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Recession Cause Changes In The Auditing Profession Finance Essay

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Date added: 17-06-26


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The financial meltdown of 2007 was a calamity to the world economy. The meltdown initiated a period of severe instability to the global financial system which resulted in the failure of several financials giants and billions of dollars from stimulus packages issued by governments around the world. However, the collapse of the housing market was the epicenter of the financial meltdown. It created a domino effect which in turn shook the economic stability of the United States severely affecting financial markets, banks, corporations, small businesses, and ultimately consumers.

Causes of the current financial recession:

The financial collapse in 2007 was triggered due to the collapse of the housing market. The housing bubble in the United States started in the mid 90s. (Baker, 2008) In the years prior to the collapse, low interest rates were pushed by the Fed in an effort to increase homeownership in the United States. This led to a rapid and continuous increase in the demand as well as the prices of residential properties. Given the circumstances, Wall Street investment banks grouped the loans and offered them as mortgage backed securities to investors. Mortgage backed securities represented the right to the debt obligation on residential properties. Under the conditions at the time, it was blindly assumed that real estate values would continuously rise and when such is the case, where the value of an asset is assumed to be constantly increasing, the concept of risk associated with that asset diminishes. Therefore, lenders increased their issuance of loans to the general public. Subprime and adjustable rate mortgages, "arms", were loans given to less than qualified buyers and their riskiness was almost always ignored. The extension of credit through subprime and adjustable rate mortgages resulted in millions of defaults around the country. The adverse affects of this process were made widely apparent when mortgage backed securities began to collapse as a result of widespread mortgage defaults. As the demand in the housing market was increasing rapidly, construction companies saw the need to accommodate prospective homeowners. This led to a home building frenzy which eventually led to a highly saturated market. Furthermore, when housing sales began diminishing, a large number of newly built homes were left empty and even more were left in progress as construction halted due to unprofitability. It is widely believed by many people that the main causes of this crisis were greed and market failure. However, the government's lack of appropriate policy making also contributed significantly to this crisis. Homes are often the most valuable asset of a family. Thus, it had always been an objective of the government to increase home ownership in the United States. Therefore, in an effort to support people, who otherwise were not worthy candidates for homeownership, the government pushed to lower lending standards. "To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy." (Manoj, Oct 2010) Down the road, these policies eventually led to the issuance of subprime and arm loans. Furthermore, later, as the demand for houses decreased, investors were the first to pull out causing another shock to the already stagnant market. (Christie, April 2007)

Did the auditing profession contribute to the financial meltdown?

The purpose of auditing is to provide investors as well as other users of financial statements with complete and accurate financial information. This objective is achieved through analyzing and assessing a corporation's financial information and issuing a statement based upon the gathered evidence. In achieving this object, it is essential to thoroughly examine a corporation's major sources of revenue and their reliability. Furthermore, it is quintessential to determine whether or not a corporation's business practices are ethical and lawful. Failure to follow these procedures can also be looked upon as a failure on the part of auditors to perform their job correctly. Therefore, taking into account the purpose of auditing, it is not farfetched to say that the auditing profession did indeed contribute to the financial meltdown, because of its failure to detect the highly risky business practices of many banks and corporations as well as failing to catch the material misstatements on their financial statements. Furthermore, during the financial crisis, auditors were placed under a lot of scrutiny by people for failing to perform their jobs correctly. For example, an audit of a mortgage company should have began with looking at their products and services, speaking to brokers and underwriters in detail, checking the creditworthiness of borrowers, examining all related paperwork, and assessing the risk of recovering the loans. An in depth analysis of the business process of such companies should have alerted auditors about the red flags of a possible failure. In many instances, lenders were practicing "predatory lending," in which consumers were mislead into signing contracts of which they knew not the details of. In consistency with the objectives of auditing, it was the responsibility of auditors to discover and report such unethical acts in their reports. However, hundreds of firms continued to practice this method of lending so that they may sell the loans to banks on Wall Street. The lack of specialized auditors for the financial industry was also another reason for the failure to detect the misstatements on financial reports. Due to the fact that many banks were performing operations with risky and highly complex financial tools such as derivatives, it was difficult for auditors to detect fraud and report accurately on these operations. Fannie Mae paid Deloitte $49.3 million in fees in 2007. "The firm was hired by Fannie Mae in 2005 because its predecessor KPMG missed accounting errors that cost the housing finance company $9 billion in previously reported profit." (Berr, Sept 2008) The necessity for diligent auditors to perform their work with greater accuracy was evident in the years before the financial collapse. Shareholders lost large percentages of their investments and suffered greatly; it could have been possible for these shareholders' investment to be safer if auditors would have been able to spot red flags related to the collapse.

Will the recession cause changes in the auditing profession?

The failure of several major banks, insurance companies, and mortgage companies, among others during this recession has left a lasting impression on the auditing profession. Due to the failure of many auditors to detect fraud and material misstatements on the financial statements of many firms, it is more than likely that the auditing profession will have to undergo more stringent policies and procedures. There is no doubt that stricter policies must be implemented to prevent any future financial crises. Enforcing auditors to focus more on governance as part of their audit would improve the audit's effectiveness because it would allow auditors to gain insight on the activities of the board of directors as well as any relevant committees. Furthermore, this will also give insight on the different employee positions and what their rights and responsibilities are. By focusing on governance, auditors will also get a better understanding of the firm's environment and be able to determine the nature of the controls as well as that of the personnel. In addition, implementation of stringent guidelines for internal auditors would significantly reduce the risk of fraud and material misstatements. It would allow for a more ethical business environment because internal auditors would be present throughout the fiscal year and would be able to provide the board of directors with thorough assessments. An important change required in the auditing profession is to make the guidelines on when to use and not to use auditing specialists. In recent years, during the peak of the financial crisis, many auditors failed to detect risks associated with complex financial instruments used by corporations. Requiring the use of competent and diligent audit specialist will ensure the quality of the audit performed. On the other side of the spectrum, however, one can also argue that the blame for the financial crisis solely lies upon auditors. Auditors jobs are not to predict the future but instead their job is to make sure that corporations have provided reliable information on their financial statements. (ACCA, Oct 2010)

Conclusion

The financial crisis of 2007 was one of the worst economic disasters since the Great Depression. In the turmoil, hundreds of banks defaulted; financial giants, such as: Merryl Lynch, Lehman Brothers, and Bear Stearns went bankrupt or were bought out. The housing and mortgage crisis played out to be the originator of the domino affect which resulted in severe calamity across the financial world. Even with billions of dollars worth of government funding, many toxic assets were still left untouched and on the books of lenders. The auditing profession contributed to the financial crisis through a lack of following the proper procedures and failing to detect the risks that were present in these firms. It is up to the auditor to issue an opinion on the financial statements of firms and one could argue that the auditors failed to give an appropriate opinion. More stringent rules and regulations will help auditors be able to perform their jobs with greater competence. In the aftermath of the financial crisis, the global economy has still not fully recovered. Furthermore, many economists believe that a double dip recession could be headed our way. Enforcing stricter auditing policies would definitely help mitigate possible threats to our financial stability and to our economy.
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