Kpmg Served as the Independent Audit Firm

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.

2.

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.

There is very much a tremendous ethical responsibility which rests upon him.

According to the Public Company Accounting Oversight Board (PCAOB), a non-profit company established by Congress, one of the foremost jobs of the auditor is to protect investors and further the public interest by conducting "informative, accurate and independent audit reports" (pcaobus.org). The reality is that with any big corporation that deals with tremendous amounts of money and wealth, there's an enormous potential for greed and dishonesty, and auditing companies need to be independent and objective enough to be able to assess the financial statements and accounting methods of such corporations to see if the national economy and investors are at any sort of risk. For example when Friehling, Bernie Madoff's auditor was arrested, "Lev Dassin, acting U.S. attorney for the Southern District of New York, said in a statement that Mr. Friehling was 'not charged with knowledge of the Madoff Ponzi scheme.' Instead, Mr. Dassin said, Mr. Friehling conducted sham audits that allowed Mr. Madoff to perpetuate the fraud. Mr. Dassin said that, by falsely certifying that he audited financial statements for Bernard L. Madoff Investment Securities LLC, Mr. Friehling 'helped foster the illusion that Mr. Madoff legitimately invested his clients' money.'" (Efrati, 2009). This is a prime example of how the dishonesty and failure of an auditing company can do irreparable damage not only to investors but to the entire national economy. According to cnn.com, the damage that Madoff's Ponzi scheme stole was around $65 billion (2009). Such a tremendous number had a direct contribution in slamming America's economy into an enormous recession. This is an extreme example, but it demonstrates clearly and without a doubt, the importance of conducting transparent and independent audits on a regular basis: the sake of the national, local and world economy is at stake. Auditing firms also act as a form of moral compass for these companies by giving them someone to answer to, if done correctly, auditing firms can save corporations from the threat of their own greed. Greed is dangerous because it not only wreaks financial Armageddon, it also causes human devastation.

For example, "Jeremy Friehling, the 23-year-old son of Bernard Madoff's former auditor, David Friehling, has died of an apparently self-inflicted gunshot wound" (Cohn, 2012). This is a tragedy. It demonstrates that the currents of greed have a far-reaching and consumptive ripple effect and it is a shining example of how independent, legitimate audits could have prevented this awful catastrophe, that swindled investors and which devastated families -- even the families of those who were doing the cheating. For example, on the death of Mark Madoff, the 46-year-old son of Bernie Madoff, "Every day for two years, he carried the toxic burden of a name that meant fraud to the world. On Saturday, the eldest son of disgraced financier Bernard Madoff hanged himself in his Manhattan apartment, another casualty in the saga that sent his father to prison and swindled thousands of their life savings" (Long & Hays, 2010). This quote clearly demonstrates the heavy ethical responsibility that auditors have: greed takes and takes. Greed not only takes life-savings, it takes lives as well. This is true regardless of whether a company is private or public.

During the audit of a public company, there is also an audit committee. The responsibilities of the audit committee are as follows: "Oversees the ?nancial reporting process, including internal control over ?nancial reporting. The audit committee also is responsible for the appointment, compensation, and oversight of the independent auditor. Often, the audit committee oversees the company's internal audit group as well" (pwc.com, 2011). These responsibilities are not to be under-estimated. The audit committee has the heavy burden of all of the overseeing of the audit, not just how well and thoroughly the audit is conducted, but the manner in which it is conducted as well. One of the most key responsibilities of the auditors, according to the Sarbanes-Oxley Act of 2002 is that it the audit committee has the responsibility to appoint, compensate, and oversee the work of any registered public accounting firm hired by that issuer (as well as finding a solution to contentions between management and the auditor in connection with financial reporting) so that an audit report can be developed or issued or in relation to comparable work (pwc.com, 2011). Furthermore, the all registered public accounting firm shall report immediately to the audit committee (pwc.com, 2011).

The auditing committee works in conjunction with the independent auditor. The job of the independent auditor involves a tremendous amount of responsibility and obligations. The independent auditor has to develop the public audit report on the company's financial statements which offers the opinion regarding whether the financial statements submitted are accurately and honestly presented and in accordance with GAAP (pwc.com). Independent auditors have the responsibility of engaging in work in accordance with specific regulations; they also need to report directly to the audit committee who works with them and checks their work.

As alluded to earlier, the key responsibility of the independent auditor is to the public. The stakes are high and the things at stake are precious: they're people's lives, jobs, savings, investments, livelihoods and the things help to stabilize the American economy. These are important for our present and future and for our way of life.

"Independent auditors perform their engagements with a skeptical mindset, and they cannot hesitate to challenge management's assertions whenever those assertions run counter to the audit evidence and the auditor's own judgment. It is not uncommon for independent auditors and company management to have different views, for example, over the accounting treatment of a particular transaction, the disclosure of certain information, or the reasonableness of an accounting estimate. However, at all times the independent auditor is called upon to act in a way that serves the public's interest, not the interest of company management" (pwc.com, 2011). This is so important and such a significant sentiment of what the independent auditor does: he needs to approach the corporation or company in question from an extremely unconvinced stance so that the entity has to essentially prove their innocence and their honesty by providing a lot of documentation and records. If any differences arise that the auditor and the company cannot work through together, the audit committee is summoned to help resolve them.

According to the Sarbanes-Oxley act, section 401, the auditors are required to check the financial statements of company for accuracy and so that they're presented in a manner that does not have incorrect statements and should also include off-balance sheet liabilities, obligations and transactions (soxlaw.com). Similarly, the auditors are also required to "attest to and report on the assessment on the effectiveness of their internal control structure and procedures for financial reporting" (soxlaw.com). Furthermore the auditor needs to check that the issuers are indeed printing on their annual reports the scope and adequacy of their internal control structures and procedure for financial reporting which also needs to evaluate the success and effectiveness of such internal controls (soxlaw.com).