Auditing and assurance

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Question1

KPMG's strategic decision of specialising in audits of subprime mortgage firms earned them a large pool of clientele that is a major advantage of being a specialist on a particular industry. In order to position themselves as specialists in particular industries are to spend their resources and train personnel on technology required according to specific industry, this way audit personnel and audit firms are better off by understanding the industry throughout where they are specialists which is very fundamental. They continuously invest in gaining more knowledge about the industry's internal control, organisation structure, way the business in conducted which helps them in reducing the time taken for audits by simultaneously improving quality. Auditors will be in a better position to advice their clients about the internal controls and how to overcome potential problems with cost effective solutions. Therefore helps them in providing a good quality audits for their clients. [1]

Differentiation strategy provides an auditor with sustainable competitive advantage also helps auditors to charge premium price avoiding the competition. Industry specialised audit firms assist clients in enhancing disclosures. Choosing an industry-specialist auditor for auditing their financial statements signals a client's intention to provide enhanced disclosures. [2]

Being an industry specialised audit firm also causes them problems with lawsuits being massive therefore poking them to diversify their clients to reduce the intensity. As for market is concerned it gives raise to anti-competitive environment giving raise to monopoly in particular industry which is what happened with KPMG in our case. It also causes issues relating to confidentiality of information across the companies as they are audited by same firm. Any misinterpretation or misrepresentation of accounting policy as with the case of New-Century they calculated their repayment loss reserve wrongly, such a way if an audit firm does any accounting policy wrongly it affects the whole industry of clients. As long as economies of scale and market are concerned it is good to have competitors for specialised industries and diversified clients for auditing firms.

References:

  1. Auditing March 2004: A journal of practice & Theory by casterella, Jeffrey R, Francis, Jere R, Lewis, Barry L, Walker, Paul L Retrieved on 15th May, 2010 from http://www.accessmylibrary.com/article-1G1-116185808/auditor-industry-specialization-client.html
  2. Auditing March 1999: A journal of practice & Theory Retrieved on 15th May, 2010 from http://www.accessmylibrary.com/article-1G1-54952484/industry-specialization-auditors.html

Question2.

The auditor who is responsible for conducting the audit usually called "Engagement Partner" is responsible for choosing an appropriate engagement team with varied range of skills, characteristics and competence to independently perform the audit as per the Auditing Standards. Some quality control mechanisms that KPMG should have followed to improve their quality of audit in case of most of inexperienced staff in an engagement team are:

  1. Training their personnel about the type of engagement and about the industry gives a bit of idea what they should be looking for during the audit. As a part of training they can gain some knowledge form
    previous years audit documentation, working papers helps them learn more about the company.
  2. Particular attention in planning should be given to complex and subjective accounting areas, as these have strong potential for fraud. Appropriate planning of audit should be conducted which assists in
    deciding the requirement for human resources.
  3. Good team work between the members of engagement team by effectively communication across the members from experienced to inexperienced personnel by raising questions and discussing the
    issues.
  4. Supervising the audit engagement by keeping track of progress, checking whether the team has sufficient time to completion, whether they interpretation of instructions are correct, whether the evidence gathered and the decisions made are appropriate.
  5. If needed a consultant or more experienced personnel with relevant knowledge and experience should be hired for the engagement.
  6. Engagement has to be reviewed by engagement quality reviewer until the reviewer approves the quality of audit the engagement partner should not sign the audit report.

KPMG failed to follow the basic quality control mechanisms therefore resulting in poor quality of audit. The significant drawbacks concerning the engagement with New-Century are

  1. Avoiding misunderstanding and maintaining a good relationship with client which would help in providing the good quality audit at low cost, also would have helped their inexperienced staff during the
    audit.
  2. Neglected the engagement quality reviewer report and did not take further steps to investigate further based on quality review report.

Reference:

  • Australia. Auditing Standards Board (27 OCT, 2009). ASA 220 Quality Control for an Audit of a Financial Report and Other Historical Financial Information. Retrieved on 15th MAY, 2010 from http://www.auasb.gov.au/admin/file/content102/c3/ASA_220_27-10-09.pdf

Question3.

