KPMG served as the independent audit firm of several of the largest subprime mortgage lenders. Identify the advantages and disadvantages of a heavy concentration of audit clients in one industry or sub-industry (40marks).
KPMG did indeed serve as the independent audit firm of many of the most massive subprime mortgage lenders in the nation. There are concrete benefits and drawbacks to such strong relationships in on particular field. The most fundamental benefit is that of industry expertise. "A report on the U.S. audit market issued by the U.S. General Accounting Office (GAO) in 2008 also acknowledges the importance of industry expertise, noting that 'a firm with industry expertise may exploit its specialization by developing and marketing audit-related services which are specific to clients in the industry and provide a higher level of assurance" (Minutti-Meza, 2010). Ideally, industry expertise leads to a greater knowledge of details, a higher level of quality of the audit in its entirety and greater detection of errors (Minutti-Meza, 2010). Such benefits are obvious and organically developed: the more an auditor or auditing firms deals with clients in the same industry, the more they get a greater familiarity with the precise details of this field of work. There's a deeper understanding of how things work, what to look for, what red flags look like, what normal and what's not. According to studies conducted by Balsam and colleagues (2003), Krishnan and colleagues (2003) and Riechelt and Wang (2010), clients who have auditors that specialize in their given field generally experience an enhanced quality of financial reporting, demonstrating a median range from 0.3 to 2.0% of lower absolute discretionary accruals, when juxtaposed to companies that do not seek out the help of auditors who specialize in their field (Minutti-Meza, 2010).
Ultimately, when it comes to having clients which all participate in the same field, the biggest advantage is that of performance quality of the overall audit. Working with the same clients for years and years breeds a familiarity and an intimacy of knowledge, allowing for the actual work of the audit to capture a greater level of precision. "The acquisition of such sub-specialty knowledge in regulated industries takes time and is gained through extensive exposure to clients in that industry. This difference was hypothesized to result in significance performance gains only in a regulated industry setting when comparing industry-specialist and non-specialist auditors with matched industry-based experience" (Arnold, 2008). This quote is so revelatory as it highlights that the performance quality benefits of such an audit come with the investment of time: the auditing firm is investing their time and their efforts so precisely and intensely in a particular field in order to gain a certain level of mastery when it comes to conducting audits in that arena. Fundamentally, specialization in a given field over a long period of time can reap the ultimate reward for auditors: mastery of the field. "Industry specialists have been found to consistently out-perform non-specialists, who have not had the opportunity to gain industry-specific sub-specialty knowledge" (Arnold, 2008).
However, some experts have alleged that for audit firms to be dealing with the same clients year after year can sometimes chip away at the independence of these auditing firms. For example, some legal and governmental entities have proposed that there be mandatory rotating auditing firms that switch off clients every few years. While some believe this is a fitting solution to some of the corporate scandals that have emerged in the last few decades, others see the inherent flaws in such a proposal. The industry expertise that has been outlined earlier, a process which exists as a result of the time and resources of the audit firm and client, are completely undermined in such a scenario. Mandatory rotations of auditing firms undermines the steep investment of time and resources that audit firms make in the first place when they take on clients from specialized industries. Creating a relationship of longevity is the overall benefit of such specialization and it's eliminated with such a proposed solution.
On the other hand, a real-life example of how even auditors with years and years of experience with a given company can still make mistakes is of course the example of Enron: "Several lessons will likely come out of the Enron disaster. One to be underscored for auditors is the paramount importance of understanding the company's business and industry to identify signi-can't business risks that increase the risk of material misstatements in the ?nancial statements. Without that understanding, it will be almost impossible to identify the next Enron" (McLean, 2001). What's just so ominous (and correct) about this statement is that it is indeed correct. Without thorough, in-depth knowledge of a given industry, which comes from years and years of experience within that industry, it's nearly impossible to know or surmise with any accuracy whether or not a company is hiding or omitting financial documents.
However, one of the clear disadvantages to working with many large clients that all participate in the same industry, is that making one mistake can often lead to repeated mistakes with different clients in the same industry.
In the example of KPGM and the scandal at New Century, the examiners found that KPGM's audits had not been conducted prudently and were not engaged in professional standards (Duska et al., 2011). Furthermore, the examiner team found that at KPGM, there weren't auditors who had enough experience in the mortgage banking industry, another significant problem for the audit as a whole. Furthermore the auditing team was dealing with new Century's own difficult accounting department (Duska et al., 2011). The problem with mistakes like these when they occur in such specialized firms is that there's a danger of them being repeated. This is a very real concern.
Furthermore, having a heavy concentration of clients in one industry can give auditors a false sense of security and a false sense of confidence. For example, while the auditing firm might develop a deep level of expertise with a given field of business, the reality is that every company is distinct, and one simply can't use the same standard or identical methods with one company as with all of them or else egregious errors will result, as they did in the case of KPGM and New Century. In retrospect, it's clear the New Century was engaging in a lot of twisted economic models and intricate but shady accounting work. KPGM was simply not experienced enough, savvy enough or comprehensive enough to deal with them. Their "experience" in the mortgage industry still did not prepare them for a company such as this one, and could only give them a false sense of confidence that they could handle such an audit, when it reality, they were not at all equipped. For example, one of the mistakes that KPGM made was that it did not catch that the Interest Recapture was missing from the repurchase reserve calculation (Knapp, 2010). KPGM did not perform necessary tests and calculations that would allow them to come to such a realization. Either these tests and calculations weren't done because the auditors thought that they weren't necessary in this case or because they didn't understand that they were crucial. Regardless, these egregious assumptions were made as the result of a false sense of security based on having many previous and current clients in the mortgage industry.
Furthermore, another stark disadvantage of having a lot of clients in one particular industry is that it could easily lead to a problem with staffing. Unless a particular auditing company has auditors that are all trained and specialize in mortgages, which few do, then having a heavy concentration of clients in one industry means that certain of those clients are going to receive staff members that don't have the same level of expertise as others.
Section (404) of the Sarbanes-Oxley Act requires auditors of a public company to analyse and report on the effectiveness of the client's internal controls over financial reporting. Describe the responsibilities that auditors of public companies have to discover and report (i) significant deficiencies in internal controls and (ii) material weaknesses in internal controls. Include a brief definition of each term in your answer in contrast with the International Standards on Auditing (ISA) 265. Under what condition or conditions can auditors issue an unqualified or clean opinion on the effectiveness of a client's internal controls over financial reporting?
"No matter how experienced the managing clerk may be the Auditor must always bear in mind that the real responsibility rests upon him, and that he is liable for damages in law where it can be proved that he has been guilty of negligence or misfeasance" -- these word were written by Francis William Pixley as early as 1918 and their truth is still relevant today. The responsibility of the auditor is a heavy one and he has to be the one that is accountable to the law and the one that upholds it.