New century financial investments review

2

Case Study

New Century Financial Corporation

Prepared by

Sandy Lopez & Carolina Wong

for Professor C.E. Reese

in partial fulfillment of the requirements for

ACC 502 – Advanced Auditing

School of Business/ Graduate Studies

St. Thomas University

Miami Gardens, Fla.

Spring 2019

April 2, 2019

Table of Contents:

Issues…………………………………………………………………………………………3

Facts…………………………………………………………………………………………..5

Analysis………………………………………………………………………………………24

Conclusions…………………...……………………………………………………………...30

Issues

1. KPMG served as the independent audit firm of several of the largest subprime mortgage lenders. What are the advantages and disadvantages of a heavy concentration of audit clients in one industry or subindustry?

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 as performed?

3. Section 404 of 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. What are the responsibilities that auditors of public companies have to discover and report significant deficiencies in internal controls and material weaknesses in internal controls? What is the definition of significant deficiencies in internal controls and material weaknesses in internal controls? Under what condition or conditions can auditors issue an unqualified or clean opinion on the effectiveness of a client’s internal control 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 are general 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. What are specific auditing standards or principles that you believe KPMG may have violated on its New Century engagements?

6. Mortgage-backed securities (MBS) produced by New Century and other major subprime lenders were a focal point of attention during the 2008 financial crisis. Many parties maintain that the mark-to-market rule for investments in securities such as MBS contributed significantly to that crisis and that the rule should be modified, suspended, or even eliminated. What are 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. What do you consider to be the three most important “take-aways” or learning points in this case? How would you rank these items in order of importance (highest to lowest)? How would you justify or defend each of your choices?

Facts

Ed McMahon was a famous television star know for his popular television program the Tonight Show that ran for thirty years. In June 2007, the press released the McMahon owed more than $600,000 on past due payments on his mortgage payments. Countrywide Financial Corporation held a $5 million mortgage on McMahon’s Beverly Hills mansion. Ed McMahon was not the only who faced losing his home as millions of Americans were at risk of loosing their homes due to the worst financial crisis in the United States since the Great Depression. As the crisis spread and the worsened, the search began for the parties responsible for it. The press identified the accounting profession specially the independent auditors among the potential culprits.

Mortgage Mess

During the past two decades, almost a half of recent homes mortgage foreclosure victims obtained their loan through a subprime lender, which became dominant forces within the mortgage industry. The largest 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. In 2007 and 2008, the financial panic in the United States quickly spread throughout the global economy.

The nation’s second largest subprime lender, New Century can be traced to be the debacle of the subprime mortgage. Three friends who previously worked a mortgage banking company founded New Century in 1995. The company’s base was in Irvine, California, which quickly grew after it’s existence. In 1996, New Century reported total revenues of $14.5 million and total assets of $4.4 million. The company after nine years reported total revenues of $2.4 billion and total assets of $26 billion.

During 2005 and 2006, New Century funded $200 million of new mortgage loans each day. In early February, a few months after company executives insisted that New Century was financially strong, those same executives unsettled Wall Street when they revealed that their financial statements had misapplication of generally accepted accounting principle and were to restate their financial statements. Two months later, New Century declared bankruptcy. A court-appointed bankruptcy examiner summarized the far-reach implications that New Century’s downfall had for the global economy.

In September 2008, the federal government assumed control of the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Company (FHLMC), 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. Only a few years removed from the sweeping reforms prompted by the Enron and WorldCom scandals, the accounting profession was once again forced to defend itself from a wide range of angry and often self-righteous critics.

Subprime Lending: A Historical Perspective

Mortgage companies struggle to achieve a proper balance between “risk” and “return” in their operations. The main risk faced by mortgage lenders is the possibility that their clients will be unable or unwilling to pay the principal and interest on their mortgage loans.

