New Century Corporation 2
1.0 Company Overview 2
1.1 Financial troubles and bankruptcy 2
1.2 To the benefit of company executives 3
2.0 Accounting errors made by NCF 4
3.0 Relevant accounting pronouncements – FAS 140 and FAS 5 6
4.0 Business risks faced by New Century Corporation 8
4.1 Reputation risk 8
4.2 Credit risk 9
4.3 Compliance risks 10
4.4 Operational and strategic risk 10
5.0 Accounting errors related to the risks 11
6.0 Reasons why accounting errors persisted 13
7.0 Controls that could have detected or prevented the errors 15
8.0 Conclusion 16
9.0 References 18
New Century Corporation
1.0 Company Overview
New Century Financial Corporation was founded by Edward Gotshall, Brad Morrice and Edward Gotshall in1995. Due to its good performance, the company managed to go public in 1996. New Century was listed on the NASDAQ stock exchange. New Century operated in United States Financial industry as a mortgage company. Its major activities included servicing, retaining, originating and selling homes to subprime consumers who did not qualify to apply for prime mortgages. With time, the company increased its services to include both fixed and adjustable rate mortgage services. Ever since its formation, New Century grew rapidly and became one of the largest mortgage companies in the United States. Through its early years, New Century performed well and recorded high profits an aspect that attracted both customers and investors. However, the quick growth and success of New Century was not long lived.
1.1 Financial troubles and bankruptcy
On February 7[th] 2007, the New Century directors announced that there will be a restatement of its annual financial reports for the second, first and third quarters of that financial year. This arouses suspicion among stakeholders. However, this was also followed by an announcement that the company will not release its previous year financial statement within the expected period of time. This made lenders furious and they ended up withdrawing their financing to the company. Pressure mounted and the company decided to revoke mortgage applications on March 8[th] 2007. The New York Stock Exchange decided to stop trading the company`s shares on the same date. The company kept on operating but later filed for a bankruptcy protection April the same year since the company did not have resources to continue running. The United States Bankruptcy Court issued an order for an investigation to be carried out.
The scope of the investigation included examining the company`s financial statement to determine if there were any misstatements. This was not enough since the company was also suffering from corporate governing issues. The investigation was also to include a thorough analysis on how the company was governed to determine if the bankruptcy was as a result of poor company governance. Further investigation was supposed to be carried out to determine if there were any errors in the financial accounts and those that were responsible. The court order expected the investigator to carry out a timely, fair and objective investigation that could help establish the reason for New Century`s failure (Bankruptcy Examiner`s Final report, p. 72).
1.2 To the benefit of company executives
Material misstatements made to the company`s annual reports greatly benefited company executives. This is because, at the end the 2005 financial year, they received very high remuneration compared to what they were actually entitled to. They received very huge bonuses to appreciate their good work that has elevated the company. It is normally common practice for a company to reward its employees in the event that they perform well. However, the New Century executives benefited from an accounting error which means their reward was not genuine.
The company`s corporate governance codes were also greatly questioned by the report. This is because the board of governors is expected to receive audit reports and review activities of the company to ensure that the executives are pursuing shareholder needs. However, this was not the case with New Century Financials, the board made very little effort to ensure that company activities are in line with SEC`s rules when it comes to corporate governance. This made the internal controls of the company weak and played a key part in enhancing activities that resulted to New Century`s failure in 2007.
2.0 Accounting errors made by NCF
In 2006, the company reported a profit of over 60 million US dollar. However, according to the findings of the report, the company was supposed to report a loss during that financial period. The cause for this was because the company failed to carry out proper loan calculations during that financial year. The accounting team carried out wrong calculations of activities that involved both investors and consumers. This led to a serious misstatement in the end year financial reports. Instead of reporting a loss to investors and other stakeholders, it reported a loss.
After realizing that there were misstatements in the financial statements, the company declared that it will restate its financial figures. This was followed by late reporting at the end of that financial year. Other than just quoting a high profit, the company also announced an increase in the earnings per share. This indicated that the company was performing as analysts projected. According to analysts, the company was expected to report an increase profits something that happened. At the same time, the company was expected to announce a 40% decrease in the earnings per share but it went ahead to announce 8% increase in earnings per share (Bankruptcy Examiner`s Final report, p. 71).
