Purpose of the assessment
Students are required to research a recent legal case where an Audit firm was sued for professional negligence. Students are required to analyse the root causes and the pertinent issues from their selected case and then specify what measures can be taken by auditors in the audit approach and in other ways, to minimise the risk of litigation and ensure professional integrity and reputation.
Learning Outcomes:
- Demonstrate an understanding of the reporting requirements of auditing standards (ULO 1)
- Demonstrate an understanding of the auditor’s professional, legal and ethical responsibilities to their clients and third parties (ULO 2)
- Understand the audit planning procedures, evaluate the business risk and assess the internal control (ULO 4)
- Prepare auditing procedures for transactions and balances by conducting control and substantive tests (ULO 5)
Assignment Specifications Purpose
This assignment aims to enhance students’ critical thinking skills and higher order application abilities by researching and analysing a legal case involving the litigation of an auditor/audit firm. Students will need to propose and document mitigating measures to address the risk of litigation and make appropriate recommendations to the audit approach, in terms of the audit strategy adopted, the audit procedures required in the audit program and other appropriate ways for the auditor to mitigate against both professional reputational damage and financial losses.
Assignment Topic – Auditors and Legal Liability
Read the following extract from the ACCA (the Association of Chartered Certified Accountants) website, which is the global body for professional accountants, as stated:
“Over the past two decades the bill for litigation settlements of Big Four audit firms alone has run into billions of dollars. Examples include Deloitte’s 2005 settlement of $250m regarding its audit of insurance company Fortress Re and PwC’s $229m settlement in the lawsuit brought by the shareholders of audit client Tyco in 2007.”
“Auditor liability is increasingly concerning, both in terms of audit quality and the reputation of the profession but also in terms of the cost to the industry and the barriers this creates to competition within the audit market.” (Source: www.accaglobal.com)
Required
Given the importance of professional liability to auditors and the negative publicity this creates for the profession as a whole, research a recent case (Post 2000) where an auditor/audit firm was sued for professional negligence. Students may research cases from the UK, USA, NZ or Canada in addition to Australian cases.
With reference to the facts of the selected case, the significant Auditing and Accounting issues and the final judgement handed down in your selected case:
- Provide a brief description of the key events and the factual issues behind the case
- Explain the culpability or which parties were deemed responsible and why. Outline the damages imposed or the penalties and consider whether they were appropriate.
- investigate and explain the relevant issues in Auditing and Accounting raised by the case,
- The root-cause of the issues such as; market pressure, organisational culture, fraud etc.
- any problems, mistakes or misrepresentations made by the defendants, which contributed to the adverse judgement and the awarding of damages,
- Finally, provide recommendations and possible improvements to:
o the Audit Strategy,
o the Audit Program,
o Other effective measures, which would prevent the recurrence of the same litigation in the future and maintain the professional reputation of auditors.
Solution
Executive Summary:
This report discusses the lawsuit of KPMG and New Century financial corporation which is one of the most considerable cases in which an audit firm was forced to pay the settlement because of negligence from the audit firm. KPMG was not able to disclose the errors and mistakes in financial statements of New Century. Although, top management of KPMG highlighted these errors but were silenced due to the relationship between New Century and KPMG associated firm. KPMG was legally sued for this act, and they were required to pay 125 million US dollars in settlement to shareholders. These 125 million US dollars were divided between KPMG, directors, and officers of New Century and underwriters. This case severely damaged the reputation of KPMG. It is highly recommended that auditors must have professional relationships with their clients, and they should not follow all international auditing standards. The top officials of the New Century were also found guilty, and they were banned from holding any director position in any public limited company for the next five years. This was a lawsuit containing mutual mistakes from KPMG and New Century. It is recommended that auditors must understand the objectives and goals of products and services offered by the client to better understand their business.
Introduction and Key Identified Issues:
The present paper is about a legal case between New Century financial corporation and KPMG. KPMG is one of the biggest audit firms around the globe responsible for conducting an audit of different recognized organizations and multinational corporations. KPMG is also responsible for conducting the audit of New Century financial corporation. New Century financial corporation is a real estate investment trust-related organization which is associated with providing related mortgage loans to investors in the United States by using its subsidiaries like New Century Mortgage Corporation. Another significant subsidiary of New Century financial corporation responsible for originating mortgage loans was Home123 Corporation. The company was formulated back in 1995 and later on it was converted into a proper real estate investment related trust. Later on, after 2 years in 2006, the company was successfully able to register the second position after HSBC Finance about issuing and generating subprime mortgages (Kardos, 2009).