Prior to the 1980s, individuals who were poor credit risks effectively had only two choices for obtaining a mortgage to purchase a home. Those alternatives were obtaining a home loan insured by either the Federal Housing Administration (FHA) or the Department of Veteran Affairs (VA). Borrowers with good credit histories, so-called prime borrowers, would typically seek financing for a new loan directly from a bank, savings and loan, or other financial institutions. The deregulation of the lending industry beginning in the 1980s made it much easier for subprime borrowers to obtain mortgage loans to finance the purchase of a new home. The Depository Institutions Deregulation and Monetary Control Act of 1980 did away with restrictions that imposed a ceiling on the interest rates lending institutions could charge on new mortgage loans. Subsequent legislation allowed mortgage lenders to create a wide array of financing alternatives to compete with the standard 30-year, fixed interest rate mortgage loan that had long been the industry’s principal product.

Despite the deregulatory legislation of the 1980s, the subprime sector of the mortgage industry did not experience explosive growth until the “securitization” of mortgage loans became increasingly common following the turn of the century.

The securitization option caused many mortgage lenders to adopt an “originate to distribute” business model. This new business model meant that the credit risk posed by new mortgages was no longer exclusively absorbed by lending institutions but rather was shared with investors worldwide who purchased so-called mortgage backed securities or MBS. By 2006, nearly one-fourth of all new residential mortgage loans in the United States were made to subprime borrowers; three-fourths of those mortgages were securitized and sold to investors in the United States and around the world.

The insatiable demand for high-yield MBS among investors, particularly institutional

investors such as large banks and hedge funds, caused subprime lenders to ratchet up their marketing efforts. To persuade individuals who were high credit risks to obtain mortgage loans, the subprime lenders developed new products designed specifically, for that sector of the mortgage market.

Among the most popular mortgage products developed for the subprime lending market were “stated-income” and “interest-only” mortgages. An applicant for a stated income loan was simply asked to report his or her annual income during the application process for the loan. The applicant’s self-reported income was used by the lender to determine the size of the loan that the individual could afford. Not surprisingly, many applicants for stated-income loans, commonly known as “liars’ loans” in the mortgage industry, grossly overstated their annual incomes so that they could purchase a larger home than was economically feasible given their actual annual incomes.

Housing prices in those regions of the country where subprime lending was particularly prevalent—such as Arizona; California; south Florida; and Las Vegas, Nevada—rose steeply during the late 1990s and into the early years of the new century.

Many subprime borrowers in those housing markets purchased a home with the express intention of reaping a short-term windfall profit. An individual who obtained a 100 percent loan to acquire a $2 million home could realize a more than $400,000 “profit” on that home in two years if housing prices rose 10 percent each year. After two years, the borrower could extract that profit by refinancing his or her mortgage. That profit could then be used to make the monthly payments on the new mortgage. Or, that individual could sell the home and use the resulting profit to purchase a much larger home—with a much larger mortgage—that he or she could also “flip” in a few years.

By late 2007, prices in several major regional housing markets had declined by 10 percent from their peak levels. By mid-2008, housing prices in those same markets had declined by 20 percent, or more, from their high-water marks. As housing prices steadily fell, a growing number of subprime borrowers began defaulting on their monthly mortgage payments. In fact, many of those individuals quickly became “upside down in their homes,” that is, the unpaid balances of their mortgages exceeded the market values of their homes.

The downturn in the housing market had an immediate and drastic impact on mortgage lenders, particularly subprime mortgage lenders such as New Century. Many of the subprime loans originated and packaged for sale by New Century included repurchase clauses. If the default rate on those packages of loans exceeded a certain rate, New Century could be forced to repurchase those loans. As the housing market weakened, New Century and other subprime lenders were flooded with loan repurchase requests.

The financial problems facing the mortgage industry soon spread to other sectors of the economy because of the securitization of subprime mortgage loans. Many high-profile companies in the financial services industry, such as Merrill Lynch, that had no direct connection to the large subprime lenders, suffered huge losses as the market value of MBS plunged. Making matters worse, a large proportion of MBS that originated in the United States was sold worldwide.

New Century: Poster Child for Subprime Mortgage Lending

In 1995, Bob Cole, Ed Gotschall, and Brad Morrice found themselves without jobs when the company they had worked for several years, Plaza Home Mortgage, was purchased by a much larger competitor. The three friends decided to pool their resources and establish their own mortgage company, a company that would focus on the “low-end” or subprime sector of the mortgage market. Cole served as New Century Financial Corporation’s chief executive officer (CEO), Gotschall was the company’s chief financial officer (CFO), and Morrice oversaw New Century’s lending operations as the company’s chief operating officer (COO). Morrice would eventually replace Cole as New Century’s CEO. In June 1997, the company went public by listing its stock on the NASDAQ—New Century’s stock would be switched to the New York Stock Exchange in late 2004.