According to the financial reporting standards, a company expected to reflect its truthful position in the annual financial statements. However, this was not the case with New Century financials, the value it quoted to investors, consumers and other stakeholders did not reflect its true and fair position. The fact that it was a well performing company attracted more investors and consumers. This was followed by an increase in company share value in the New York Stock Exchange as a result of good performance. However, this was not its true position.
One group of stakeholders that was affected by the news of bankruptcy is the company lenders. This is because lenders always look at the way a company performs before they take on the decision to offer financial assistance. The good financial books presented by New Century attracted lenders each and every financial year. This is because, the lenders believed that New Century was a going concern but this was not the case. Therefore, lenders kept on offering financial assistance to the company without knowing the actual position of the company. However, in early 2007, lenders withdrew their finances after learning the actual position of the company.
The fist error made by New Century Cooperation was improper data collection and recording. As it will be seen earlier, the company developed a data collection model that did not ensure proper availing of accounting information at all times. On the other hand, different records were handled in different departments. This made it hard to bring the documents together when needed. This made calculations at the primary level extremely difficult an aspect that translated to errors. Errors at data recording level translated into material misstatements in the final reports. Therefore, improper record keeping is one of the major mistakes made by the company.
A company is expected to report all its activities to stakeholders at the end of a given financial year. At the same time, it has to take all measures to ensure that shareholders` investment is protected at all costs by setting up measures such as enterprise risk management to ensure that the business is shielded from accounting and corporate governance risks. However, New Century did not take this step an aspect that greatly jeopardized its internal controls hence giving room for accounting errors that led to its bankruptcy (Bankruptcy Examiner`s Final report, p. 33).
One of the major accounting errors made by the company is poor returns calculation from repurchase of earlier sold loans. According to the accounting standards governing the repurchase of sold loans, it is important for the company to report any loss or profit made from the repurchase. The company is also expected to use current data when it comes to recording the transactions in the accounting books. However, this was not the case with New Century the company used historic data which indicated that it made a profit whereas it made a loss hence misleading stakeholders (Landier et al., p.13).
Though it is not advisable sometimes to do something simply because other members of the industry are doing it, at times it is important to ensure that a company maintains conventional industry practices. For example, companies in the mortgage industry treat loans as performing and non performing loans to ensure that they calculate their annual returns effectively and come up with the actual value. However, the choice by New Century to combine the two types of loans. This translated into confusion when calculating profits and recording the two types of loan an aspect that contributed to the overstatement of returns.
3.0 Relevant accounting pronouncements – FAS 140 and FAS 5
These two standards are very important in the financial sector especially when it comes to the repurchase of already sold loans. It is important for each and every organization to ensure that they observed FAS 140 when it comes to recording to repurchase of already sold loans. According to the standard, all companies must recognize all assets and liabilities incurred from the process and the relevant accounting treatment made. The company enjoyed good financial performance throughout its ten year spell. At some given point, New Century purchased defaulted loans from consumers.
When preparing financial statements, the company was expected to calculate the value of repurchased loans and determine whether it incurred a profit or loss based on actual data from the repurchase process. However, the company did not follow the conditions outlined in FAS 5, it instead recorded the repurchase process based on historical data. Therefore, since the company was performing well in previous years, the statements indicated that the company made a profit while in real sense the company suffered a loss. These mislead a lot of people on the actual financial position and performance of the company (Palepu et al., 8).
On the other hand, though the company ensured that there is an external auditor to ensure all financial statements reflect the actual position of the company, the auditing company (KPMG) failed in this role. It was expected to ensure that all controls are followed and that the company is reporting using the right techniques but due to lack of proper professional care. The examiner`s report clearly outlines the mistakes made by the auditing team when it comes to investigating the company reports. KPMG did not carry out extensive analysis of the company`s internal controls nor compliance with accepted accounting principles.
