Kendallville Bank Case Questions

1. On a scale 1 to 10, how serious of a problem exists at Kendallville Bank?

Kendallville had a serious fraud and integrity problem that affected the bank’s functions. The

bank is concerned with financial reporting fraud prevention and detection, there I would rate the

severity of this problem a 7.

2. What is the main issue of the case?

The main issue of the case is that Kendallville Bank is trying to minimize fraud. The study shows

the financial reporting and fraud at a multidimensional level. It also explores the corporate

governance arrangements and management controls at Kendallville Bank.

3. What did Davis do to the Allowance for loan and lease losses (ALLL) in the second quarter?

Kendallville was able to cutdown on some real estate business because of Davis, which enabled

Kendallville to cutdown business in those sectors due to a slow economy. Kendallville had also

experienced some losses, but they were minimal. Kendallville had a chance to act quickly. When

management was able to confirm that all or a portion of a loan would not be repaid, they

“charged-off” or reduced the carrying amount of the loan, which was the amount that they did

not expect to collect. However, a recovery occurred when the bank collected payments on a loan

previously charged-off. At each balance sheet date, bank management estimated the ALLL

needed based on the loan portfolio as of that date. Management then made an adjusting journal

entry to increase or decrease the ALLL account to the needed balance; the offsetting entry was

recognized through an account called the Provision for Loan and Lease Losses (PLLL) that

appeared as expense on the bank’s income statement.

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4. Was the change appropriate?

Change was appropriate because it improves how the bank functions, it reduces loss, and it

helps to identify where the bank needs to make changes in the areas that need improvement.

5. How might changing the look-back period from 8 quarters to 12 quarters impact the ALLL?

It will reduce losses, increase efficiency in the bank, and the make the day-to-day operation run

more smoothly.

6. How does changing the look-back period impact the financials?

This will reduce more expenses and increase profits. The look-back period described how much

historical data was used in the quantitative part of the ALLL. Many banks used a 12-quarter look-

back period. Throughout most of its existence, Kendallville had also used 12-quarter look-back,

but it had changed to an 8-quarter look-back during the economic downturn because the

conditions were changing rapidly. Therefore, Davis decided that shortening the look-back would

place greater weight on recent events.

7. What may have motivated Davis to propose changing the look-back period?

Since the discussion had already occurred, the CQC members typically agreed by consensus to

the ALLL proposed by Davis. The CQC rarely made any adjustments, however, when Davis made

a proposal, they did. This was partly due to the design and format of the meeting, the members

respect for Davis, his track record and his sterling reputation at Kendallville. After the meeting,

Davis wrote up a summarized memorandum covering what the CQC had decided, he had the

loan officer review it, and then presented it to Kmetko for approval.

8. Were the discussions at the Credit Quarterly Committee meetings at the appropriate level of

detail?

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The CQC was responsible for making several estimates necessary for Kendallville’s financial

reporting. One of the most important of these was measuring the ALLL. The CQC was lead by

Davis, and also included the corporate controller, the loan review officer, and John Jones, the

senior Vice President. Representatives from both internal and external audits attended frequent

CQC meetings to assess designs and test effectiveness.

9. What did Davis do to the ALLL in the third quarter? Was the change appropriate?

During the third quarter CQC meeting, Davis made several suggestions, which could make a big

impact. He noted economic concerns and suggested that there were positive and negative

economic indicators. Davis explained that he felt it was time to drop the separate commercial

real estate loan by combining them with the commercial real estate loan category for purposes

of the ALLL calculation and utilizing the default rates from the CRE1 loan category for the new

combined portfolio.

10. Do using the historical loss rates from only the CRE1 loans distort the ALLL?

Historical loss has a significant impact, as they determine the reserve needed for impairment in

the loan pools, frequently these pools of loans make up a considerable portion of the bank’s or

credit union’s portfolio and reserve calculation, so gathering and accessing data for historical loss

rates is important to the success of the ALLL calculation. Most financial institutions utilize a

single method to calculate historical loss rates for their FAS 5 pools: the traditional historical loss

rate calculation or migration analysis.

