Case 1.

11

New Century Financial Corporation

Prepared by:

Alexa Rodriguez

for

Professor C.E. Reese

in partial fulfillment of the requirements for

ACC502-- Advanced Auditing

College of Business/Graduate Studies

St. Thomas University

Miami Gardens, Fla

Term SP2/Spring, 2020

March 24, 2020

1
 Table of Content

Issues 3

Facts 4

Analysis/Authority 6

Conclusions/Recommendations 10

References 12

2
Issues:

1. What would be the benefits of having an audit firm that is familiar with the industry and has multiple

clients in that field? Why could it also be detrimental to have an audit firm with so many clients in the

same industry?

2.

When an audit firm has almost a complete turnover of staff what procedures can they put in place to

ensure that the quality of the team members assigned and the audit itself will not be jeopardized?

3.

According the Section 404 of the Sarbanes Oxley Act what is the definition of significant deficiencies and

material weaknesses? What are the auditor’s responsibilities in discovering and reporting significant

deficiencies and material weaknesses? What conditions must be prevalent in order for an auditor to

issue an unqualified opinion?

4.

When looking at important accounting estimates, what are the general procedures that auditors should

follow?

5.

What professional auditing standards did KMPG violate and how did they defend the noncompliance?

6.

What are the principal arguments for those against the market-to-market rule and are those arguments

legitimate?

7.

What are the three most important lessons learnt from this case in order from most important to least

important? Why are they in that order?

3
Facts:

New Century was one the largest subprime lending companies in the nation and it grew

dramatically; in 1996 its revenues were $14.5 million and its assets were $4.4 million, whereas just nine

years later its revenues were $2.4 billion and its assets were $26 billion. Although it was considered a

strong company for years, in 2007 the company restated its previous financial statements and shortly

after filed for bankruptcy.

Subprime lending comes with the struggle of balancing between risk and return because the

companies are lending money to individuals with low or bad credit. Because the economy took a hit in

2006, the housing prices fell, and the subprime borrowers were unable to pay their monthly mortgages.

This caused New Century to receive an influx of loans to be repurchased.

New Century was founded by three friends and went public in 1997. Due to the high mortgage

interest rates, helpful economic and regulatory environment, and the booming house market, New

Century had much success for a while. Unfortunately, the data entry systems and accounting systems

were not being kept up to date by the company in order to handle the magnitude of business; the loan

production process was done manually and it was difficult to track loan repurchase claims. The

company’s audit committee frequently questioned management’s decisions regarding the accounting

and financial reporting.

In 2007 the management team finally recognized that the company’s reserve for loan

repurchase losses was grossly understated, so they filed a Form 8-K with the SEC, but did not disclose

the extent that the reserve had been understated. Soon after the company feel apart with its audit firm,

KPMG, resigning and having to declare bankruptcy.

KPMG was considered a go-to auditor for this industry and they had worked for New Century

since it was founded. KPMG failed in its auditing duties on several accounts: it was improperly staffed,

4
its independence was impaired, and it failed to recognize New Century’s lack of internal controls.

Multiple members on the new audit team had transferred from the Los Angeles office that was in charge

of servicing New Century. Because the firm was concerned about being dismissed it impaired its

independence. New Century had five major internal control concerns to KPMG including its ineffective

method of tracking repurchase claims, but the firm still characterized them as inconsequential in their

report and failed to mention it to the audit committee. Also, even though two FDR specialists did not

sign off on the company’s accounting decisions because it failed to provide documentation, KPMG still

released an unqualified opinion for New Century.

New Century’s earnings were significantly overstated, they did not adhere to the 90 day look

back period, their reserves for loan repurchases was understated, and they failed to take into

consideration interest recapture. KPMG therefore was also criticized for not performing more audit

procedures to catch these mishaps as well as not insisting that they take the 90-day period and interest

recapture into account.

Some professionals, like an accounting professor at University of Chicago, felt that KPMG was

not completely at fault and that the economic model for this industry was a contributing factor. KPMG

was however involved in multiple other incidents and faced criminal charges for questionable tax

shelters. In response to the financial misstatements, SEC banned Morrice and Kenneally from being

officers of a public company again and they had to pay fines of $750,000 and $160,000 respectively.

5
Analysis/Authority:

1.

Having a heavy concentration of audit clients in the same industry is beneficial because it means

the auditors should be well versed in the industry and how it works (Caldwell). That will help them be

better able to identify what audit procedures and tests would be best to use for this industry, which

makes the team more efficient (Caldwell). The disadvantage to this would be that the audit firm may

feel more comfortable working with company’s in this industry and therefore may turn down potential

clients that fall outside of it (Caldwell). The auditors would also have to spend a lot of time

understanding the way the industry works to tailor to the needs and wants of the clients (Caldwell).