Other than just outlining accounting standards to be followed by company, the GAAP also makes sure that auditors have a procedure to follow during the auditing process. For example, the auditors are expected to carry out a thorough review of the company`s financial statements and make necessary recommendations to the board of directors. However, New Century did not have a good auditing platform that ensured all accounting elements are adequately reviewed to ensure that the right conclusion is made after the process. On the other hand, the board of directors did not conduct a thorough analysis of internal controls to ensure that he auditing process is conducted effectively.
4.0 Business risks faced by New Century Corporation
According to the examiner`s report, there were those risks that the company faced and were no reported in the annual financial reports. The company only reported those risks that will keep its image `up` in front of stakeholders. Some of risks that New Century faced could have jeopardized its position in the securities market and in front of the lenders. Some of the primary business risks faced by New Century Corporation included the following
4.1 Reputation risk
All public listed companies are answerable to shareholders and other company stakeholders. According to the stakeholder theory, a company is surrounded by different stakeholders who have varying expectations from the company. The company has to ensure that these expectations are met and in time if indeed it has to stay on top and keep operating. This is because most stakeholders would like to be associated with a good performing company and one that has a future. However, of late companies have been working on a new type of risk knows as reputation risk.
This is the risk that the company`s image before stakeholders will be tarnished. This form of risk occurs as a result of poor performance or poor corporate governance. Ever since 2005, the company has been faced by this form of risk. This is mainly because the information presented to stakeholders at the end of each financial year did not reflect the true position of the company. This indicates that the company`s corporate governance codes were not functional. At the same time, it indicates that the internal control system is ineffective. Through time, the company has always been facing this risk. However, in 2007 the risk came to pass as the company`s accounting errors and misstatements were brought to light (Bartels, 14).
4.2 Credit risk
This is the risk that the company will not be able to meet its long term and short term obligations. Due to good performance, New Century was able to attract investors, consumers and lenders. This is because the annual statements portrayed the company as a going concern. Lenders always rely on this when making and financing decisions. It was easy for the company to access loans due to its positive financial books. However this was not the case and it greatly increased the company`s obligations.
According to financial books, it was shown that the company was able to pay all these debts both long term and short term. However, according to its actual financial position the company could not pay. The fact that it attracted many lenders over time increased its credit. Even if the company`s books reflected its actual financial position, the amount of credit that the company had access to still could have increased its credit risk. This is due to the fact that, prevailing economic trends are very uncertain and it is hard to determine if an entity will perform well for long.
Despite the fact that the company was faced with a chance of not meeting its long term and short term maturing obligations, the company was also faced with the risk that most of its debtors will not pay. The declining economic conditions in the United States in 2007 put many consumers and businesses in a hard financial position. Therefore, there was also a great chance that a huge number of consumers could not have met their obligations with regard to mortgages owed. This could have greatly decreased the company`s performance for a considerable period of time.
4.3 Compliance risks
This is the probability that the entity will not act within the set rules and regulations that govern its activities. This is the risk that the business will go against the legal obligations surrounding it. Compliance with legal requirements comes in different ways. It can be out of will, error or the prevailing circumstances could lead to non-compliance. New Century did not report that it is facing this risk despite the fact that it was performing poorly and its financial statements were indicating otherwise. The company went against financial reporting standards that required organizations to ensure that their financial accounts show a fair and true view of the entity`s position. Just like the reputational risk faced by the company, this risk came to pass (Landier et al., p.17).
4.4 Operational and strategic risk
Operation and strategic risks are among the broadest risks that a business can face. Operational risks are broad but are short term. This is the type of risk that affects everyday operation of the entity. This is the type of risks that occurs as a result of failed processes, systems, people or other external events. New Century Corporation was by a great extent faced by this risk. This is because operational risks jeopardize business activities and could occur as a result of business fraud. This is a scenario where an intentional misstatement causes jeopardy in the way the business runs and fails to offe5r services to consumers as expected. The presence of poor accounting policies and internal control feature greatly exposed New Century to operational risks. This is because acts of fraud or employment of untrained personnel could have resulted to failure in day to day business operations.