New Century thrived from its inception thanks largely to three key factors. First, during the mid-1990s mortgage interest rates spiked, stabilized and then generally trended downward for more than a decade—lower mortgage rates serve to fuel the housing and mortgage industries. Second, the economic and regulatory environment at the time made subprime lending the most lucrative sector of the mortgage industry. Finally, the booming housing market in Orange County, California, where the company was located, provided New Century a large and easily accessible market to tap.

New Century operated more than 200 retail mortgage offices in the United States from which company employees originated new mortgage loans. The company’s wholesale division, which produced the bulk of its loan originations, operated through a far-flung network of more than 35,000 independent mortgage brokers. In 2004, New Century’s management reorganized the company as a real estate investment trust (REIT) so that it would qualify for favorable tax treatment under the Internal Revenue Code. This organizational change had little impact on the company’s operations or the underlying nature of its principal line of business, that is, originating subprime mortgage loans. New Century experienced impressive growth from its founding in 1996 through 2001, however, a significant increase in subprime lending activity quadrupled New Century’s revenues from fiscal 2002 to fiscal 2005. In the latter year, New Century originated or purchased more than $56 billion of mortgage loans and securitized $17 billion of those loans, resulting in net earnings of $411 million for the company. The decision by New Century’s management to focus the company’s marketing efforts principally on stated-income and IO loans contributed significantly to its remarkable growth in revenues beginning in 2002.

Throughout the period that New Century’s revenues were increasing, company spokespeople repeatedly insisted in press releases and public filings with the SEC that the company had a strong and sophisticated system of internal controls. Those claims were subsequently questioned by the bankruptcy examiner appointed to investigate the collapse of New Century.

The bankruptcy examiner’s report went on to note that the company’s accounting system was particularly lax with regard to tracking “loan repurchase claims.” According to the examiner, New Century did not develop an “automated system or protocol” for tracking such claims until late 2006. By that time, the company was being swamped by loan repurchase requests due to the weakening housing markets in the principal geographical areas that it served. Besides failing to properly track loan repurchase requests throughout most of its history, New Century “did not have a formal policy spelling out exactly how to calculate reserves” for loans that it would be required to repurchase. By late 2005, several members of New Century’s board of directors were openly challenging top management’s high-risk business strategies as well as questionable accounting and financial reporting decisions made by the company. The most vocal of these critics was Richard Zona, an outside director who also served on the company’s audit committee.

Earlier in his long and distinguished career, Zona had been a senior partner with Ernst & Young (E&Y) and had served for a time as E&Y’s National Director of Financial Services, a position in which he oversaw the firm’s audit, tax, and management consulting services. In the late 1990s, Zona had also served on an advisory council to the Federal Reserve Board. In late 2005, Zona drafted a resignation letter, which he addressed to New Century’s board of directors. In that letter, Zona suggested that company management was manipulating reported earnings, employing “aggressive” revenue recognition methods, and failing to provide an adequate allowance for loan losses.

Throughout 2006, New Century’s financial condition and operating results deteriorated rapidly. New Century’s third quarter earnings press release for 2006 admitted that subprime lenders faced “challenging” market conditions because of increasing loan delinquencies. On January 31, 2007, New Century’s management team met with the company’s board of directors and audit committee. At that meeting, management told the board and audit committee that New Century had understated its reserve for loan repurchase losses for each of the first three quarterly reporting periods of 2006. New Century’s controller, David Kenneally, attributed those understatements to an “inadvertent oversight” in the method used to compute the reserve.

On February 7, 2007, New Century filed a Form 8-K with the SEC, which publicly disclosed the prior understatements of the loan repurchase loss reserve. The 8-K indicated that the understatements were due to the company failing “to account for expected discounts upon the disposition of repurchased loans” and due to its failure to “properly consider the growing volume of repurchase claims outstanding that resulted from the increasing pace of repurchase requests.” The 8-K filing did not disclose to what extent the loan repurchase loss reserve had been understated but instead simply indicated that the previously reported earnings for the first three quarters of 2006 “should no longer be relied upon.”

