KPMG LLP served as the external auditor for some of the largest subprimemortgage lenders in the U.S. leading up to and during the housingmarket crisis of the mid to late-2000s. The audits of two of theirlargest lending clients, New Century Financial Corporation and Countrywide,ultimately led the firm to settle litigation charges in 2010 for$44.7 and $24 million, respectively. The business model of these twosubprime mortgage lenders consisted of providing loans to borrowerswith weak credit histories. The business model had begun to fail during2007, when the economy weakened, borrowers began defaulting, andhome prices declined drastically. New Century filed for bankruptcy andCountrywide was purchased by Bank of America, which subsequentlysuffered massive losses related to business failures at Countrywide.Just before the housing crash of 2007 put the companies in severefinancial crises, KPMG had given both companies unqualified auditopinions.In both cases, KPMG was subsequently accused of violatingprofessional standards, lacking independence, and being negligent. KPMGdefended itself by arguing that its audits were not the cause of the financialwoes at New Century and Countrywide. Rather, the firm contendedthat the failed business model of the two companies led to investor losses.a. How does the economic environment affect the litigation riskfaced by audit firms?b. Should auditors be held liable if their client’s business fails or ifthe financial statements contain a fraud that the auditors did notdetect?c. What defenses do auditors use in response to litigation?d. What actions can auditors take to minimize litigation exposure?
KPMG LLP served as the external auditor for some of the largest subprime
mortgage lenders in the U.S. leading up to and during the housing
market crisis of the mid to late-2000s. The audits of two of their
largest lending clients, New Century Financial Corporation and Countrywide,
ultimately led the firm to settle litigation charges in 2010 for
$44.7 and $24 million, respectively. The business model of these two
subprime mortgage lenders consisted of providing loans to borrowers
with weak credit histories. The business model had begun to fail during
2007, when the economy weakened, borrowers began defaulting, and
home prices declined drastically. New Century filed for bankruptcy and
Countrywide was purchased by Bank of America, which subsequently
suffered massive losses related to business failures at Countrywide.
Just before the housing crash of 2007 put the companies in severe
financial crises, KPMG had given both companies unqualified audit
opinions.
In both cases, KPMG was subsequently accused of violating
professional standards, lacking independence, and being negligent. KPMG
defended itself by arguing that its audits were not the cause of the financial
woes at New Century and Countrywide. Rather, the firm contended
that the failed business model of the two companies led to investor losses.
a. How does the economic environment affect the litigation risk
faced by audit firms?
b. Should auditors be held liable if their client’s business fails or if
the financial statements contain a fraud that the auditors did not
detect?
c. What defenses do auditors use in response to litigation?
d. What actions can auditors take to minimize litigation exposure?
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