CASE 1.11
NEW CENTURY FINANCIAL CORPORATION
Synopsis
New Century Financial Corporation’s bankruptcy filing in April 2007 was the initial incident in a
series of events that would eventually plunge the U.S. and global economies into full-fledged panics.
declining. Suddenly, subprime lenders were flooded with loan repurchase requests. These
repurchase requests came primarily from institutional investors that had purchased large blocks of
mortgage-backed securities or MBS that the subprime lenders had sold “upstream” via the
securitization process. As one observer noted, securitization effectively spread the “cancer” of
subprime mortgages around the globe. The resulting worldwide financial crisis imposed huge losses
Case 1.11 New Century Financial Corporation 83
New Century Financial Corporation—Key Facts
1. New Century Financial Corporation was one of the leading firms in the subprime sector of the
mortgage industry until it suddenly collapsed into bankruptcy in April 2007; New Century’s
collapse contributed to the onset of a worldwide financial crisis in late 2008.
3. Despite its deteriorating financial condition and operating results, New Century continued to
insist that it was financially healthy until late 2006.
5. New Century’s court-appointed bankruptcy examiner maintained that because KPMG failed to
6. The bankruptcy examiner alleged that the New Century audit engagements were improperly
staffed and that the independence of certain KPMG auditors may have been impaired.
7. The bankruptcy examiner also charged that the KPMG auditors failed to adequately consider
8. Among other allegations, the bankruptcy examiner maintained that a KPMG senior manager
10. Other parties have also come to the defense of KPMG, including an accounting professor who
11. At a minimum, the New Century bankruptcy report added to a series of embarrassing public
relations incidents experienced by KPMG in recent years.
12. In response to the massive financial crisis triggered at least partially by the huge losses in the
subprime sector of the mortgage industry, the U.S. Congress passed a $700 billion bailout plan in
.
84 Case 1.11 New Century Financial Corporation
Instructional Objectives
2. To examine the importance of proper staffing of an audit engagement team.
3. To demonstrate how auditors’ perceived independence can be impaired when significant auditor–
client conflicts arise.
Suggestions for Use
This is a very timely case given the current economic environment. The case clearly establishes
that independent auditors play a critical, if underappreciated, role in the nation’s economy.
Likewise, the case documents that auditors of high profile clients may find themselves involuntarily
thrust into the spotlight and be asked to justify, in minute detail, key decisions that they made on
previous engagements for such a client. Since this case is still unfolding, consider asking a group of
Suggested Solutions to Case Questions
1. Several academic studies have found that the major international accounting firms have
historically specialized, that is, have had heavy concentrations of clients, in certain industries. For
example, Arthur Edward Andersen built his namesake firm into a powerhouse in large part by
focusing on the electric utility industry.
The obvious advantage of having client concentrations in certain industries is economies of
Case 1.11 New Century Financial Corporation 85
the industry.
An obvious disadvantage of establishing an audit practice that specializes in certain industries is
2. The PCAOB’s quality control standards provide broad guidelines and recommendations that
accounting firms can use to ensure that the professional services they provide are competent. QC
20.03 mandates that a CPA firm “shall have a system of quality control for its accounting and
auditing practice.” QC 10.14 notes that an accounting firm’s quality control system should include
policies and procedures that address the following five elements: independence, integrity, and
objectivity; personnel management; acceptance and continuance of clients and engagements;
engagement performance; and monitoring.” (Note: the quality control standards included in the
established to provide reasonable assurance that personnel refer to authoritative literature or other
sources and consult, on a timely basis, with individuals within or outside the firm, when appropriate
(for example, when dealing with complex, unusual, or unfamiliar issues).” Given the almost
complete turnover of the New Century audit engagement team from the 2004 audit to the 2005 audit
and the lack of experience that certain members of the new team had with the client’s industry, it
team from one year to the next. You may want to remind your students that in the “real world” such
simple solutions are not always feasible. In fact, during the time frame that the 2004 and 2005 New
Century audits were being performed, the major international accounting firms were facing large
personnel shortages. The huge amount of SOX Section 404 work that was necessary beginning with
86 Case 1.11 New Century Financial Corporation
3. As pointed out in the Suggestions for Use, PCAOB Auditing Standard No. 2 was in effect during
the time frame that the 2004 through 2006 New Century audits were being performed by KPMG. In
2007, the PCAOB replaced AS No. 2 with AS No. 5. The title of AS No. 5 is, “An Audit of Internal
Control Over Financial Reporting That is Integrated With an Audit of Financial Statements.”
[Sidebars: You may want to point out that in 2007 the SEC issued new interpretative guidance to
streamline and reduce the cost of SOX-mandated assessments of internal control by the management
Internal control deficiency: “A deficiency in internal control over financial reporting exists when
the design or operation of a control does not allow management or employees, in the normal course
of performing their assigned functions, to prevent or detect misstatements on a timely basis.”
Significant deficiency in internal control: “A significant deficiency is a deficiency, or a
combination of deficiencies, in internal control over financial reporting that is less severe than a
material weakness, yet important enough to merit attention by those responsible for oversight of the
company’s financial reporting.”