On March 2, 2007, New Century informed the SEC that its 2006 Form 10-K would be delayed and that it would eventually report a loss for the entire year. At the same time, New Century disclosed that KPMG was considering issuing a going-concern opinion on the company’s 2006 financial statements—KPMG resigned as New Century’s auditor a few weeks later without having issued an opinion on those financial statements. On April 2, 2007, New Century filed for bankruptcy in a U.S. federal court. At the time, New Century was the ninth largest company to file for bankruptcy in U.S. history.7 In May 2008, company management announced that New Century’s audited financial statements for 2005 should no longer be relied upon.

A few days of New Century’s bankruptcy filing, the company’s stock price fell to less than $1 per share, down from more than $30 per share two months earlier— the stock had reached its all-time high of $66 per share in 2004. Stockholders and other parties were enraged by the company’s sudden collapse that replicated the downfall of Enron and WorldCom a few years earlier.

“Go-To Auditor”

The New York Times characterized KPMG as the “go-to auditor” for the subprime sector of the mortgage industry. KPMG’s audit clients in that sector included the largest subprime lenders, namely, Countrywide, HSBC, New Century, and Wells Fargo. KPMG served as New Century’s auditor from the company’s inception in 1995 until its resignation in April 2007. New Century’s bankruptcy filing resulted in heated criticism of KPMG.

The federal bankruptcy examiner appointed for New Century carried out an exhaustive investigation of the large subprime lender’s sudden failure. A major focus of that investigation was KPMG’s 2005 audit of New Century and the accounting firm’s reviews of the financial statements included in the company’s Form 10-Qs for the first three quarters of 2006. KPMG was required to provide the bankruptcy examiner with nearly 2 million pages of documents relating to those engagements. In his 560-page report, the bankruptcy examiner alleged that KPMG had failed to perform its New Century engagements “in accordance with professional standards.”

The examiner’s specific allegations included charges that the 2005 New Century audit was improperly staffed and the independence of certain KPMG auditors may have been impaired. The examiner also maintained that KPMG failed to adequately consider serious internal control problems evident in New Century’s accounting and financial reporting system and failed to properly audit the company’s critically important loan repurchases loss reserve.

Staffing Issues on the Century Engagement

In spring of 2005, an almost entirely new team of fifteen KPMG employees were assigned to New Century. There was only two members from the prior year that were two first-year associates. The two key members of the 2005 audit team were new to the engagement and to the Los Angeles office. John Donovan, which was the engagement partner had previously worked at Arthur Andersen for 17 years and a partner at E&Y for three years before joining the same position at KPMG.

New Century’s audit committee was unhappy with KPMG’s decision to appoint Donovan as the audit engagement partner for the 2005 audit. Members of the audit committee believed that Donovan’s lack of experience with the mortgage industry made him a poor choice to supervise that audit and asked KPMG to appoint another partner to oversee the engagement. When KPMG refused, the audit committee considered dismissing KPMG and retaining a different audit firm. “Ultimately, the Audit Committee determined that a switch to a new accounting firm would be tremendously disruptive and would send a bad signal to its lenders.”

In May 2005, Mark Kim accepted a position with KPMG, and was assigned to serve as the senior manager on the 2005 New Century audit engagement. Kim had several years of prior experience as an auditor and had served for three years as the assistant controller of a small mortgage lending company. During his tenure on the New Century audit team, Mark Kim complained to John Donovan that it was difficult to recruit a “good team” of auditors to work on the engagement. In an email to Donovan, Kim remarked, “We will never get a good team out here because of the reputation that the engagement has.” Another email sent by a New Century accountant to the company’s controller, David Kenneally, seemed to corroborate Kim’s opinion. This latter email noted that KPMG had not assigned the best team to the New Century audit.