New Century financial corporation was liquidated and became bankrupt in 2007. The headquarters of the company was situated in California, the United States and the company was responsible for providing employment opportunities to approximately 7200 employees according to the reports issued in 2007 by the company. During 2007, New Century financial corporation faced significant amounts of financial difficulties, and it was also reflected in the stock price of the organization in the New York stock exchange. In 2007, the stock price of New Century financial corporation experienced significant decreasing trend in New York stock exchange on April 2nd, 2007, company officially presented Chapter 11 bankruptcy declaring that the company is not able to conduct business anymore. It was a significant setback for the investors and shareholders related to the company. It was one of the most noteworthy and shocking lawsuits related to Audit and material misstatement.
Damages Paid by the Involved Parties:
This was one of the most important lawsuits related to an audit in which the audit form was required to pay heavy settlement due to negligence. It is important for the auditors to make sure that they work professionally with their clients. Due to the lawsuit between KPMG and New Century financial corporation, it was identified that the top three officers in the management of the organization were involved in committing fraud, and they agreed with the court to pay approximately 90 million US Dollars in shape of settlement, and they also agreed that they would not accept any position of director for any public limited company for at least the upcoming next five years (Nilanjan, 2014).
According to the judgment provided by the federal judge, it was decided that responsible parties will pay the approved amount of 125 million US dollars to shareholders of the New Century financial corporation. A federal judge also suggested that the Ex-executives, auditors, and underwriters of the organization will pay this settlement. New York teacher’s pension fund was considered to be the leading plaintiff in this legal case against New Century financial corporation and KPMG. Accusations were raised that KPMG was not able to provide proper information to shareholders regarding the risk associated with the subprime lending situation in the company. Subprime lending, which is a New Century financial corporation, was involved in hiding material information from the shareholders and stakeholders of the company (Reuters, 2010).
According to the settlement payment, it was decided that the directors and top-level officers of New Century will they approximately 65 million US Dollars to shareholders, auditor KPMG will be required to pay approximately 45 million US Dollars to shareholders and under related to investment banking will be required to pay an amount of 15 million US Dollars to the shareholders of the company. During the proceedings of the case, the new century was not able to defend itself because it already submitted bankruptcy in April 2007.
Investors were being led by the New York State teacher’s retirement system Pension Fund. They were accusing the New Century Company of hiding significant information regarding the financial condition of the company from the shareholders and stakeholders of the company. The decision of the case was applicable to people who purchased the common stock as well as preferred stock and call options and sold put options related to the New Century from May 2005 till March of 2007 (Reuters, 2010).
Investigate and explain the relevant issues in Auditing and Accounting raised by the case:
Top level management of New Century financial accused KPMG of conducting auditing behavior in reckless and gross manners. Shareholders believe that KPMG was not able to disclose the actual financial problems of the company in front of the shareholders and stakeholders due to which the decision-making process of shareholders was negatively influenced. In contrary, KPMG has rejected the claims made by the shareholders and the top-level management of New Century financials regarding the third largest auditing organization around the globe (Bajaj & Creswell, 2008).
The lawsuit against KPMG suggested that auditors were responsible for providing legal certification to the material email stated financial reports and financial statements of New Century financial. Auditors were not able to provide an appropriate and independent audit report regarding the financial reports and financial statement of the company. It was one of the most major neglected acts by agents on behalf of shareholders. According to the spokesperson of KPMG, they were inclined towards following the professional standards related to auditing while conducting the audit of New Century financial corporation. According to the KPMG, it was not an accounting issue or audit issue rather it was a business failure on the part of New Century financial corporation which was being imposed on KPMG from audit perspective (Deal Book, 2009).
KPMG accused New Century financial corporation that they are responsible for paying more than 3 billion US dollars to their creditors that is why they have legally presented a lawsuit against KPMG for 1 billion US dollars to settle the claim for the creditors of the company. During the proceedings of the lawsuit, different emails were presented in front of the judge suggesting that it was officially communicated from KPMG to the top-level management of New Century financial corporation regarding the errors and mistakes in the financial statements and financial reports of the company. It was also highlighted during the lawsuit that the partner firms of KPMG silenced this identification of errors and mistakes to maintain a relationship with New Century financial corporation because it was important for partner form to obtain fees from their client and to formulate a positive relationship with them for future audit as well. This suggests that it audit conducted by the partner form of KPMG was not according to the professional requirements of international auditing standards and responsible auditors directly violated the professionalism during their conduct of audit procedures related to New Century financial corporation. This was a direct violation of international auditing standards due to which the judge was forced to place a penalty on KPMG as well as KPMG was also found guilty in this lawsuit (Kollewe, 2009).
