Financial Recession And The Auditors Role Essay Example Pdf - Free Essay Example

The current recession was precipitated by the rapid growth of the internet industry, mainly dot-com businesses, sparked investor interest. Millions of dollars were invested in these internet companies and unfortunately they were unable to produce a profit causing a crash in the stock market in 2000 and 2001. In addition to the trouble caused by the internet boom, the terrorist attacks on September 11, 2001 caused the United States economy to suffer greatly (Barth et al, 2009). In an effort to stimulate the economy, the Federal Reserve began lowering short term interest rates which eventually fell to around 1.1 percent by 2003 (Kolb, 2010). 1With the interest rate dropping drastically, homeownership became an attainable goal and subprime mortgages helped those with blemishes on their credit record to achieve this goal. From 2001 to 2006 house prices in the United States increased by 51 percent; 34 percent when adjusting for inflation (Ovanhouser, 2009). It was during th is time that subprime mortgage share went from 7.2 percent in 2001 to 20.1 percent in 2006. The growth of house prices and subprime mortgages became rampant as did securitization. Proper documentation for originating a loan was increasingly incomplete due to the lack of oversight, growing from 20 percent in 2001 to more than 35 percent in 2006 (Jarusic, 2010). Its been suggested that documents were missing due to the fact that the demand in homeownership caused lenders to leave appropriate documentation out or that lenders saw an opportunity to gain on these subprime mortgages by giving borrowers unrealistic loans. Normally such loans would not be permitted as they are considered predatory lending, but the lack of documentation gave lenders the ability to do so (Jarusic, 2010). Subprime mortgages, although riskier for the borrower, became very popular during this time resulting in a 451 percent increase in the amount issued(Kolb, 2010). The ability to refinance, sell, or take out a home equity loan was made possible and profitable as homes continued to appreciate, creating positive equity (Jarsulic, 2010). These subprime loans were packaged into mortgage-backed securities and sold on Wall Street generating robust earnings and diversification of portfolios. Similar to any economic bubble, rapid growth is not a realistic constant. Eventually house price appreciation dropped from 13 percent in 2006 to 3 percent by mid-2007 (Ovanhouser, 2009). As a result, borrowers endured negative equity and defaulting on mortgages became more probable because their loan to value ratio exceeded 100 percent. Refinancing loans and selling homes became very difficult. Firms and financial intermediaries alike began to report losses from their subprime mortgage securities. Those with large concentration of these assets relative to their capital became insolvent during this time and bankruptcy declaration by Mortgage giants such as Bear Sterns, New Century Financial and Lehman Brot hers caused widespread panic (Jarusic, 2010). Foreclosure on homes was very common at this time. Not only were mortgage companies affected by the burst of the housing bubble, but hedge funds that invested in mortgage backed securities suffered major losses as well. The burst of the housing bubble was the cause of the financial recession. 2The auditing profession has been accused of playing a role in the financial crisis. In a Wall Street Journal article, Reilly reports that Ernst Young was investigated by a bankruptcy examiner assigned to Lehman Brothers. The examiner alleges balance sheet manipulations and earnings management though Ernst Young maintains that financial statements were within the boundaries of generally accepted accounting principles (2010). KPMG was also invested by an examiner when New Century Financial, their client and one the largest subprime mortgage companies at the time, declared bankruptcy in 2007. The examiner mentions negligence on KPMGs part but sta tes it would be hard to prove. Whether theres a need for proof or not, the examiners report is catching the attention of analysts. The accounting profession is likely to see more accusations in their role of the current financial crisis, but the bankers, regulators and rating agencies are truly the key players in the financial recession. The recession is sure to cause changes in the auditing profession. Mortgage-backed securities, a part of level three in the hierarchy for fair value estimation, will need to examined thoroughly because they are very risky and prone to under or over-valuation; which may lead to material misstatement. In addition to the risk posed by fair value estimations of mortgage-backed securities the recession has created economy-wide budget cuts. These cuts can lead to the desegregation of duties or reduce their internal controls which are typically very costly but are necessary in reducing audit risk. Also, during economic hardship, people may be more despe rate and the motivation to commit fraud, whether theyre social or economic factors, will become great. Auditors will need to adjust to these changes by reevaluating their audits, substantive and analytical procedures. 3