2.

When an auditing firm has a high turnover rate, they need to ensure that the new audit team is

equipped to handle the case. There were several concerns in regards to KPMG’s choice of new team

members for New Century. First, the majority of the auditors had come from the Los Angeles branch

which had serviced New Century before, meaning that the auditor’s independence came into question

because you cannot provide non audit services like bookkeeping or consulting when also performing an

audit (Audit Committees and Auditor Independence). Furthermore, the audit senior, Debbie Biddle, had

just joined the practice from the UK and had no experience auditing in the US or with SOX, which meant

she was unaware of many of the rules and procedures required by GAAP. In addition, the firm needs to

make sure the team in complying with the standards and any violators should be severely disciplined

(DesParte, 2019).

3.

According to the PCAOB a significant internal deficiency is when the design of the control does not allow

for accurate prevention and detection of misstatements on a timely basis (Auditing Standard No. 5).

Material weakness in internal control is when a deficiency exists that may result in a reasonable

6
possibility of a material misstatement (Auditing Standard No. 5). Significant deficiency still require

attention but they are less severe than a material weakness (Auditing Standard No. 5). Auditor’s are

responsible for identifying all potential sources of material weakness and looking for some deficiencies;

they need to communicate their opinion on the client’s ability to implement and adhere to sufficient,

adequate internal controls (Auditing Standard No. 5). An unqualified opinion should be issued when the

auditors determine that the company’s financial records are free from material misstatements, which

would mean they need to be confident in the company’s internal controls (Henderson, 2019).

4.

When auditing an accounting estimate, the firm needs to obtain sufficient evidence to provide

reasonable assurance that any estimates that could eb material have been developed, the accounting

estimates are reasonable in the given circumstance, and they have been presented in conformance with

GAAP (AS 2501: Auditing Accounting Estimates). When determining if an estimate is reasonable, the

auditor must consider historical evidence, but consider any recent changes; they should also understand

how management came up with the estimate (AS 2501: Auditing Accounting Estimates). They could

further test the evidence by reviewing management’s process and following up on subsequent events

(AS 2501: Auditing Accounting Estimates).

5.

First, KPMG was inappropriately staffed, which meant its independence was in question,

violating an important aspect of the auditing principles. Its independence was questionable again,

considering the firm was concerned that New Century would dismiss it for its delays in the auditing

procedures. Without declaring independence, it is unknown if the audit report is free of bias.

Furthermore, KPMG’s lack on follow up on the internal control weakness found, is another major

violation of the auditing standards; they found five significant deficiencies and although they concluded

they were not material weakness, they should have done more tests and at least disclosed the

7
deficiencies in the financial statement or notified the audit committee. Even after two of their own

specialists refused to sign off on the company’s accounting decisions, the firm still issued an unqualified

opinion, without gathering additional evidence or performing further tests. Their failure to insist that

New Century adhere to a 90 day window when recording repurchase loss reserve and considering

interest recapture was another huge failure to adhere to the auditing procedures; if they had performed

sufficient testing hey would have discovered it and the company needed to have implemented it in

order to have accurate financials.

6.

According to Tuovila, mark to market is known as a “method of measuring the fair value of

accounts that can fluctuate over time, such as asset and liabilities” (Tuovila, 2020). It is used to provide

a realistic estimate of the company’s current financial situation in relation to the market conditions

(Tuovila, 2020). Those against mark-to-market accounting rules, believe that it led to the financial crisis

in 2008, and they also believe it played a role in the Great Depression (Why Mark-To-Market Accounting

Rules Must Die, 2013). They state that when Roosevelt suspended the rule in 1938 to the time it was

reinstated in 2007 there were no financial depressions (Why Mark-To-Market Accounting Rules Must

Die, 2013). Because this method causes the banks to write off loses before they even occur, it affects

the growth by wiping out capital, which led to the demise of many investment banks (Why Mark-To-

Market Accounting Rules Must Die, 2013). Others argue that mark-to-market accounting allows for a

more current value and therefore a more accurate method of valuing a company (Tuovila, 2020). Both

sides share important concerns, but since the mark-to-market method is not considered accurate if the

market is unfavorable or volatile it may be better to not use it as it is most necessary in those times

when the markets are not at their strongest that individual need to have an accurate value of the

company (Tuovila, 2020).

7.