Determinants of the problems:
After studying the lawsuit of KPMG and New Century financial corporation, it can be suggested that different factors and determinants were responsible for this massive negligence from KPMG as well as from the top-level management of New Century financial corporation. According to the lawsuit, KPMG failed to act as a watchdog, which is one of the significant duty of an independent audit organization. KPMG was also accused that they were not able to identify the significant and catastrophic problems related to the financial performance of New Century financial corporation which resulted in the implementation of accounting as well as financial mistakes and errors. This contributed towards the collapse of the company and also negatively influenced the decision making of the shareholders and stakeholders of New Century financial corporation.
Another significant cause for this massive audit mistake from KPMG was to formulate a strong relationship with New Century for future work. It was highlighted by KPMG that there are some errors and mistakes in the financial statements and financial reports of New Century, but the identified errors and mistakes were silenced keeping in view the relationship between the client and Audit from. This suggests that the unprofessional behavior of KPMG is another significant cause of this massive audit lawsuit (Deal Book, 2009).
The lawsuit also acute KPMG that they issued independent auditor’s report for New Century for the financial statements and financial reports of 2005 before completing the audit so that company could complete their annual report in 2005 and issue there an official annual report for the securities and exchange commission and shareholders of the organization. This claim was completely rejected by the management of KPMG.
Experts also suggested that the cause for this significant audit failure and bankruptcy was the implementation of aggressive business practices by the top-level management of New Century financial corporation. The company was initially had mortgage loans of approximately 357 million US dollars during its initial operational year in 1996, which significantly increased to approximately 60 billion US dollars in 2006. This is a massive increase just in 10 years. This suggests that the top-level management of New Century financial corporation was not implementing business practices by analyzing the risk associated with their decisions. It is important for top-level management in any organization to ascertain the risk associated with their decision making to make sure that the implemented business practices have the least or minimum amount of risk (Deal Book, 2009).
This also suggests that organizational culture in New Century financial corporation was not in favor of increasing the wealth of shareholders. One of the primary and significant responsibilities of top-level management and directors of public limited companies is to enhance the wealth of shareholders. It should be kept in mind that enhancement in the wealth of shareholders should be made by official means. Top level management of New Century financial corporation was accused and found guilty of not providing appropriate and complete information to their shareholders due to whom decision making of shareholders was negatively influenced. This culture of hiding information from shareholders can also be considered as a significant cause of this failure and bankruptcy, along with the negligence of KPMG during the audit procedures.
Problems, mistakes, or misrepresentations by the defendants:
After analyzing this case, I believe that KPMG properly defended this lawsuit because the top level management of KPMG continuously stressed that they were not involved in any kind of fraud or illegal activity. They even shared the email communication with the judge to justify that they already communicated the issues and errors related to the financial statement of the client. It was the responsibility of the management of the organization to resolve those identified issues by the auditors.
Top level management of KPMG continuously insisted that all the international auditing standards and Generally Accepted Accounting Principles were followed by the audit team to conduct the audit of New Century financial corporation. The claim made by the New Century financial corporation against KPMG was of 1 billion US dollars, but the settlement was decided on 125 million US dollars and out of this decided settlement amount, KPMG was required to pay approximately 44.75 million US dollars. This suggests that defendants were able to defend this lawsuit properly, but it was not possible for KPMG to ignore any settlement because they were also wrong in some aspects.
Recommendations:
Recommendations for improving the Audit Strategy:
Audit strategy is associated with the formulation of schedule related to the direction, scope, and timing of the concerned audit procedures. Various recommendations can be implemented to improve audit strategies. It is important to formulate a proper complaint about feedback audit programmed consisting of the managers, stockholders, top-level management, supervisors, and functional level managers. Collection of feedback from these tough will help the auditors to formulate an effective audit strategy to reconcile it with the audit program to achieve the basic objectives of the audit (Sikka et al., 2015).
Audit strategy can be further improved by reviewing the organizational objectives as well as department objectives as it will help during the audit program and Audit strategy formulation. It is also important for the auditors to make sure that they continuously upgrade their audit competency to identify as well as different report performance related issues. It will not only help the management in resolving those issues but will also help the shareholders to get complete information regarding the performance of the company which will improve the decision making of the shareholders and stakeholders of the company. Another significant recommendation to improve audit strategy is to make sure that recommendations should be formulated for the identified problems and issues and those recommendations must be communicated to the top-level management, and findings should also be communicated to top-level management to resolve those identified issues and problems (Russell, 2009).