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summary, if an auditor discovers one or more material weaknesses in internal control, then he or she
cannot issue an unqualified or “clean” opinion on the given client’s internal controls. So, in a
•“The auditor must communicate, in writing, to management and the audit committee all
material weaknesses identified during the audit.”
•“If the auditor concludes that the oversight of the company’s external financial reporting and
internal control over financial reporting by the company’s audit committee is ineffective, the
auditor must communicate that conclusion in writing to the board of directors.”
4. For audits of SEC registrants, AU Section 342, “Auditing Accounting Estimates,” of the
PCAOB’s Interim Standards is the authoritative source most relevant to this question. Paragraph .04
summarizes the “macro” level responsibilities of auditors regarding client accounting estimates.
“The auditor is responsible for evaluating the reasonableness of accounting estimates made by
management in the context of the financial statements taken as a whole . . . when planning and
performing procedures to evaluate accounting estimates, the auditor should consider, with an
attitude of professional skepticism, both the subjective and objective factors [that were relied on
by management in arriving at those estimates].”
The remaining two sections of AU 342 provide guidance to auditors that is intended to assist
them in “Identifying Circumstances that Require Accounting Estimates” and “Evaluating
Reasonableness [of accounting estimates].” Listed next are specific procedures that AU 342
88 Case 1.11 New Century Financial Corporation
recommends that auditors use in evaluating the reasonableness of management accounting estimates.
•“Review and test the process used by management to develop the estimate.”
•“Develop an independent expectation of the estimate to corroborate the reasonableness of
management’s estimate.”
Clearly, several of the recommended procedures for auditing accounting estimates would have
been relevant to auditing the period-ending balance of New Century’s loan repurchase loss reserve.
Arguably most relevant would have been the recommendation that auditors consider “changes in the
business or industry” in analyzing the reasonableness of an accounting estimate. The rapid changes
5. The most effective way to address this question is to simply “walk through” the ten generally
accepted auditing standards (GAAS) included in AU Section 150 of the PCAOB’s Interim Standards
and identify possible violations of each by KPMG.
[Note: The AICPA Professional Standards (the “clarified” auditing standards) do not explicitly
include the ten “generally accepted auditing standards” found in the PCAOB’s Interim Standards—
General Standards:
1. Technical training and proficiency in auditing: Certainly, the bankruptcy examiner’s report
raised legitimate concerns regarding the issue of whether the 2005 New Century audit
Case 1.11 New Century Financial Corporation 89
Making matters worse was the fact that nearly all of the subordinate members of the audit
team were new to the New Century engagement.
2. Maintaining an independent mental attitude: As mentioned in the case, the bankruptcy
Field Work Standards:
1. Adequate planning and proper supervision of subordinates: The bankruptcy examiner
pointed out that the 2005 audit team apparently did not properly review the prior year
workpapers, at least with regard to the internal control deficiencies discovered by the 2004
2. Obtaining a sufficient understanding of the entity, its environment, and its internal control:
The most serious allegations made by the bankruptcy examiner against KPMG involve this
3. Obtaining sufficient appropriate audit evidence: Whether KPMG obtained “sufficient
appropriate audit evidence” to support the period–ending balances of the loan repurchase loss
Reporting:
1. Presentation in accordance with GAAP: KPMG stated in its 2005 audit report that New
Century complied with GAAP. Certainly, a reasonable argument can be made that the 2005
year-end balance of the loan repurchase loss reserve may not have been determined in
90 Case 1.11 New Century Financial Corporation
compliance with GAAP. The absence of an adequate system to track loan repurchase
“reviewed” the financial statements for those three periods.
2. Consistent application of GAAP: Again, this standard is most directly relevant to the
accounting change made in early 2006 for the loan repurchase loss reserve. Since this issue
did not affect the pre-2006 audit reports, KPMG was not responsible for commenting on that
consistency violation in those audit reports.
3. Assessment of adequacy of disclosure: One could certainly argue that New Century’s
6. You can find a slag pile of articles in recent years that have debated the role that mark-to-market
accounting has played in the serious financial crisis that engulfed the national and global economies
in late 2008. The principal (pre-codification) technical standard relevant to mark-to-market
accounting is Statement of Financial Accounting Standard No. 157, “Fair Value Measurement.”
That standard defines “fair value” as “the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement date.”
Prominent members of the accounting profession forcefully defended the mark-to-market rule
and insisted that critics of the rule had adopted a “kill-the-messenger” attitude. Among the most
vocal defenders of the rule were former SEC Chairman Arthur Levitt and former SEC Chief
Accountant Lynn Turner who addressed the need to retain the rule in an editorial appearing in the
Wall Street Journal (September 26, 2008).
Ultimately, those who blame fair-value accounting for the current crisis are guilty of the
Case 1.11 New Century Financial Corporation 91
7. I commonly conclude the discussion of a case by asking students to identify the key “take–
aways” for that case. In fact, in pre-coverage, in–class quizzes I frequently ask students to list and
rank the most important take-aways for the cases to be discussed in the given class and require them
to defend their choices. Listed next is a sample of what I consider to be important take-aways for
this case.
•The independent audit function is critically important to the proper functioning of a free market
economy.
•When planning an audit, auditors should pay extremely close attention to important industry
developments that may impact the integrity of the client’s financial statements.