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KPMG LLP served as the external auditor for some of the largest subprime mortgage lenders in the U.S. leading up to and during the housing market crisis of the mid to late-2000s. The audits of two of their largest lending clients, New Century Financial Corporation and Countrywide, ultimately led the firm to settle litigation charges in 2010 for $44.7 and $24 million, respectively. The business model of these two subprime mortgage lenders consisted of providing loans to borrowers with weak credit histories. The business model had begun to fail during 2007, when the economy weakened, borrowers began defaulting, and home prices declined drastically. New Century filed for bankruptcy and Countrywide was purchased by Bank of America, which subsequently suffered massive losses related to business failures at Countrywide.

Just before the housing crash of 2007 put the companies in severe financial crises, KPMG had given both companies unqualified audit opinions. In both cases, KPMG was subsequently accused of violating professional standards, lacking independence, and being negligent. KPMG defended itself by arguing that its audits were not the cause of the financial woes at New Century and Countrywide. Rather, the firm contended that the failed business model of the two companies led to investor losses.

1. How does the economic environment affect the litigation risk faced by audit firms?

2. Should auditors be held liable if their clients business fails or if the financial statements contain a fraud that the auditors did not detect?

3. What defenses do auditors use in response to litigation?

4. What actions can auditors take to minimize litigation exposure?