Recommendations for improving the Audit Program:
Improving the audit program will help the audit team to reduce the chances of errors or frauds in the financial statements of the client. One of the most noteworthy recommendations to improve the audit program is the implementation of three inspection steps. This means that substantive testing implemented by the Audit Team should be implemented in three inspection steps as it will help the audit team to identify any error or leak in the financial reports of the client. It will also help to improve efficiency as well as the effectiveness of the audit program.
Another significant recommendation to improve the audit program is to make sure that the organization has properly implemented a strong internal control system. With the implementation of a strong internal control system, the auditor will not be required to use extensive substantive testing during the audit procedures to formulate independent audit opinion on the financial reports of the company (Sikka et al., 2015).
Another significant recommendation to improve the audit program is that the Audit Team should properly understand the objectives of the top-level Management and organization related to the products and services offered by that organization to its customers. This will significantly help the audit team during the audit program schedule formulation (Russell, 2009).
Effective measures which would prevent the recurrence of the same litigation:
Some same recommendations can be implemented to avoid similar lawsuits in the future. One of the most significant recommendations is that there should be a professional relationship between auditors and the client. It is the responsibility of the auditor to make sure that relationship prevailing with the client does not exceed the limitations of professionalism. It is the primary requirement of auditing standards to make sure that the relationship between auditor and client is professional. The primary objective of the auditor is to provide an independent opinion on the true and fair representation of financial data of the company while management of the company is responsible for providing correct and complete information to auditors for the audit purpose (Sikka et al., 2015).
Another significant recommendation is to make sure that most of the communication between the auditor and the client should be kept official and documented. This will help to collect evidence in case of any misunderstanding or case of any fraud committed by any party during the audit procedures. It is also recommended that the senior auditors should continuously follow up with the audit team to make sure that all the audit standards are being properly implemented during the audit procedures and they should also analyze the documented communication between the audit team and client to identify any kind of error or fraud from any side.
Conclusion:
In the end, it can be concluded that the lawsuit of KPMG and New Century financial corporation suggests that the top-level management of New Century was at the mistake, and they were involved in not including the material items in financial statements of the company. KPMG was also wrong because, despite the identification of errors in financial statements, they were not able to issue an unqualified audit opinion regarding the financial statement of the company. This lawsuit demanded 1 billion US dollars from KPMG, which was later decided for a settlement amount of 125 million US dollars. Out of these 125 million US dollars, KPMG was required to pay approximately 45 million US dollars while the rest was required to be paid by directors, officers and top-level management of New Century, and underwriters related to investment banking.
This lawsuit also suggests that KPMG was not able to maintain a professional relationship with their client New Century due to which all incidents occurred. It is highly recommended that auditors should keep professional relations with their clients according to international auditing standards.
References
Bajaj, V. & Creswell, J., 2008. A Lender Failed. Did Its Auditor? [Online] Available at: https://www.nytimes.com/2008/04/13/business/13audit.html [Accessed 22 May 2019].
Deal Book, 2009. KPMG Sued Over New Century Collapse. [Online] Available at: https://dealbook.nytimes.com/2009/04/02/kpmg-hit-with-lawsuit-over-new-century-collapse/ [Accessed 22 May 2019].
Kardos, D., 2009. KPMG Is Sued Over New Century. [Online] Available at: https://www.wsj.com/articles/SB123860415462378767 [Accessed 21 May 2019].
Kollewe, J., 2009. KPMG sued for $1bn over New Century collapse. [Online] Available at: https://www.theguardian.com/business/2009/apr/02/kpmg-sued-new-century-subprime [Accessed 22 May 2019].
Nilanjan, R., 2014. Handbook of Research on Strategic Business Infrastructure Development and Contemporary Issues in Finance. 1st ed. IGI Global.
Reuters, 2010. Judge OKs $125 mln New Century lawsuit settlement. [Online] Available at: https://www.reuters.com/article/newcentury-settlement-idUSN1018298820100811 [Accessed 22 May 2019].
Russell, J.P., 2009. Gauge Audit Program Value. [Online] Available at: http://asq.org/quality-progress/2009/06/standards-outlook/standards-outlook-effective-audit-programs.html [Accessed 22 May 2019].
Sikka, P., Filling, S. & Liew, P., 2015. The audit crunch: reforming auditing. Managerial Auditing Journal, 24(2), pp.135-55.