Kenneally, a former KPMG employee, was the key reason that the New Century engagement had a negative reputation within KPMG’s Los Angeles office. The New Century bankruptcy examiner collected evidence that suggested the company’s accounting function was “weak” and was overseen by Kenneally who “domineering” was and “difficult, condescending, and quick-tempered.” One KPMG subordinate on the New Century audit team testified that Kenneally often berated Donovan and Kim. In another email sent by Kim to Donovan, the KPMG senior manager indicated that “Dave [Kenneally] seems to know the answers for everything and anything and the rest of the accounting department is on almost the same boat as the audit team is—little knowledge of what’s going on. This intimidates everyone on the engagement team.” The tense relationship between the KPMG audit engagement team and New Century’s management worsened as the 2005 audit neared completion. Two individuals with KPMG’s FDR (Financial Derivatives Resource) Group were brought in to review New Century’s accounting for certain hedges and other financial derivatives during the final phase of the audit. They requested various documents from New Century that were needed to complete their review of the mentioned items. When New Century failed to provide that documentation, the two specialists refused to “sign off” on the company’s relevant accounting decisions.

This refusal prevented Donovan from releasing the opinion on New Century’s financial statements that were to be included in the company’s 2005 Form 10-K. A high-ranking KPMG partner in the firm’s New York headquarters office told Donovan to release the unqualified opinion on New Century’s 2005 financial statements. Donovan was instructed to release the opinion even though the two FDR specialists had not approved the company’s accounting decisions for its financial derivatives. Due to the incident, New Century’s audit committee deferred the decision of whether to reappoint KPMG as the company’s auditor for the 2006 fiscal year.

Donovan later testified that he had been concerned that the audit committee would dismiss KPMG. Over the following two months, Donovan assured New Century’s audit committee that “a situation like this will never happen again.” After receiving that assurance, the audit committee reappointed KPMG as New Century’s audit firm. The bankruptcy examiner further questioned KPMG’s independence when he maintained that the New Century auditors had been eager to please the company’s management team.

Inadequate Consideration of Internal Control Problems

Section 404 of the Sarbanes–Oxley Act requires auditors of public companies to audit the effectiveness of their clients’ internal controls over financial reporting. In 2004 and 2005, KPMG concluded that New Century maintained effective internal control over its financial reporting function. During the 2004 internal control audit, KPMG auditors identified five “significant deficiencies” in internal controls and they were reported to New Century’s audit committee. In 2004, KPMG auditors concluded that those deficiencies did not qualify as “material weaknesses,” the audit firm was able to issue an unqualified opinion on New Century’s internal controls. During the 2005 internal control audit, KPMG did not identify any significant deficiencies or material weaknesses in internal controls.

New Century’s bankruptcy examiner challenged KPMG’s conclusion that the company’s internal controls over financial reporting were effective during 2004 and 2005. The examiner pointed out that throughout its existence New Century did not have an “effective mechanism for tracking, processing and handling [loan] repurchase claims.” This internal control weakness prevented the company from determining the magnitude of loan repurchase requests at any point in time, which, in turn, prevented the company from properly considering those requests in arriving at the period-ending balances of the loan repurchase loss reserve. A related internal control weakness was New Century’s failure to adopt “formal policies and procedures” for calculating the loan repurchase loss reserve at the end of each accounting period. The lower-level accountants who were assigned the task of computing the reserve balance each reporting period testified that they simply followed the instructions passed down to them by the individual who had previously been responsible for the reserve computation.

During 2004 and 2005 audits, KPMG auditors discovered the internal control weaknesses related to New Century’s loan repurchase loss reserve. The bankruptcy examiner noted that those control weaknesses had particularly critical implications for New Century in 2005 when the volume of loan repurchase requests had increased rapidly. Despite those implications, KPMG characterized those weaknesses as “inconsequential” during the 2005 audit. Since the internal control problems were not deemed significant deficiencies or material weaknesses, KPMG did not communicate them to New Century’s audit committee.

The bankruptcy examiner insisted that in the 2005 audit, the inadequate accounting procedures for loan repurchase requests qualified as a material weakness in internal control that should have caused KPMG to issue an adverse opinion on New Century’s internal controls. In fact, New Century’s management reached a similar conclusion in early 2007.

