Assignment I: Due in class Friday, January 23, 2009
CASE STUDY: First National Bank
The First National Bank is a large commercial bank located in Baltimore, Maryland. The services which it offers include demand deposits (checking accounts), savings accounts, trust accounts, loans, and credit cards.
Each of these services is managed by a separate department within the bank, and each of these departments has its own set of operating procedures and controls. The purpose of these procedures and controls is to ensure that bank personnel carry out their responsibilities correctly, completely, and honestly. Commercial loan procedures, for example, require that the following steps be taken when a loan is granted. First, the credit rating of the debtor must be established; second, the interest rate must be determined; third, the collateral required for the loan must be specified; fourth, the authorized officers from the borrowing corporation must sign the loan; and fifth, the authorized loan officers of the bank must approve and sign the loan agreement.
After the loan has been granted, the commercial loan department must continue to monitor the loan. Have payments been made regularly? Is the market value of the collateral sufficient to cover the balance of the loan? Are the bank records up-to-date, accurate, and complete? If the answer to any of these questions is no, the loan department must initiate whatever corrective action is warranted by the situation.
But the operations of a department are not exclusively under its own control. Federal banking laws require that commercial banks maintain an independent internal audit staff for the purpose of examining the controls and procedures used by each operating department. These periodic examinations must conclude that the department either is adhering to these controls and is therefore “in control” or is not adhering to these controls and is therefore “out of control.” During these examinations the internal auditor must also be on the lookout for any fraudulent activity within the department.
At the present time Tom Martorano and Diane Richmond have just started to audit the commercial loan department. Tom has performed this audit four times in the last year, but Diane has been on other assignments. From his experience with the department, Tom feels that there is a 90 percent chance that it is adhering to its current procedures and controls. Diane, however, is more skeptical. The audit was started by selecting a commercial loan and examining its documentation and collateral. Tom feels that if the department was “in control,” the probability is just 2 percent that any error will be uncovered during the examination. But if the department was not “in control,” the probability of
uncovering an error increases to 50 percent.
The loan they examined was made 1 year ago to the Acme Corporation. Their examination showed that the credit rating of the debtor was properly established, that the interest rate was sufficient, and that the authorized signatures of the bank’s loan officers were obtained. But they found that one of the
required signatures from Acme Corporation was missing. According to a corporate resolution, which
First National Bank retained in its files, both the vice president of finance and the treasurer of the Acme
Corporation were required to sign every loan agreement. The present loan was signed only by the vice
president of finance.
Both Tom and Diane agreed that additional loans must be examined. They selected a second loan and
found everything in order. A third loan was examined and again everything was in order.
Tom said, “I am satisfied that the loan department is adhering to its procedures and controls. Before we
started the audit I was very confident that it was. Even though we did find one error, the result of the
next two samples restored my confidence. I think we should give the department our approval and
move to the next audit.”
“I don’t agree,” replied Diane. “We found one error in three accounts. This could mean that one-third of
the accounts in its files are in error. I think that something could be wrong with its controls and that we
ought to continue the audit by examining additional records.”
1. Should the prior knowledge which Tom Martorano has influence his decision?
Please develop and neatly and efficiently constructed Excel spreadsheet to answer the following
2. If Tom’s prior knowledge is used, what is the revised probability that the loan department is “in
control” after the first sample has been taken?
3. What is the revised probability that the loan department is “in control” after the second sample
has been taken?
4. What is the revised probability that the loan department is “in control” after the third sample
has been taken?
5. What conclusion would you reach after the third sample?
6. Is Diane Richmond’s position justifiable?
7. In addition to the three loans which have already been audited, how many more loans with no
errors would it take before the revised probability that the department is “in control” reaches
Your answers should be submitted in summary fashion in hard copy and your spreadsheet should be
submitted electronically to my inbox.