with the cash from the loan, he would be able square his books and get his company back on its feet.   

White-collar offenses have three defining characteristics that distinguish them from other forms of crime.  First, white-collar offenders have legitimate access to the target of their illegal activities because of their occupational positions.  Because of his role as a mortgage banker with a warehouse line of credit, it was not difficult for Toby to submit a fraudulent loan application.  Second, the illegal actions of a white-collar offender have a superficial appearance of legitimacy. Due to his position and experience with the mortgage banking and loan application process, Toby prepared applications that appeared legitimate.  Finally, white-collar offenders are often spatially separated from their victims.  In this case, the victim was the bank that held Toby’s warehouse line of credit, and Toby never met with the owners of the bank to get his loan.  These characteristics made it easy for Toby to rationalize submitting multiple fraudulent loan applications.

The lesson? When a client is lying, it can make the auditing process extremely difficult.

Solution

Question 1. Betty’s ethical dilemma using the six-step approach

An ethical dilemma invokes a mental conflict between moral essentials in which a decision to obey one transgresses another. The six-step approach first requires obtaining of the relevant facts from the situation. The next step is the identification of the ethical issues from the available information followed by ascertaining the people affected by the result of the dilemma and the way each person is affected. The fourth step is identifying the alternatives available for solving the dilemma which is followed by a fifty procedure; recognizing the possible effects of these choices. The last step is deciding on the proper action plan.

In this particular case of Betty, the audit team faced a dilemma obtaining the relevant information from Toby and his employees. Toby always designed methods to let the review team believe false claims about financial reporting. Therefore, the team had difficulties identifying ethical issues from cooked data. Also, it was challenging to determine the party affected by the outcome of the dilemma since employees of Groves Funding Corporation hide most of the information. For instance, Betty could not know whom the significant funds, falsely allocated to mysterious expenses was affecting. By the scope of her company’s mandate, Betty had no of extending the auditing despite the fact that she doubted the information given to her. She did all her audit work including inspection of forty-five files of over two-thousand available files at Groves Funding Corporation (Lindberg & Beck, 2004).

Question 2. Independence in appearance

It is the tendency to avoid circumstances and facts which are so essential that an informed and third party, with knowledge of all necessary information, would reasonably conclude firms integrate, objectivity or professional skepticism has been compromised. For example, Betty doubted that Toby was hiding significant facts about the miscellaneous expenses, but they avoided to show doubts. Instead, her team attempted to get comfortable with Toby’s false information.

Question 3

Betty’s level of professional skepticism using the six characteristics of skepticism

The six components are a search for knowledge, a questioning mind, a suspension of judgment, an Interpersonal understanding, Autonomy, and Self-esteem (Jagadeesan, Jeffrey, Pitcher & Riely, 2009). Betty has a right attitude of curiosity and interest in her mandate. She continually seeks further clarification from Toby, demands prove, reasons and justification for doubtful information.

 She has a weak suspension of judgment; she should have suspended the decision based on unreliable data.  Her searching for knowledge is moderate; her investigation to acquire added information to reduce doubts is insufficient. Betty has a profound interpersonal understanding because while most people understood reasons behind Toby’s behavior, she unawares until Toby is convicted. It is also possible that her low self-esteem makes her to not further question Toby and employees even though she knows they were lying.

Question 4

If I were in Betty’s audit team, I could have asked Toby to give an explanation to account for the vast amount of expenses. I could not get satisfied with non-convincing responses. I think the audit team ought to have investigated further because the information they received was unsatisfactory to them.

Question 5: Lesson

My lessons from Betty’s experience is that although false information makes auditing a tiresome exercise, the auditor should ensure that any information provided for auditing is reliable.

Bottom of FormReferences

Jagadeesan, R., Jeffrey, A., Pitcher, C., & Riely, J. (2009, September). Towards a theory of accountability and audit. In European Symposium on Research in Computer Security (pp. 152-167). Springer Berlin Heidelberg.

Lindberg, D. L., & Beck, F. D. (2004). Before and after Enron: CPAs’ views on auditor independence. The CPA Journal, 74(11), 36.

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