Debbie Biddle was the KPMG audit senior principally responsible for the 2005 internal control audit. Biddle had joined KPMG’s Los Angeles office shortly before the 2005 New Century audit began. Biddle had transferred to the Los Angeles office from a KPMG affiliate in the United Kingdom. Prior to being assigned responsibility for the 2005 New Century internal control audit, Biddle had “virtually no experience auditing U.S. clients and no prior SOX experience.” The bankruptcy examiner reported that Biddle and her colleagues failed to thoroughly review the 2004 audit workpapers for New Century. As a result, they may have not been aware of the internal control problems discovered by KPMG auditors the prior year and thus failed to properly consider those problems in planning and carrying out the 2005 audit.

Failure to Properly Audit New Century’s Loan Repurchase Loss Reserve

The increasing delinquency and default rates on loans originated by New Century caused a large increase in the number of loan repurchase claims filed by investors that had purchased large blocks of those loans. Because of the inadequate accounting procedures and internal controls for loan repurchase claims, New Century’s accounting staff failed to record the needed increases in the loan repurchase loss reserve throughout 2005 and beyond.

New Century’s bankruptcy examiner estimated that the understatement of the loan repurchase loss reserve and errors in related accounts inflated New Century’s reported pretax earnings for fiscal 2005 by 14.3 percent or approximately $64 million. The examiner determined that errors in those same accounts overstated New Century’s reported pretax earnings for the first three quarters of 2006 by approximately $200 million or 59 percent.

New Century’s accountants used a 90-day “look-back” period in determining the adequacy of the loan repurchase loss reserve each financial reporting period. Which meant only repurchase requests for loans sold in the 90 days immediately preceding the balance sheet date were considered in arriving at the reserve balance. In fact, the company often received repurchase requests for loans sold more than three months earlier. The bankruptcy examiner criticized KPMG for not insisting that New Century use a longer than 90-day “window” in computing the loan repurchase loss reserve. In fact, a KPMG workpaper suggested that policy was reasonable.

A secondary factor that contributed to the understatement of New Century’s loan repurchase loss reserve was the company’s failure to consider an “interest recapture” as an element in computing that reserve each reporting period. The bankruptcy examiner found this obvious oversight by the company’s accountants “perplexing.” A workpaper memorandum that summarized the audit tests KPMG applied during the 2005 audit to the loan repurchase loss reserve indicated that interest recapture was a component of the reserve.

The evidence that KPMG relied on to reach that erroneous conclusion was a statement made by David Kenneally. The bankruptcy examiner criticized the KPMG auditors for not corroborating Kenneally’s assertion with more audit evidence. “If KPMG had performed adequate tests and calculations, it would have determined that Interest Recapture was omitted from the repurchase reserve calculation.”

Kenneally testified that the change in accounting for the reserve account was recommended by Mark Kim, the KPMG senior audit manager. Kim would later testify that he did not explicitly remember making that recommendation. Nevertheless, evidence collected by the bankruptcy examiner caused him to conclude that a KPMG auditor “almost certainly” recommended the change in accounting for the reserve account.

In November 2006, New Century hired a new chief financial officer (CFO) who had 30 years of prior experience in the mortgage industry. The CFO immediately questioned the adequacy of the company’s loan repurchase loss reserve and asked KPMG to provide him with a written statement that the reserve was properly stated.

KPMG refused to provide that written assurance. As a result of the new CFO’s persistent inquiries, New Century’s accounting staff eventually recognized that the accounting change made in early 2006 for the loan repurchase loss reserve had been improper and had materially understated the reserve for each of the first three quarterly reporting periods of 2006. That realization led to the February 7, 2007, 8-K filing in which New Century reported those understatements. That 8-K disclosure triggered the series of events that resulted in New Century filing for bankruptcy less than two months later.

In Defense of KPMG

KPMG representatives responded forcefully to the allegations against their firm in the report prepared by New Century’s bankruptcy examiner. Particularly galling to the large accounting firm was the suggestion that KPMG auditors had “deferred excessively” to client executives during the New Century engagements. In response to that allegation, a KPMG spokesperson told a reporter with the New York Times, “There is absolutely no evidence to support that contention.” In a subsequent interview with the Times, that same individual suggested that the bankruptcy examiner’s report was unfair and “one-sided.”