Another risk faced by the company is strategic risk. Strategic risk normally affects the business at a later date. Strategic risks can occur as a result of change in the number of competitors. However, the risk faced by New Century could not take this dimension, this is mainly because the company was established in the industry and had a huge market share. However, the presence of huge companies in the industry always posed the risk of two companies merging and creating a huge company in the mortgage industry. Therefore, it was important for New Century to ensure that they stay on toes to avoid being toppled by another company. On the other hand, the company during its business circle kept on unleashing new products due to their great success. There always existed the risk that some of the new products being launched could fail.
5.0 Accounting errors related to the risks
As observed earlier, the company faced compliance. The major risk that the company faced was non conformity with the general accounting standards accepted in the U S. The company used improper methods when it comes to underwriting of loans and ensuring that the qualities of loans are monitored using appropriate channels. The examiner found out that the company flouted several principles outlined in the GAAP. They included the following
Repurchase of reserves (interest recapture and premium recapture)
New Century did not calculate repurchases of reserves properly. Instead of using techniques outlined in the GAAP, the company used a historical repurchase data based method that only used information from successful loans. The fact that repurchases data was handled by people from different departments made this data less consistent hence inaccurate calculations when it comes to calculating repurchases of reserves (Bankruptcy Examiner`s Final report, p. 51). The internal control system was not adequate enough to facilitate proper data collection from different departments. This greatly contributed to improper calculation of repurchases of reserves. the figure below shows the method used by the company to calculate repurchas3ed reserves
Source: Bankruptcy Examiner`s Final report, p. 38
Loan valuation account
The company also had poor techniques when it comes to calculating the value of their services in the market. The lower cost of market technique used by New Century was not in line with general industry practices. Generally, loans were grouped and monitored as both performing and non performing loans. This made it easy for companies to monitor and value loan performance. However, New Century did not use this approach and instead combined the two into one group. This resulted to confusion and mistakes when it comes to valuation of loans. This had an income in the overall income of the company since performing loans were valued highly and non performing loans were not recorded in time.
Residual interest account
The financial statements presented by New Century in 2005 and 2006 had a lot of misstatements. This is due to poor residual interest calculation. The company developed an internal valuation model using Microsoft excel. However, this model did not ensure that adequate documentation techniques are applied and that information provided by the system is reliable. On the other hand, senior management failed on their task of ensuring that all business activities and strategies are adequately accounted for, this is to include assumptions made when developing the residual interest valuation model. This mean that the model used was not justified or tested if it would work properly in the real life situation. Poor reserve interest valuation resulted to misstatement of earnings in the 2005 to 2006 financial year.
6.0 Reasons why accounting errors persisted
New Century was a mortgage company and it is important to ensure that proper underwriting and evaluation standards are followed in its day to day operations. However, Lack of proper underwriting regulations and poor corporate governance codes within New Century`s internal control contributed to negligence when it comes to compliance with GAAP standards. New Century`s senior management was negligent and did not put up adequate measures to ensure that the risks faced by the company are mitigated. The company`s business codes and procedures did not have adequate control over the business activities. On the other Hand, the relationship between management and the board of directors was not positive. The company did not observe general industry practices without considering the fact that it will impact on business activities.
The Poor relationship between the board of directors and management also led to poor performance and failure of the company and continuation of fraud. This is because, the board of directors is supposed to put company managers in check and ensure that stakeholder interests are pursued. If the board of directors and senior management could have come up with adequate measures to ensure that he business is running properly, such negative impacts of poor accounting could have been avoided. Proper coordination between the board of directors and executives could have helped in ensuring that internal controls are reviewed from time to time to ensure that he employees and other company assets are in check. Risk management would have also been given the required priority hence mitigating some of the risks faced by the company.
According to the examiner`s report, the auditing company is also to blame for the problems suffered by New Century. This is because the audit team did not carry out thorough analysis of business activities and revision of the internal controls to reduce the probability of errors in the financial statement. According to the Sarbanes Oxley Act, the audit company or auditor is expected to affirm the truth and fairness of financial statements presented by a public listed company. KPMG did not do enough when it comes to analyzing the financial statements presented by New Century. This is because they affirmed the accounting methods used by New Century, it was very difficult for stakeholders to determine that the financial statements were wrong since it is not their job and they also rely on the audit report for judgment. According to the examiner`s report, the audit team did not do enough questioning and did not carry out extensive testing of the internal control system used at New Century. If this had been done, then the accounting errors in New Century`s financial statements could have been detected.