11. What may have motivated Davis to propose dropping the CRE2 category at this time?

These loans fell into Kendallville’s CRE1 category. Occasionally, these customers got involved in

commercial development in larger cities.

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Kendallville created a new category, CRE2, for these loans, and the business grew rapidly. During

the economic downturn, however, Kendallville increasingly felt the high risk in the CRE2 loans,

which were experiencing higher default rates and as a result, higher than expected loss rates and

charge-offs.

12. If you were Sandra Renford, how would you manage Dan Davis?

Davis needs supervision and professional advice when making decisions that concern

Kendallville. In addition, I would assign a team of four personnel to oversee everything he is

doing. I would also ask him to bring daily reports and update the board on the bank’s progress.

13. What is your assessment of the governance environment at Kendallville?

The governance environment at Kendallville has some setbacks and management is fearful of a

loss, hence forgetting the main objective, which is running the bank smoothly.

14. Is Kendallville Bank a typical company with typical challenges, or is there something unusual

about it?

The annual goals for internal audit focus mostly on operational efficiency opportunities and

identifying weaknesses in the loan underwriting department, which had been developed by

Kmetko and Lee’s predecessor at the beginning of the fiscal year. Lee knew that the internal

auditors needed to interact more directly with the audit committee and that the annual audit

plan needed to be more risk-based, however she struggled with improving the functions. Thus,

Lee was looking forward to a meeting with Renwood and Kmetko to discuss the issue but was

not sure if Kmetko would be very supportive.

15. Was independence of internal audit an issue at Kendallville?

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Lee had two reports that were profitable and could account, but they were not experienced

enough to challenge the status quo on their own. After Lee took over the function, Lee had a

conversation Kmetko. She explained to him that she was unfamiliar with several aspects of the

job that had been handled by her former boss. This included testing the operating effectiveness

of the controls related to the Allowance for Loan and Lease Losses.

16. Has the corporate culture at Kendallville impacted internal audit’s ability to be objective?

Businesses operate under risky conditions. To achieve its objectives, businesses must implement

management control processes by which administration can motivate employees to reach their

goals.

17. What were the effects of LaSalle’s new business activities on the quarterly review?

Renwood had pushed for steady, “smart” growth, she focused on running the current bank as

effectively and efficiently as possible. To keep profits growing and shareholders satisfied, she

pushed her team hard to compete for new business and to drive down costs wherever possible.

Cost cutting had primarily occurred in back-office, non-facing customer departments to not

undercut business and revenue. While the bank avoided laying off employees for fear of

retaliation, hurting morale or bruising the bank’s reputation, Renwood strongly encouraged her

team to not hire replacements for staff who quit on their own.

18. What should Watkins have done when she realized she was in over her head?

This included evaluation of factors impacting the quantitative component, including how loans

were divided and the look-back periods to use for historical loss rates.

19. Was the overall level of skepticism at Kendallville appropriate?

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The level of skepticism at Kendallville was appropriate and necessary because it was on the

verge of experiencing a bigger loss, therefore, in this case, skepticism was needed.

20. What about communication? Who is trying to do it well? Who is avoiding communication?

During the second quarter CQC meeting, Davis explained that he had seen some troubling signs

that the economy was slowing down, but he considered them to be minor negative points in an

overall ongoing recovery. During his presentation, he recommended increasing the look-back

period used to calculate the ALLL from eight quarters to twelve.

21. What actions should the board of directors, audit committee, and compensation committee

take?

The Board of Directors should have included charge-offs and recoveries when they determined

loans were not going to be paid. They should conduct recovery plans on loans with charge-offs.

Furthermore, management should adjust the journal entries to increase or decrease the ALLL

account.

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