Failed Banks: Accounting and Auditing Reforms Urgently Needed
AFMD-91-43
Published: Apr 22, 1991. Publicly Released: Apr 22, 1991.
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Highlights
GAO analyzed the financial reports prepared by managers and regulators' examination reports for 39 banks that failed in 1988 and 1989 to identify: (1) the impact of accounting and internal control weaknesses on those failures; and (2) reforms that could minimize future losses to the Bank Insurance Fund.
Recommendations
Matter for Congressional Consideration
| Matter | Status | Comments |
|---|---|---|
| Congress should enact legislation requiring that, as a condition for federal deposit insurance, depository institutions prepare annual financial statements in accordance with generally accepted accounting principles and have them audited by an independent public accountant. | The FDIC Improvement Act of 1991 includes requirements in accordance with GAO recommendations. | |
| Congress should enact legislation requiring that, as a condition for federal deposit insurance, depository institutions maintain a system of internal accounting controls which meets requirements like those included in section 13(b)(2)(B) of the Securities Exchange Act of 1934, as added by the Foreign Corrupt Practices Act. | The FDIC Improvement Act of 1991 includes requirements in accordance with GAO recommendations. | |
| Congress should enact legislation requiring that, as a condition for federal deposit insurance, depository institutions maintain controls to ensure compliance with laws and regulations and with special regulatory directives such as memorandums of understanding or cease and desist orders. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes compliance reporting and auditing requirements that address GAO recommendations. | |
| Congress should enact legislation requiring that, as a condition for federal deposit insurance, depository institutions evaluate internal controls in accordance with guidelines issued by FDIC, OCC, and FRB to prepare an annual management report to be published along with the audited financial statements, and which: (1) describes management's responsibility and action taken by it for establishing and maintaining an effective internal control structure and for preparing financial statements; (2) includes management's assessment of the effectiveness of the internal control structure and reports material weaknesses that have not been corrected; and (3) is signed by the chief executive officer and the chief accounting or financial officer of the institution. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes a management reporting requirement as recommended by GAO. | |
| Congress should enact legislation requiring that, as a condition for federal deposit insurance, depository institutions have truly independent audit committees made up solely of outside directors with duties that include reviewing with management and the independent accountant the basis for the reports of management and the independent accountant. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes an audit committee requirement as recommended by GAO. | |
| Congress should enact legislation requiring that the regulators conduct annual on-site, full-scope examinations of all depository institutions. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes the annual, full-scope examination requirement as recommended by GAO. | |
| Congress should enact legislation requiring that independent public accountants, acting as auditors of federally insured financial institutions, be required to report on management's assertions described in its report on internal controls by studying and evaluating the institution's internal controls in accordance with generally accepted auditing standards or other procedures prescribed by the regulators and include the auditor's report in management's annual report. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes a requirement for the independent public accountant to review and report on management's internal control assertions. | |
| Congress should enact legislation requiring that independent public accountants, acting as auditors of federally insured financial institutions, be required to report to the institution and the regulators the internal control weaknesses that are important but are not defined as material to the financial statements or already included in management's annual report. | On December 19, 1991, the FDIC Improvement Act was enacted, and it does not specifically include the reporting requirement, but language is broad enough that the requirement can be included in implementing regulations. | |
| Congress should enact legislation requiring that independent public accountants, acting as auditors of federally insured financial institutions, be required to report to the institution and the regulators on the institution's compliance with: (1) laws and regulations that are identified by the regulators as relating to safety and soundness where compliance can be objectively determined; and (2) special regulatory directives as defined by the regulators to maintain prudent operations or to restore the financial health of the institution. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes a requirement for compliance reporting by the auditor. | |
| Congress should enact legislation requiring that independent public accountants, acting as auditors of federally insured financial institutions, be required to immediately pursue indications of illegality by the institution and inform an officer authorized to sign management's annual internal control report and the audit committee of the institution if the accountant determines that an illegality likely occurred and, then, inform the institution's board of directors in a timely manner. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes a requirement for compliance reporting by the auditor that is broad enough that regulations could cover the specific recommendation. | |
| Congress should enact legislation requiring that independent public accountants, acting as auditors of federally insured financial institutions, be required to resign from the audit engagement or report to the regulators on the illegality, or both, if the illegality is substantial and the institution does not take corrective action. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes a compliance reporting requirement that is broad enough to allow for regulations to include the specific recommendation. | |
| Congress should enact legislation requiring that independent public accountants, acting as auditors of federally insured financial institutions, be required to notify the regulators of the timing and reasons for changes in their status as the auditor of a federally insured financial institution. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes a requirement for direct notification by the auditor. | |
| Congress should enact legislation requiring that independent public accountants, acting as auditors of federally insured financial institutions, be required to undergo periodic peer review such as that prescribed by the American Institute of Certified Public Accountants (AICPA) self-regulatory program or such other quality assurance program acceptable to the regulators. | On December 19, 1991, the FDIC Improvement Act was enacted, and the requirement is included in it. | |
| Congress should enact legislation requiring that federal regulators of depository institutions share with the institution's independent public accountant their knowledge of potential illegal acts by the institution, with exceptions for ongoing litigation and investigations. | On December 19, 1991, the FDIC Improvement Act was enacted, and the requirement is included in it. | |