Other parties also defended KPMG. An accounting professor at the University of Chicago maintained that KPMG was not at fault in the New Century case and instead attributed the company’s bankruptcy to its high-risk business model. “The business model of New Century depended on real estate values that would continue to go up and certainly not go down. The economic model here is what is at fault. It’s the cause of what happened, not anything that KPMG did.”

At a minimum, the New Century bankruptcy report served to sustain a string of embarrassing public relations incidents for KPMG. In 2005, KPMG had faced potential criminal charges for a series of questionable tax shelters that it had marketed to well-heeled tax clients. In that same year, KPMG had agreed to pay the SEC $22.5 million to settle charges that audits of one of its largest clients, Xerox, were flawed. Subsequent to that announcement, KPMG paid $80 million to settle civil litigation stemming from its Xerox audits.

Even before the New Century bankruptcy report was released, KPMG had been linked to the ongoing crises and scandals in the mortgage industry. Charges of largescale earnings manipulation by Fannie Mae was questionable the quality of KPMG’s audits of that organization, which for decades had played such a large role in the mortgage industry. In early January 2008, KPMG was named a codefendant in a large class-action lawsuit that charged Countrywide, another KPMG audit client, with perpetrating an accounting fraud.

New Century’s collapse resulted in numerous criminal investigations by regulatory and law enforcement authorities as well as a barrage of civil litigation. In July 2010, the SEC announced that it had reached a settlement to resolve fraud charges that it had filed against three former New Century officers including Brad Morrice and David Kenneally. In addition to monetary sanctions of approximately $750,000 for Morrice and $160,000 for Kenneally each was barred from serving as an officer of a public company for five years. The civil litigation prompted by New Century’s bankruptcy included a class-action lawsuit filed by the company’s former stockholders. In 2010, KPMG reportedly contributed $45 million to a settlement pool to help resolve that lawsuit.

1. Advantages

As the firm specializes in one industry or subindustry, they would be familiar with typical transactions and regulations specifically assigned to that industry. This would be beneficial for the client as it helps decrease the time needed to arrange for an audit because minimum research would be necessary for the audit team to acquaint themselves with the specific company. Another advantage would involve the questionable fame of the firm within that industry. If a new company for some reason were to originate within that industry, it would be more feasible for the company to select an accounting firm that is acquainted with the industry preferably than dealing with a firm with very little or no information about the industry.

Disadvantages

The firm could potentially loose skepticism as they could become confident that the industry or subindustry is solely audited by them. Specialization can expose the firm to influences such as regulatory and foreign competition. The specialization aspect might make it difficult for the firm to attract clients from outside the industry.

2. PCAOB has guidelines to firms that would help in conducting high-quality audit. When there is a high turnover, firms should: make sure the internal controls involved in the company being audited are strong to enable the new team to conduct its activities without encountering numerous difficulties; enhance improved personnel management that will ensure the engagement team leader informs the team of the relevant requirements; and ensure monitoring prospects are also high to ensure that the team members meet expectations.

The AICPA’s guidelines and standards provide guidelines and recommendations that accounting professionals can use to make sure they are providing the best professional service. QC 20.07 identifies the following five fundamentals that an accounting firm’s quality control system should address Independence, Integrity and Objectivity, Personnel Management, Acceptance and Continuance of Clients and Engagements and Engagement Performance; and Monitoring.

Also, the firm should give the new staff enough time to review prior year audits and assess previous findings as it can help guide the audit and determine what are potential flaws in prior year’s audit.

3. Section 404 (b) of the Sarbanes-Oxley Act requires the relevant auditors to assess and provide an own opinion regarding the effectiveness of the internal controls by conducting varied substantive tests. Significant deficiencies in internal controls occurs when there is more than a remote likelihood of a misstatement occurring, which is more than inconsequential and be undetected. Material weaknesses occurs when there is a deficiency that involves a material amount.

Auditors issue an unqualified opinion on the effectiveness of a client’s internal control when there is no existence of material weaknesses. When an independent auditor issues a “clean” opinion on the company’s financial statements, this is a representation to the public that the auditor has followed applicable auditing and related professional standards so as to allow the auditor to conclude with reasonable assurance that the financial statements are fairly presented in conformity with GAAP in all material respects.

4. The general principles or procedures auditors should follow when auditing accounting estimates as indicated under AS 2501 which are:

· Identifying situations for which accounting estimates are required.

