From 1962 to 1992, Ed McMahon served as the quintessential sidekick and straight man to Johnny Carson on the long-running and popular television program The Tonight Show. After leaving that program, McMahon stayed in the television spotlight for 12 years by serving as the host of Star Search, a syndicated talent show. McMahon’s resume also included long stints as cohost of TV Bloopers and Practical Jokes, the annual Macy’s Thanksgiving Day Parade, and the Jerry Lewis Labor Day Telethon and as commercial spokesperson for such companies as Budweiser and American Family Publishing.

McMahon’s fifty-year-plus career in television made him one of the most recognized celebrities in that medium. Understandably then, the American public was shocked when press reports in June 2007 revealed that McMahon was more than \($600,000\) past due on his home mortgage payments. The \($5\) million mortgage on McMahon’s Beverly Hills mansion was held by Countrywide Financial Corporation.

Unfortunately, millions of everyday Americans with mortgage balances only a fraction of Ed McMahon’s have recently faced the unhappy prospect of losing their homes due to the worst fi nancial crisis to strike the United States economy since the Great Depression. As that crisis quickly worsened and spread to the global economy, the search began for the parties responsible for it. Among the potential culprits identifi ed by the press was the accounting profession, in particular, independent auditors.

Nearly one-half of recent mortgage foreclosure victims in the United States obtained their loans from so-called subprime lenders that became dominant forces in the mortgage industry over the past two decades. The largest of those lenders were Countrywide, HSBC, New Century Financial Corporation (New Century), and Wells Fargo, but more than a dozen other large companies provided loans to borrowers with suspect credit histories. The implosion of the lucrative but high-risk subprime sector of the mortgage industry in 2007 and 2008 ignited a fi nancial crisis in the United States that would quickly engulf the global economy.

The origins of the subprime mortgage debacle in the United States can be traced to the collapse of New Century, the nation’s second largest subprime lender. New Century was founded in 1995 by three friends who had previously worked together at a mortgage banking company. New Century, which was based in Irvine, California, grew dramatically over its brief existence. In 1996, New Century reported total revenues of \($14.5\) million and total assets of \($4.4\) million. Nine years later, the company reported total revenues of \($2.4\) billion and total assets of \($26\) billion.

During the heyday of subprime mortgage lending in 2005 and 2006, New Century funded \($200\) million of new mortgage loans on a typical business day. In early February 2007, just a few months after company executives insisted that New Century was fi nancially strong, those same executives unsettled Wall Street when they revealed that the company would be restating previously released fi nancial statements as a result of the misapplication of generally accepted accounting principles (GAAP). Two months later, New Century declared bankruptcy. A court-appointed bankruptcy examiner summarized the far-reaching implications that New Century’s downfall had for the global economy In fact, New Century would be just the fi rst of many high profi le companies brought down by the turmoil in the United States’s mortgage industry. Longtime stalwarts of the nation’s fi nancial services industry that fell victim to that turmoil included Bear Stearns, Lehman Brothers, and Merrill Lynch.

In September 2008, the federal government assumed control of the Federal National Mortgage Association and the Federal Home Loan Mortgage Company, two “government-sponsored” but publicly owned companies better known as Fannie Mae and Freddie Mac, respectively. At the time, the two organizations owned or guaranteed nearly one-half of the approximately \($12\) trillion of home mortgages in the United States. For decades, the federal government had used Fannie Mae and Freddie Mac to create an orderly and liquid market for homeowner mortgages, but the enormous losses each suffered in 2007 and 2008 undercut that role and forced the U.S. Department of the Treasury to take over their operations.

Angry investors lashed out at a wide range of parties who they believed bore some measure of responsibility for the massive financial crisis. Those parties included the major subprime mortgage lenders in the United States, such as New Century, and the politicians, regulatory authorities, ratings agencies, and independent auditors who had failed to prevent or rein in the imprudent business practices of those lending institutions......

Questions 

1. 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.

2. As noted in the case, there was an almost complete turnover of the staff assigned to the New Century audit engagement team from 2004 to 2005.
What quality control mechanisms should accounting firms have in such circumstances to ensure that a high-quality audit is performed?

3. Section 404 of the Sarbanes-Oxley Act requires auditors of a public company to analyze 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

(a) significant deficiencies in internal controls

(b) material weaknesses in internal controls. Include a definition of each item in your answer. 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?

4. One of New Century’s most important accounts was its loan repurchase loss reserve. Each accounting period, New Century was required to estimate the ending balance of that account. What general principles or procedures should auditors follow when auditing important “accounting estimates”?

5. New Century’s bankruptcy examiner charged that KPMG did not comply with applicable “professional standards” while auditing the company. List specific generally accepted auditing standards (GAAS) that you believe KPMG may have violated on its New Century engagements. Briefl y defend each item you list.

6. Mortgage-backed securities (MBS) produced by New Century and other major subprime lenders have been a focal point of attention during the recent fi nancial crisis. Many parties have maintained that the mark-to-market rule for securities investments such as MBS has contributed signifi cantly to that crisis and that the rule should be modifi ed, suspended or even eliminated. Briefl y summarize the principal arguments of those parties opposed to the mark-to-market rule. Do you believe that those arguments are legitimate? Why or why not?

7. Identify what you consider to be the three most important “take-aways” or learning points in this case. Rank these items in order of importance (highest to lowest). Justify or defend each of your choices.