| Congress should enact legislation authorizing the regulators to remove the auditors for cause with appropriate due process. | The requirement is included in the FDIC Improvement Act of 1991, which was enacted on December 19, 1991. | |
| Congress should enact legislation that requires large institutions to maintain an audit committee that: (1) includes members with banking or related financial management expertise; (2) includes an attorney member or has its own outside counsel; and (3) does not have members that are large customers of the institution. | The requirement is included in the FDIC Improvement Act of 1991, which was enacted on December 19, 1991. | |
| Congress should enact legislation that requires large institutions to have the independent public accountant that audits their financial statements: (1) review and report on the institution's quarterly financial reports employing specific procedures agreed upon with regulators; (2) examine a 1-year financial forecast prepared for the independent public accountant; and (3) meet at least annually with the institution's regulators and audit committee to review the institution's annual financial forecast and assessment of internal controls with more frequent meetings, if quarterly or annual reports disclose significant internal control or financial weaknesses. | On December 19, 1991, the FDIC Improvement Act was enacted, and it includes authority for the regulators that requires a review of an institution's quarterly financial reports only. | |
| Congress should enact legislation that requires the regulators to periodically review the independent auditor's procedures and working papers for large institutions as a basis for regulatory reliance thereon. | On December 19, 1991, the FDIC Improvement Act was enacted, and it provides the regulators with authority to review auditors' working papers. | |
| Congress should enact legislation that authorizes the appropriate regulator to require the independent public accountant for large institutions to review specific operations of the institution as deemed necessary to ensure objectives are met. | The FDIC Improvement Act of 1991, which was enacted on December 31, 1991, does not make this requirement; however, it has provisions that allow and facilitate regulators to implement this requirement. Properly implemented, the act should achieve this requirement. | |
| Congress should enact legislation requiring that the regulators biennially report to Congress on the effectiveness of the auditing and management reforms at large institutions. | The FDIC Improvement Act of 1991, which was enacted on December 31, 1991, does not make this requirement; however, it has provisions that allow and facilitate regulators to implement this requirement. Properly implemented, the act should achieve this requirement. |
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Financial Accounting Standards Board | AICPA and the Financial Accounting Standards Board (FASB) should issue accounting guidance in accordance with the following guidance: (1) a problem loan should be accounted for as an in-substance foreclosure unless there is clear evidence of the lender's ability to collect the loan based on its contractual terms, as opposed to existing accounting rules that require probable non-payment and clear evidence that the loan will default; (2) the value of in-substance foreclosed loans and other real estate owned should be determined based on existing market conditions unless there is clear evidence to support projections of improved financial and economic conditions. The carrying value for other real estate owned should be reduced by estimated carrying costs, including a cost of capital, to the expected date of sale; and (3) the accounting rules and audit procedures for related party transactions should be enhanced to clarify that related party transactions are required to be accounted for and reported based on their economic substance. Also, to assist in identifying transactions where economic substance differs from the legal form of the related party transactions, guidance should be provided on how to determine economic substance. |
FASB plans to reiterate the requirements of existing accounting rules which GAO believes will not significantly alter the problem. GAO is closing the recommendation, as it has ongoing work that will further clarify the issue and sustain the recommendation through other means.
|
| Other | AICPA and the Financial Accounting Standards Board (FASB) should issue accounting guidance in accordance with the following guidance: (1) a problem loan should be accounted for as an in-substance foreclosure unless there is clear evidence of the lender's ability to collect the loan based on its contractual terms, as opposed to existing accounting rules that require probable non-payment and clear evidence that the loan will default; (2) the value of in-substance foreclosed loans and other real estate owned should be determined based on existing market conditions unless there is clear evidence to support projections of improved financial and economic conditions. The carrying value for other real estate owned should be reduced by estimated carrying costs, including a cost of capital, to the expected date of sale; and (3) the accounting rules and audit procedures for related party transactions should be enhanced to clarify that related party transactions are required to be accounted for and reported based on their economic substance. Also, to assist in identifying transactions where economic substance differs from the legal form of the related party transactions, guidance should be provided on how to determine economic substance. |
AICPA deferred to FASB for dealing with the accounting rules. FASB plans to further reiterate the requirements of existing accounting rules which GAO believes will not significantly alter the problem. GAO is closing the recommendation, as it has ongoing work that will further clarify the issue and sustain the recommendation through other means.
|
| Office of the Comptroller of the Currency | The Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and the Board of Governors of the Federal Reserve System (FRB) should adopt the revised accounting guidance for all depository institutions. |
Action can not be taken until guidance is adopted, and it presently appears unlikely that it will be adopted.
|
| Federal Deposit Insurance Corporation | The Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and the Board of Governors of the Federal Reserve System (FRB) should adopt the revised accounting guidance for all depository institutions. |
Action can not be taken until guidance is adopted, and it presently appears unlikely that it will be adopted.
|
| Board of Governors | The Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and the Board of Governors of the Federal Reserve System (FRB) should adopt the revised accounting guidance for all depository institutions. |
Action can not be taken until guidance is adopted, and it presently appears unlikely that it will be adopted.
|
| Other | AICPA should review its professional standards and ethics rules and make appropriate revisions to facilitate the conduct of the additional audit work recommended. |
The recommendation is too broad. GAO will better define what is needed in future work.
|
Full Report
Topics
Accounting proceduresAuditing proceduresBank examinationBank failuresBank managementBanking regulationCorporate auditsFinancial recordsInsured commercial banksReporting requirementsRisk management