The objective of auditing firm is to issue an unqualified opinion on the company's internal control, financial reports of the year-end and the effect of internal control in issuing an opinion on financial reports according to section 404 of Sarbanes-Oxley Act. As the internal controls have significant effect on the financial reporting the effective internal controls of a company gives a reasonable assurance over the reliability of reports and also on the financial statements generated for external purposes.[1]

The auditor's responsibility is to perform an integrated audit to accomplish objectives of both internal controls over financial reporting and financial statements.

To identify whether material weaknesses exist in a company's internal controls the auditor has to plan and execute audit to obtain evidence beyond reasonable doubt to issue an opinion. Even though financial reports are not materially misstated there is a scope for material weakness of company's internal controls during the financial reporting period.

"Deficiency of internal control exists when the normal course of operations assigned to management or staff does not allow detecting the misstatements as and when they occur on timely basis." [1]

"Significant deficiency is a deficiency or combination of deficiencies in internal control, which affects the company's ability of initiate, record, process, authorise or report external financial information in accordance with accounting standards such that the occurrence is more probable that a misstatement of a company's financial statements those are more than inconsequential will not be detected or prevented."[1]

"Material weakness is a significant or a combination of significant deficiencies which prevents in detecting a material misstatement of financial statements which are more probable." [1]

During the audit process each control deficiency is evaluated to determine whether the deficiencies either individually or in combination, are material weakness according to the management's assessment for the reporting period. However an auditor need not look for deficiencies those are lesser than material weakness.

Under testing controls auditor obtains evidence by

  1. Testing design effectiveness
  2. Testing operating effectiveness

During the audit Entity level controls are tested using a top down approach. All the significant accounts and its disclosure are verified as per the management's assertions.

The auditor forms an opinion based on the evidence obtained from all sources including testing of controls, effectiveness of internal controls during the period of financial reporting and any identified control deficiencies or misstatements in financial statements during the audit. If all these evidence does not provide any significant deficiencies of internal control over financial statement or material weaknesses in financial statements then the auditor issue's an unqualified opinion.

The auditor must communicate to the management in written about all deficiencies found over financial reporting and also about any ineffectiveness in the measure of internal controls by internal audit committee about those findings during the audit. He must communicate all these issues in detail to internal audit committee and management.

In the case of New Century's audit by KPMG, auditors failed to identify the significant deficiencies in internal controls and material weaknesses resulted in financial statements.

Reference:

  1. Public Company Accounting Oversight Board (November 2007). Auditing standard no. 5 "An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements". Retrieved on May 16th 2010 from PCAOB
  2. http://pcaobus.org/Standards/Auditing/Pages/Auditing_Standard_5.aspx#_ftnref7

Question4.

Accounting estimates are made when there is an uncertainty in the outcome of an event due to past transaction or most likely future transaction. A firm's management is responsible for making accounting estimates which is based past events, certain facts and assumptions where a professional judgement has to be made according to the framework of accounting standards and adequate disclosures.

The auditor's role is to verify the reasonableness of all the accounting estimates made by management is in accordance with accounting standards framework and its disclosures. It is difficult to have control on these estimates for the management as these estimates are subjective and objective factors. Generally the process of accounting estimates are handled by competent personnel based on certain assumptions and past available data.

If the Internal control based on which the accounting estimates are made are effective that will reduce the likelihood of misstatement of these estimates. The ineffective internal controls affected in case of New Century's calculation of loss revaluation reserve resulting in the misstatement of accounting estimates. Auditor has to verify internal controls relating to accounting estimates.

  1. The auditor should obtain sufficient evidence that the effective internal controls based on which the accounting estimates are calculated are relevant, reliable and sufficient.
  2. Verify whether the estimates are consistent throughout and proper disclosures are made in terms of explaining the estimates.

Auditors when evaluating account estimates he audits and obtains evidence that those estimates developed were reasonable and are presented in accordance to the accounting standards and its disclosures.