Rsk management is a very important aspect in modern business. Since company managers can`t be there to oversee each and every activity carried out by employees, it is vital to ensure that measures are put up to reduce fraud or other activities that are not in conformity with company regulations. The internal control system should help in ensuring that errors and misstatements are detected and eliminated in time. However, lack of proper internal control mechanisms at New Century made it hard for the board of directors or senior management to prevent the accounting errors that led to the failure of the company (Landier et al., p.11). Another aspect that the company did not take serious consideration when it comes to risk management and mitigation, this is because, as time went by, the more the number of risks being faced by New Century increased by with no mitigation measures in place.
7.0 Controls that could have detected or prevented the errors
The errors which led to the demise of New Century Corporation could have been detected and even prevented at an early stage. There are accounting controls which ensure that all accounting procedures are carried out in the right manner and with the right persons. The first one is that, the company should have ensured all employees are adequately trained and have the required qualifications to handle the positions allocated to them. This is through ensuring that all employees go through a thorough vetting process before assuming positions in the company (Palepu et al., 10).
It is vital to ensure that the independence of both the internal and external auditors is observed at all times. The team should not be subject to any control from executive or non executive directors to ensure that they carry out their mandate at all times. The audit and accounting teams should also ensure that all professional principles are observed during the accounting and auditing process. This could have helped in ensuring that all calculations made by the New Century accounting teams are according to the prescribed standards. This could have gone a long way to prevent the accounting errors.
Ensure that both the internal and external audit teams have adequate evidence before making any conclusions on the annual financial statements. This is important since it will prove whether or not the auditors` conclusion on the financial statements is true. New Century lacked because the auditors made conclusions that he financial statements reflected a true and fair position of the company. This is a clear indication that executives and board members did not take a good look at the audit evidence presented that if there was any. This made it hard for them to determine if there were errors in the company`s accounting books.
Finally, the company should have developed an internal control system that ensures proper data collection and recording. This would have played a critical part in making sure that accounting calculations are done using the right figures hence avoiding errors. The internal control system should also be designed in such a way that all models used by the business are in line with prescribed standards. The model used could be different from the conventional model. However, it is vital to make that it is within the prescribed accounting principles to avoid errors such as the ones experienced in 2005 and 2006.
The accounting and business model embraced by New Century between 2004 and 2007 played a very critical role in its failure. It is the task of top management to make sure that there are adequate internal controls in the company to ensure that employees and other stakeholder follow the right procedures when it comes to accounting and other business activities. However, lack of proper care by the board of directors and senior management translated into lack of adequate controls to ensure that the company is running properly. This translated to accounting errors which in the ended led to the failure of New Century.
Some of the accounting errors made was as a result of lack of precautions when it comes to observing accepted accounting principles. Internal controls are supposed to ensure that employees follow all regulations governing the business at all times. On the other hand, the company had weak controls when it comes to business and enterprise risk management. This elevated the number of business and corporate governance risks facing the business. Some of the business risks that the company was exposed to contributed to its failure. In order to ensure, that errors are detected and prevented, it was vital to ensure that the internal controls are strong and revised from time to time.
Bartels J. Sub-Prime Crisis Revisited +- uValue Chain to Financial Meltdown. (10[th] August 2008). November 2012
Landier, A. Going for broke: New Century Financial Corporation (4[th] January 2010). Web. 8[th] November 2012
NEW CENTURY TRS HOLDINGS, INC., FINAL REPORT OF MICHAEL J. MISSAL, BANKRUPTCY COURT EXAMINER, UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF DELAWARE, CASE NO. 07-10416(KJC). 2008. PRINT
Palepu et al. NEW CENTURY FINANCIAL CORPORATION. Harvard Business School. 2009. Print
New Century Corporation 2