· Identifying the relevant factors that may affect the accounting estimate.

· Accumulating relevant, sufficient, and reliable data on which to base the estimate.

· Developing assumptions that represent management's judgment of the most likely circumstances and events with respect to the relevant factors.

· Determining the estimated amount based on the assumptions and other relevant factors.

· Determining that the accounting estimate is presented in conformity with applicable accounting principles and that disclosure is adequate.

5. The following are auditing standards that KPMG violated during the audit engagement with New Century.

· AS 1005, “Independence.” As mentioned in the case, the bankruptcy examiner “speculated” that the 2005 10-K “incident” impaired the independence of Donovan and Kim. After that awkward and embarrassing incident for KPMG, the two senior members of the audit team may have attempted to “bend over backwards” to get back “in the good graces” of client’s audit committee.

· AS 1010, “Training and Proficiency of the Independent Auditor.” The audit engagement was improperly staffed. New Century’s audit committee questioned the appointment of Donovan as the new audit engagement partner given his lack of familiarity with the mortgage industry. Also, Debbie Biddle as an audit senior to oversee the 2005 SOX internal control audit seemed to be a questionable decision since she had no prior SOX experience and “virtually no experience auditing U.S. clients.” Making matters worse was the fact that nearly all of the subordinate members of the audit team were new to the New Century engagement.

· AS 1015, “Due Professional Care in the Performance of Work.” KPMG failed to inform the investors regarding how New Century’s had five deficiencies. However, since they weren’t considered material KPMG did still issued an unqualified opinionated audit.

· AS 1105, “Audit evidence.” Whether KPMG obtained sufficient appropriate audit evidence to support the period-ending balances of the loan repurchase loss reserve is questionable that will likely be debated in coming years. Based upon the information available in the bankruptcy examiner’s report, the adequacy and propriety are questionable.

· AS 2101, “Audit planning.” The bankruptcy examiner alleged that the 2005 audit team did not properly review the prior year workpapers, at least regarding the internal control deficiencies discovered by the 2004 audit team. AS 2201 notes specifically that “In subsequent years’ audits, the auditor should incorporate knowledge obtained during past audits he or she performed of the company’s internal control over financial reporting into the decision-making process for determining the nature, timing, and extent of testing necessary” (AS 2201.57). This general audit planning principle was apparently not invoked by the KPMG auditors.

· AS 2201, “An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements.” The auditors gave an unqualified opinion regarding the internal controls when there was the presence of material weaknesses with regards to tracking loan repurchase claims.

6. The arguments include:

· Procyclicality is more of an unintended consequence of fair value accounting, but it is more of an issue for policymakers.

· Mark-to-market accounting acts as a reinforcer of the downward cycle of panic falling prices, losses, illiquidity and credit contraction. As panic grows, it leads to further falling prices and this results to increased losses.

· When there is a market failure of some sort, values get distorted during that time hence not reflecting true value at maturity

These arguments are legitimate because mark-to-market rule ensures that corporations value assets pursuant to the current market price. This is beneficial when markets are increasing due to profits involved, but it is devastating when the market crashes because risky assets are priced at rock-bottom levels.

7. The following are three most important “take-away” or learning points in this case:

· A firm’s auditors should maintain a level of skepticism about the going concern of an organization. KPMG failed to adhere to some required auditing standards, which made it difficult for them to identify misuse of the standards in the organization.

· Risky business models are detrimental to a company’s long-term operations as it is affected by other external factors. New Century’s risky business model that involved subprime lending strategy contributed to the collapse of the company since the clients became unsustainable.

· A company filing for bankruptcy can uncover issues within that the public was not aware of. The bankruptcy examiners should investigate and assess how the company reached there.

Conclusion

In the New Century case, we can see that there were a lot of deficiencies in their internal controls. After the issue KPMG had, they wanted to stay in the good graces of the audit committee, which led to them lowering their level of skepticism. The downfall of New Century affected many investors as prices quickly went spiraling down in 2005. Hopefully, those in management of large audit firms realize the consequences of the lack of professional due diligence when conducting an audit. Also, that managers of all business learn to asses better the issues that can come from entering a high-risk industry.