The auditors review and test the management's process

  1. All the assumptions were reasonable and consistent and relevant with past data and also analyse the data used is sufficiently reliable for the purpose.
  2. Any change in business has to be considered to verify the significant effects that might cause on the assumptions.
  3. All the documentation regarding assumptions used for developing estimates has to be reviewed. Even if an auditor needs a specialist advice can be exercised.
  4. Reviewing of transactions and events that occurred subsequent to the balance sheet date are significant in evaluation of reasonableness of the estimates and assumptions used.

Reference:

  1. American Institute of Certified Professional Accountants (January 1989). AU Section 342 Auditing Accounting Estimates Retrieved on 16th May 2010 from http://docs.google.com/viewer?a=v&q=cache:4eGr-5n1mv4J:www.aicpa.org/download/ members/div/auditstd/au-00342.pdf+au+section+342&hl=en&gl=au&pid=bl&srcid=ADGEESiC-_b99DFDBKZNK85e6OM7LKzqYmViX5MuHGg5_x2AdzEgkk009d2k9efLWzQ4yQYQmOToNdF78FPUJnjbTrv0RxoUhquF8kccgirNQut4j_XDBrhvs72FRsDjs8zurRnqBVSB&sig=AHIEtbS4WRGv1G6PJKt62iXYb1DOVjetBQ

Question5.

Generally accepted auditing standards that KPMG has violated and was charged by bankruptcy examiner for not complying with standards are

  1. General standards[1]
  2. The auditor should be competent to perform the audit. The very first rule was violated by KPMG when they appointed John Donovan as an engagement partner for 2005 audit who lacks experience with the mortgage industry.

    The auditor should be independent from all means in relation to the audit. But KPMG's auditors Donovan and Kim were concerned about losing his client and were not sceptical enough during audit. They went on further to act unethically by providing erroneous way of calculating loan repurchase reserve which worked out in favour of firm failing the accounting standards.

    Due professional care has to be taken by auditor in regards to execution of audit and in preparation of report. During 2004 KPMG's audit committee identified five significant deficiencies in internal controls which were later concluded as not material weaknesses. The audit committee failed to investigate the findings further to obtain evidence beyond reasonable doubt.

  3. Standards of field work[1]
  4. The planning for audit was inadequate. Before developing an overall audit plan auditor performs analytical procedures, access control risk and inherent risk. Despite of increase in loan repurchases from 2004 to 2005 KPMG failed to plan and perform increased testing or procedures.

    Understanding the entity's financial statements, its internal controls, risk of material misstatement are adequate to design effective audit procedures. Inexperienced staff lacked understanding and new audit committee failed to review completely 2004 audit papers which resulted in lack of knowledge of the underlying internal control problems from previous years.

    As the auditor should be sceptical throughout the audit and should obtain evidence beyond reasonable doubt to issue an opinion. Here auditors are not sceptical enough when they were conducting 2004 audit. During the audit of 2005 the auditor did not obtained enough evidence to declare the significant deficiencies found in internal control were inconsequential. The audit opinion was biased.

  5. Standards of reporting
  6. The conformity of the New Century's financial statements in accordance with generally accepted accounting principle was properly stated in the auditor's report.

    Auditor's report should disclose any changes in the accounting principles from previous year to current. When Kim and Donovan provided proactive advice in calculation of repurchase reserve they failed to disclose the details about the changes in accounting policy in their audit report.

    The auditors must state in the report if any disclosures are reasonably inadequate. I did not find any evidence in violation of this rule by KPMG auditors.

    The auditor must clearly state the quality of work undertaken and should express an overall opinion about the financial statements in the auditor's report. I did not find any evidence in violation of this rule in KPMG auditor's report.

Reference:

  1. American Institute of Certified Professional Accountants (December 2001). AU Section 150 Generally Accepted Accounting Standards. Retrieved on 16th May 2010 from http://www.aicpa.org/Storage/Resources/Standards/DownloadableDocuments/AU-00150.PDF

Question6.

Mark to market rule is an accounting policy which values the assets and liabilities based on the current market realisable value instead of recognising by historical value. As the market condition change the values of balances on balance sheet change frequently. The fair value of assets are based on market not entity specific, the value is the price at which an asset can be sold in a normal transaction between the market participants on the measurement date.