8
 The three greatest takeaways from this case are the importance of evaluating the company’s

internal controls, maintaining auditor independence, and making sure the audit teams are properly

staffed. First, learning the way the company operates and the policies it has in place helps the auditor

gain an understanding of how the company itself functions; it then needs to evaluate the internal

controls in place and make sure that they are sufficient and being complied with. Without internal

controls the company is at huge risk for fraudulent activity. Without maintaining the auditor

independence aspect, the audit cannot be relied upon as being accurate because the company has not

been able to maintain an unbiased opinion. If the company has incentive to give an unqualified report

to a company that does not deserve it, many other individuals are at risk because they rely on those

audit reports. Finally, without the correct staff that has experience and can accurately perform the

audit, the reports also lack merit and cannot be relied upon.

9
Conclusions/Recommendations:

1.

Auditing firms may want to discuss the possibility of niche auditing in which they focus on a particular

sector or industry; it will give them a specific area to concentrate and will help them become experts in

their certain field. When selecting an audit firm, it may be wise to choose one that has experience in the

company’s specific industry as it can help save time in the audit process as they already know the way

the industry operates.

2.

When an auditing firm is choosing its team, it is vital that the firm ensure that the auditors are

independent, and the senior auditors are sufficiently experienced to conduct the audit. Without a good

team to conduct the audit the firm is in jeopardy of inaccurately performing an audit and worse yet

incorrectly evaluating it by giving an unqualified opinion to a company that has material misstatements.

This is a huge liability for the firm, so it is in its best interest to selectively and carefully choose its team

members.

3.

Unqualified opinions should not be issued out by auditing firms without much care; they need to

be positive that they accurately completed the audit and sufficiently investigated the company’s internal

control procedures. Without being sure that no material weaknesses in internal controls exist and that

there are not many internal control deficiencies, the firm should not issue an unqualified opinion.

Individuals rely on the assurance form these reports that the financial information provided is correct,

so the firms need to be cautious when writing an unqualified report.

4.

Because the accounting estimates cannot be totally verified as they are just an estimate, the

auditors must take extra precaution when evaluating its reliability. Following the procedures specifically

10
outlined by the PCAOB will help auditors be able to determine if the estimate is accurate or not.

Because the auditors in this case did not follow up with these procedures for accounting estimates, New

Century’s loan repurchase loss reserve was severely understated.

5.

While some defend KPMG by stating that they had no fault in the misstatements of New

Century, they violated multiple audit procedures, failed to gather sufficient evidence, and did not

perform enough testing. That makes them wholly responsible for their opinion and mistakes; they also

were facing similar charges with other firms, which indicates that this is not their first and only offense.

KPMG was clearly not taking the auditing procedures into consideration.

6.

Even though many argue that the mark-to-market method is best because it gives a current

value of the company, the fact that it can be inaccurate when the market is unfavorable is a strong

reason why it should be eliminated. It is most important that companies have an accurate current

value, especially when the market is down so that others do not make mistakes when investing or

relying on this information.

7.

When performing an audit, reviewing the internal controls should be the firm’s number one

priority as it will give great insight as to how the company works and if it is at risk for fraud. They should

also be concerned with maintaining their independence and staffing the team correctly to be able to

perform the audit to the best of their abilities.

11
References:

Audit Committees and Auditor Independence. (2017, May 12). Retrieved March 24, 2020, from

https://www.sec.gov/info/accountants/audit042707.htm

AS 2501: Auditing Accounting Estimates. (n.d.). Retrieved March 24, 2020, from

https://pcaobus.org/Standards/Auditing/Pages/AS2501.aspx

Auditing Standard No. 5. (n.d.). Retrieved March 24, 2020, from

https://pcaobus.org/Standards/Archived/PreReorgStandards/Pages/Auditing_Standard_5_Appe

ndix_A.aspx

Caldwell, C. (n.d.). Specialization vs Generalization: Niche Accounting Pros & Cons. Retrieved March 24,

2020, from https://www.firmofthefuture.com/content/pros-and-cons-of-niche-marketing-for-

accounting-firms-and-bookkeepers/

DesParte, D. (2019, September 12). Improving Audit Quality through a Renewed Focus on Quality

Control. Retrieved March 24, 2020, from https://pcaobus.org/News/Speech/Pages/DesParte-

Improving-Audit-Quality-through-a-Renewed-Focus-on-Quality-Control.aspx

Henderson, K. J. (2019, March 7). What Are the 4 Types of Audit Reports? Retrieved March 24, 2020,

from https://smallbusiness.chron.com/4-types-audit-reports-3794.html

Tuovila, A. (2020, March 5). Mark to Market (MTM). Retrieved March 24, 2020, from

https://www.investopedia.com/terms/m/marktomarket.asp

Why Mark-To-Market Accounting Rules Must Die. (2013, June 19). Retrieved March 24, 2020, from

https://www.forbes.com/2009/02/23/mark-to-market-opinions-

columnists_recovery_stimulus.html#5035134f738b

12