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.
Within a few years of its founding in 1995, New Century had become one of the largest subprime
mortgage lenders in the U.S. New Century and other major subprime lenders such as Wells Fargo,
Countrywide, and HSBC catered to potential home buyers who had poor or “subprime” credit
This new age, real estate Ponzi scheme came to a screeching halt when housing prices began
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
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New Century Financial Corporation—Key Facts
Case 1.11 New Century Financial Corporation 81
1. New Century Financial Corporation was one of the leading firms in the subprime sector of the
3. Despite its deteriorating financial condition and operating results, New Century continued to
insist that it was financially healthy until late 2006.
4. KPMG served as New Century’s audit firm from the company’s inception in 1995.
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.
Instructional Objectives
82 Case 1.11 New Century Financial Corporation
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
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.
Case 1.11 New Century Financial Corporation 83
2. The AICPA’s quality control standards provide broad guidelines and recommendations that
accounting firms can use to ensure that the professional services they provide are competent. In fact,
QC 10.03 mandates that a CPA firm “establish a system of quality control to provide the firm with
reasonable assurance that the firm and its personnel comply with professional standards and
applicable regulatory and legal requirements . . .” QC 10.14 notes that an accounting firm’s quality
control system should include policies and procedures that address the following six elements:
leadership responsibilities for quality within the firm, relevant ethical requirements, acceptance and
to the 2005 audit and the lack of experience that certain members of the new team had with the
client’s industry, it seems reasonable to suggest that KPMG should have emphasized the need for the
2005 engagement team to make full use of the large firm’s considerable “consultation” resources. In
fact, as pointed out in the case, certain “specialists” were brought in to review some of New
Century’s most complex transactions. Unfortunately, those “FDR” specialists did not complete their
personnel shortages. The huge amount of SOX Section 404 work that was necessary beginning with
calendar-year 2004 audits consumed an enormous amount of those firms’ manpower and other
resources. In addition to requiring their employees to work an inordinate amount of overtime, the
major firms implemented other unconventional measures in an effort to provide at least minimal
staffing for all audit engagements. These latter measures included tracking down former employees
and offering them attractive salaries to return to work and “borrowing” staff from international
84 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
65.]
Following are definitions of three key terms that were taken directly from AS No. 5. [As a point
of information, the following definitions from AS No. 5 are consistent with the comparable
definitions included in SAS No. 115, “Communicating Internal Control Related Matters Identified in
an Audit” and SASE No. 15, “An Examination of an Entity’s Internal Control Over Financial
Reporting That Is Integrated With an Audit of Its Financial Statements.” These latter standards were
adopted by the Auditing Standards Board to parallel the requirements of AS No. 5.]
Internal control deficiency: “A deficiency in internal control over financial reporting exists when
Significant deficiency in internal control: “A significant deficiency is a deficiency, or a
Material weakness in internal control: “A material weakness is a deficiency, or a combination of
deficiencies, in internal control over financial reporting, such that there is a reasonable possibility
that a material misstatement of the company’s annual or interim financial statements will not be
prevented or detected on a timely basis.”
Paragraph 3 of AS No. 5 notes that “The auditor’s objective in an audit of internal control over
Case 1.11 New Century Financial Corporation 85
nutshell, the key operational responsibility of auditors under AS No. 5 is to “plan and perform the
[internal control] audit to obtain reasonable assurance about whether material weaknesses exist.”
Likewise, the key reporting responsibility of auditors is to disclose whether or not material
weaknesses are present in the client’s internal controls over financial reporting. Paragraph No. 62 of
“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
4. AU Section 342, “Auditing Accounting Estimates,” 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
Paragraph .07 defines the key operational responsibilities of auditors vis-à-vis a client’s accounting
estimates.
“The auditor’s objective when evaluating accounting estimates is to obtain sufficient appropriate
audit evidence to provide reasonable assurance that—
a. All accounting estimates that could be material to the financial statements have been
developed.
The remaining two sections of AU 342 provide guidance to auditors that is intended to assist
86 Case 1.11 New Century Financial Corporation
them in “Identifying Circumstances that Require Accounting Estimates” and “Evaluating
Reasonableness [of accounting estimates].” Listed next are specific procedures that AU 342
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
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
5. The most effective way to address this question is to simply “walk through” the ten generally
accepted auditing standards (GAAS) and identify possible violations of each by KPMG.
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
engagement team was properly staffed. As noted in the case, even New Century
2. Maintaining an independent mental attitude: As mentioned in the case, the bankruptcy
examiner “speculated” that the 2005 10–K “incident” impaired the independence of Donovan
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3. Exercising due professional care: This standard is a “catch–all” professional standard. If it
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
2. Consistent application of GAAP: Again, this standard is most directly relevant to the
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accounting change made in early 2006 for the loan repurchase loss reserve. Since this issue
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
the markets in question. To calm the capital markets, many parties, including respected members of
the investment community, called for the mark-to-market rule to be repealed or at least temporarily
suspended. One critic of the rule succinctly summarized his position by stating that, “FAS 157 Is
Worse than Al Qaeda.”
Prominent members of the accounting profession forcefully defended the mark-to-market rule
7. I commonly conclude the discussion of a case by asking students to identify the key “take–
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this case.
—The independent audit function is critically important to the proper functioning of a free market
economy.