Principle arguments opposing the mark-to-market rule are

  1. The rule pre-assumes the existence of an active functioning market, even when someone is forced to sell the asset the underlying value is taken into consideration as fair value. Therefore arguments are
    made against stating that distress sale considerations have significant effects on the values of assets in financial statements due to huge write-downs (due to volatile markets) therefore resulting in reporting
    a loss in share holder's equity which can happen during the financial crisis.[1] Therefore the application of fair value accounting does not result in the best valuation of assets. These short term fluctuations
    effects on how traders value those securities due to panic distorting the long-term economic value of those securities.
  2. Accounting rule forced more companies to give the actual value of assets based on current market value helping the investors in decision making. But on the other side this argument is significant since the balances in balance sheet always vary. My opinion is to make the necessary changes overcoming flaws while keeping the main purpose undisturbed which is reviewed.

  3. The fair value accounting method causes the pro-cyclicality in the assets of firms like banks which is an unintended fashion during the market raise which reflects into profits inflating the estimates.[2]
  4. As per my opinion these inflated estimates has to be properly disclosed including the detailed calculations. The fair value recognizing rule should need a change in the calculations where the value should be realised based on actual facts instead of considering the inflated market conditions.

  5. This rule allows no depreciation unlike the generally realised book value assets. It always realises the market value.
  6. If security instruments are considered then there is no question of depreciation as long as they trade on active market. So, it should not affect the present rule as per my opinion.

  7. Since there was no active market for certain securities therefore asking traders to use certain complex models, assumptions to determine the fair value. This created an opportunity for traders to assign
    values based on personal interests providing misleading financial statements.[2]
  8. According to my opinion for those securities which does not have active market should be provided with a set of guidelines of how to calculate their values and proper disclosures in reports. All the firms should obtain an approval on the way they are calculated from the organising accounting bodies.

    Reference:

    1. Mark-to-market accounting (May 2010). Retrived on May 16th, 2010 from http://en.wikipedia.org/wiki/Mark-to-market_accounting#Effect_on_subprime_crisis_and_Emergency_Economic_Stabilization_Act_of_2008
    2. Mark to Market tool or trouble by Marv Dumon. Retrived on May 16th, 2010 from http://www.investopedia.com/articles/fundamental-analysis/09/mark-to-market-accounting.asp
    3. Mark to Market. Retrived on May 16th, 2010 from http://www.investopedia.com/terms/m/marktomarket.asp

    Question7.

    1. The highest learning outcome as far as my opinion is "Internal controls of a firm play a key factor in the relevance of financial statements".
    2. Internal controls had significantly deficiencies which prevented the detection of the actual value of loss revaluation reserve which affected New Century viability into its future. Proper revaluation reserves could have saved the company from bankruptcy. From the view of auditor the proper investigation on the identified deficiencies of internal controls would have helped to inform management about the significance of deficiencies and also to obtain an opinion beyond reasonable doubt.

    3. The relationship between the auditor and client firm is important in understanding, obtaining any relevant information and support from internal auditor and internal audit committee. Auditor should be
      independent and should maintain a good mental attitude and should maintain professional scepticism while planning and performing an auditing. The KPMG's auditor's were concerned about the losing
      their client which disabled their professional scepticism which they would have been in normal case. The auditors went on to suggesting an erroneous way of calculating revaluation reserve which boosted
      the profit in financial statements to salvage the KPMG relationship with New Century which impaired the independence of auditor.
    4. Engaging experienced staff for an audit is more important in obtaining a quality audit. Obtaining enough evidence before making a judgement beyond reasonable doubt is most essential, if needed
      specialist investigation report should be exercised. I would say that inexperienced staff cost KPMG with poor quality audits which lead them to facing a lawsuit. The lack of understanding of industry were
      unable to pick up the errors in the internal controls during their 2005 audit the engagement team could not identify the deficiencies in internal controls since they have not reviewed the 2004 working papers/br> properly before the 2005 audit, which resulted in a misstatements of financial statements due to material weaknesses in internal controls.

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